Moody's Calls Out Stock Options

December 30, 2002 ( - Credit rating agency Moody's has released a new report pointing out current, and potential future flaws, in the way stock options are issued, monitored and accounted for.

The report, “Analytic Implications of Employee Stock-Based Compensation,” authored by Dagmar Silva and Patrick Finnegan, says the current accounting treatment of employee stock options has clouded the transparency of US corporate reported earnings over the past several years,

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. “Irrespective of the guidance in generally accepted accounting principles dealing with this subject, Moody’s will analytically take such costs into consideration when evaluating the quality and consistency of an issuer’s earnings and cash flow,” Silva says.

Interests Aligned?

Moody’s points to two corporate governance implications related to the widespread use of stock-based employee as a form of compensation.

The first is the increasing tendency for companies to purchase their stock in the open market to offset the potential dilutive effect the exercise of stock options can have on reported earnings per share.

According to Moody’s, stock buyback programs can represent a substantial commitment of economic resources that could otherwise be used for debt reduction or reinvestment in the business. “Large share repurchase programs could therefore have a negative impact on credit ratings. In Moody’s opinion, share buybacks should be driven by a firm’s capital needs, not as an adjunct to employee compensation.” Finnegan says.

Second, Moody’s questions the extent to which stock-based compensation plans have been successful in aligning the interests of management, employees, and other stakeholders. “When the vesting period is short and options are a substantial component of compensation that is not tied to long-term performance criteria, for instance, management’s interests may differ from those of the company’s other shareholders,” Finnegan says.

In addition, the decline of a stock’s price below the option’s exercise price can create a dilemma for management, who must then decide whether to modify option terms or risk losing key employees.

Therefore, Moody’s sees the potential for option re-pricing to be perceived as rewarding employees for failed performance.

Cash Flow

Anther corporate governance issue Moody’s sees is the use of options, a non-cash resource, for employee compensation to have potential beneficial effect on operating cash flows. For example, some option programs are allowed, under current tax laws, to deduct from their taxable income the difference between the exercise price and the market value of the options on the option’s exercise dates.

Also, other companies are permitted to realize cash benefits related to the exercise of some kinds of stock options irrespective of the accounting for GAAP purposes. The benefit from the deductibility of options is reflected as a reduction in the company’s tax liability, which is reported as an element in the cash flows statements.

“We estimate that some companies in the S&P 500 realized more cash benefits related to the exercise of stock options than they did from their actual operations in 1999 and 2000,” Finnegan says.

On the Horizon

However, Moody’s believes change may be in the air and that the Financial Accounting Standards Board (FASB) will reconsider whether the US companies should continue to have two alternatives for accounting for employee stock options. The agency says that if such as change is adopted, it will likely require the use of a fair value approach. “Several recent corporate scandals and heightened investor demand for more transparent financial reporting have precipitated such a change,” says Silva.

The FASB might very well be following the lead of the International Accounting Standards Board (IASB), which is on course to require the expensing of options and recently issued an exposure draft that would require the expensing of all equity compensation awards using a fair value approach at grant date. Proposed standard implementation would begin in 2003.

Also, the agency says it appears as though at least some US companies are beginning to agree as over 150 companies have recently announced their intentions to prospectively adopt such accounting standards.