State of Innovation

Patents and Innovation Economics

Stock Options – Accounting or Controlling

            Intellectual capital, financial capital and human capital were the three pillars of the incredible innovation of the 90s.  Human capital in the form of scientists, engineers, management, etc. was typically lured into a risky start-up company with stock options.  According to the online accounting dictionary an option is a right given the holder to buy a specified number of shares of stock at a certain price by a particular date.  Stock options were the prize if the venture worked out for talented individuals to forego better paying, less stressful positions with established organizations that often had better benefits.  The strike price of the stock option was always set at or below the fair market value of the stock at the time option was issued, meaning the option had no inherent value.  The promise was that if the venture succeeded the employees would be able to cash in their stock options and receive a large reward.  If the venture failed, these stock options would end up being worthless.  Some accountants believed that stock options should have an associated expense at the time of the option grant.  The Financial Standards Accounting Board (FASB) implemented a rule requiring expensing of options in December 2005. 

            Before delving into the rules of stock options, it will be helpful to first define the role of accounting.  Dictionary.com defines accounting as a detailed report of the financial state or transactions of a person or entity.  In layman’s terms accounting is the measurement of financial parameters.  A key concept in measuring physical parameters is to make sure the measurement system does not disturb the parameter being measured.  If the measurement system alters the system being measured, then the user does not know how the system is behaving or how to adjust the system to meet the objectives of the user.  Analogously, the goal of accounting should be to measure the financial parameters without altering the business being measured, so the client can make decisions about how they want to run their business.  As we will see, the FASB rule on stock options is so complicated and expensive that it alters the entity being measured. 

            According to an article in the Journal of Business & Economic Research,[1] stock options were necessitated by the separation of company ownership and management.  Stock options were used to overcome the “agency problem” and tie the interests of management and owners.[2]  In 1972, the Accounting Principles Board (APB) Opinion No. 25, defined how to account for stock options.  This rule only required expensing stock options that had intrinsic value – in the money options with a strike price below the market value.  Between 1985 and 1988 FASB conducted research on stock based compensation programs.[3]  The conclusion was companies should be required to expense the fair value of stock options, resulting in out of the money stock options being expensed.  Many high technology companies criticized the conclusions and FASB received over 200 letters on the issue, most of which were critical of the proposed rule.[4]  During 1992-1993, FASB again reviewed the issue of employee stock options.  They reached the same conclusion as in 1988 and received over 450 letters mainly against the proposed change.  Opponents of expensing employee stock options argued that expensing stock options would result in their elimination.[5]  The other concern was that companies’ earnings per share would be significantly reduced by the extra phantom expense. 

            Despite this, Congress and the SEC (Securities and Exchange Commission) applied intense pressure on FASB to change the rule in the early 2000’s.  FASB reasserted its position in 2004 that employee stock options without any intrinsic value should be expensed.  This time, they received over 6,000 letters mainly against the rule.  The critics against expensing stock options included several Nobel Prize winning economists.  In December 2005 FASB implemented a rule, statement no. 123, requiring expensing of options.  Why did FASB implement a rule that went against the wishes of many of their clients?  The accounting profession is supposed to provide financial information for their clients, that the clients believe is useful in running their business.  Unfortunately, most accountants do not work for the people that pay them.  For instance, if you hire an accountant to help you with your taxes, the law has made it clear that the accountant’s first obligation is to the IRS – not to the client paying them.  Today as a result, it is almost impossible to get good tax advice now days.  Accountants preparing the books for a publicly traded company have a greater duty to the SEC than to the company paying their bill.  Other accountants do DOD (Department of Defense) auditing work or Medicare auditing work.  In all these cases the accountant is preparing information for the benefit of a government agency instead of the client.  As a result, many accountants do not consider a company’s goals for their accounting system to be important.   

            Government intrusion into accounting has changed it from a tool for business when making decisions into a government compliance issue.  As a result, some CEOs are suggesting that recent changes in the accounting rules, including those relating to stock options, have made it impossible for them to understand what is happening in their own business.[6]  The goal of accounting should be to measure the financial parameters that businesses find important, not measuring parameters the government believes are important. 

