by Paul B.W. Miller and Paul R. Bahnson

Assuming that the Financial Accounting Standards Board follows through and requires expensing of stock options, we expect a noticeable decline in new option grants.

However, we disagree with those who think that this change will hurt the U.S. economy. In fact, we think reduced reliance on options will be a good thing, even the right thing.

Why?

Our view is that the long tradition of accounting for options as if they are free has led many, if not most, managers to mistakenly believe that they have no real economic cost.

We liken this thinking to a person who, upon seeing a picture of themselves when they’re losing the battle of the bulge, vows to look better by touching up the photo instead of committing to eating right and exercising.

This action amounts to managing the perception, not the underlying reality. Because personal health and well-being have more to do with reality than perception, this solution is not in the individual’s long-term best interests.

We think that financial executives who argue against expensing also fail to distinguish perception and reality. Despite the lack of accounting recognition, options really do have a cost: the future loss that occurs when selling shares to an option holder at a price less (at times far less) than market value.

Be sure of this point: The capital markets understand how real this cost is. Ample evidence shows that option grants reduce stock prices whether the options are reported as income statement expenses or in the footnotes. Thus, whatever is “saved” (in specious earnings) by giving options in lieu of cash wages is more than given back (in higher real capital costs).

Furthermore, we don’t think that substituting options for other forms of compensation is a good idea because they are inherently expensive. Watson Wyatt, the world-wide consulting firm, recently reported the results of a survey of more than 600 upper-income corporate employees who received options at least once during their careers. These subjects were asked to describe their preferences for options vs. cash. The findings are that “employees greatly undervalue their stock option grants relative to the options’ cost to the company.”

On average, the respondents valued options at 50 percent to 70 percent of their Black-Scholes value. (The range reflects different scenarios — specifically, larger grants were associated with deeper discounts.) Watson Wyatt’s suggested explanation is that employees tend to be “risk averse and poorly diversified,” making options less than ideal as compensation from their point of view. Employees’ lack of enthusiasm for options means that companies granting them will get less, often much less, bang for each buck of options compared to other forms of compensation.

For argument’s sake, let’s assume that all employees impose a discount of 30 percent. Consider managers who follow existing accounting rules. If they focus on perception (reported income) instead of reality (real economic profit), they will prefer to use options because each $1 of grant date value given will have $0 income statement cost but provide access to a human resource worth $0.70. Certainly, this manager is going to howl when FASB threatens to require a $1 expense to be reported for these options. Alternatively, the reality is that the $1 cost produced only $0.70 in benefits.

Because the capital markets view options as costly, managers’ decisions surely should be driven by reality, not perception. Sadly, this is not always the case.

Geoffrey Colvin, writing in a 2001 Fortune magazine article, “Earnings Aren’t Everything,” provides some telling comments about earnings-obsessed managers. He commented on the results of an extensive survey by Stern Stewart that categorized the respondent companies into two broad categories: aligned and nonaligned.

The aligned group is described as having managers who “are pulling for the same things as their shareholders.” Aligned managers express a willingness to trade short-term accounting profits for long-term shareholder rewards. The nonaligned managers do not, preferring short-term profits, even at the sacrifice of long-term benefits. (Notably, the stock performance of aligned companies eclipses the nonaligned.)

Colvin summarized the responses from the survey to illustrate the differences between the two groups. “Your company has a hot new product or service opportunity. Accelerating development will depress earnings for the next few quarters. Do you go after it? Most companies in the aligned group say they would. Most in the nonaligned group say they wouldn’t.”

Colvin concludes that “the pattern is clear. The poor-performing companies worry about reported profit and admit they will even destroy shareholder wealth to get it. The top-performing companies know that what really counts is not reported earnings but something else. It’s what finance types call economic profits.”

It’s too bad that the survey didn’t look into options. We suspect that nonaligned managers use options much more than the aligned. Accordingly, here is what to expect if or when FASB follows through.

Nonaligned managers will watch a form of compensation that was ostensibly free become very costly, indeed. When the reported cost (100 percent of grant date fair value) is compared with the lower benefits perceived by employees (50 percent to 70 percent of fair value), we expect a substantial reduction in the use of options as nonaligned managers scramble to find more cost-effective forms of compensation. Other incentives, like restricted stock, will undoubtedly become more prevalent because employees impute greater value to them.

But what about the aligned managers? We expect far less difference between pre- and post-recognition behavior. Why? Because managers who adopted the long view were probably less enamored with options. Certainly, mandatory expensing will cause some to de-emphasize options to an extent, but not to the same degree as those who thought of options as free.

Despite allegations that diminished reliance on options will damage the economy, this is simply not the case. Will option usage in nonaligned companies go way down? Clearly the answer is “Yes,” but this is good news for the economy, not bad. Giving up a dollar of corporate resources in exchange for 50 to 70 cents of employee efforts is a bad deal, no matter how it’s packaged or reported in the financial statements. These and other inefficient expenditures are not sound transactions and FASB’s requirement will naturally curtail them.

While it is important to expense options so that shareholders and other statement users can more clearly see what is happening, our analysis
reveals that improved reporting should also enhance accounting’s contribution to fostering good stewardship. Whereas opaque accounting may promote ineffective use of resources, transparent reporting reinforces cost effectiveness.

For any nonaligned managers out there, we hope that expensing options makes you change your ways. If new decisions are based on understanding that options are costly, your behavioral changes are definitely for the better.

There is the old saying that people manage what gets measured. Now that the days of this free lunch are growing short, we’re betting that the hindsight of a few years hence will make us wonder how in the world everyone treated options for so long as if they cost nothing.


Paul B.W. Miller is a professor at the University of Colorado at Colorado Springs, and Paul R. Bahnson is a professor at Boise State University. The authors’ views are not necessarily those of their institutions. Reach them at paulandpaul@qfr.biz.

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