Stock and Option Expensing, the Bottom Line

A Case of Mistaken Identity

The purpose of recording expenses, in particular, compensation expenses, is to subtract them from revenues and produce a corporate net income, or bottom line. Historically this has been used in all sorts of ways to judge the health of a business and an investment. For just one example, the net income has been an important indicator as to whether a company's cash dividend is secure. If the net income is comfortably larger than the cash paid out in dividends, either in total or on a per share basis, it is unlikely that the dividend payout will be cut in the near future, since investors tend to react negatively to any such cut.

Also historically, these recorded expenses, and the resulting bottom line, have been used to simultaneously measure both the business and the effect on shareholders. As long as all employee compensation was in the form of cash or direct cash equivalents, this presented no problem.

However, as soon as employee compensation started to include either company stock and/or options on company stock, it became no longer true that a single bottom line could simultaneously accurately represent the financial results for both the company and its shareholders. This fact apparently snuck in under the radar as accounting failed to create two separate bottom lines, one for the business and one for the shareholders. It was assumed by default that the bottom line for business and the one for shareholders was a single identity.

To easily see that this cannot possibly be correct, imagine that the government applies an annual shareholder ownership tax of 1%. For every 100 shares owned, the shareholder must give the government one share each year. While this undoubtedly negatively impacts the shareholder, and both reduces his return on investment and affects his investment choices, it is inconceivable that this tax should be applied to the company itself in any way, or that it has any relevance for the business performance of the company itself.

But the end effect of granting company shares and/or options to employees is to reduce the ownership percentage of existing shareholders. But this is also the effect of the imaginary government shareholder ownership tax. For every specific case of grants of shares or options, the effect on shareholders could be precisely matched by a particular choice of rate of the government shareholder ownership tax. It thus seems only logical that, in both cases, two separate bottom lines must be calculated and reported.

If the option expensing controversy were really a question of accuracy and transparency in accounting, then it would seem to be a simple matter to simply report both bottom lines, giving everyone pretty much what they claim to want. No one, however, is naive enough to believe that.

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For every specific case of

For every specific case of grants of shares or options, the effect on shareholders could be precisely matched by a particular choice of rate of the government shareholder ownership tax

"Precisely matched" is going a little too far. The difference is small, but there is a difference between the government and the employees having the new shares. For example, if an employee has the new shares, the marginal benefit of them doing a slightly better job at work has now gone up by a tiny fraction of a percent. (Because it increases their salary potential exactly the same, but they share a smidgeon of the effect on the company's bottom line). Going beyond the purely rational model, this may have psychological benefits in terms of making them feel like part of a team since they share in the profits, and make them happier with their job.

But I agree with you in general, I just think you've gone a little too far in stating an exact equivalence. (Us mathematicians are anal about these things) The tax is a good thought experiment.

Patri, Thanks for the

Patri,

Thanks for the comment, and I agree. Precise was intended in the sense of the degree to which the financial accounting performance of the company proper is passed along to shareholders.

Regards, Don

Swoosh!! (went straight over

Swoosh!! (went straight over my head)

Right idea, but way too

Right idea, but way too oversimplified. Here's my take: http://www.techcentralstation.com/080703D.html

Here's a short version:

The big problem with options is that no dollar amount will be right.

Call options, by there very nature, grow less valuable every day unless and until the stock price goes up (or grows more volatile). But unless and until they are exercised, options have no impact at all on shareholders. The dilution of current shareholders can only be calculated accurately upon exercise, which may be years after the grant.

Any figure recorded as an expense in the year of issuance will be wrong, often by a huge margin.

At the heart of the issue: Is disclosure alone adequate, or do investors want to see management's estimates of the dilution on net income?

This estimate, BTW, is a fiction. Diluted shareholders get smaller slices of a big pie. Expensing attempts to show the same sized slice taken from a smaller pie.

To the extent that companies

To the extent that companies depend on the options grants to attract employees, the situations don't seem parallel. (And to the extent that the companies don't depend on this, then why the big fuss?)

Consider two companies, each with a corporate gross income of $100M, and each with costs-other-than-payments-to-employees of $80M; but there the parallels end, because the two companies use completely oppositely extreme strategies for compensating workers.

Company A needed to convince 80 people to work there in order to run their operations, and did so by paying a total of $10M in cash.

Company B needed to convince 150 people to work there in order to run their operations, and did so by giving out stock options worth a total of approximately $40M. Furthermore, an omniscient angel on loan from God Almighty has determined that in order to hire 150 comparable people for cash, the company would have needed to pay at least $21.5M.

