It needs no reminder that companies respecting themselves, their stockholders, bondholders, and the general public account in their income statement for all their expenses. Based on this principle, different entities have chosen different methods in accounting for executive options. For instance, in 2002 Crédit Suisse Group has decided to:
● Adopt the fair value method of expensing stock option awards as of 1 January 2003, and
● Modify its practice with regard to the use of stock options, so that awards are reasonable and documented.
Stock option awards continue to be part of Crédit Suisse compensation plans as a means of retaining key personnel, but this is now happening at a lower level than in preceding years. In addition, the bank has introduced three-year vesting for all option awards granted in future compensation cycles, which is a com- mendable practice.
Other companies dropped stock option grants altogether. On 8 July 2003, Microsoft said that it would no longer grant stock options. Instead, it will rely on potential awards of stock to its almost 50 000 employees. There has been a very good reason for that decision.
● In the decade from 1991 until mid-2000, Microsoft’s outstanding shares increased from 4.2 billion to 5.3 billion.
● Over that same period, the company issued about 1.6 billion new shares under its share option schemes and it bought back 677 million.
The share buyback cost the company $16.2 billion but, at the time, that figure did not appear as an expense in Microsoft’s profit and loss statement. Microsoft had the courage to be transparent on these figures. A myriad of other companies who did the same, or even worse, kept such numbers close to their chest so that share- holders do not know how much money is taken out of their pockets.
Microsoft has also changed its accounting practices, adopting a standard that tries to accurately assess the impact of stock grants and stock options on the com- pany’s balance sheet. Beneath this and similar actions lies the fact that the unac- counted treatment of options makes it hard for investors to form a clear judgment of a company’s financial strength. This can be particularly serious in the high- tech industry, where lack of transparency as well as other issues has greatly con- tributed to the share price bubble.
Microsoft’s practice is an excellent example for other firms to follow – particularly those companies who, over the past two decades, relied very heavily on the stock market to pay their executives and CEOs, at the owners’ expense. For instance, a 1999 study in the United States by Bear Stearns, the investment bank, estimated that operating profits at computer networking companies:
● Would have been 26% lowerunder fair value accounting, and
● This would have meant a similar or larger drop in the market value of their shares.
Along the same frame of reference, at Wall Street analysts calculated that while the shareholder takes all the risks he or she gains only 75% of the profits. Taking high fees of this sort, which skim the cream off the top, has become very similar to the policy followed by hedge funds. The exact figures are that:
● In the general case options trim 10% off annual company profits, and
● For technology companies this rises to between 20 and 25% – and it can go up to 50%, as in the case of Intel.
As we saw in section 6 with EDS, bumper bonuses and derivatives losses corre- late. As Warren Buffett aptly suggests, derivatives are so complex, and based on outcomes so distant, that parties on both sides of a given bet are able to book a notional profit. That essentially means big trading bonuses today, and who cares about future losses which:
● Destroy shareholder value, and
● Bring to its knees the company which bets its future?
Moreover, senior management tends to award executive options for results it did not deliver. Only few people have the decency to give back these options after having second thoughts about their wisdom. On 23 January 2003, Tom Siebel, chairman and chief executive of the software company that bears his name, handed back $56 million worth of stock options to head off concerns that their excessive use was hurting other shareholders. As Warren Buffett puts it:
● If options aren’t a form of compensation, what are they?
● If compensation isn’t an expense, what is it?
● If expenses shouldn’t go into the calculation of earnings, where in the world should they go?
The answer to be given to this question on how to account for stock options varies by jurisdiction. Mid-July 2000, in the UK, the Accounting Standards Board (ASB) delivered a common sense approach with its proposal that share options should be measured at fair value at their vesting date, spread over the performance period and recorded in the profit and loss account. The message behind the ASB thesis has been that both companies and their stakeholders should appreciate that options are not a free lunch. They are a claim on future profitsand, therefore,
● They should be valued at the point they become available to the employee, and
● They should be accrued over the period the services are provided.
The UK Accounting Standards Board initiative obliged companies to scale back profits to reflect the cost of options given to employees or used to pay for services such as consultancies, with their value computed by using the Black–Scholes formula.
Finally, the irony of lavish executive stock options is that they can turn to ashes.
Starting with the 2000 burst of the stock market bubble a large number of options sank beneath the water. By mid-October 2000, as the market turned south in a big way, 52 CEOs at 200 of the better-known US companies were holding worthless stock options.
● When issued, these were worth billions of dollars
● But all that value was wiped out by the drop in their companies’ stock prices.
One of the worst hit was C. Michael Amstrong, then chairman and CEO of AT&T, who saw the value of his $26 million in stock options vanish with the 61% slide in the company’s stock price. The fate of other self-rewarding CEOs was not much different. Some of the big beneficiaries could wait for better times, but oth- ers could not. As reported in the press – according to regulatory filings – Bernie Ebbers, then president and CEO of WorldCom, had to sell 3 million shares in his long-distance communications company to meet a margin call from his broker- age account, because the value of his stock had dropped so much.
● All of Ebbers’ stock options granted in the past three years had become worthless by mid-October 2000.
● Then, mid-2002, came WorldCom’s bankruptcy, and by 2005 Bernie Ebbers was in court on a long list of fraud counts.
