Share options and executive pay

["Ulhas Joglekar" <joglekarulhas@xxxxxxxxxxx>]

Economist.com

Share options and executive pay

Coming clean on stock options

Apr 25th 2002 | NEW YORK
>From The Economist print edition

Is there no accounting for them?

OF ALL the accounting problems highlighted by the collapse of Enron, the one
that would seem easiest to put right is the reporting of employee share
options. These days they make up a huge slice of pay, particularly for
senior management. Last year, stock options accounted for 58% of the pay of
chief executives of big American companies. Yet the cost to the company of
providing these options is typically not deducted as an expense when it
calculates its profits. As a result, reported profits are misleadingly high.
Although the extent is debatable-the Federal Reserve reckons that it comes
to about 2.5 percentage points a year between 1995 and 2000-the
overstatement is not in doubt. So, what could be simpler than to require
companies to treat share options as an employment cost?
A fierce lobbying effort by the world's biggest companies is under way
against attempts to make this happen. It will probably succeed, just as it
did when similar reforms were proposed in 1994. A bill introduced by
Senators John McCain and Carl Levin, which seeks to remove the tax
deductibility for options not counted as expenses, has little chance of
succeeding.
Currently, firms count options as a cost when they calculate their profits
for the government, but not for their shareholders. The Financial Accounting
Standards Board, which sets the rules for American accounting, seems
unlikely to act any time soon. Its chairman is to step down at the end of
June, and its future shape and status are both in doubt in the light of
Enron. A move to introduce a charge for options under International
Accounting Standards, the chief international alternative to America's
accounting principles, also faces intense lobbying, including from the
European Commission.


Principles v greed
Those who oppose the expensing of share options thus seem to be winning.
What are their arguments, or are these little more than a fig-leaf to cover
executive greed?
Their first point is that the accounting treatment of options did not play a
significant role in Enron's collapse. True, up to a point, but beside the
point. Compared with the use of off-balance-sheet vehicles, the distortion
to Enron's profits from non-expensed share options was small. Hardly a
reason not to make a sensible accounting change, though, and if Enron's
failure provides the spur, fine.
A more interesting argument is that the theory of efficient financial
markets does away with the need to expense options. Efficient-market theory,
at the heart of so-called modern financial economics, argues that a share
price accurately reflects all available information relevant to the value of
a company. Thus, provided all the information necessary to calculate a
firm's true profits is disclosed, it does not matter what the firm reports
as its profits. Even if a firm ignores the cost of options when calculating
its profits, the market will not.
One problem is that economists have identified weaknesses in the
efficient-market theory. Arbitrage does not work as it should. Investors who
know the true value of a share do not necessarily drive out investors who
are ignorant. The psychological biases of investors appear to affect share
prices. Markets, in other words, are not truly efficient-and shareholders
may be misled by reported profits that exclude the cost of options.
On the other hand, if markets really are inefficient, those who fear that
investors might turn against the use of share options once they are expensed
may also be right. Options are said to be particularly useful as an
incentive for start-up companies that have little cash but want to give
employees a big carrot to make the firm succeed. Expensing options may dent
profits severely or (more likely) increase losses at a time when start-ups
are struggling to succeed. This could make it harder to raise the capital
that small firms need to grow.
On the other hand, start-ups tend to have more sophisticated investors who
are less likely to be misled by accounting. What is more, the process of
going public provides an excellent opportunity to explain to investors what
the accounting numbers really mean. On balance, if markets are inefficient,
the benefits of expensing options probably outweigh the costs.
The National Venture Capital Association argues that expensing options would
actually make accounting profits more misleading, however. First, a cost
would be shown for many options that are never exercised. This is certainly
true if the share price falls below an option's pre-determined strike price.
At the very least, though, issuing an option involves the risk of a cost.
And, exercised or not, the option has a value to those who were awarded it,
in the same way that a lottery ticket has value. Accounting for this is
tricky. But since most options are eventually exercised, the cost should
still be charged against profits at some point.
Second, says the association, the theoretical problems of valuing options
means that any number expensed in the accounts is "arbitrary at best".
Again, there is something to this. Work on the impact of share options by
Smithers, a British research firm, uses three different valuation methods.
One is the value of options issued during a given accounting year: this can
be calculated using the Black-Scholes model of option pricing. Another is
the cost of all outstanding options if they were "immunised" by the company
buying identical options in the market. The third is "full cost": the change
in the value of all outstanding options, plus the cost of those exercised
during the year.
These three methods yield rather different results. In 2000, according to
Smithers, the first suggested that charging for options awarded would have
reduced reported profits amongst 325 large American firms by 17.1%. The
second method would have reduced them by 21.6%. The full-cost method would
actually have increased reported profits, by 5.1%, because falling share
prices sharply reduced the value of outstanding options, particularly for
technology firms that were big users of employee share options.
Robert Merton of the Harvard Business School, who won a Nobel prize for
economics in part for his contribution to options-pricing theory, considers
that options can be valued quite well enough to be expensed. And although
there is room for debate over which pricing model is best, he also points
out that the degree of precision for option pricing is orders of magnitude
better than for valuing any number of things that are now expensed for
accounting purposes. Think of the challenge of accurately assessing the
useful economic life of a factory, machine or computer for purposes of
depreciation-calculations that can have a huge impact on reported profits.
Underlying all these arguments is a fear that expensing options will
discourage the use of a wonderful means of providing incentives for
employees, especially managers, to maximise shareholder value. Actually, the
present accounting treatment may discourage the use of better incentives,
such as paying people in shares rather than share options. Brian Hall of the
Harvard Business School points out that share options are a "fragile"
incentive, in that they pay out unevenly: employees get nothing below a
certain share price, but lots above it. Holding shares directly is a far
smoother form of incentive. Share schemes are easier to understand, and they
encourage managers to act more in the interests of shareholders.
All the same, awards of share options by firms dwarf awards of shares-partly
because shares are expensed against profits, while share options are not.
The lack of parity between these different forms of incentive creates huge
distortions in the way people are paid. And that, says Mr Hall, may be the
biggest cost of all from not expensing options.

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