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To: Stock Farmer who wrote (64554)	9/14/2003 10:37:00 PM
From: Don Lloyd	Read Replies (3) \| Respond to of 77400

John et al, Indeed, most accountants are agreed that stock options represent a wage expense, and the knowledgeable debate centers not on whether or not this is a legitimate expense, but the magnitude of the expense. Just about everybody arguing from a point of rational impartiality agrees that "zero" is not the right answer. You've largely mischaracterized the area of disagreement, although there are opponents of option expensing who erroneously think the magnitude of the expense is central to the argument. 1. Everyone agrees, or should agree, that stock or option grants ARE a compensation expense. 2. The entire argument revolves around exactly who pays that expense and how it should be recorded. 3. The supporters of option expensing say that it is the company that pays, or is at least responsible for, the expense and that it must appear on the P&L statement in such a way as to reduce reported profits or increase reported losses, as may be. 4. The opponents of option expensing say that it is the shareholders that pay through a dilution of their company ownership share. If we look at the situation immediately after a new share grant, for example, the existing shareholders have the same absolute number of shares, but some of their percentage ownership is now held by the employees in the form of their new shares. If this is completely disclosed, in a footnote or by some other method (not on the P&L) nothing is being held back from the shareholders. If it is desired to do so, there can be an additional disclosure that calculates the dollar amount of the injury to the shareholders by simply taking the number of dollars required for shareholders of their own money to expend on the purchase of the shares needed to restore their previous percentage positions in the ownership of the company. Which method of recording the compensation expense wouldn't be of any consequence if no one ever used the reports for anything. The supporters of option expensing apparently want the compensation expense to appear directly on the P&L report, while opponents would say that a full footnote report is not only sufficient but that it avoids other undesired consequences described below. It seems to me that one legitimate use of the P&L statement is to help distinguish a viable company from a non-viable one. To do this we simply assume that the current P&L report will be replicated into the indefinite future. In this case, a viable company would be one that shows a positive or zero profit and a non-viable company would be one that shows a positive loss. Assume a company that shows a $10M annual positive profit when stock and option grants are NOT expensed on the P&L statement. Also assume that the same company shows a $10M positive loss when the stock and option grants ARE expensed on the P&L statement. In other words, when the compensation expense is recorded on the P&L statement, it is a $20M expense. Clearly, the choice of how the expense is reported is also the choice between an apparently viable company as seen from the P&L statement, and one that is not. Since both supporters and opponents of stock and option expensing agree that the compensation is not a cash expense, the company, if it takes no action to the contrary, will see its bank account increase by $10M each and every year independent of whether it chooses to expense stock and options on the P&L statement or not. This is a viable business, taking in more cash than it expends, but whether it is a desirable company for its shareholders is a different kettle of fish. If instead of a $20M employee compensation expense being recorded on the P&L statement, there were a $20M cash transportation expense, there would be no question of company viability as it would pay out more than it takes in every year. A company that shows an annual loss of $10M on its P&L statement, no matter from where its expenses come from, would be expected to eventually run out money completely, depending on how much money it started with. However, this is not true for the non-cash compensation expense, as it adds money every year. From the view of the shareholder, even though the company adds cash every year, the high rate of his dilution from new shares may well mean that his share of the company is actually worth less year after year. However, and this is the key point, the shareholder's value of the company can NEVER be reduced to zero by dilution. This is entirely at odds with the P&L statement containing stock and option compensation expensing as some year must come along in which the value of the company apparently passes from a positive into a negative value region both for itself and for its shareholders, and continues to become more and more negative year after year. Only at most one of the two methods of expensing stock and option grants can be valid, as they give P&L statements that are completely in conflict in terms of valuing either the total company or an individual shareholder's holding over time. You can say that you don't care whether the P&L statements give any indication as to the actual viability of a company, or whether it distorts shareholder value over time, but that seems to be farfetched. Regards, Don

To: Stock Farmer who wrote (64554)	9/15/2003 7:59:57 AM
From: Boca_PETE	Read Replies (1) \| Respond to of 77400

