Kip Hagopian

Point of View: Expensing Employee Stock Options Is Improper Accounting

Kip Hagopian

In December 2004, the Financial Accounting Standards Board (FASB) approved a new standard for the accounting for employee stock options (ESOs). This rule, entitled Statement of Financial Accounting Standards 123R “Share-Based Payment” (FAS 123R), requires that ESOs be valued at the date of grant and expensed over the vesting period of the options. In March 2005, the SEC issued Staff Accounting Bulletin 107 (SAB 107), its interpretive guidance on FAS 123R, thereby making it, de facto, an SEC rule.

The signatories to this position paper, having considered this issue carefully, believe that the expensing of ESOs is improper accounting that will result in the serious impairment of the financial statements of companies that are users of broad-based option plans. Consequently, we are strongly opposed to this rule.

The case against expensing ESOs is extremely compelling. There are three basic reasons why ESOs should not be expensed: First, an ESO is a type of “gain-sharing instrument” which, by its nature, means it cannot be an expense of the granting entity; second, the cost of an ESO (if any) is already properly and fully accounted for; and third, neither the grant nor the vesting of an ESO meets the standard accounting definition of an expense.

An ESO Is a Gain-Sharing Instrument

The case for expensing is intuitively appealing. Employee stock options (“ESOs”) do have economic value to the employees that receive them. It is understandable, therefore, to expect there to be an economic cost somewhere on the other side of the transaction, since almost all transactions have approximate if not perfect accounting symmetry.

Like all “pay-for-performance” compensation instruments, an ESO has economic value to the recipient based on its potential for future profit. This value is not realizable but it is meaningful, otherwise the employee wouldn’t want it. Likewise, an ESO has a corresponding economic cost to the shareholders of the granting entity based on its potential for dilution to shareholder ownership. If such dilution occurs, the cost to the shareholders will become real. However, are ESOs also an expense to the granting entity? We believe the answer is clearly no.

An ESO, by design and by its terms, is a gain-sharing instrument in which shareholders share their gains (stock appreciation) with the ESO holders. There are two terms contained in a standard ESO contract which combine to make it a gain-sharing instrument:

• Setting the exercise price at fair market value — This practice limits the ESO holder’s profit to a share of the shareholders’ prospective gains.

• Non-transferability — This term eliminates the cash value of the call premium that is always extant in a transferable option. Consequently, the holder cannot take a profit on the ESO (or its underlying option) unless and until the shareholders have a gain. Non-transferability also ensures that the ESO’s benefits will be limited to the particular person to whom it was originally granted. This limitation is an essential element of a gain-sharing instrument.

The fact that an ESO is a gain-sharing instrument invalidates the case for expensing. Here’s why:

• As in all gain-sharing instruments, an ESO cannot have an accounting cost unless and until there is a gain. Accordingly, an ESO that is granted at the money has no accounting cost on its grant date.

• The cost of a gain-sharing instrument must be located where its associated gain is. Since the gain to be shared by the ESO holder is stock appreciation, the cost must be a share of that appreciation. To separate the cost from the gain—as FAS 123R requires—is an economic and accounting non sequitur. It should be clear, therefore, that the cost of an ESO is borne by the shareholders. Stock appreciation has no effect on the books of the enterprise.

Discussion

There are many types of gain-sharing arrangements, all of which have economic value to the recipient and none of which are accorded the accounting treatment mandated by FAS 123R. Two of the most common gain-sharing instruments used by companies are profit-sharing plans and sales commission agreements. Neither of them is treated as an expense unless and until there is either profit or revenue to be shared.

One of the most illustrative examples of a gain-sharing arrangement is a contingency lawsuit. If a company engages a plaintiff’s law firm to litigate a case for a 30% contingency fee, it should be clear that, although the law firm has received something of value, the company has not incurred any accounting cost when it enters into this arrangement.

However, the logic of FAS 123R would require the company to calculate the discounted present value (DPV) of the fee—30% of the expected value of the monetary award—and expense it over the period the suit is being tried. This would be done without consideration given to the value of the award on which the fee is dependent.

