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Strategies & Market Trends : Employee Stock Options - NQSOs & ISOs -- Ignore unavailable to you. Want to Upgrade?

To: hueyone who wrote (85)	6/20/2002 11:12:52 AM
From: Stock Farmer	Respond to of 786

Hi Huey - I think you are converging on an appropriate way to account for option expense. According to the Levine bill we want to see what is reported to the IRS be the same as what is reported to shareholders. And we know that what is reported to the IRS is equal to the difference between strike and market price at exercise. Now, if the companies report less cost to shareholders, then they will get a lower tax break and this will have the effect of reducing shareholder assets because the company will have to pay more tax. This is bad. So we want an accounting mechanism that reports the full cost of options. No more, no less. Equal. One way to do this would be to put the cost of stock options as exercised as a charge against earnings. Just the same way as it is shown to the IRS. There's nothing wrong with this from an economic perspective, except it's very-after-the-fact reporting with a lag measured in years. Which means that the governence and disclosure aspects are not high. Another way to do this would be to put the cost of stock options as estimated at grant as a charge against earnings. Unfortunately this number is an estimate given by a formula that is hugely sensitive to small changes in the input assumptions. The likelihood that it agrees with the number that ends up being reported to the IRS is small indeed. Except over a millenium or so. So we end up suggesting a reconciliation model. Which is, to my mind, not unlike the way companies account for stuff like goodwill or in-process R&D). Take In-Process R&D as an example ('cause some nitpicker will point out that Goodwill doesn't have to be amortized any more). A big chunk of IPR&D is purchased. This cost to shareholders is accounted for on the earnings statement by "depreciation" as a charge against earnings over the life of the asset. In the cash flow statement, this amount is reversed as a credit to cash flow. And on the balance sheet, the asset "Goodwill and Intangible Assets" is reduced by the amount of depreciation. Now add the complexity of having purchased this IPR&D with stock. The cost is reflected by increasing the amount of "paid in capital" under shareholder equity. If the shares that were issued to purchase this asset are later repurchased, then the paid in capital account will be debited. Effectively what this accounting allows us to see is the amount of shareholder equity that the company has built up for us versus the amount that we shareholders have contributed to it. This is a very important ratio for young companies, and we don't like to see it stagnate or get smaller (or go negative!). Now stock options. When an option is issued it has an estimated cost to shareholders of X given by the black-scholes equation or whatever voodoo management wants. This cost is only an estimate, based on the best mathematical expectation of what the stock option will be worth over a large number of iterations etc. and so on. Much the same way that "reserves for bad debt" is only an estimate. Accountants know how to handle this. They just create a reserve and when the actual stuff happens they draw it down against the reserve, reconciling the different amounts at the time that the exact amount is known. Watch the "restructuring charges" accounts that were created over the last couple of years very carefully and you can see this process in action. Anyway, this estimated stock option cost of X is written down against earnings, added back in cash flow, and accumulated in shareholder equity under "additional paid in capital". Total shareholder equity is not affected. So far, so good. When the option is exercised, it has an actual cost to shareholders of Y given by the difference between strike and market price. The difference Y-X represents the un-reported cost to shareholders (which may be positive or negative), which is also charged against earnings, added back to cash flow and accumulated in shareholder equity under "additional paid in capital". Again, total shareholder equity is unaffected. So far so good. What we end up seeing is having the total value reported to shareholders of: X + Y-X = Y. Which is the same value as reported to the IRS. So the Levine bill is made happy. Earnings reflect the same cost of stock options to shareholders as they do to the IRS And accountants are happy. Shareholder equity remains unaffected, cash flow remains un affected and we can simply look at the ratio of retained earnings to shareholder equity to determine how REALLY profitable the company is net of recourse to equity financing. Which is how things are supposed to be anyway. Really, it's not that complex. Except it requires folks to realize that shareholders bear the actual cost Y whether or not they report X. Which realization is dawning on some folks faster than it is on others. John

To: hueyone who wrote (85)	6/20/2002 1:28:37 PM
From: Gary L. Kepler	Read Replies (1) \| Respond to of 786

I am leery of changes to the rules of the game. The problems I would like see resolved are the abuse of executive pay and the lack of "effective" shareholder representation. The accounting treatment of options is only one part of the problem as I see it. My problem is that it took me ten years to readjust my portfolio away from real estate in 1986 with the change in tax laws related to ERISA. I had several master limited partnerships conservatively financed with generous cash flows that went bankrupt not because the business was flawed but because they could not be refinanced in an unfriendly, changing financial environment. In other words, the government changed the rules. And then the IRS had the gall to claim that income resulted from debt forgiveness and wanted additional taxes even though the capital risk was supposed to be limited to 100%. As a result, I have little faith in rule changes from Washington that could have massive adverse impact. I believe the use of options by public companies in the US is widespread. I am in favor of options as an incentive for all employees in proper proportions. I do believe that options have been abused by senior management and the total rewards to senior management needs to be addressed. The problem is not solely options. I am not anxious to see earnings depressed along with the stock market for the next five to ten years by an accounting change just to stop the abuse of stock options. The current treatment may or may not be best but it has been acceptable for ten to fifteen years. There has to be other ways of confronting the real issues. To change accounting treatment now could significantly depress the stock market for an extended period. Individual incomes would be depressed and government deficits would mount and interest rates would have to rise to the further detriment of business. Sounds like a death spiral to me particularly if we are to conclude companies like Cisco, Seibel, NTAP, etc. have never made money as some have suggested. To me this conclusion is surely not accurate. If true, then this country does have some fundamental problems. So if stocks are bad then does one shift to bonds and risk losing principal when interest rates rise? The real problem for me is senior executive compensation which favors the "star system" rather than be based on measured contributions. Boards are not exercising their fiduciary responsibility nor are the institutions which represent stock holdings in retirement accounts and in street name. There are no checks and balances with these institutions solely focused on short-term interests. In summary, changing accounting treatment might help solve the problem but it might also kill the economy. Aren't there better ways of addressing the real issues? Sorry for rambling but I am not a clear and concise thinker and thus do not post often.