An initial discussion of the proper accounting for employee stock options -
A furious controversy of recent years has been as to whether or not an additional entry line should be included in corporate earnings statements to reflect a compensation expense due to the granting of employee stock options.
Every few weeks a new magazine, or newspaper, or on-line electronic article comes out and decries the fundamental absurdity of not counting employee stock option grants as a listed expense that reduces earnings. As far as I can remember, I have never seen anyone who is not in line to benefit from these options argue in favor of not adding them to the earnings report. There are a variety of arguments made that all seem to support their addition, but many of the articles really drop the hammer by quoting Warren Buffet as below -
From the 1998 annual report of Berkshire Hathaway, Inc. -
berkshirehathaway.com
"...A few years ago we asked three questions in these pages to which we have not yet received an answer: "If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?" ..."
While Warren doesn't get much wrong, the implications and conclusions drawn from these questions, and all of the other arguments made to support the addition of a new option expense entry line, are the result of fundamentally flawed economic reasoning and would tend to create error, rather than eliminate it.
The question is not whether option grants can and do form a part of a pattern of both real and potential abuse, but whether adding an expense line is the proper remedy.
Many of the arguments revolve around just what is the appropriate number to use as an expense, with part of the argument being about whether an option pricing formula more or less suitable for exchange traded options can be used for options which are not and cannot be traded. This may well be an interesting question, but is not the one that I am addressing here. Rather, my claim is that no such expense line whatever can be appropriately included.
My present problem is not in trying to find an argument that will clearly demonstrate this fact, but rather in selecting from among so many that I am unable to keep all of them in mind at once. Therefore my approach will be simply to try to demonstrate plausibility in this post and to provide other examples in later posts in due time.
Note that this entire post, other than this paragraph, has no reference to Austrian Economics at all. This is because Austrian Economics is not something separate from economics in general. Economics is not fundamentally marked by different schools, but rather, as per Milton Friedman, by good economics and bad economics, depending on their connection to reality. For this problem, Austrian Economics will likely appear in the refutation of various arguments that only survive because they depend upon widely accepted economic myths.
Example -
Assume that public company XYZ Corporation is about to write to Warren and offer to sell the company to Berkshire, lock, stock and barrel. Assume that XYZ is an asset-heavy company, much of whose value is represented by large amounts of cash and cash equivalents. Just before writing, executive bonuses come due and the management faces the question as to whether pay them out in cash or in an equivalent amount of new stock valued at current prices. (note that the granting of stock will be assumed to be essentially equivalent to the granting of stock options for the purposes of this discussion). From reading Warren's views on stock option grants, the tendency is to not take that path. However, if we assume that Warren will rationally appraise how much he is willing to pay for the company, we need to compare what the value of the company is under the alternate choices.
Before the bonuses are paid, and if no future obligation to pay them exists, the existing cash will be part of the value received in a buyout and will clearly be appraised dollar for dollar. Assume that Warren would be willing to pay $100M in this case.
If compensation bonuses totaling $2M are paid out in cash, the purchase price will clearly be reduced to $98M.
The question is what price should Warren be willing to pay for the entire company if the executive bonuses are paid out in the form of $2M in new stock. Answers, reasoning, and applicable arguments are requested.
Regards, Don |