If such consideration were given, the company would book a net profit at the time it entered into its agreement with the law firm. This, of course, would be nonsensical from an accounting perspective and no such accounting treatment is permitted under Generally Acceptable Accounting Principles (GAAP).

In all of the above-described gain-sharing arrangements, it is the enterprise that reaps the gain and, accordingly, it is the enterprise that incurs the ultimate cost, if any. In the case of an ESO, however, it is the shareholders that reap the gain. Logically, therefore, it is the shareholders that must bear the cost.

This gain-sharing arrangement between employees and owners is not unique to ESOs. A classic form of a gain-sharing arrangement is embodied in almost all hedge fund and venture capital partnerships. Hedge fund and venture capital managers typically receive 20% of the profits derived from investing their limited partners’ capital.

When these partnerships are formed, the gain-sharing arrangement is consummated. It should be instructive that there is no provision in GAAP to charge an expense to either the enterprise (the partnership entity) or the individual investors (the limited partners) when these gain-sharing arrangements are entered into. The same accounting treatment should apply to ESOs, but under FAS 123R it does not.

Summary of the Gain-Sharing Argument

We believe that the case against expensing ESOs is very difficult to refute. It can be summed up in six simple statements:

• An ESO is a gain-sharing instrument in which shareholders agree to share their gains, if any, with employees.

• A gain-sharing instrument, by its nature, has no accounting cost unless and until there is a gain to be shared.

• The cost of a gain-sharing instrument must be located on the books of the party that reaps the gain.

• In the case of an ESO, the gain (stock appreciation) is reaped by shareholders and not by the enterprise; the cost of the ESO, therefore, is borne by the shareholders.

• This cost to shareholders—which, not coincidentally, exactly equals the employee’s post-tax profit—is already properly accounted for under the treasury stock method of accounting, as provided in FAS 128, entitled “Earnings per Share,” as a transfer of value from shareholders to employee option holders.

• Neither the granting nor the vesting of an ESO meets the standard accounting definition of an expense.

These six statements lead to the logical conclusion that an ESO, while it does have an economic cost to shareholders, is not an expense of the entity that grants it.

The Economic Cost of an ESO Is Fully Accounted For

There is an unfortunate misconception held by the press and the general business public that large profits may be reaped from ESOs without the imposition of any accounting or economic consequences on the other side of the transaction.

This conception is erroneous. As in virtually all other transactions, if gains are realized from an ESO, an equal amount of cost will be incurred on the other side of the transaction. This cost, if incurred, is and always has been properly and fully accounted for.

The grant of an ESO is an arrangement in which gains in ownership value may be shared between an entity’s preexisting shareholders and its employees. When an employee exercises an ESO, he or she acquires ownership in the granting entity while simultaneously realizing a profit equal to the intrinsic value of the option.

Intrinsic value is the “spread” between the exercise price and the market price; hereafter intrinsic value and spread will be used interchangeably.

When this occurs, the preexisting shareholders’ ownership is diluted, thereby reducing its value. Thus, the shareholders effectively transfer value from their balance sheets to the employees’ balance sheets. This transaction is symmetrical; that is, the after-tax gain to the employee is exactly the same as the after-tax reduction in the value of the shareholders’ ownership.

The objective of an ESO plan, like any other incentive compensation program, is to increase employee productivity and, in so doing, raise the market value of the enterprise to a level in excess of the value that might be attained if the plan did not exist, even after taking into account the plan’s dilutive effects.

If this objective is achieved, the use of an ESO plan will result in a net economic gain to shareholders, and not a cost. Nonetheless, for the purposes of this paper, shareholder value transfer is treated as a cost because it reduces the preexisting shareholders’ nominal gain.

At any point in the life of the ESO, and prior to its exercise, both the profit in the option and its corresponding cost can be determined on a pro forma basis. Calculating the profit side of the transaction is straightforward; it is simply the gain in the option less the assumed tax.