John Shannon: RE: ("part of the shareholder wealth held in custody by management is authorized share capital, reserved for the issuing of stock options!!!") In the form of "authorized share capital", capital (ie. cash in exchange for the sale and issuance of authorized common shares) is yet to flow into the company. If capital has not flowed into the company, it could not possibly be held in custody by the company because it is still in the hands of potential shareholders. Authorization for the sale and issuance of common shares does not raise capital for the company - it merely authorizes future sales and issuances of common shares that will raise capital in the future. The long standing accounting for options described in Accounting Principles Board Opinion 25 CORRECTLY TREATS the grant and exercise of employee stock OPTIONS as A CAPITAL RAISING TRANSACTION, not a "Wage Expense". 98% of companies chose not to book expense for employee stock options under Statement of Financial Accounting Standards No. 123, yet 98% of companies are not tech companies with large disclosed pro forma impacts from stock options in their footnotes. This fact should tweak peoples' curiosity. People should ask “why did companies fight the proposal to book 'stock option grant expense' so hard". If companies sought congressional help to stop that train, why? The answer to the above question is clear when you FOLLOW THE CASH FLOWS related to employee stock options. - When options are granted, the exercise price equals the market price at date of grant and no cash moves. - When the company stock price rises and falls, no cash moves. - When the employee exercises the option, cash or assets come into the company in exchange for newly issued shares of company stock or shares issued from treasury shares from a precious capital contraction. Conceptually the repurchase of shares is a capital contraction because treasury shares are required to be classified as part of stockholder's equity, not as an asset. The MAIN POINT is that NO ASSETS LEAVE THE COMPANY WHEN A STOCK OPTION IS EXERCISED. - When the employee resells the shares obtained from exercising his/her stock option, the employee receives the proceeds of that share sale from a new or existing shareholder, not from the company. This is a significant point because the employee profit on the sale of those shares is entirely funded in a shareholder-to-shareholder transaction independent from the company. Therefore NO ASSETS LEAVE THE COMPANY WHEN THE EMPLOYEE RESELLS SHARES OBTAINED FROM EXERCISING HIS/HER STOCK OPTION. Under double entry accounting, when no assets leave the company associated with the granting and exercise of a company stock option and the resale of those shares, that's a challenge for the great minds that came up with the proposal to book stock option grant expense. The FASB research guru solution was to require offset of the theoretical stock option grant expense charge with a credit to Paid-in Surplus, another category of Stockholder's Equity. Since the charge to stock option grant expense is a reduction of earnings and since earnings ultimately become part of the Retained Earnings category of Stockholder's Equity, you basically have a reclassification from Retained Earnings to Paid-in Surplus for the amount of the Stock Option Grant Expense charge (one category of stockholder equity to another category of stockholder equity) - no impact on net assets of the company since no assets left the company. This is mumbo jumbo accounting – it’s illusory. It accomplishes nothing. The fact is that the income statements of companies do reflect stock option expense, but everyone is looking for it in the wrong place. It is reflected net in the form of a lower earnings per share than there would have been without stock option compensation which results from dividing the greater number of shares outstanding (including those from exercised and exercisable stock options) into the company's net income for each period. So why do famous so-called "experts" like Warren Buffet and Alan Greenspan not see things as described above? My perception is that none of them are accountants and none of them have researched the issue in depth enough to understand the cash flows and their implications. They confuse company cash flows with cash flows of company shareholders which are of course separate and independent from the company. When you examine the actual cash flows related to stock option compensation, you can't help but see that stock option compensation is paid for directly by the shareholder, not by the company. Employee stock options only have value if the executive employee performs by increasing shareholder value and demand for the stock. That's done by implementing the most profitable business model, outperforming the competition, and continually improving because the competition is most always doing the same. Most large successful companies design competitive compensation packages to retain talent they need. If they did not do this, their executives would desert to companies that had the best compensation packages. It's not about class warfare - nobody is seeking to ream anybody! It's about supply and demand for competent talent. And yes, the system occasionally breaks down when dishonest people who lack integrity collude to steel from the shareholders. This is no reason to tar and feather all accounting principles and all auditors like the media seem addicted to doing to increase ratings. The undeniable truth is that stock option compensation to employees is directly funded by dilution of existing shareholder interests. Since such funding has nothing to do with the company issuing the stock option, no stock option expense however calculated should hit the company’s income statement. Company Abuses of Stock Options: I would assert that a consequence of the FED’s failure to raise margin rates when Alan Greenspan first used the words “irrational exuberence” and the stock market price bubble that followed was to encourage increased use by corporate executive managements of STOCK OPTION COMPENSATION to PICK THE PUBLIC’s WALLETS. We know that on the date stock options are granted, the market price must equal the option strike price executives are entitled to buy company shares at under the stock option contract. Employee holders of stock options fork over cash equal to the option strike price on the date they exercise their option to buy company shares increasing company assets. While stock option grants are intended to align management interests with company shareholders, my theory is that as the stock market price bubble inflated, managements increasingly saw that granting themselves larger and larger numbers of options was a way to easy self