The horde of CEOs who lost their options perks grew in the September/October 2000 timeframe. At the top of the list, right after Amstrong, were: Alan McCollough, of Circuit City, with $25 million; Lawrence Weibach, Unisys, $23 million; Daniel Carp, Eastman Kodak, $17 million; Leo Mullin, Delta Air Lines,
$14 million; Donald Carty, AMR, $9.4 million; David Novak, Tricon, $6.6 mil- lion; David Whitwam, Whirlpool, $6.5 million; Steven Rogel, Weyerhaeuser,
$5.8 million, and Charles Holliday Jr, DuPont, $2 million.
Nor was such a debacle limited to year 2000. Senior management and other employees at the world’s largest investment banks ‘lost’ nearly $30 billion in the October 2001 to September 2002 timeframe, from the fall in value of equity they held in their companies. This figure is based on the fall in share price of 10 of the largest investment banks. However, given that share prices in 2001 were
already far lower than at the end of the bull market in 2000, overall losses have been significantly higher.
One of the worst affected firms in the aforementioned timeframe has been the Crédit Suisse Group. It saw a 60% dive in the value of its shares, wiping $32.7 billion off the company’s capitalization. Crédit Suisse employees owned about 5% of the firm, which makes it easy to calculate their losses. (However, as we saw at the beginning of this section, Crédit Suisse has since changed its account- ing practices related to executive options.)
With a late 2002 share price below $20, about 92% of JP Morgan Chase’s options were also below the water line. Analysts estimated that staff at JP Morgan Chase, including the chief executive, had lost nearly $4.25 billion on the value of the shares that they owned in their employer. At Goldman Sachs, bankers lost $5.44 billion. At the time, Goldman’s staff owned more than 40% of the firm – by far the largest employee stake of any of the large investment banks.
According to certain estimates, staff at Citigroup have lost about $7.8 billion between them, but because the company employs so many people, their wallets are unlikely to have been as badly hit as bankers at JP Morgan Chase and Goldman Sachs. Another estimate has been that at Morgan Stanley and Merrill Lynch possible staff losses stood at $4 billion and $2.6 billion respectively, based on 15% ownership.8The story these numbers tell is that, apart from being a less- than-ethical practice, fat stock options are also a gamble. Options are derivative instruments anyway; and it is better to expense them at fair value.
Notes
1 Basel Committee, Supervisory Guidance on the Use of the Fair Value Option by Banks Under IFRS, BUS, Basel, July 2005.
2 The Economist, 15 June 2002.
3 The Economist, 21 May 2005.
4 D.N. Chorafas, After Basel II: Assuring Compliance and Smoothing the Rough Edges, Lafferty/VRL Publishing, London, 2005.
5 Business Week, 8 July 2002.
6 The Economist, 15 January 2005.
7 The Economist, 6 March 2004.
8 Financial News, 21–27 October, 2002.
12
Forward-Looking
Statements, Models, Earnings, and Goodwill
1. Introduction
Forward-looking statementsare forecasts focusing on the likely evolution of the company’s business. As such, they contain no statistics but projections. Mainly they are projections relating to the implementation of strategic initiatives in a particular country or worldwide, the development of new products and services, or a contemplated expansion of operations.
● All of these factors relate to future business developments and economic performance.
● What they have in common is business riskas well as management risk, which is inseparable from projections being made.
With the exception of financial reporting on goodwill, forward-looking state- ments are not regulated. They only represent management’s judgment and future expectations concerning the development of the company’s operations in the market(s) in which it is active, as well as risks associated to the operations. Part of the risks are uncertainties and other factors that could cause actual results to differ materially from expectations. Such factors include, but are not limited to:
● General economic trends
● Changes in local and international markets
● Changes in currency exchanges rates and interest rates
● Competitive pressures and technological developments
● Changes in the financial position or creditworthiness of the firm’s cus- tomers, obligors, and other counterparties
● Legislative and political developments including the impact of terrorist attacks
● The aftermath of management changes and of other key factors that could positively or adversely affect the entity’s financial performance.
Even with these reservations, forward-looking statements have become fairly popular. Increasingly, in addition to historical information and statistics, Annual Reports by exchange-listed companies contain statements that reflect manage- ment’s beliefs, objectives, and expectations. Among other things, these relate to:
● Revenue growth
● After-tax profit margin, and
● Return on stockholders’ equity.
They also reflect on the company’s ability to sustain and improve its competitive position, as well as management’s intentions to be implemented in the year or
years to come, including restructuring initiatives, cost control measures (usually expressed in downsized head counts), and other factors affecting the company’s profitability.
For instance, important factors that may cause differences in terms of future expec- tations include, but are not limited to, the company’s success in building a closer relationship with its clients; the effect of client procurement patterns on company revenues and earnings; changes in revenues and profit margins due to market fluc- tuations; volatility affecting the securities market and economy as a whole.
Other factors with an impact on performance are primarily internal. Examples are the company’s inability to attract and retain key personnel; timing and impact of changes in the company’s level of investments; changes aiming at technological leadership; computer system failures; security breaches, and so on.
Projected political, regulatory, and legal changes, too, can have a significant impact on the message conveyed by the forward-looking statement. This is the case of pending legislation, regulation, or changing industry practice which may favourably or adversely affect the company. Moreover, results of litigation may be onerous; and the effects of competitors’ pricing and intensified industry compe- tition may lead to lower profit margins than those experienced in the current year.
Like all forecasts (see section 2), forward-looking statements are not fail safe.
While they represent the senior management’s judgment and future expectations concerning the development of the company’s business, a number of risks and uncertainties could cause unexpected developments and end with results that differ materially from projections. At the same time, however, they provide a warning about the likelihood of different events and their probable consequences.