Determining the cost side is somewhat more complex but can be readily achieved using a standard accounting convention known as the “treasury stock method” (TSM). The TSM, which is described in FAS 128 (entitled “Earnings per Share”), measures dilution—which translates into cost—on a pro forma basis.

The treasury stock method measures net dilution to shareholder ownership by assuming that all outstanding options that are “in the money”—that is, the stock price is higher than the exercise price—on any particular reporting date are exercised and the cash proceeds from exercise, together with the entity’s tax savings resulting from the deductibility of the spread, are used to minimize dilution by purchasing shares of the entity’s stock in the open market.

This pro forma calculation takes into account the fact that an ESO, when exercised, generates cash, which can be used to benefit the issuing entity and its shareholders.

The assumption that the cash is used to buy back stock is a default position. If the company has a use for the cash that would produce a higher return, it can invest the cash accordingly. Using the treasury stock method, the precise dollar amount of the shareholder value transfer resulting from dilution may be calculated at any time.

To illustrate, assume a company with 10 million shares outstanding grants one million at-the-money ESOs at $10 per share. Assume also that over the next five years the stock fully vests as it rises to $25 per share.

At this point, the ESO holders have a pre-tax gain of $15 million and an after-tax gain—assuming a combined state and federal tax rate of 40%—of $9 million.

The shareholders’ value transfer is determined as follows. It is assumed that all one million ESOs are exercised and the cash proceeds from exercise ($10 million) are used to buy in the company’s stock at $25 per share.

It is also assumed that the $15 million spread in the ESOs is deducted from the company’s pre-tax income, resulting in tax savings of $6 million. This cash would also be used to buy shares of the company’s stock.

The $16 million total would buy 640,000 shares, resulting in net dilution of 360,000 shares. Accordingly, total “diluted shares” would be 10.36 million.

The market value of the entity would be $259 million ($25 times 10.36 million shares). The preexisting shareholders’ percentage ownership after dilution would be 96.53% (10 million preexisting shares divided by 10.36 million diluted shares), resulting in dilution of 3.47%.

Thus, the residual value of the preexisting shareholders’ ownership would be $250 million, and the amount of value that is effectively transferred to employees would be exactly $9 million.

Rises in the company’s stock price will increase the value transfer amount while declines will decrease it.

Note that in the above example—which assumes the same tax rates for both the employee and the corporation—the transaction is precisely symmetrical: the profit to the employee is the same as the cost to the shareholders.

Exercise-Date Accounting

Inasmuch as the shareholders’ market value is reduced by the full amount of the spread, post-tax, the TSM is effectively mark-to-market, “exercise-date” accounting applied to the shareholders’ accounts.

Because exercise-date accounting requires no estimating or use of complex models, it is the most simple, accurate, and reliable means of accounting for options.

Proposals to Enhance the Usefulness of Financial Statements

The treasury stock method is quite accurate at determining both the net dilution to shareholders’ ownership and the dollar amount of the value transfer from shareholders to employees as a result of outstanding ESOs.

It does this by taking a “snapshot” of dilution at a particular moment in time, normally at the end of a reporting period. This allows the users of financial statements to see exactly what the shareholders would receive if, on the day of the measurement, the company were liquidated and all assets were distributed.

In addition to the presentation of this calculation of current dilution, we believe the users of financial statements would gain significant benefit from seeing a clear presentation of a company’s historical levels of dilution and shareholder value transfer, as well as the dilution and value transfers that might obtain in the future at higher and lower stock prices.

Expensing ESOs Conflicts with Established Accounting Principles

The FASB’s rationale for expensing is that an ESO, like a transferable option, has tangible value that, once vested, is payment for employee services and should be expensed.

In our opinion, this rationale is without merit. Here are the reasons.

An ESO Grant Doesn’t Meet the Standard Accounting Definition of an Expense

Under any reasonable interpretation of paragraph 80 in the Statement of Financial Concepts No. 6 (Con 6), the grant of an ESO does not meet the standard definition of an expense.

According to Con 6:

“Expenses are outflows or other using up of assets or incurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations.”

In short, a transaction, as described, is recorded as an expense if it results in a decrement to an asset account or an increase in a liability account.

