While Congress and the Financial Accounting Standard Board churn over accounting standards regarding stock options, employees are left wondering about their financial lives.
Some Fortune 500 companies like Coca-Cola and The Washington Post have already made the move to voluntary expensing, as has Bank One. The question is whether the proposed change would do away with this type of compensation or not.
Despite the fact that the headlines are full of stock option expense fever, the long-term implications for executive clients may not be so onerous. However, expensing options might cause such a drag on the profitability of some companies that the lower stock prices greatly reduce the attractiveness of options as a form of compensation.
If all companies must expense options, the impact on employees at old-line companies, like those mentioned above, would not be as great as at smaller companies. New companies without much cash depend on stock options to reward employees, and loudly claim that if they are required to expense the options they will no longer be able to afford them.
CPA Michael Gray's San Jose, Calif., office is in the heart of a start-up capital of the world. "Stock forms of compensation have been important in my area," he said. "In the recent tech heyday, even the secretary at the front desk received stock options."
Not only are options a critical source of compensation for smaller companies, but, when counted as an expense, they are a larger drag on earnings. Big tech companies like Cisco and Intel disclose the potential option expense in the required footnotes. Cisco's earnings would drop by $1.21 billion, or 28 percent, if the accounting standards change; Intel's would drop by $991 million, or 16 percent. "Even some of the big winners from the tech boom may well have not had any earnings at all if they had had to record expenses related to options," Gray said.
As the impact would be less for big companies than for small, the expensing requirement will affect executives less than other employees. "Even start-ups are still going to do whatever it takes to attract talent," said Gray. "But it's less likely that options will be offered to employees outside the key group under the new rules."
From a financial planning perspective, the larger task is often diversifying out of the position of assets concentrated in one stock. Tanager Financial recently raised minimums for new accounts to $2 million, and deals only with the key group of executives that are less likely to be affected by any accounting changes on their employer's income statements. "We look at stock options from the micro view, or how to advise our clients once the awards have been made," said manager Glenn Frank, CPA, PFS, CFP. "From the investor's point of view, the biggest decision is whether to exercise."
Uncertainty surrounding options and the future of the stock price, as well as the tax treatment of the incentive stock options, make the decision difficult. "There's so much misinformation out there that encourages them not to exercise," said Frank. "So many people get paralyzed about their options and do nothing."
Tanager's concept of the financial floor helps their clients pull the trigger. During the planning process, clients work with advisors to determine how much is enough to meet their financial goals. "What's insane is that people's net worth can fluctuate so wildly," said Frank. "Investors need to learn to pull the trigger on what is enough."
The tax treatment of incentive stock options adds to the paralysis on the part of many clients. When exercised, the option becomes a preference item and investors must pay up to the Internal Revenue Service even if the stock is not sold. The new accounting rules at the employer would not change the personal tax rules, but if expensing options becomes a drag on earnings, stock price volatility could increase.
For investors, price volatility confuses the decision to exercise. "We tell clients it's illogical not to exercise as soon as they can," says Frank. "And while they don't like to hear it, we make the point that even the top executives do not know where the stock price is ultimately going to go."
Frank's goal is to reduce volatility throughout the holdings. "Some of these clients own the options as well as company stock in other plans, on top of having their job tied up in one source," he said. "They question how any new investments might perform, but mathematically a diversified portfolio will be less volatile than a single stock."
When the employer is a small company, however, the volatility could be greatly increased by a move to expensing stock options. "Companies had a free ride using non-qualified options," said Gray. "They could use them to pay for something of value, but they didn't have to record the expense."
In addition to the confusion of company-level accounting changes, the IRS is tinkering with the investor's tax regulations. Specifically troubling Gray is Treasury Decision 9144, which changes the treatment of options exercised before vesting. Some pre-initial public offering companies allow employees to exercise early if the stock issue is imminent. The new ruling does not allow the favorable election under Section 83(b), and investors who sell before a two-year holding period get hit with ordinary income.
Part of Gray's practice is to assist other advisors on the changes in stock option laws through his newsletter, Michael Gray CPA Option Alert, which can be accessed at www.stockoptionadvisors.com.
Big companies can also swallow the ongoing costs of accounting for options, making it easier to continue to reward employees, but the costs may be too high for smaller companies. "Start-ups are hit on several levels, with options accounting as well as Sarbanes-Oxley compliance," said Gray.
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