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Expensing Stock Options
Many Fortune 500 corporations in the United States are feeling pressure to classify stock
options as an expense in the wake of the Enron Corporation and Worldcom accounting scandals.
Due to the amount of money many of the executives from each of these companies made from
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stock options, the Securities and Exchange Commission needs to regulate stock options or force
companies to expense the stock options on their annual and quarterly financial statements.
Typically, an option plan gives the employees the right to buy company stock at a certain price;
the strike price which is usually the market price on the date of the grant of the options. Under
current U.S. accounting rules, companies can choose whether to deduct option costs from
expenses or disclose the options in the footnotes section of the financial statements. Proponents
argue that if expensing stock options does not become a requirement, companies will continue to
shower executives with outlandish option awards worth millions.
The first major U.S. corporations to begin expensing stock were Coca-Cola, General Electric,
and Proctor & Gamble. Each of these companies announced plans to account explicitly for the
cost of the options they use to compensate executives and other employees. Originally, these
options were used as bonuses for executives; however, over the last three - four years, this type
of payout has become more of compensation as salaries rather than bonuses without having to
show this expense on financial statements.
For example, the following CEO’s of Fortune 500 companies received compensation in the
form of salary and stock options without having to show the full expense on any of the
company’s financial statements, including income statements or statements of cash flows for the
fiscal year 001
Company CEO Salary Stock Option Bonus
Dell Computer Corp Michael Dell $8,08 $10,400,000
Hewlett-Packard Carleton S. Fiorina $1,000,000 $1,51,781
IBM Lou Gerstner $1,000,000 $115,000,000
Motorola Christopher Galvin $0 $,70,000
While CEO’s of these and all other major corporations make the most in salary and bonus
packages, the true reflection of their compensation is not computed into the income statement.
Rather, each company will list these amounts as footnotes and choose not to go into detail about
the amounts they receive or how the bonus compensation is structured.
However, in November, 00, the International Accounting Standards Board (IASB) published
a proposal to require all companies to take the same route as Coca-Cola, General Electric, and
Proctor & Gamble. The IASB submitted five specific principles to help boards and senior
management align more closely the role of options as managerial incentives with the interests of
the shareholders
1. Explicitly tie compensation to individual value creation. In case after case, investors have
seen executives reap extraordinary rewards tied to share price increases that had little to do
with the management and everything to do with factors beyond its control, such as interest rate
movements and changes in macroeconomic decisions. Indexed options can be a useful tool in
these cases. Unlike standard options, indexed ones make it possible to benchmark an executive
against a set of his or her peers.
. Minimize incentives to alter the company’s risk profile. Investors have discovered that
executives of top companies whose shares they own have ample opportunity to affect share
prices by managing in ways that aren’t necessarily in investors’ best interest. Increasing the
financial leverage of a company or the degree of business risk it bears are two prime examples.
To guard against such circumstances, the board’s best response might be to reduce the weight of
stock options in the CEO’s compensation.
. Favor the grant of restricted stock over stock options. As noted, indexed stock options offer
one way to distinguish between value created by external forces and value arising from
individual performance. Another answer would be to replace stock options with restricted stock,
granted under conditions relating to executive tenure and performance. By requiring executives
to invest some minimum proportion of their wealth or multiple of their salaries in the stock of
the companies they run, boards can ensure that they will care about a sustained drop in share
prices. Either of these changes in compensation policy will force companies to begin to give an
accurate reporting in their financial statements of CEO salary and total compensation; not just
footnotes at the bottom of the page.
4. Restrict the timing stock sales. Boards can also restrict the sale of a significant portion of a
CEO’s stock awards for a period of time (ex two years beyond the end of his or her tenure).
This would ensure that CEO’s focus on the creation of long-term value and not on short-lived
bumps in stock prices.
5. Limit the potential for hedging strategies. Senior executives have many ways to hedge their
holdings in the shares they own. But hedging poses a danger because it can, without
shareholder knowledge, limit the real exposure to the companies without having to publically
report this information on any financial statements.
The major argument against expensing stock options is the reduction in earnings over the fiscal
year and during each quarter. However, in a USA Today analysis of 4 of the largest
corporations, earnings would be reduced by only 4.% on average (throughout the entire fiscal
year). There are two exceptions to this study; Intel Corporation reported that earnings would
have been 7% lower if it had expensed stock options, and Cisco Systems stated losses would
have been nearly three times as large, if it had expensed stock options. However, General
Electric’s earnings would have been only .% lower in the same fiscal year 001.
Initial research indicates that as companies begin expensing options they are almost certain to
get stingier about handing them out because of the impact on the bottom line. That will have
major implications for how a wide array of employees negotiate their compensation packages.
Also, this will give a more accurate representation of the true compensation packages, especially
for senior or executive management. Furthermore, investors will be able to see the full effect
these “salaries” have on the bottom lines of these companies.
From an individual employee standpoint, expensing options may hurt when negotiating for
bonuses, better overall compensation packages, or performance awards. But with executives
making millions when companies are struggling or having to lay-off thousands of employees, the
net result will be more beneficial for the non-management employee and investor. For example,
in the case of Enron and Worldcom, the company executives may have still not completely
divulged the entire stock option information; however, these filings would have been on record
with the SEC as well as posted in the company’s financial statements. With these changes, the
collapse of each company may have been avoided and thousands of lay-offs may not have
occurred. Alan Greenspan, Federal Reserve Board Chairman, predicted in Congressional
testimony that the Financial Accounting Standards Board (FASB), which sets accounting rules in
the Unites States, would vote in favor of the switch due to the vague rules that currently exist.
Standard & Poor announced in 001 that they will now report earnings for companies by
subtracting the footnote options expensing from income. The IASB has approved staff
recommendations to establish options accounting standards and the European Union adopted the
IASB standards in 00. Currently, the SEC is studying the issue.
In conclusion, with the total amount of stock options increasing each year and becoming the
major incentive in CEO compensation packages, the SEC needs to follow other accounting
boards initiative and begin making expensing stock options mandatory in all financial
statements. With these changes, companies will begin showing more accurate earnings results
while CEO’s will not be able to receive outrageous compensation packages and the companies
they run continue to struggle with thousands of employees lose their jobs.
Works Cited
Jubak, Jim. “In Lean Times, Fat Cat CEO’s Get Fatter.” April 16, 00
WWW.TheStreet.com
Dignan, Larry. “Who Wants to Be A Gazillionaire”? April , 00
WWW.C/NetNews.com
“The Job Security Double Standard.” 00.
WWW.AFL-CIO.com
“Dell Chairman Gains 18.7 Million From Exercising Options
In Fiscal 001.” May 1, 001. WWW.DowJones.com
“Getting What You Pay For With Stock Options.” December 1, 00
The McKinsley Quarterly. WWW.Forbes.com
Krantz, Matt. “Firms Expensing Stock Options Aren’t Taking A Huge Hit.”
August 8, 00. USA Today
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