In each of the stated criteria—an outflow of cash or an asset that is convertible into cash, the using up of an asset that was acquired for cash or an asset convertible into cash, and the incurrence of a liability which is an obligation to lay out cash or an asset convertible into cash at a future date—the past, current or future consumption of cash is required to establish the existence of an expense.

Neither the act of granting an at-the-money ESO, nor its vesting, meets that standard.

In arguing that the grant of an ESO does meet the definition of an expense, the FASB asserts that the grant of an ESO is made in return for employee services and that these services are an asset that is “used up” simultaneously with its creation.

Putting aside the FASB’s premise that ESOs are granted for services—which we believe is wrong—this argument is difficult to comprehend, since it skips a step, namely, the transaction in which the “asset” to be used up was actually acquired.

Since the FASB has expressly stated that an ESO is neither an asset, and cannot therefore be an outlay, nor a liability, how, in the acquisition of the asset (services), can the grant of an ESO be considered an expense?

Not an Opportunity Cost Either

Since the granting of an ESO does not meet the FASB’s literal definition of an expense, the only possible justification for a charge to the entity is if the entity can be deemed to have incurred an opportunity cost at the time the ESO is granted.

The FASB makes only passing reference to this argument, saying that when an entity grants an ESO to an employee it foregoes the cash that it could have received if it had sold “similar options to third parties.”

With due respect to the FASB, we believe the opportunity-cost argument is also without merit.

To be sure, the issuance of common stock or transferable stock options (TSOs) to employees for no consideration would be an opportunity cost because both of these securities could be sold in private or public transactions for cash or for some asset convertible into cash.

In that event, the entity would have forgone the cash it could have received if it had sold the TSO for market value.

In FAS 123R, the FASB is effectively saying this is also true for the issuance of an ESO. In taking this position, the FASB is asserting that a transferable stock option and an employee stock option are essentially the same instrument and, provided the ESO has vested, have substantially the same value.

We believe the FASB’s assertion is incorrect. As is explained below, an ESO is fundamentally different from a TSO in both an accounting and an economic sense.

Transferable Stock Options

A typical TSO has a cash value, termed a call premium, that is established by the marketplace at the time of its issuance.

Financial economic theory holds that this call premium is implicitly a calculation of the discounted present value of the expected gain in the option at the end of its expected term.

At any time during the term of the option, a TSO may be sold for the amount of the call premium plus the spread. A TSO will always have a realizable call premium greater than zero, whether there is a spread in the option or not.

Employee Stock Options

In addition to its vesting provisions and certain other differentiating characteristics, an ESO is different from a TSO in two fundamental ways: First, ESOs may only be granted to employees; and second, ESOs are not transferable.

The combined effect of these two features is that only an employee of the issuer can ever realize a profit in an ESO.

The non-transferability feature means that the only way the holder of an ESO that is granted at the money can realize a profit is through the exercise of the option and the sale of the underlying stock.

By its terms, therefore, only the spread in an ESO can be realized—not the call premium—and only the original recipient of the ESO can realize that spread.

The critical importance of the concept of “realizability” to the recognition of “revenues and gains” is stated in paragraph 83 of “Statement of Financial Concepts No. 5,” entitled “Recognition and Measurement in Financial Statements of Business Enterprises.”

Recognition of revenue and gains involves consideration of two factors: being realized or realizable and being earned, with sometimes one and sometimes the other being the more important consideration.

This statement is elaborated upon in paragraph 83a: revenues and gains are realized when assets are exchanged for cash or claims to cash. Revenues and gains are realizable when related assets received or held are readily convertible to known amounts of cash or claims to cash.

This pronouncement makes it clear that the receipt of an instrument whose value is not realizable—and which has not been earned—would not be recognized under GAAP as a gain to the recipient.

By only modest extension of this logic, the grant of such an instrument should not result in a loss or an expense to the grantor.

The lack of a cash-realizable call premium is a distinction that transforms the instrument from being an immediate accounting expense to the granting entity to a contingent economic cost to the shareholders.

