IP: Re: Time to Look at Stock Options' Real Cost

[David Farber <dave () farber net>]

> From: "Jonathan S. Shapiro" <shap () eros-os org>
> To: <farber () cis upenn edu>
>
> > Mr. Oxley, who did not respond to an interview request, led his charge
> with
> > letters opposing an effort by the accounting board to re-examine how
> > companies account for stock options.
>
> Dave:
>
> For those on your list who may not track corporate finance, perhaps a brief
> explanation of the option accounting issue is in order.
>
> Stock options are a vital tool for keeping employees. This is especially
> true in startup companies (software or other), where over the last decade
> stock options have been a primary source of wealth for people willing to
> take risks. For new companies, stock options are a way to compensate for the
> fact that the employee takes a large risk in coming to the company. For
> established companies, stock options are a way to keep your employees from
> running away to join one of those pesky startups.
>
> Today, the cost of stock options is not considered a "cost" to the business
> for accounting purposes. From any rational perspective it should be, and
> IASB is proposing that we should change the accounting rules to account for
> them as a cost. The U.S. accounting standards body, FASB, has floated
> similar proposals several times in recent years.
>
> Why are stock options a cost?
>
> When a company offers an employee stock purchase plan, the employee
> typically gets the shares at 85% of market cost. The company must pay for
> the other 15%, and this is clearly a cost.
>
> When pure options (i.e. incentive shares) are given to an employee, the
> company must (in effect) buy those shares from the market. This is also, by
> any rational metric, a cost.
>
> So what's the big deal?
>
> The big deal is that companies like Microsoft issue (at the last report I
> saw) 10% of their market capitalization in incentive stock each year. If
> this were accounted as a cost, Microsoft would not be profitable. In fact,
> Microsoft *isn't* profitable. They appear profitable because the current
> accounting rules are wrong. Microsoft very intentionally funds itself out of
> the continuing rise in price of its stock.
>
> Stronger companies are placed at a greater disadvantage if shares are
> accounted as a cost, because the company must buy shares at the
> market-inflated rate. This does not hit all companies uniformly. The market
> trades strong companies at a much higher premium than weak companies. The
> social effect of this rule, then, is to make it harder for strong companies
> to *stay* strong, which is definitely a problem.
>
> There is a possible middle ground: If the makers of Waterford crystal gave
> an employee a valuable crystal vase, we would account for it at the cost of
> manufacture, not at the market price. Similarly, it can be argued that since
> a company *produces* the value of a share, the share should be accounted at
> its cost of production, not at the market-inflated cost. The problem is
> determining what this cost of production should be. The only ways I can
> think of do this involve more harm than good -- perhaps someone can suggest
> a good one.
>
> So the argument in favor of the accounting change is that the current
> accounting practice is flat wrong, and the argument against the accounting
> change as proposed is that the proposed fix is also wrong and will damage
> our strongest businesses. Not a great set of options.
>
> My own opinion is that stock options *should* be considered a charge --
> this would go a long way toward leveling the playing field between new,
> innovative companies and large, established companies. New business is what
> makes our economy go. *But*...
>
> Now, at a time when we are entering a slump, is not the time to yank the rug
> out from under the American economy.
>
>
> Jonathan S. Shapiro
> Johns Hopkins University Information Security Institute


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