Fewer Companies Volunteer Stock Option Expenses

January 27, 2003 (PLANSPONSOR.com) - Interest in option expensing may be on the decline as the number of companies volunteering to expense their employee stock options fell to a paltry seven in November and December 2002.

Compared to the flood of companies volunteering to expense stock options in July and August (89), the past few months have slowed to little more than a dribble.   September and October saw only 36 companies unveiling similar plans, and November and December trickled in only seven, according to a recent study by strategic advisor Oxford Metrica.

The reasons given for the decline were numerous.   The study found companies announcing voluntary expensing of stock options toward the end of 2002 were greeted with much less favorable treatment than the early-birds of the summer.   This trend hints that investor interest in the stock options debate may be slipping a little as investors may have concluded such action now amounts to little more than public relations smoke-and-mirrors, designed to create the appearance of good corporate governance practices.

Other reasons the study found for the lack of willing participants is that many companies are now taking a “wait and see” approach on what new regulations may lie ahead.   Additionally, many companies are simply faced with a lack of reliable, uniform means to arrive at the value of their options.  

Not surprisingly, about 21% of firms whose operating profits would shrink less than 1% have chosen to expense options, but not a single company whose operating profits would be hit by more than 50% has opted to count stock options as a compensation expense, according the study’s findings.  

However, a study by Towers Perrin of 103 companies, 60 days before and 60 days after the announcement of stock option expensing, revealed share performance to be the same on average as the S&P 500 (See   Expensing Options Has Little Effect On Stock Price).   Following the July and August announcements of the companies to adopt FAS 123 option expensing standards Towers found the average stock price did not show any significant change during the 120 trading days surrounding the declaration, even though option expensing had reduced earning per share (EPS) by 10%.

From these results Towers concluded that the economic costs of using options had been known to investors before companies began showing profit & loss (P&L) expenses. 

All For Not

No matter the reason, the dearth of volunteers in the waning moments of 2002 may soon become moot.   Although expensing stock options may not be as hot an issue now as it was a few months ago, the climate for the adoption of tougher accounting rules still remains.   That bodes well for proposals by accounting rulemakers that would make expensing stock options mandatory.

The International Accounting Standards Board (IASB) in November 2002 outlined a proposal that would require non-US companies to treat stock options as an expense by the year 2004 (See  IASB Releases Option Expensing Proposal) .   The splash of such a proposal has sent ripples across the pond as US accounting rulemakers, too, are considering such a move (See  FASB Speeds Up Option Disclosure Effective Date ).

Under current US guidelines, companies can choose to subtract the expense of stock options from their income statements or disclose their theoretical value in the footnotes of their financial statements.   With the exception of a handful of early volunteers and the approximately 130 recent coverts, most companies opt to record the expenses in their footnotes.

Expensing a Problem

One very vocal opponent to the current system sees a very apparent need for an overhaul.   Credit-rating agency Moody’s Inc in the recent publication ” Analytic Implications of Employee Stock-Based Compensation,” says the current accounting treatment of employee stock options has clouded the transparency of US corporate reported earnings over the past several years   (See  Moody’s Calls Out Stock Options ).  

The agency says although stock options are widely used for employee compensation, they are generally not treated as a corporate expense for financial statement purposes by most corporations; making them a cheap form of compensation from the perspective of a corporation’s management.   As an example, Moody’s points out that the aggregate net income of the Standard & Poor’s 100 Composite in 2001 would have been reduced by 16%, had it be adjusted for the fair value of employee stock option compensation; an accounting method Moody’s actively supports by adjusting the financial statements it analyzes on this basis as part of its rating process.

In addition, the agency estimates that the exclusion of stock option compensation expense from reported earnings added about 2.5% to reported annual growth in earnings for the S&P 100 Composite between 1995 and 2001.