            Does the expensing of employee stock options make sense economically?  Bob Pavey in the November 2002 NVCA magazine points out that employee stock options neither result in a cash cost to the issuing company nor do they result in an opportunity cost.  He shows that there is no cash cost to the company by the hypothetical situation where a company with a thousand shares, grants a thousand shares to a new shareholder.  The company now has 2000 shares, but its revenues, expenses and assets are exactly the same as they were before the grant.  Similarly, granting stock options does not change the cash situation of the company, and the exercising of these stock options does not change the cash situation of the company either.  Since there will never be a cash expense associated with the granting of a stock option, why should companies have include a phantom expense for these options?  According to Mr. Pavey, the company has not incurred any opportunity costs since the company has not foreclosed any other equity sales opportunities.  The justification used by FASB and proponents of expensing stock options is that they have value to the employees receiving them.  If I own the rights to a book with a royalty stream and I assign a portion of that royalty stream to another person, I have not incurred an expense and neither has the book.  The assignment of a portion of the royalty stream has value to the other person, but no expense is incurred because of that transaction.  Expensing stock options does not make sense logically.  This is the same conclusion reached by a UC Berkeley business school position paper in 2006 that was signed by several Nobel Prize winning economists. 

            Another justification given by FASB for expensing stock options is that it would achieve convergence between U.S. and international accounting standards.  Is this a good reason for passing a law/rule?  This reasoning has weakened our patent laws and is used here to again attack the foundations of our high technology start-up community. 

            There is no logical way to determine the value of an employee stock option for a non-publicly traded company.  The Black Scholes model is based on an actively traded market for options.  In addition, this model was designed for options that are freely traded, while most employee stock options have a number of restrictions.  FASB’s solution is to suggest that companies use a lattice model to expense employee stock options.  According to Wikipedia:

a lattice model can be used to find the fair value of a stock option. The model divides time between now and the option’s expiration into N discrete periods. At the specific time n, the model has an infinite number of outcomes at time n + 1 such that every possible change in the state of the world between n and n + 1 is captured in a branch. This process is iterated until every possible path between n = 0 and n = N is mapped. Probabilities are then estimated for every n to n + 1 path. The outcomes and probabilities flow backwards through the tree until a fair value of the option today is calculated. A simple lattice model for options is the binomial options pricing model.

The lattice model is clearly a very complex method of estimating the unknown and the unknowable.  The complexity of expensing stock options has resulted in most start-up companies no longer issuing them.  As a result, the FASB rule on expensing stock options fails the goal of accounting – to measure an entity’s financial parameters without affecting them.  Washington accountants are dictating how businesses can conduct their business with this rule.

            This rule should be repealed.  Employee stock options should never be expensed, even when they are “in the money” at the time of grant.  Stock options should only be taxed when converted into cash.  One of the supposed benefits of an income tax is that liability is only incurred when a person has the means to pay the tax.  Presently, stock options are generally taxed when converted to stock.  This has lead to some disastrous situations where an employee exercises their stock options and incurs tax liability, but shortly thereafter the stock price crashes and selling all of the stock does not even cover the tax liability.  The federal government wants the best of both worlds: to tax non-cash transfers but refusing to accept anything but legal tender.  As long as there are legal tender rules, income should only be recognized when an entity receives legal tender. 

 


[1] Werge, William, Myring, Mark, Schroeder, Joe, “Accounting for Stock Based Employee Compensation: A Continuing Controversy”, Journal of Business & Economic Research, April 2005, Volume 3, Number 4, pp. 31- 38.

[2] Ibid. p. 32.

[3] Ibid. p. 32.

[4] Ibid. p.32.

 

[5] Ibid. p. 33.

[6] Rodgers, T.J., “Corporate Accounting Congress and FASB Ignore Business Realities” Cato Institute Briefing Papers, No. 77, October 25, 2002.

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July 5, 2009 - Posted by | -Economics, -Legal, Innovation | , , , ,

1 Comment »

  1. […] ü       Modeling the term structure of interest … market research, surveys and trends Stock Options – Accounting or Controlling « State of Innovation             Intellectual capital, financial capital and human capital were the three […]

    Pingback by Binomial options pricing model - Topic Research, Trends and Surveys | July 15, 2010 | Reply


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