As stated above, an ESO may only be issued to employees, or company directors and consultants. In fact, each ESO is designated for a specific individual, so for each grant there is a market of only one person.

Thus, issuing “similar options to third parties” would be contrary to the ESO’s purpose and is proscribed.

Moreover, if a company were to offer options on the open market with the same terms as ESOs, it is inconceivable that there would be any “willing buyers” for such securities.

ESOs have two provisions that make this so.

First, as stated above, only the spread in an ESO can be realized. This means that if a buyer paid a cash premium for an at-the-money option, the cash realizability of the call premium would disappear at the time of purchase.

Second, prior to vesting, ESOs are cancelable at the will of the issuer by terminating the employee.

Would anyone other than an employee buy an option that loses its cash value the moment it is purchased, cannot be sold, and can be canceled at any time? The answer is clearly no.

What this illustrates is that the only person to whom an ESO has value is an employee of the entity that grants it. This is because the entity and its shareholders want the employee to succeed and do not, therefore, have an incentive to cancel the option.

So, does the company incur an opportunity cost by foregoing the cash it might receive by charging its employees for the ESOs it grants?

No. An ESO is a type of incentive compensation device designed to increase market value to a level that otherwise might not be attained.

Requiring an employee to pay for the right to participate in such a gain-sharing arrangement is nonsensical, inasmuch as it would erode and ultimately nullify the incentive value of the device.

This would defeat its purpose and would, therefore, be contrary to the issuer’s economic best interests. A company cannot incur an opportunity cost for not doing something that is contrary to its best interests.

To put this into perspective, consider whether a company incurs an opportunity cost if it does not charge its employees in advance for their right to share in profits or earn a bonus, a stock appreciation right, payout, or a sales commission.

Similarly, does a hedge fund partnership or its investors incur an opportunity cost for not charging the fund’s managers for their rights to a share of the profits?

Apparently, the FASB does not think so, because in none of these cases is such a charge mandated under GAAP.

In summary, if a transaction does not result in a decrement to an asset account or an increase in a liability account, and it is not an opportunity cost, it cannot be an expense.

Conclusion

Mandating the expensing of employee stock options is one of the most radical changes in accounting rules in history. It should not have been done without absolute certainty that it would improve the usefulness of financial statements.

In 1993, in letters to the FASB regarding this issue, all of the then-existing “Big Six” accounting firms vigorously opposed the expensing of stock options.

Commenting on the issue back then, the Chairman of Coopers & Lybrand had this to say:

“It has been a general tenet of accounting that standards should be altered only when there is clear evidence that a proposed change would improve financial reporting. There is no convincing proof that any financial statement user would benefit from the changes being discussed regarding accounting for stock options.”

We believe this assessment was correct then and is correct now.

But we would go further: The changes mandated in FAS 123R are serving to impair the usefulness of financial statements, not improve them.

We believe that proponents of expensing are slavishly adhering to an incorrect thesis, namely that because the grant of an ESO confers potential benefits upon the holder, it must result in a current expense to the granting entity.

As we have shown, this is simply not the case.

An ESO is a unique instrument that provides for the sharing of shareholders’ gains with the employees of the entity owned by those shareholders.

The effects, if any, of this sharing arrangement occur outside the confines of the entity’s financial statements, resulting in a profit to one party—the employees—and a cost of the same magnitude to the other—the shareholders.

All of the details of this arrangement are approved either directly or indirectly by the shareholders and are fully disclosed to all users of financial statements.

In summary, an ESO is a gain-sharing instrument in which shareholders’ gains are shared with employees.

The cost, if any, of the ESO, therefore, is borne by the shareholders and not the entity that grants it.

This cost is already fully accounted for as, in effect, a value transfer from shareholders to employees.

The expensing of ESOs on the financial statements of the granting entity does not meet the standard accounting definition of an expense and it is not an opportunity cost.

Charging an expense to the granting entity, as FAS 123R requires, results in a misstatement of the economic cost of ESOs and a material impairment of the usefulness of the financial statements of users of broad-based employee stock option plans.