CSFB: Options Should Be Reported As A Liability

The CSFB analysts, though, do not disagree that stock options are an expense and should be recognized in the financial statements. Rather the two take issue with the methodology that was proposed.   In their view, employee stock options should be reported as a liability on corporate financial statements, with changes to the fair value of option grants running through earnings,  according to their June 14 research paper “The Cost of Employee Stock Options.”  

Under the FASB’s Exposure Draft issued on March 31, all forms of share-based payments to employees would be treated the same as other forms of compensation by recognizing the related cost in the income statement. The expense of the award generally would be measured at fair value at the grant date (See  The Bottom Line: Expensing Proposition ).

The hook of the CSFB research paper is in valuing how employee stock options are exercised.   Under most stock option arrangements, a company is forced to sell shares of stock at less than fair value when employees chooses to exercise their stock options.   Thus, the ultimate cost of the options depends on the stock price at the time of exercise. At that point the cost is simply how much the options are in the money, or put differently, the difference between the stock price and the strike price.

At the time of the option grant, however, a transfer of wealth took place from the shareholders to the employees. Therefore, the employee stock options that are outstanding have a claim on the shareholders’ stake in the company.   “Shareholders can, therefore, view that claim as similar to any other claim on the firm’s future cash flows. We would treat that claim as a liability,” Zion and Carcache say.

“That is the same way that the FASB plans to treat certain types of share-based compensation, like cash-settled Share Appreciation Rights (SAR),” the research paper states.

SAR Example

To better illustrate their point, Zion and Carcache provide the following comparison in their report:   A company grants 100 options to an employee with a $10 strike price.   The employee pays $1,000 for 100 shares that are worth $2,500, which would provide a profit of $1,500.   Likewise, a company agrees to pay an employee the appreciation on 100 share of stock above $10 per share, in what is referred to as a cash-settled SAR.   The employee exercises the SAR when the stock is at $25 and the company writes the employee a check for $1,500, in which case the employee’s profit is $1,500.

“The profit to the employee and the cost to the company are the same in both instances;

the only thing that is different is that the profit/cost take different forms: one is paid in cash and the other in shares; economically, they are the exact same thing,” the report finds.

Zion and Carcache realize in the current environment, such an accounting treatment of stock options would be difficult, due to how the accounting rules define equity and liability.   Under current rules, stock-option pay is defined as “equity” – because companies pay option holders in stock, not in cash. If the pay were in cash, it could easily be treated as a liability.

“In effect, we want the FASB to come up with a new definition of liabilities,” the research paper states.

The CSFB analyst though do not think such an idea is far-fetched or revolutionary.   Pointing to their September 2002 report “The Magic of Pension Accounting,” the two analysts say they have applied the same process to defined benefit pension plans.   Additionally, the analysts see promise for their proposal in another FASB project – codifying the definition of liabilities and equities.   Results of that project are due out in the first quarter of 2005.

“There is still the possibility that as part of that project employee stock options will be treated as a liability, in the same manner that we have proposed,” the paper says optimistically.