As I understand it, your "bottom line for business" figures say that company A made a $10M profit last year, and that company B made a $20M profit last year. If that is incorrect, could you clarify? Or if it is correct, would you like to say a few words about in what meaningful sense company B was more profitable than company A? Otherwise, it seems to me that your "bottom line for business" figure might be more useful for accounting sleight of hand (moving labor costs into a category which one claims is not a cost, presto!) than for measuring business performance.

Other problems with

Other problems with expensing options are (1)the recognition of an accounting expense will never result in a corresponding cash outflow from the company. In fact, the opposite is true to the extent the option is execised as the option price represents a cash inflow to the Company, and (2) The comparability between companies is distorted because of the inconsitency of applying the Balck-Scholes model, e.g beta factors.

Other problems with

Other problems with expensing options are (1)the recognition of an accounting expense will never result in a corresponding cash outflow from the company. In fact, the opposite is true to the extent the option is execised as the option price represents a cash inflow to the Company, and (2) The comparability between companies is distorted because of the inconsitency of applying the Balck-Scholes model, e.g beta factors.

Stephen, I like your post at

Stephen,

I like your post at TCS, but it doesn't go far enough either.

"...Options affect shareholders' equity, not profits. Indeed, that is exactly how options have been reported for years. So expensing options is a lie, basically. It is merely an attempt to ignore the new slices and depict a smaller pie shared among the pre-option crowd...."

This is also true for stock grants, but the lie in their expense has been the status quo for years of accounting practice.

"The basic argument in favor of calculating and reporting stock options as an expense says that people are willing to forego some cash compensation in exchange for stock options..."

It is a fundamental fallacy of popular economics that things voluntarily exchanged for one another have equal values. This is of course absurd, as things exchanged MUST have reverse-ordered subjective values for the two traders. I'm sure that I have things that no longer have any value to me that you might value if I offered to give them to you.

However, in the case of stock and stock options, the problem is not so much different valuations, but that the REAL expense impacts the shareholders, and not the company proper which they collectively own.

Regards, Don

Bill, It is a pernicious

Bill,

It is a pernicious belief that proper accounting should treat two unique companies comparably on a line for line basis. What is important is accuracy for the company under consideration.

The accounting function is paid for by existing shareholders of a given company, either a public or private company. If potential investors want a computer database that pretends to reduce all companies to a single number, they should be the ones to pay for it, rather than compromising all company reports.

To be sure, a real problem exists as companies abuse both stock and option grants, but expensing is an absurd pseudo-solution. It is the buyback of stock at any price to mask and offset visible ownership dilution that needs to be dealt with.

Imagine a company that pays only cash wages, and pays out all of its profits in dividends, and its yearly results are absolutely constant into the infinite future.

This company can be fundamentally valued by choosing a discount rate and summing the infinite geometric series of dividends to be paid out. For a 5% discount rate, and the first dividend payment of $1M total starting this afternoon, the present value of the total company would be :

$1M + $1M(0.95) +$1M(0.95 X .095) + ...

which is equal to $1M/(1 - 0.95) = $20M.

If there existed 1M outstanding shares, the present value of a single share would be $20.

If the company increased its cash wages, the profits and the dividend payouts would be smaller, and the total present value of the company would also be smaller, as would be the per share present value.

However, if the company instead granted shares to employees, the present total value of the company would still be $20M as all the payouts are unchanged.

The effect of the stock grants is to spread the payments out over more recipients, reducing the payouts per share (more shares).

For example, if the company granted enough shares each year to double the number of outstanding shares, then every per share cash dividend would be reduced by 50% from the previous year.

Thus the present value of a single share can be represented by an infinite geometric series using a ratio that combines the 5% discount rate and the 50% annual ownership dilution rate.

For a single share, the geometric series would be :

$1 + $1(.95 X .5) + $1(.95 X .5)(.95 X .5) + ...

or $1/(1-0.475) = $1/(0.525) = $1.90476.

As shown above, to calculate the present total value of a company, all you need to know is the future cash payments and the discount rate. If stock or option grants are made, you additionally need to know the annual rate of ownership dilution to calculate the present value of a single share.

NOTE: The rate of ownership dilution that must be used is the rate that would result in the absence of any share buybacks. Buybacks reduce the share count, but use up cash that otherwise would be paid out in the dividends.

Trying to convert the grants to a company expense leads only to garbage.

Regards, Don