Expensing Employee Stock Options Looks Like a Major Mistake
About This Event

Since Enron, public officials and others have urged the Financial Accounting Standards Board to require that companies place a value on the stock options they grant to employees and treat that value as an expense in computing their earnings. The FASB has responded with a commitment to impose this requirement for financial statements beginning in the year 2005. It now appears, however, that there is no accepted method for establishing the value of employee stock options, which are long-term contracts with many variables and contingencies. Most observers agree that the Black-Scholes model, which values short-term options and which the FASB initially preferred, is inadequate to value employee stock options. Other models have also failed to provide sufficient specificity.

Two papers that will be presented at this conference argue that it would be questionable accounting policy to require the expensing of employee stock options without an accepted and adequate method for doing so and could subject companies using different valuation methods to substantial litigation costs. The authors contend that the FASB should abandon the effort to expense stock options until a satisfactory method of establishing their value has been developed.

Agenda

10:45 a.m.
Registration
11:00
Introduction:
Kevin A. Hassett
Panel I: Modeling the Value of Employee Stock Options
Presenter:
Charles W. Calomiris, AEI and Columbia University
Discussant:

Deen Kemsley, Columbia University

Moderator:
James K. Glassman, AEI
12:15 p.m.
Panel II: Accounting Issues
Presenters:

< P>Kevin A. Hassett, AEI
Peter J. Wallison, AEI

Discussants:
Paul Atkins, Securities and Exchange Commission
George Benston, Emory University
Moderator:
James K. Glassman, AEI
1:00
Adjournment

Event Summary

January 2004
Expensing Employee Stock Options Looks Like a Major Mistake

On Thursday, January 8, 2004, AEI hosted a conference evaluating the upcoming decision by the Financial Accounting Standards Board on whether to expense employee stock options.  While the FASB has responded with a commitment to impose this requirement for financial statements beginning in the year 2005, there is no accepted method for establishing the value of employee stock options, which are long-term contracts with many variables and contingencies. The two papers presented at this conference argued that it would be questionable accounting policy to require the expensing of employee stock options without an accepted and adequate method for doing so and could subject companies using different valuation methods to substantial litigation costs. The authors contend that the FASB should abandon the effort to expense stock options until a satisfactory method of establishing their value has been developed.

Charles Calomiris
AEI and Columbia University

The prospective benefits of any change in FASB are not significant.  Discussions about accounting standards need to take a reality check on the way markets actually function.  Financial economics valuation theory is about free cash flow and appropriate discount rates, not about earnings in general or earnings per share.  Accounting standards may have been useful when information was transmitted in paper via a postal system, but now a push of the button on your PC can switch from GAAP to IAS.  Accounting standards are largely irrelevant. Competition among ways of defining concepts (by competing financial analysts) will increasingly guide the way information is reported in the future.  This is where disclosure gains importance. Finance theory suggests that the costs of bad standards are minimal. But to the extent that there is any reliance on accounting standards, noisy standards may distort investors' decisions. Better to tell unsophisticated investors that they have an incomplete picture-that valuation is not the same as accounting-and encourage them to rely on experts' recommendations or even better, buy index funds. Errors do occur when accounting standards are imposed on stock options.   For example, the cash equivalent cost of equity is not one to one due to external finance costs.  The illiquidity of options is also misleading.  Illiquidity discounts can be large, and customization of stock options increases illiquidity.  Nevertheless, the Black-Scholes method of accounting for stock options assumes perfect liquidity.  Lastly, employees exercise their options differently. The "just do it!" approach doesn't make sense, despite the fact that proponents are right that stock options are a hard-to-measure cost. The fact that stock options are a real cost does not mean that this cost should be addressed through GAAP rules. There are lots of similar valuation problems (real options, contingent assets and liabilities of firms), and we deal with those complex valuation problems through financial market analysis, not accounting standards. Accounting probably does not matter very much, but to the extent that it does, misstated costs will distort securities purchases and firms' investment decisions, and harm small, growing firms the most. Focus on disclosure, and think "information age."

Deen Kemsley
Columbia University

The Calomiris/Hubbard paper insists that a firm's value is a function of future cash flow, not accounting.  However, the correlation between current accounting earnings and future cash flow is much higher than the correlation between current cash flow and future cash flow.  Therefore, the analysts and investors often use current earnings to begin assessing future cash flow. Whether it is through the financial statements or not, managers typically use accounting conventions to communicate their inside information regarding complex transactions.  While it is true that analysts compete by developing their own accounting conventions, even the analysts are not perfectly efficient.  Therefore, the regulated accounting standard still has a potentially important role.  As I see it, GAAP already requires firms to disclose the stock option expense in footnotes.  Therefore, as Calomiris and Hubbard argue, there could very well be little benefit from booking the expense in the income statements.  Furthermore, if there is significant measurement error and/or discretion in the recorded expense, booking the expense could actually be more misleading than simply footnoting it.  It is very difficult to estimate the value of employee stock options because they are illiquid, inherently volatile, and shadow costs decrease the real cost of an option.  In conclusion, booking stock option expenses will increase discretion over reported earnings through estimated volatility and exercise dates.  Booking stock option expenses will also increase "noise" in reported earnings through problems with the Black-Scholes formula in this context.  This noise would vary across firms.  In some ways, at least, I believe it is clear that expensing employee stock options could be a major mistake.  It makes science out of an art.

