Study: Option Expensing Will Not Affect Stock Price

April 17, 2003 ( - The stock markets have already factored in the effect of stock option expensing making the effect of mandatory expensing on a company's stock price minimal at worst.

This contention is based on the results of a study that found the median option expense at companies increased to $11.8 million in 2001 from $7.5 million in 1999, while the per employee option expense jumped to $1,032 in 2001 from $763 in 1999 .   Thus, in the current market, an increase in stock option expense has been associated with lower total returns to shareholders (TRS), according to a new analysis by Watson Wyatt of 800 publicly traded companies in the S&P 1500.

“What our analysis found is that the stock market has already factored the disclosed stock option costs into today’s stock prices,” said Ira Kay, national director of compensation consulting at Watson Wyatt. “As a result, stock prices should not be negatively impacted by future expensing for options. Obviously, results for individual companies will vary with their own specific circumstances.”

For example, companies that experienced a 227% increase in stock option expense between 1999 and 2001 saw their TRS decline 15.1% in 2002. On the other hand, those whose option expenses declined 16% over the same period experienced a drop of just 6.7% in shareholder value.

The results are similar to a study by Towers Perrin that examined 103 companies, 60 days before and 60 days after the announcement of stock option expensing. The Towers study 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

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.