Case Overview, Stock Option Expensing

 

           Employees holding stock options are given the right to purchase shares in their company at a fixed price at some later date. For example, if an employee of Worldwide Widgets is given the option to buy 1,000 shares of company stock at $30 a share three years in the future, he or she will profit if the price at that time exceeds $30. If the stock price is at $50 at that date, they can purchase the stock at the $20 discount or cash them in for the $20 per share profit. In this hypothetical example, cashing them in would yield a nice $20,000 bonus on top of one's regular salary (1000 shares times the $20 difference in the current price of $50 and the strike price of $30). If Worldwide Widgets is doing poorly three years out and the stock price has dropped below the $30 strike price, the options are worthless. Since the employee does not have to put any money down while the option period is underway, there is no actual out-of-pocket loss if the stock price is "below water" when the option period ends.

           Stock options are a common part of compensation packages for business executives. They became increasingly common during the high tech boom of the 1990's. Many Internet and high tech start up companies used options as a large part of their compensation packages, not just for executives but for a broad range of employees. This enabled them to hold down salary expenses early on before they launched their products and produced a revenue stream. Options are also a way of keeping valued employees from jumping ship and going to a competitor. Individuals with options who quit before the options can be exercised, leave those options behind.

           Stock options became controversial after the accounting scandals emerged at companies like Enron and Worldcom. Stock prices at both companies got wildly inflated by dishonest accounting. Looking broadly at the high tech sector, some wondered if the stock price bubble was partly a function of generous options. Executives had an enormous stake in pushing their stock price higher, which would be good for the company in a number of ways but also good for them personally because it would enhance the value of their options. Another aspect of the controversy over options was that companies typically did not list options as an expense on their balance sheets. This may seem to be a rather arcane accounting issue but it goes to the heart of the policy question. Companies that don't list options as a current expense make their balance sheets look stronger because this potential expense is not included as a debit. A lobbyist for a computer company defended this practice by arguing that "when [our company] grants stock options there is no cost to us, no real cost at that time." Defenders also argue that there is no way of valuing an option. Said one defender, "can you find a value in the present time for options that aren't tradable on the market?"

           Critics of current stock option practices scoff at such defenses. Paraphrasing a newspaper op-ed by the respected investment guru Warren Buffett, one congressional aide told us, "If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it?" Moreover, economists have developed means of calculating the value of stock options. Finally, in the wake of the controversy some large Fortune 500 companies chose voluntarily to start expense options, lending support to the idea that options can be fairly priced in current dollars.

           In 2001 senators Carl Levin (D-MI) and John McCain (R-AZ) introduced legislation to require that options be expensed. They were not trying to terminate options; there is widespread agreement that options can be useful in certain circumstances. Neither political party seemed to have an interest in the issue as it is complex and elicits little public interest. Since companies back in their districts and states were asking them not to support the legislation, most legislators were happy just to ignore the Levin-McCain bill and watch it die a quiet death as the accounting debacles at Enron and other companies moved off the political stage.