Accounting
for Stock Options: A Different View
by
Dana Warren
This
article was first published by
Reforming
the accounting treatment of stock options has become a hot
button for investors angry at having been misled by executives
using arcane accounting techniques to hide their misdeeds.
But commentators and legislators, wanting to strike back
at those who have abused options, have jumped on a "solution"
that, instead of clarifying a company's true financial status,
will only serve to obscure it further.
The news abounds with calls for recording option grants
as expenses on the income statement when they are issued,
which reduces a company's current profits. The problem is
that, at the time they are granted, there is no good way
to estimate the ultimate value of options (and thus their
"cost" to the company.) Consequently, the expense
recorded, and its effect on current results, is necessarily
speculative.
Certainly, options have value, and valuation techniques,
such as Black-Scholes, do exist. But even this Nobel-winning
formula works well only for large, stable companies with
heavily traded stock. A key to the Black-Scholes calculation
is a stock's volatility; low volatility produces a more
accurate valuation. This is why companies like Coca Cola
and General Electric are willing to report option grants
as an expense.
Once you get past the Fortune 100 or so, although Black-Scholes
is still useful, its margin of error starts to grow. With
small- and micro-cap companies, the calculation is significantly
less reliable and, with a small company, the relative impact
of an error on the bottom line is magnified. For private
companies, whose shares don't trade, Black-Scholes simply
does not work.
Reformers should remember that income statements are intended
to show how much revenue is made by producing and selling
widgets, what that process costs, and whether any earnings
are left at the end. The rules for preparing income statements
aim for consistent application to all companies, so their
relative performance can be compared. Recording an estimated
expense that depends upon a projection of the future price
of an individual company's stock would interfere with determining
that company's earnings and with comparing earnings among
companies.
In short, what investors really want is to insert the "cost"
of stock options into earnings per share (EPS) so they can
see how options affect the value of a company's stock. Since
there is no accurate mechanism for working options into
the "earnings" part of that calculation, perhaps
we should stop trying to assign a current value to options
and focus instead on how the number of shares reserved for
option issuances affects the "per share" portion
of the fraction.
To calculate "basic" EPS, a company's earnings
essentially are divided by its number of shares outstanding.
"Diluted" EPS adds shares deemed to be outstanding,
which includes shares subject to issuance upon the exercise
of outstanding options whose strike price is equal to or
lower than the current price of the stock.
When venture capitalists value private companies, they assume
that all the shares set aside for options ultimately will
be issued. They regard option plans as shareholder concessions
that allow employees to participate in company ownership.
Venture capitalists measure the cost of these concessions
by treating all shares issuable under option plans as outstanding,
thereby recognizing their dilutive effect on share ownership.
A similar approach might well be applied to all companies.
Basic EPS unrealistically ignores options. Do away with
it. Make companies report diluted EPS as currently calculated,
along with a new "fully diluted" EPS that treats
as outstanding all shares reserved for issuance under option
plans. After all, once shareholders have approved allocating
shares to an option plan, they, just like venture capitalists,
should recognize the near-certainty that all of those shares
will one day be issued.
While showing fully diluted EPS would not change the face
of stock analysis, it would compel a focus on the denominator
of the EPS calculation and shed light on the impact shares
reserved for options have on the value of a company's stock.
When seeking shareholder approval for option plans, management
would have to explain why setting aside shares for options
is worth the hit to EPS as shown by the new fully diluted
EPS. And analysts could set earnings projections against
potential increases in share ownership to determine what
kind of growth would be necessary to overcome the dilutive
impact of the shares reserved for options.
Requiring companies to disclose the new fully diluted number
of shares and include them in EPS projections would permit
investors finally to measure the cost of options by seeing
their potential impact on EPS, without distorting the income
statement by adding an artificial cost to a company's operating
results. Isn't that really what everyone is trying to accomplish?
Dana Warren is a principal in the Westlake Village and Los
Angeles offices of the law firm Riordan
& McKinzie. Mr. Warren is engaged in a general corporate
and securities practice, primarily acting as outside general
counsel to growth companies originally financed by venture
capital investors. For the convenience of his clients, many
of whom are high-technology companies located in the western
San Fernando Valley and Eastern Ventura County, Mr. Warren
maintains offices in the firm's downtown Los Angeles headquarters
as well as its Westlake Village branch.
