Stock Options: Still Alive? Don't Count Them out Yet. Many Types Are Still Viable

By Shah, Sam | Strategic Finance, October 2003 | Go to article overview

Stock Options: Still Alive? Don't Count Them out Yet. Many Types Are Still Viable


Shah, Sam, Strategic Finance


In 2002, we witnessed the fall of corporate giants. WorldCom. Global Crossing. Even noted linguist William Safire couldn't resist the urge to coin a new word on the street: "Enronnish." The atmosphere reached a low point, forcing the federal government to respond by pledging to restore investor confidence and promising to hold corporations and their officers accountable.

In 2003, we have seen Sarbanes-Oxley in motion. The phrase "corporate governance" is peppered across every type of business and financial media outlet. The government attempted to set a path in 2003 to avoid the ills of 2002.

In 2004, we can't safely foresee an increase in movement on corporate governance (if the government's lack of movement in 2003 is any barometer). But we can expect to see a shift in the manner in which companies choose to compensate their employees. Companies that have historically attracted, retained, and motivated employees with stock options will now have to adhere to major changes in accounting standards with respect to stock options.

ARE STOCK OPTIONS THE ENEMY?

The debate surrounding stock option expensing initially polarized the financial world, casting options as a major factor in the country's economic recession. Major investors like Warren Buffett of Berkshire Hathaway said companies should expense their option costs. Coca-Cola heeded the words of its largest shareholder (Berkshire) and announced in mid-summer 2002 that it would voluntarily expense options.

Technocrats such as Intel's Craig Barrett adamantly opposed expensing options. In the technology sector, Barrett argued, firms relied on options as a vital tool to stimulate business, reward performance, and retain key employees. Expensing, he said, would dissuade companies from offering them.

SURVEYS AND EMPIRICAL RESEARCH

The stock options debate, as this magazine aptly noted, turned out to be "much ado about nothing." A Towers Perrin survey of 100 companies with stock option plans found that during a 90-day period before and after these companies announced they would expense options, their stock prices did not change significantly (other than what would normally be expected for this time period, given normal market fluctuation).

The National Center for Employee Ownership (NCEO), curious to learn what academics thought, conducted its own survey of 37 business school finance professors. Only 16% of the respondents believed option expensing would have a "significant" impact on stock prices of companies with option plans. The remaining 84% said expensing would have "little" or "no" impact on companies' stock prices. As Corey Rosen, executive director of the NCEO, said, "The options expensing debate turned out to be the 'Y2K' of stock options--much feared, but of little consequence." He argued, "These results, along with recent empirical studies, suggest that companies should stop designing equity compensation plans to fit an accounting standard. Instead, these plans should be designed to optimize the value for their cost."

FASB'S DECLARATION

This debate raged throughout 2002. The Financial Accounting Standards Board (FASB) eventually weighed in during 2003, and its recommendations will most certainly alter the landscape for options accounting in 2004. In short, companies issuing options will have to record the expense on their income statements.

Retrospectively, however, the results from the surveys, the research, and FASB should have been intuitive: Markets already considered the options expense. The crux of the debate centered on where, exactly, this cost would be reflected. Before 2003, companies traditionally disclosed option costs in footnotes, where any capable equity researcher could find them and incorporate them into their valuations.

FASB put an end to this, recently announcing that, sometime in 2004, it would recommend that options must be expensed on the income statement (FASB's decision is also believed to be synchronous with guidelines drafted by the International Accounting Standards Board (IASB)). …

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