- Stock options are hard to value
Yes, stock option expense is difficult to estimate accurately; so are pension liabilities, bad debt assumptions and reserve requirements for insurance companies. Accounting contains numerous assumptions and estimations but no one advocates we ignore those. Representatives utilizing this “why bother” approach don’t realize that over or underestimating stock option expense is a far lesser crime than ignoring it altogether.It is interesting to note that the Internal Revenue Service allows companies to write off stock option expense as compensation, reducing net income and total taxes reported and owed to the government. You never hear a CEO telling the IRS stock options aren't an expense.
- If stock option expense is reflected on the income statement, it will lower reported net income, scaring away investors. Some companies in Silicon Valley that have actually reported millions in profit will have to reveal they haven’t made any money in the past several years.
Accounting should not be subject to any social, economic or political influence. The sole purpose of accounting rules and guidelines should be to increase the accuracy of reported financials to the owners and managers of a business. It is not the place of accountants to attempt to manipulate the numbers for a specific purpose; the ends do not justify the means. Ignoring economic reality will not make it go away.
The Compromise
HR-3574 was born in an effort to strike a compromise between the two sides of the debate (those who don’t want any options expensed and those who think all options should be expensed). The legislation overrules the FASB and requires that only stock options granted to the CEO and the next four highest compensated employees should be expensed on the income statement. Furthermore, these restrictions do not apply if a company has revenues or a market capitalization of less than $25 million.Common sense, of course, requires me to point out the simple fact that if stock options cost existing shareholders money when given to the CEO, they cost money when given to the mail room supervisor, a secretary, a janitor or a middle-manager. Additionally, if a stock option is an expense to a large company, it is also an expense to a small company.
Sadly, the House’s deceit does not end at excluding all but five of a company’s employees. First, however, you must understand the fair value method of estimating stock option expense.
Fair Value Method of Estimating Stock Option Expense
Under the fair value method of estimating stock option expense, management must use a complex mathematical formula and make assumptions including the risk free interest rate and price volatility of the common stock. Generally, the fair value method results in significantly more reported compensation expense than an alternative, the intrinsic value method. Management can still manipulate the result by changing the variables. Consider the case of Krispy Kreme Doughnuts (NYSE: KKD).Between 2001 and 2003, Krispy Kreme Doughnuts reported net income of $26.378, $33.478 and $57.087 million respectively. These are the numbers the investor would find proudly displayed in the company’s annual report. Yet, buried in the 10K report to the Securities and Exchange Commission, the investor will discover management had, on a fair value basis, unreported stock option expense of $4.751 million in 2001, $8.653 million in 2002 and $11.481 million in 2003. In other words, the company actually made 18%, 26% and 20% less during the previous three years than it reported to shareholders on the income statement.
Unfortunately, that is not where it ends. Recall that the option expense under the fair value method can be altered by changes in the estimates of certain variables. The investor, delving further into the 10K, will find that management has changed the volatility assumption (one of these variables) over the past three years from 52.6% to 41.6%. In other words, Krispy Kreme’s management is saying that it expects the price of Krispy Kreme common stock to fluctuate far less than it has in the past. The problem? Krispy Kreme has fallen over sixty percent this year! The stock far more volatile today than it was a year ago, yet management is saying just the opposite. The result is that the pro-forma disclosure concerning stock option expense is understated! Even in the footnotes, they are painting a far rosier picture than exists.
