The cost of options made simpler
By Jessica Einhorn
Published: May 7 2003 19:49 | Last Updated: May 7 2003 19:49
[As we sometimes divert to this subject, here is a piece from Financial Times suggestig a radical approach.]
In the wake of accounting scandals and the bursting of the market bubble, attention is riveted on improving corporate governance, agreeing universal accounting standards and managing conflicts of interest in the capital markets. In this broad landscape, the arcane issue of executive share options continues to loom large, and seemingly defies resolution.
Three separate arguments are under way on options. First is the question of the appropriateness of using options as an incentive to align the interests of corporate leaders with those of shareholders. The second question is whether such options should be expense items on companies' income statements or whether they should continue to be accounted for in the footnotes to financial statements. Finally, there is the recondite debate on how to value options, whatever the accounting treatment chosen.
When markets were exuberant, companies and their accountants were able to fend off the questions of appropriateness and accounting treatment comparatively easily. Now their position has become more awkward. For instance, Paul Volcker, former chairman of the Federal Reserve, has argued eloquently that fixed price options have too often distorted incentives; Alan Greenspan, the present chairman, has lent his gravitas to the notion that, if you grant options, they are an expense. Against such firepower, the opposition argument has shifted to the notion that there is no reliable option pricing model, so accounts would be sullied in their usability and comparability if options were explicitly counted.
This, however, is not necessarily true. It is time to consider a new approach to the problem that begins with what we are trying to achieve with the accounts and moves from there to a simple and usable approach to the numbers.
In corporate remuneration, stock options typically are issued to employees, granting the right to buy a certain number of company shares in the future at the price of the stock when the options were issued (the "strike" price). The customary argument is that, since the options only have "value" if the share price rises, the interests of shareholders are aligned with those of managements. Now, that phrase "they only have value" if the share price goes up is true in fact but not in theory - which is where pricing models come in. Theoretically, options have value embedded in the volatility of markets: even if the price is down now, it might go up, and the right to buy shares at a lower price than available in the market has value in itself. But does that matter to shareholders?
The shareholder has little interest in the embedded value of an option at issue. And so long as the price of a share in the market is below the strike price, it remains of little interest. If prices remain below the strike price, the options will expire worthless. But if prices rise, a new situation arises, in which shareholders are at risk of having additional shares enter the market at a discount to the price the market would pay for a new issue of equity.
If we look at the options expense issue in terms of this opportunity cost to existing shareholders, a different and quite simple approach emerges for accounting for the expense. To meet shareholders' information needs, we should think of the mark-to-market value of outstanding options as the difference between the market price and the exercise price at any point in time.
Accountants would then simply keep a running account of the mark-to- market effect on shareholders of outstanding options and the opportunity cost to existing shareholders when options are exercised. Under such an approach, at the moment options were issued they would have no value; but with each quarterly statement, companies would list on their balance sheet as a liability the contingent cost of all outstanding options marked to market. These liabilities would either expire worthless over time (if the stock price went down) or they would be converted into current expenses whenever options were profitably exercised. The combination of the contingent liability converted over time either into actual expenses or a reduction in liabilities would give shareholders a good sense of what was happening in cash flow terms to their company.
There has been so much enrichment of corporate leadership through options in the past decade and so much hype on their usefulness as an instrument of aligning interests. After we account for the options, all the most important issues will remain for consideration in the boardrooms, business schools and financial press. But accounting for them in a way that aligns the accounts with the interests of shareholders would be a step in the right direction.
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