Hi Timbabear:
Welcome to the thread! Here is another Business Week article that reviews some various methods to expense options. Please note that, as Ron readily pointed out, the so called intrinsic value method that Business Week is favoring involves a different definition of intrinsic value than the FASB is already using per FAS 123.
Five Ways of Valuing Options
Of these possible methods, only one results in reliable, tamperproof, financial results
To determine the bottom-line impact of the various methods for valuing options, BusinessWeek used a hypothetical grant of 5.3 million options. That's the median number of options granted by S&P 500 companies in 2001, and approximately the number granted by several well-known companies, including Aetna, Walgreen, Scientific-Atlanta, and CVS.
We plotted two different performance scenarios: In one, the stock price increases 15% a year over three years. In the other it decreases 15% a year. For each scenario, we examined the impact on earnings from using two types of accounting: fixed accounting, which values options on the grant date and expenses them over time regardless of changing stock price and options value, and variable accounting, which values and expenses options every year.
Black-Scholes
How it works: Uses formula based on dividend yields, volatility, and other factors to estimate option value.
Advantage: Accounts for most factors affecting future option value.
Disadvantage: Doesn't discount for vesting and other restrictions, so it overestimates option value.
Impact on earnings:
If stock increases in value: $66.5 million (fixed), $96.6 million (variable).
If stock decreases in value: $66.5 million (fixed), $31.7 million (variable).
Verdict: Thumbs down. Companies would overpay for underwater options; formula easily manipulated to boost earnings.
Binomial
How it works: Uses Black-Scholes variables, but assumes options will be exercised when optimally profitable.
Advantage: Reflects how options really are exercised.
Disadvantage: If company pays dividends, this model results in bigger hit to earnings than Black-Scholes.
Impact on earnings:
If stock increases in value: $67.3 million (fixed), $97.3 million (variable).
If stock decreases in value: $67.3 million (fixed), $31.8 million (variable).
Verdict: Thumbs down. No improvement over standard Black-Scholes.
Minimum Value
How it works: Calculates Black-Scholes value assuming zero volatility.
Advantage: Of the Black-Scholes variants, this model requires the smallest earnings charge. When stock tanks, company can escape with no charge by using variable accounting.
Disadvantage: No public company stock has zero volatility.
Impact on earnings:
If stock increases in value: $26.4 million (fixed), $69.3 million (variable).
If stock decreases in value: $26.4 million (fixed), $472,230 (variable).
Verdict: Thumbs down. Pure fiction.
Growth & Discount
How it works: Instead of volatility, this method relies on assumptions of future stock gains to determine option value.
Advantage: Simpler than Black-Scholes, and allows companies that use variable accounting to avoid charge when options plunge underwater.
Disadvantage: Difficult to determine future stock gains with 100% accuracy. With fixed accounting, an expensive alternative.
Impact on earnings:
If stock increases in value: $86.1 million (fixed), $120.7 million (variable).
If stock decreases in value: $86.1 million (fixed), $24.4 (variable).
Verdict: Thumbs down. Too pricey, and too easy to manipulate.
Intrinsic Value
How it works: The stock price, minus the exercise price, is the value of the option. Since grant date value is zero, fixed accounting can not be used.
Advantage: The simplest method of all, impervious to manipulation, and underwater options are free.
Disadvantage: As with any variable accounting treatment, earnings charge could fluctuate wildly with stock price.
Impact on earnings:
If stock increases in value: $52.9 million (variable).
If stock decreases in value: $0 (variable).
Verdict: Thumbs up. This method accurately tracks true options value over time. Uses no "assumptions" that can be tweaked to boost earnings. And it's cheap: With stock gains, other methods would result in much bigger charges, and with a depreciating stock, there's no charge at all.
Data: BW; Earnings impact calculated by Towers Perrin
Note: For the purposes of this illustration, BusinessWeek assumed the options were granted on June 30, with the exercise price set at a current stock price of $30, and vested in equal installments on the grant date anniversary in 2003, 2004, and 2005. Calculations assume 40% volatility, 1.5% dividend yield, 1.1 beta, 4.5% risk-free rate, and 10.5% market return. Impact on earnings is the cumulative earnings reduction over three years, not adjusted for taxes.
businessweek.com
And from another part of that same Business Week we have this:
Why not just wait until the options are exercised? By waiting until employees exercise their options, then booking the difference between the exercise price and the stock price as an expense, companies would record the precise cost of the options. That sum would equal the amount the company would spend to buy those shares on the open market, or the amount the company is forgoing by not selling the shares and pocketing the funds itself. And options that never get exercised never get expensed. This is the only way of accurately stating the true cost of options to the company.
Unfortunately, simply waiting also violates most of the accounting principles about expense recognition that auditors hold dear. Companies are required to deduct expenses during the period in which they are incurred -- that's why equipment is amortized over its useful life instead of being expensed when it's purchased or sold. Expensing options only when they are exercised violates that basic principal, sometimes requiring companies to deduct the option expense long after the employee's period of service. An executive who retires with a boatload of vested options would, in this scenario, create a huge expense when he exercises them -- one that should properly have been taken throughout the period when he was employed.
Business Week is heavily promoting their version of intrinsic value method for valuing stock options. Ron has noted that this still violates a basic accounting principal by failing to recongnize any value for the options at date of grant. Actually the options have value from the moment they are issued and they even when they are underwater. Nevertheless, the Business Week solution is probably something I could live with, but I tend to think any method of valuing and expensing stock options is better than the charade of valuing and expensing stock options as zero.
businessweek.com
Best, Huey |