enrichment hidden by the inadequacies of current accounting rules. Of course company boards of directors that approved generous stock option grant policies are also partly to blame for what is seen today as obscene executive compensation. As discussed in reality, executives' profits on stock options are funded entirely by shareholder-to-shareholder transactions when the executive resells the shares in the open market, NOT FROM company treasuries. When you cut through stock option cash flows, it’s the public that funds the huge profits executives make on their stock options, not companies (That’s why those who urge companies to record “stock option grant expense” are so dead wrong). So IT WAS THE PUBLIC's POCKETS THAT GOT PICKED (in the form of buying shares purchased under option plans from company executives at increasingly inflated prices) as a result of the huge increased liquidity introduced into the system by the FED coupled with readily available speculative margin borrowing the grew increasingly unfettered as the stock market price bubble expanded. The main effect from stock option grants is the dilution of the earnings pool over a greater number of outstanding shares with resulting lower earnings/dividends per share for each shareholder. This dilution impact has been invisible because there has never been and there currently is no required disclosure of a Pro-Forma (you’ll pardon the expression) Earnings Per Share figure excluding shares issued under company stock option plans to point to the real historical dilution impact of exercised options. Only potential dilution from in-the-money remaining outstanding options is reflected in the currently required “Diluted Earnings Per Share” under FASB Standard No. 128 for EPS What’s Really Needed Now: On STOCK OPTION PLANS, what is sorely needed is a revised Earnings Per Share and Stock Option Plan quarterly report disclosure that focuses the reader on past and potential dilution of earnings per share. The dilution impact should be derived not only from exercisable stock options as is now required, but also from all exercised stock options. What is NOT needed and what will move financial statements away from the objective of ultimately reflecting a business’ cash flows over time is a requirement to book a theoretical stock option expense amount which is offset in capital surplus as originally proposed by the FASB is the standard that was enacted as FASB Standard 123, and, as recommended by the two famous non-accountants, Greenspan and Buffet. Here is how I see a revised stock option plan disclosure working: 1.) BASIC EARNINGS PER SHARE (now required, using average outstanding shares [including those outstanding shares issued from past exercises of stock options] divided into net income for the period). 2.) PRO FORMA BASIC EARNINGS PER SHARE (using pro-forma average outstanding shares [excluding any shares issued to employees from past exercises of stock options] divided into net income for the period). 3.) EARNINGS PER SHARE DILUTION FROM STOCK OPTION PLANS (1 minus 2). -------------------- 4.) DILUTION FROM (In-the-money) POTIALLY EXERCISABLE STOCK OPTIONS (As currently calculated under FASB Standard 128 for Earnings Per Share). 5.) TOTAL DILATION FROM STOCK OPTION PLANS (3 plus 4). ----------------------- With the above proposed disclosure, I'm saying that neither the disclosures under the old rule (Accounting Principles Board Opinion 25) nor the pro-forma stock option expense disclosure under the new rule (FASB Standard Number 123) adequately reflect a real dilution impact of stock option plans that corresponds to the real cash flows related to such option plans. Also needed is a requirement to disclose dilution to book value per share and dividends per share from stock option plans. Such dilution would be computed similar to the above calculations showing the data with and without outstanding shares related to exercised employee stock options on a cumulative basis since plan inception. Corporate Income Tax Deduction for Resold Employee Stock from Option Plans Under current tax law, companies get a corporation income tax deduction when their employees sell company shares they bought under stock option plans. The tax deduction on each such share amounts to the difference between the price the employee paid for the stock (ie. the option price) and the price of the market price of the stock on the date the employee exercised the stock option and bought the stock. The individual capital gain tax that such employees ultimately must fork over to the government when the employee sells the stock acquired under stock option plans finance this corporate tax reduction. Taken in its entirety, this process amounts to another invisible hand steeling from employee wallets the money to finance corporate welfare in the form of the reduction of cash tax owed by companies with stock option plans. So we have a convoluted scheme here of redistribution of the capital gains tax paid by employees to their employer that granted them stock options. Presumably, congress’ intent was to give companies an incentive to use stock options as a form of compensation. This tax return deduction for corporate taxes entirely represents “corporate welfare”. It bears no relationship to the reality if employee stock option cash flows. It is inconsistent with the tax treatment of other transactions related to expansion and contraction of corporation capital which generate no such tax benefit. RE: ("Just about everybody arguing from a point of rational impartiality agrees that "zero" is not the right answer.") I assure you that I am rational and impartial. From my experience, none of the people who you refer to seem to focus on WHO PAYS OPTION "EXPENSE" and THE EVIDENCE OF SUCH PAYMENT. Those answers are revealed by examining the cash flows related to employee stock options and thinking about them in the context of consolidated financial statements. Therein is where the logic of expensing stock options on the company's books completely breaks down. Other than the above views, I have no strong opinions on these issues <grin>. P