The Employee Ownership Update
July 16, 2002
Senate Passes Accounting Reform Bill; Options Not AffectedThe Senate passed an accounting reform bill that makes major changes in accounting procedures but leaves stock options accounting rules untouched. Efforts by Senators McCain and Levin to require expensing options or, alternatively, to require an SEC study of the matter, were denied votes on procedural moves. Neither proposal, had the needed votes to prevail, but a vote was avoided as this was not an issue where every member wanted to go on record opposing options accounting reform. Levin and McCain have vowed to keep up the fight, introducing their amendments to other legislation.
Coca-Cola, Level 3 Communications, and the Washington Post Company Will Expense OptionsMeanwhile, Coca-Cola, Level 3 Communications, and the Washington Post Company have announced that they will expense options. Coca-Cola is taking an innovative approach to valuing the options, asking two investment banks to help determine a price. "We're going to ask each of them for a price to buy 10,000 options and sell 10,000 options, and then we will average those four prices," Coke spokeswoman Kari Bjorhus said. The hypothetical options will have the same features as employee options. Chances are the formula will come in at less than a Black-Scholes approach because the investment bankers can figure in a discount for the lack of marketability of the options (the Black-Scholes formula, commonly used to value options for currently required footnote disclosures, was developed to price traded stock options, not untradable employee options).
IASB Issues Draft Requiring Options ExpensingThe International Accounting Standards Board (IASB) has issued an initial draft proposal to require companies to account for the value of stock options. The proposal would go into effect January 1, 2004. A final version will be put out for comment later this year. The proposal would require companies to value options at the date of grant, but would not require any specific method for determining the value. IASB is a private standard-setting organization based in London with board members from nine developed countries. The European Union will adopt its standards in 2007, Australia in 2005. The U.S. is not bound by these standards, but U.S. companies will now face increasing pressure to expense options.
So Is Expensing Inevitable Anyway?Growing pressure from investors, threats of Congressional action, the push by the International Accounting Standards Board to require options expensing, constant media exposure, the decision by Standard & Poor's to report earnings as if options were expensed, and the increasing practice of the financial press to disclose how options would affect corporate earnings in major companies, all suggest that options expensing may be inevitable. Of course, things can change quickly if the market steadies, corporate scandals decline, executive compensation comes back down to near orbit, if not to earth, and the media goes on to some other topic. But the fact remains that the presence of options expensing in footnotes has made the issue increasingly moot. Investors who want to look at earnings minus options costs just need to make an additional calculation. If that's the case anyway, companies may want to earn brownie points with investors by being more up-front with their accounting.
And If It Is, Then What? Will Broad-Based Options Be Cut?One likely change in options practices that would result from expensing is that there would be more performance-based options. Performance options typically require that some economic condition, such as outperforming the market, be met before an options vests. These kinds of options currently must be expensed, whereas "fixed" options, ones whose vesting is determinate (such as in time-based vesting), do not have to be expensed. Performance options are particularly important for executives, who otherwise are receiving potentially very large amounts of compensation for living and breathing while the stock market goes up even as their own company does not perform exceptionally well.
Another change that opponents of options argue will happen is that broad-based option plans will be reduced or eliminated. Employees, this argument goes, will be the sacrificial lambs thrown to investors to reduce the options expense item. But even in companies that currently grant options broadly, options to non-management employees only account for about 30% of the option value, while options to top executives account for half. So cutting employee options would not have that dramatic an impact. And it would look pretty awful to both the press and the employees. Imagine the headlines: "GreedCo CEO cuts employee options to save his own." On the other hand, companies who have made only a modest commitment to employee ownership through options might well cut back, but the impact of that would be minor because these programs are small to start with. Other companies, facing the tight labor markets demographers expect to redevelop, wanting to maintain "ownership cultures," or just philosophically committed to the idea of ownership will continue to share options broadly.