Stock Option Expensing and the Sex of Angels …
Posted By John Schroy On 26th October 2004 @ 17:35 In Corporate Managers | Comments Disabled
The problem with finding a way to expense stock options lies in the reluctance of company executives and market intermediaries to acknowledge the true cost and to the meddling of theoretical economists in areas best left to practical accountants. This can be illustrated with a simple example.
Company ABC has assets worth $1,000, represented by 500 shares entirely owned by Shareholder A. The management of the company decides to issue 500 shares of Company ABC and give these shares to the CEO as remuneration for services rendered. These shares are granted in the form of options issued on January 1st and exercised on December 31st. How much should the company’s accountants post as the cost of this remuneration?
Consider the following:
- The value of the company before and after granting the options is $1,000, represented by cash in the bank. Therefore, from the point of view of a creditor that is considering lending money to the company, the value of the enterprise has not changed.
- Shareholder A still holds 500 shares that now are worth only $500, instead of $1,000. She has suffered a loss of $500. From her point of view the company should show a loss of $500.
- The CEO now has 500 shares worth $500 for which he paid nothing. The income tax authorities will tax him on his $500 profit.
- If Company ABC were to debit the expense of $500 to an account “cost of options granted”, it would have to credit the same amount to an account “new stocks issued”. The capital accounts of the company would now show $1,500 in capital issued and a $500 loss in current income and the net worth would be unchanged at $1,000.
- The government, if it were taxing the company and the CEO at the same rate, would receive taxes from the CEO that would be offset by the tax saved by the company on the $500 loss posted.
The economist now comes into the picture and flashes the Black-Scholes model and a handy calculator and says:
“The value of the options should be determined by the risk-free rate of interest, the variance in stock prices in the past, the current stock price and the value at which the option is exercised.”
The banker and the shareholder say, “but … but … ” However, the economist whips out seven pages of finely printed stochastic partial differential equations and a Nobel prize certificate that immediately zaps the brains of these mortals.
Even though it seems obvious that Shareholder A actually lost $500 in “intrinsic value”, whatever the past price fluctuations on the stock market or interest rate might be, the economist pontificates that according to the Efficient Market Hypothesis, “the actual price of a security will be a good estimate of its intrinsic value.”
(See [1] The Non-Efficient Market)
Of course the CEO doesn’t want to expense the options at all, because this might make his “performance” look bad, but if options must be expensed, he prefers the economist’s approach because then he has room to fiddle with estimates of past market variance, interest rates, and the time lag between when options are granted and exercised.
Finally, and this is perhaps the most important point of all, the confusion over option prices completely obscures the much larger ethical and accounting question about the cost of the stock buybacks used to ramp up market prices to give options value. This is the real cost.
(See: [2] The Boeing Buyback: A Case Study and [3] The Great Misleading.
For an interesting discussion among economists on this matter, see [4] Should STOCK be Expensed from Mises Economics Blog. This is where our title reference to the sex of angels becomes relevant.
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Article printed from Capital Flow Watch: http://capital-flow-analysis.com/capital-flow-watch
URL to article: http://capital-flow-analysis.com/capital-flow-watch/stock-option-expensing-and-the-sex-of-angels.html
URLs in this post:
[1] The Non-Efficient Market: http://capital-flow-analysis.info/investment-tutorial/lesson_7.html
[2] The Boeing Buyback: A Case Study: http://capital-flow-analysis.info/investment-essays/boeing_buyback.html
[3] The Great Misleading: http://capital-flow-analysis.info/investment-essays/buyback_fallacies.html
[4] Should STOCK be Expensed: http://www.mises.org/blog/archives/001802.asp
[5] accounting: http://capital-flow-analysis.com/capital-flow-watch/index.php?tag=accounting
[6] black scholes: http://capital-flow-analysis.com/capital-flow-watch/index.php?tag=black-scholes
[7] executive compensation: http://capital-flow-analysis.com/capital-flow-watch/index.php?tag=executive-compensation
[8] income tax: http://capital-flow-analysis.com/capital-flow-watch/index.php?tag=income-tax
[9] stock buybacks: http://capital-flow-analysis.com/capital-flow-watch/index.php?tag=stock-buybacks
[10] stock options: http://capital-flow-analysis.com/capital-flow-watch/index.php?tag=stock-options
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