Panel II:  Accounting Issues

Kevin Hassett
AEI

In options modeling we observe the share price moving through time, and then we fit models to history, specifically how the price has changed in the past, and refer back to these models to determine how it will act in the future.  The Black-Scholes model assumes a geometric/Brownian motion, which is a continuous time version of the simplest model.  For example, if a particular share is trading at $10, then the geometric/Brownian model would say that this share's price would go up a penny a day, and then you add a variance.  The problem with this model for stocks-though convenient mathematically-is that over time there are periods when stocks are really variable and other times when it is more stable.  Deen suggested that you can select the time frame, but the problem with that, as indicated in financial literature, is that variance shows up everywhere.  The fact is that there is not one variance to fit.  My own guess is that we will end up using non-parametric methods where we do not say it is a normal distribution, but we approximate with non-linear methods.  The fact is that for any specific firm, we know that Brownian motion is wrong, we just do not know how it is wrong.  It is not that we cannot find an answer to fit one company, it is that we cannot find an answer to fit all companies.

Peter J. Wallison
AEI

The Hassett-Wallison paper says that, taking it in its accounting merits, it is not good policy to require the expensing of employee stock options. There are many good reasons for not expensing options that have been part of the debate in Washington: differential effect on small, growing companies; reducing management incentives; and discouraging companies from going public. However, this paper will only deal with the question as an accounting matter-where it also fails.

The principal reason that expensing stock options is not good accounting policy-as explained in the Calomiris-Hubbard paper-is that there is no way to place a consistent value on employee stock options. As a result, while everyone can agree that these options have some value, there is no consistent or reliable way to estimate what that value is. Under these circumstances, including an estimate of this value in Earnings per Share (assuming it has any value) will distort this number. As the Calomiris-Hubbard paper points out, there can be many different outcomes to the valuation question, none of them necessarily correct. From an accounting standpoint, this raises the fundamental question of whether there is any limit to the use of what is called "fair value" accounting. From its inception, accounting has relied on real numbers-transactions, costs, and market prices-to establish values. In recent years, as more and more productive assets were intangible assets, the cost of assets has become less any less relevant. The market value of S&P 500 index has been six times book value. Accounting theorists have encouraged companies to value these assets at "fair value," so that their balance sheets would bear a closer relationship to their actual market value. Fair value is usually defined as what a willing buyer and willing seller would pay for an asset. But where there is no market, it is permissible to estimate fair value. Unfortunately, as shown by Enron, leaving this judgment to management and auditors can have serious adverse consequences. Part of the fraud in Enron consisted of management's wildly distorted "fair value" assessment of some of the company's contracts. Thus a key question for the FASB and for policymakers generally is whether there are any applicable standards for the use of fair value accounting. Fair value is the underlying idea behind placing a value on employee stock options.

Most of those who have argued that employee stock options should be expensed probably believed that it was possible to use a formula or model of some kind to establish this value. The Black-Scholes model was frequently cited for this purpose. If this had been true-if the Black-Scholes model worked to value employee stock options-then using it to estimate the fair value of this expense would have been possible. However, as the Calomiris-Hubbard paper points out, Black Scholes does not work for long-term options such as employee stock options. In September, the FASB seemed to recognize this. Although it reaffirmed its intention to require expensing of stock options, it withdrew its endorsement of the (Black-Scholes and so-called binomial) models as a way of making the estimate. Companies were advised that "the use of any specific option-pricing model would not be precluded." In other words, companies were not given any guidance about what would be a suitable model. If FASB cannot find a model, how can companies?

So the question comes down to this: does it make sense to require a fair value estimate of the expense associated with employee stock options when there is no agreed-upon way of making such a valuation? Our answer is no. Allowing companies to choose a complex model that will produce different outcomes depending on the assumptions that are used will be inconsistent with three key accounting goals-reliability, consistency, and comparability. The result will be unreliable because the estimates will be completely uncertain-basically pulled out of thin air-and will produce inconsistency because models will change over time as the technology improves, and companies will adopt different models that will produce different outcomes. The results will reduce comparability because companies in the same industry will adopt different models from one another.

What are the arguments in favor? First, there is no doubt that employee stock options have some value. Failing to account for this value ignores a part of the real costs of the company in producing its earnings. So proponents of expensing can argue that, from the standpoint of the accounting concept of conservatism, it is better to reduce EPS by some amount-no matter how uncertain-than to leave the number blank. These arguments seem very thin when weighed against the damage expensing would do to the credibility of financial statements' reliability, consistency, and comparability.  As significant would be the litigation costs. Without an agreed options pricing model, companies would be sitting ducks for plaintiff's bar. No company could ever be sure that its model was accurate. Earnings could be overstated or understated. It seems to us that the sensible result is for FASB to defer requiring the expensing of employee stock options until it or others have developed a satisfactory options-pricing model for employee stock options.

Paul Atkins
SEC
A transcript of Paul Atkins' comments may be accessed at http://www.aei.org/events/filter.all,eventID.710/transcript.asp.

George Benston
Emory University

Both papers strongly criticize the use of the Black-Scholes model.  The Hassett/Wallison paper cites other papers for their reasoning, while the Calomiris/Hubbard paper specifically relies on underlying asset returns, negative autocorrelation, and the ability of employees to exercise their options at different times.  The Calomiris/Hubbard paper also points out that the value of options compared to cash payments differs, because the cost of new stock issues varies considerably among companies.  There are reasons not to expense stock options that were not mentioned by either paper.  Options are valuable incentives, particularly for companies with growth options.  Expensing could discourage the use of options.  Lastly, options really are costless to shareholders:  If stock price goes up, employees and shareholders benefit. If stock price declines, shareholders benefit from not having paid employees in cash.  Therefore, expensing options could be harmful to the economy.   Employee stock options definitely constitute an expense that is no different conceptually than a cash payment or payment in goods.  The essential accounting issues are the amount of total expense and the allocation to revenue over time.  The bottom line is that zero is a number-it is not preferable to an estimate. 

AEI staff assistant Jessica Browning prepared this summary.

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AEI Participants

 

Charles W.
Calomiris

 

Kevin A.
Hassett

 

Peter J.
Wallison
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