Expensing non-qualified stock options at grant date

By Barbara H. Pietrowski, CPA, CFP, PFS

Many articles have been written recently about the necessity of expensing stock options when they are granted, using the Black Scholes formula to value the options. I believe this is a bad idea because it will make the income statement even less representative of what the real earnings of the company are.

In the case of non-qualified stock options, no expense is currently recorded when they are granted, for the very good reason that there is no real value. Non-qualified stock options constitute the bulk of all options issued. Only a small percentage are incentive stock options, which are treated differently than non-qualified stock options.

Non-qualified stock options have no real value at the grant date because the option exercise price is the fair market value of the stock on the date of issue. If the exercise price is $10 and the fair market value is $10, there is no value to the employee at that date.

"Ah ha!" say some critics, "but there is a value of $10." However, they may not understand that when these options are exercised by the employee, he is required to pay the company $10 for each option exercised, either by expending his own funds or selling the stock. Therefore, there is really no value on the option's grant date.

As a result, accountants who are required to expense options on the grant date must assign an artificial value to the option using the Black Scholes formula, which links the value of the option to such variables as the expected future volatility in share prices, expected future dividends and other future variables. We all have seen how impossible it is to ascertain where a stock's price will be tomorrow; trying to predict what will happen five years from now is ludicrous. This estimate is treated as fact. What is worse, the estimate is now part of the company's income statement, and no recognition of the future real value is made when the stock goes up and down. How do you account for the many options issued in the last few years that are now valueless because the stock has sunk below the option's exercise price?

It would be more correct to value the option initially at zero and revalue it each year as the stock goes up and down, with consequent corrections to compensation expense. What a nightmare that would be!

The present system is much better. When an option is exercised — say, at $20 per share with an exercise price of $10 — the employee pays the company $10 per share for the stock and an immediate compensation expense of $10 per share is recognized; this compensation expense is subject to income and FICA taxes. The stock the company provides either is purchased on the open market at that time for $20 per share, or paid out from the treasury stock the company holds. This treasury stock may have been purchased in an open market transaction (with a consequent cost), or issued as original treasury stock or new treasury stock issues authorized by the shareholders. So it may or may not have an actual cash cost.

The accounting profession has chosen to assign a cost to this option equal to the fair market value less the option exercise price that is paid to the company. This seems like a reasonable way to approach this problem. This cost is expressed as employee compensation when the option is exercised. This is as it should be. The newspaper articles that rave about the fact that options are never expensed, totally escape financial scrutiny and seriously distort earnings are simply wrong.

In addition, the fluctuation in option value is footnoted in the financial statements and expressed in the calculation for fully diluted earnings per share. The real importance of outstanding stock options for investors is the potential dilution in earnings per share of the stock if all of the outstanding "in-the-money" options are exercised. This calculation should be made more transparent, and the amount of outstanding options with exercise price and current value (less exercise price) if exercised should be readily available.

The Sept. 3, 2002 issue of the Wall Street Journal includes an interesting article by Reuven Brenner of McGill University and Donald Luskin of Trend Macrolytics LLC. Their thesis is that expensing options when issued will seriously distort the income statement, as using the current expensing method when exercised results in a much higher compensation expense then using fair value calculations when the options were issued.

These gentlemen suggest a different approach which recognizes that option expenses cannot be known until the options are exercised, so that it more properly should be recognized on the balance sheet as a liability and therefore adjusted for changes in this liability over the life of the options. The authors state that at Microsoft, for instance, the exercise value of all outstanding options is $23.7 billion — a potential future liability which is not shown on the balance sheet and is twice as large as all the other liabilities shown. To paraphrase the article, this is a way to illustrate how much a company is paying for its human capital.

This may be an excellent idea, and the accounting community needs to discuss such alternatives before allowing the politicians to rush out and require immediate option expensing. Expensing options at grant date when there is no sound basis for estimating the future value of the options has the very real potential to create much more harm than good.

The real goal should be to make the income statement more representative of the actual earnings and expenses of the publicly traded company.

The investor will be the loser if companies decide to expense options when granted using tenuous assumptions about the future value of the stock.

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