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The new rage on Wall Street
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On the heels of the corporate finance scandals at Enron, WorldCom and Global Crossing, a big battle is brewing in Congress over accounting standards. With the public expressing a lack of confidence in Corporate America, Congress is moving to reform rules that determine how companies treat stock options, a popular compensation tool used to attract and retain executives and other key employees.
Regulators and other public officials believe that the current manner in which stock options are treated provides opportunities for fraud and inflated stock prices. Executives at Enron and WorldCom were able to boost their company's stock value beyond sustainable levels because accounting rules were too lax.
Over the course of the next year, the debate over "expensing options" is expected to draw the usually dull world of accounting into the contentious arena of public policy. Already some big names have weighed into the debate as Congress rushes to establish a series of reforms that investors and Corporate America hope will inspire economic confidence. The current vehicle for reform is Senator Carl Levin's awkwardly named "Ending the Double Standard for Stock Options Act" (S. 1940). The bill, co-sponsored by Sen. John McCain, is now under consideration by the Senate Finance Committee.
On one side are Alan Greenspan, the Chairman of the Federal Reserve and billionaire investor Warren E. Buffet, who are prominently supporting legislation to expense options. On the other side, lined up to oppose the expensing of options are President George W. Bush and a number of high tech companies such as Intel, Oracle and Cisco. Aligned with both camps are a bevy of trade associations and professional boards that would like a hand in fashioning accounting rules. The Council for Institutional Investors and the International Accounting Standards Board support expensing while the National Venture Capital Association and the US Chamber of Commerce, including a number of high technology companies, are opposed.
Although everyone is eager to resolve the accounting scandals and to restore some measure of credibility to the markets, some are wondering whether the cure may turn out to be worse than the disease. Of key concern to high technology companies, particularly in Massachusetts, is whether small, cash-strapped firms will continue to use stock options as a way of attracting talent. Management at high tech firms worry that new laws could be so onerous that such firms will quit using stock options altogether.
Despite the recent bad publicity, stock options were once pivotal in launching successful companies along Route 128 in Massachusetts and Silicon Valley in California. Start-up companies with little available cash make use of stock options rather than high salaries as compensation to staff.
Young, eager staffers who get in with a company on the ground floor may more closely tie their own success to that of the company if they are offered stock options. The idea is that they exchange future riches for smaller salaries in the present. Stock options give executives and other employees the right to buy company stock at a set price over a period of time. According to the National Center for Employee Ownership, nearly 10 million Americans have received stock options.
Currently there are two types of stock issued by U.S. companies. A fixed-price option is an option for which the option-exercise price equals or exceeds the fair-market-value of the underlying stock. An incentive-based stock option is an option for which the exercise price is less than the fair market value of the stock. Under generally accepted accounting principles (GAAP), U.S. companies have the choice whether to expense fixed-price-stock options, but they must expense incentive-based options. Most stock options at the center of the debate are fixed-price-options. If the company elects not to expense the option, the pro forma effect must be footnoted in the financial statements.
Critics of the status quo, such as former Securities and Exchange Commission chairman Arthur Levitt, contend that merely footnoting expenses creates a lack of accountability, dilutes shareholder value and overstates earnings. Moreover, critics contend, the current system provides management with the wrong set of incentives that work against the interest of shareholders. This misalignment of interests is usually called the agency problem. Most of the major accounting scandals at Enron and WorldCom centered around the ability of management to maintain a level of what economists call "asymmetric information" where such insiders possess more information than shareholders. Such a failure has increased the calls for more transparency and the nature of executive compensation.
"The stock options were the mechanisms that turned those companies into Ponzi schemes," Sarah Teslik, executive director of the Council of Institutional Investors told the San Jose Mercury News.
The major argument against expensing stock options is that they are not easily and accurately valued. How does one know how much the stock will be worth in the future?
Accountants have used the so-called Black-Scholes pricing model named after two Nobel Prize winning economists. By most measures, the Black-Scholes model works well if the stock price is stable. But the model is less accurate when it comes to pricing the options in volatile markets such as the ones in which high technology companies participate.
In a volatile market these pricing models lead to overstatement of the expense and inaccurate financial statements. Companies may expense an option on the grant date that is considerably less by year-end. For example, for the year 2000, Yahoo reported, in a footnote of its annual report, options valued by Black-Scholes at $55 each. By year-end the value of Yahoo shares had fallen to $18 and the value of the options had fallen to about $3. Thus, the option expense was considerably overstated. Current rules do not require a revaluation of the options at year-end. Furthermore, Black-Scholes requires a liquid market for the options. In other words the stocks must be able to be sold quickly. Otherwise predicting the value of a stock is like predicting who will win a lottery ticket.
The companies most likely to expense options are those with low stock price volatility and good cash flow. In July, Coca-Cola, a company whose stock has been relatively stable, voluntarily agreed to treat options as an expense. Some 43 other firms, including Bank One and the Washington Post, also announced plans to expense options. But these blue-chip companies such as Coca-Cola, don't use stock options as often as startups. Thus, the impact of a new law may be limited.
In contrast, companies, such as cash-strapped high tech start-ups depend upon stock options to attract andreward talent.
Another argument against expensing is that options are not a company expense, but rather are costs shifted to shareholders. Footnoting the expense should permit analysts to properly price the stock without distorting a firm's profit and loss statement. While there are many estimates used in GAAP, recording a major expense calculated using a very complex and potentially inaccurate pricing model would further complicate financial statements - making them less transparent.
Writing in the Wall Street Journal recently, Professor Burton Malkiel, professor of economics at Princeton, and Professor William Baumol, professor of economics at New York University, said, "there is no way to measure the 'cost' - the value of the options at the time they are granted - with reasonable precision."
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