Point of view: Expensing employee stock options is Improper accounting

California Management Review

Volumn 48, Issue 4, 2006, Pages 136-156

  Hagopian, Kip ^a  

^a Brentwood Associates

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EID: 33748424689     PISSN: 00081256     EISSN: None     Source Type: Journal    
DOI: 10.2307/41166364     Document Type: Review

References (11)

1. The allocation of 20% of the profits of a hedge fund or venture capital partnership is the exact economic equivalent of granting the investment managers a non-transferable option on 20% of the partnership's assets at cost. The limited partners of a partnership are conceptually identical to the shareholders of a corporation and the assets of an investment partnership are economically the same as the assets of a corporation.
2. Note that value is not actually transferred from shareholders to employees; rather the share-holders' gain is shared between shareholders and employees at the time it is created. The term "value transfer" is used herein to describe the amount by which the shareholders' gain is reduced as a result of dilution.
3. This assumes that the employee and the corporation have the same combined federal and state tax rates. When an employee exercises an ESO, the employee incurs a taxable gain. On the other side of the transaction there is a tax deduction, which is taken by the corporation on behalf of its shareholders.
4. The title of FAS 128, "Earnings Per Share," is a misnomer because it implies that the TSM's only purpose is to calculate diluted EPS. In fact, the TSM's primary function is to calculate dilution. Dilution not only reduces the shareholders' claims on corporate earnings, but on assets, equity, and market value as well. The TSM is used to determine the impact of dilution on each of these categories.
5. This accounting convention is flawed because it includes even ESOs which are not vested. As a result, the TSM overstates dilution, thereby overstating the amount of the value transfer and understating earnings per share.
6. In mark-to-market, exercise-date accounting, the full spread in the option is reflected as a cost if, as and when it occurs (pro forma). In contrast, the FASB's approach is to use a complex model to value the option at the time of grant (which is a calculation of the discounted present value of the expected spread), and then expense that amount over the vesting period, regardless of whether the cost ever actually occurs.
7. Consider a case in which a large number of ESOs are granted and the granting entity is liquidated prior to any appreciation of the stock underlying the options. Would the value of the assets distributed to the shareholders be any different as a result of the grants? The answer, of course, is no.
8. In our opinion, ESOs, like bonuses and sales commissions, are not granted for services, per se. but are incentive compensation instruments that are granted for the purpose of achieving a particular result, specifically, employee retention and shareholder stock appreciation. The rendering of services is a necessary but insufficient requirement for achieving that result. Therefore, the cost of an ESO, like a bonus or a commission, is contingent upon that result being attained, and not simply on the rendering of services.
9. ESOs are also granted to members of the board of directors and to consultants. The essential criterion for grant is that the individual have an ability to affect positively the market value of the granting entity.
10. The absence of a realizable call premium does not mean that the ESO has no value to the holder. There would still be an implicit call premium, which is the discounted present value of the holder's expected gain. By the same token, shareholders in a company that has issued ESOs should incorporate an estimate of future dilution (and the amount of the corresponding value transfer) for the purpose of projecting their net gains.
11. Appendix 2 contains excerpts of the anti-expensing arguments made in 1993 by five of the "big six" accounting firms (Arthur Andersen is excluded). To our knowledge, there have been no changes in accounting concepts since 1993 that would challenge these arguments.