Magazine article European Business Forum

Why Europe Must Participate in the Debate on Expensing Options: The Unopposed Adoption of Option Expensing Will Result in a Flawed Standard Based on Labyrinthine Methods. It Will Significantly Reduced European Company Earnings Leading to a Reduction in Employee Financial Participation in Their Enterprises

Magazine article European Business Forum

Why Europe Must Participate in the Debate on Expensing Options: The Unopposed Adoption of Option Expensing Will Result in a Flawed Standard Based on Labyrinthine Methods. It Will Significantly Reduced European Company Earnings Leading to a Reduction in Employee Financial Participation in Their Enterprises

Article excerpt

Recent corporate scandals have provided commentators with an opportunity to generate headlines berating business executives for all manner of corporate governance abuses, real and imagined. However, executive compensation has increasingly dominated the debate both in Europe and the US.

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The most passionate arguments at the moment surround stock option incentive schemes and the proposal by the International Accounting Standards Board (IASB) to require the cost of these options in future to be 'expensed' (deducted from company earnings). This follows widespread suggestions that executives have been able to issue options to themselves while avoiding the lowering of reported profits and the attendant adverse affect on their company's share price.

Understandably, corporate executives are reluctant to enter the debate, for at best being seen to be self-serving, at worst being perceived as deceptive. But in my view the unopposed adoption of option expensing by the IASB will result in a flawed standard based on labyrinthine methods, seeing no improvement in corporate governance, with significantly reduced European company earnings leading to a reduction in employee financial participation in their enterprises.

In the vast majority of companies--in particular where companies have broad-based option plans--it is the employees that benefit rather than the so-called 'fat cats' of senior management. The cost of the IASB's proposal will therefore be borne by European citizens as employees and shareholders since Employee Stock Options (ESOs) will effectively be abolished. This is a bad idea for Europe.

There is considerable evidence of the value of broad-based employee share ownership. It allows firms to compete for the best talent and retain them through long-term incentives that are aligned with the long-term interests of shareholders. This has generated demonstrably improved long-run corporate performance. The benefits of employee participation are particularly important in start-up businesses and in industries with high uncertainty, which require both innovation and a long-term investment horizon.

In short, Europe is unlikely to be the high-innovation/high performance economy it aspires to be without ESOs. Instead, expensing options will lock business into sub-optimal short-term incentive schemes emphasising short-term earnings. The potential demise of ESOs was illustrated by the recent announcement from Siemens that it would discontinue options in the light of recent German regulations.

The new requirement is likely to have effects that conflict with official European policy, given the European Commission's endorsement of ESOs. "Stock options ... have been a feature of the 1990s in the US", the Commission said last year. "By giving employees a stake in future gains, they help companies retain skilled employees.

Notwithstanding recent scandals in certain US corporations that have used stock options, they remain a valid and innovative way to share in the future profits of enterprises ..." (Communication COM(2002) 610 final, page 8).

Impact on Europe

It is generally believed that Europe does not have as significant an equity-orientated culture as the United States. While true, this obscures the fact that over the last few years European companies have been adopting ESOs at an increasing rate. Every one of the 146 European industrial companies that make it into the Global500 by size now has an active ESO. The impact on European companies is likely to be much larger than generally understood.

Figure 1 shows the impact of expensing as a percentage of reported earnings for the 146 largest European industrial companies.

The impact across sectors is of interest, firstly because the impact is asymmetrical and secondly because it has a significant impact on a number of key industries other than Information Technology. …

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