The Declarer (Floyd McWilliams' Blog)

Sunday, March 07, 2004

An issue of importance to the tech industry is whether stock options granted to employees should be recorded as expenses -- the current legal position is that they are not expenses, though some companies such as Microsoft have chosen to expense them voluntarily. Today in the San Jose Mercury News opinion page, three people wrote letters advocating that stock options be expensed. If these are the best arguments that the pro-expense side can muster -- and they do seem fairly typical of what I have seen elsewhere -- then it would appear that the pro-expense faction has a very poor case.

The commentary on stock option accounting by executives at Intel, Cisco and Sun (Opinion, March 1) principally justified its arguments on the basis that these companies offer ``broad-based'' stock option plans. But no description of how these plans are broad-based was provided. If those plans are like most in the Valley, stock option grants are extremely skewed, as a percentage of base salary, toward the top level executives.

Perhaps a law needs to be passed to force companies to really offer ``broad-based'' stock option plans in return for an exemption from stock option expensing. One way to do that is to require that a 401(k)-type discrimination test, applied to stock option plans, be met (ratio of stock options granted to base salary for the higher paid group cannot be different by a fixed amount from the same ratio for the lower paid group). The public should favor this law, as it would perceive it to provide for a more equitable allocation of option grants between all classes of employees.

Bob Roston
San Mateo

The debate over stock options concerns what large corporations report to the owners of their stock. Whining about rich people in this context is silly. Is there some accounting scheme under which corporate executives would not make vastly more money than ordinary employees?

So Roston wants to make expensing of stock options conditional upon implementation of various reforms advocated in Das Capital. Well that is exactly what I want as an individual investor! I can compare companies ABC and XYZ, and purchase ABC because XYZ's financials are inferior. Later I find out that XYZ had different accounting standards than ABC, because XYZ did not believe that it was as important to retain receptionists as it was to keep their CTO.

The arguments against expensing stock options by CEOs Craig Barrett, John Chambers and Scott McNealy (Opinion, March 1) were all too predictable.

Nobody can deny that stock options are a valued form of compensation. As a form of compensation, with a real cost to companies, they should show up as an expense on the income statement, just like salaries.

Unfortunately, the current accounting for stock options hides their cost, giving investors the illusion that many companies, particularly tech companies, are more profitable than they really are. Of course, to a CEO, stock options are the next best thing to a free lunch. They provide the perfect vehicle for companies to pay (and often wildly overpay) their CEO, the board, the senior staff, and regular employees without the real cost of doing so showing up on the income statement.

Eugene Shekita
San Jose

Certainly stock option grants are valuable forms of compensation. But are they forms of compensation which represent expenses for the company? The one does not necessarily imply the other. Consider that my employer recently named a "Quality Employee" of the year. This was compensation -- the employee was certainly gratified to be recognized as a key performer -- but it did not cost the company money.

Microsoft employees enjoy the benefit of discounts on Microsoft software. This is a form of compensation, but I would be very surprised if it appeared on Microsoft's books.

Shekita's assertion that options have a "real cost to companies" is the exact opposite of the truth. I am due to vest options next month. Let's say that I exercise 1000 options at $3 each. I will write a check to my employer for $3000. How is this a cost? Option grants affect shareholders by diluting their holdings, and shareholders are not informed as to the extent of the dilution by reading a balance sheet that shows increased expenses.

Craig Barrett, John Chambers and Scott McNealy make the mistake of equating options with employee ownership. Options, in fact, are not a form of ownership. Owners have real assets at risk. Those with options only exercise them if and when the stock value goes up. Often, they only own the stock momentarily on the day they cash out. And if the stock value goes down, options holders can walk away having lost nothing.

Options create a distorted incentive to boost stock price in the short-term by any means, legal or otherwise. Genuine employee ownership, on the other hand, creates incentives to build long-term value in ways that are good for employees, companies, and the broader community.

David Smathers
San Jose

It is true that corporate employees are free to sell their options. But they are also free to sell anything else that they own. A homeowner is free to sell his house whenever he feels like it; does that mean that public policy designed to promote individual home ownership is a fraud?

Now it is true that stock option grants allow employees to choose a time when they can buy and sell their stock. But how is that significantly different from me deciding to sell other stock that I own because I think it is at a high? And short-term gains are taxed more heavily than long-term gains, so employees have an incentive to acquire and hold their stock, rather than make a quick sale.

Smathers says that stock options encourage their holders to "boost stock price in the short-term by any means, legal or otherwise." This is true, but hardly profound. Any other metric of performance would encourage short-term manipulation of that metric. We focus on the short-term because it is hard to predict the long-term. (It's a good thing, in this context, that option grant holders can choose when to exercise their options. If they could cash in only on a specified date, there would be more incentive to manipulate the stock price.)



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