by Cynthia Harrington
Financial advisors took a break from dealing with stock option issues as fewer clients presented new wealth from exercising options.
Options on the books were under water and represented less and less of clients’ overall wealth. But forces demanding the expensing of this form of employee compensation, once again, placed the issue at center stage for CPA advisors.
The anticipated changes affect advisors in several ways. Ways of accounting for the expense confuse financial reporting, while added volatility in earnings overhangs the entire market. Corporate executives worry about possible incentive compensation for themselves and valued employees. Nor do the proposed regulations for shifting options to the income statement lift the burden on advisors.
"How this is being handled adds whole clouds of uncertainty over entire market," said Jeff Diercks, CPA, of InTrust Advisors, in Tampa, Fla. "Even now, companies have the choice to expense or not, and they choose how to value the expense. Investors are looking at financial statements with less confidence and thinking, ÔMaybe I’d be better off buying bonds.’"
Mitchell Freedman, CPA, PFS, of MFAC Financial Advisors, in Sherman Oaks, Calif., pointed out the challenge for his entrepreneurial clients. "Consider high-tech and biotech startups that grant stock options as way to encourage top talent to come to work for them at lower than market salaries," said Freedman. "Expensing means these companies report dramatically lower earnings per share, and that means difficulty raising capital to grow."
Dealing with stock options fell off the daily task list for Jay L. Heller, CPA, and president, of HJ Financial Group, in Plymouth Meeting, Pa. "We saw lots of wealth created in 1990s for our clients by stock options, but we’ve not dealt at all with that in the last couple of years," said Heller. "Where the effect is the most dramatic is in companies with sales around $100 million. They’re hurting because those options are deeply under water."
The biggest difficulty for advisors, right now, is the tremendous ambiguity. While there is much talk of impending regulations, nothing definitive has been handed down. Some companies expense now and others don’t. "Most of the ones that now expense are old-line companies where the impact on the bottom line is minimal," said Freedman. "So, perhaps, they’re not as altruistic as they appear to be."
Not only are companies free to choose whether to expense options, they also get to choose the method for valuation. Guidance for valuations is provided by FASB 123, which states that the "... fair value is determined using an option-pricing model that takes into account the stock price at the grant date, the exercise price, the expected life of the option, the volatility of the underlying stock and the expected dividends on it, and the risk-free interest rate over the expected life of the option...".
The most common method that is used is the Black-Scholes calculation, but many companies use fair market value. One of the early entrants in the field, Coca-Cola, uses fair market value that they define as the average of quarterly quotations from several independent financial institutions.
It matters which valuation method and inputs a company uses. A recent study revealed that the range of charges between the highest and lowest valuations swung from -1.03 percent to 6.79 percent of pretax income.
"Investors are wary. They don’t know how a company is handling the expense," said Diercks. "They wonder if they owned stock in the company and a quarter from now they change their way of handling the charge or if the way the company uses its earnings."
The volatility of earnings affects companies and employees as much as it does shareholders. "Management is left trying to explain the potential quarter-to-quarter swings," said Heller. "And although the tax issue isn’t in the mix, it could be that once expensed, options become a quarterly taxable event for employees. If they make this move, then tax work for corporate executive clients becomes much more complex."
The potential elimination of stock options presents a thorny problem. Studies show that incentive compensation produces higher growth rates for those companies. Management and employees want to feel that they will participate in the future growth of the company that they helped to create. So, advisors must help solve this dilemma for clients that own companies, and must consider the implications for growth companies as an asset class.
"Company management could be left with a difficult decision," said Freedman. "They have to find the way to compensate employees for exceptional work. Too much cash is no good. Other benefits and perks, like corporate jets and screening rooms in their personal residences are out of the question. Giving employees the chance to create great wealth through some program of buying shares at discounted prices still looks pretty good."
While the issue of expensing options burns up the front pages of the financial press, it hasn’t made much difference in the day-to-day work of financial advisors.
One reason is that the asset managers that are used for clients don’t rely on earnings so the potential for increased volatility in individual companies is a non-event. InTrust Advisors places client assets with outside money managers. "I wouldn’t expect any of our managers to report changes in their analysis," said Diercks. "They focus on the cash flow that companies generate. So this non-cash expense would be added back in anyway as part of the analytical process."
At HJ Financial Group, advisors had instituted a new planning approach years ago that focused clients’ attention away from periodic wealth generators and back to the basics. They divide the planning process into Plan A, which they call the Progression of Wealth, and Plan B. "Plan A is plain- vanilla investing like regular savings, retirement planning and investing for big expenses, like college," said Heller. "Plan A gets clients through to financial independence based on fairly predictable factors. This helps clients survive and prosper in all times."
Heller presents Plan B to clients once the first part is in place. Plan B directs the actions after some event that creates instant wealth, like the exercise of stock options, the sale of a business or winning the lottery. "Our clients that bought into our Progression of Wealth plan before the crash are actually doing much better now that there’s a general regression of wealth," said Heller.
Despite the uncertainty, Freedman welcomes the potential regulations. "If all companies are required to expense options it’s going to be dilutive and it’s going to affect valuations," he said. "I’d love to see the market get back into line with long-term historical benchmarks."
