Stock options are a peculiar instrument of executive compensation, as well as a form of creative accounting at senior management level. Although lavish stock options make a mockery of shareholder value, and they have been largely used for self-grat- ification, with little or no link to performance, until very recently they have not been recognized as expenses in income statements. Like EBITDA, stock options are:
● A way of not lowering reported earnings, and
● A loophole in financial reporting favoured by companies across the board.
This loophole is evidenced by the fact that once stock options are vested or exer- cised they obviously reduce per share earnings, as companies simply issue more shares to meet their option obligations. This is a practice which hurts stock prices, is generally against shareholder interest, and constitutes a way of dis- guising financial statements.
Companies try to cover this loophole in two ways. One is buybacks. By regularly purchasing more of their own shares than they currently need for option exer- cises, companies prevent such dilution in ownership from coming to light. At the same time, share buybacks tend to push up stock prices. Thus:
● Enriching people holding stock options, and
● Pleasing shareholders who might otherwise be upset by huge executive option awards
● But, at the same time, depriving shareholders of a regular dividend.
As we have seen in Chapter 3, the rules of IFRS ensure that companies can no longer bury stock option handouts as footnotes to their financial statements. The
new accounting rules make management responsible for showing the full value of all stock options it grants to itself and the employees. This section elaborates on the effects of this requirement.
The other way to cover up equity dilution through non-expensed options is to play with derivative financial instruments. Eventually, this means significant derivatives losses. On 24 September 2002, the shares of EDS, the computer serv- ices company, plunged for a second time in a week:
● The first drop was 52%
● The second another 43%.
Investors confidence was shaken by the company’s huge losses with derivative products, a gamble which was not part of its core business. The way it has been reported, EDS used derivatives to try to reduce the cost of issuing shares, under its employee stock option plan.
That is far from being the only case. Storebrand, the Norwegian insurance com- pany, did the same – with equally disastrous results. In EDS’ case, the cost from sour derivatives was $225 million, and these losses made it more difficult to fund the upfront cost of large insourcing deals. Apart from the damage done to shareholders, EDS also attracted SEC’s attention.
For how long can this loophole, particularly exploited in the last two decades, remain open? Stock options dilute ownership but at the same time the rising vol- ume of buybacks reduces the number of outstanding shares of large companies.
In the United States this has happened at the rate of about 1% a year over the 1994–99 timeframe – the stock market’s boom years. At Wall Street, financial analysts suggested that it:
● Produced a steady upward pressure on share prices, and
● Magnified its own impact by being factored into market expectations.
The steady growth of stock options and buybacks meant that companies devoted more and more of their earnings to buying their own shares, reducing dividends to historically low levels. During the bubble of the 1990s, payouts to sharehold- ers has been mainly done through rapid appreciation of stock price – essentially a Ponzi game, since profits depended on other investors buying up inflated stock.
By 1999, total payout through dividends and buybacks had hit 80% of cash flow, which led to more and more leveraging of companies. Because at the same time
they continued to spend a big chunk of their earnings on capital investment, they went deeper and deeper into debt. In retrospect,
● This led to serious weakening of the companies’ financial staying power, and
● In the early years of the 21st century management had to concentrate on repairing the balance sheet.
A most significant challenge to the option mania, leading to a change in corporate accounting, was proposed in April 2004 by the Financial Accounting Standards Board (FASB), when it asked companies to deduct option costs from their earn- ings. The aim has been one of changing the secrecy practice, where options costs:
● Are footnoted in financial reports
● But do not have to be subtracted.
FASB’s initiative could not have come at a more opportune moment. It followed on the heels of an announcement that Intel more than doubled the number of stock options granted to Chief Executive Craig Barrett in 2003, when the top chipmaker’s profit surged 81%. Intel also paid Barrett a bonus of $1.5 million, up 41% from a year earlier.
As this and many similar examples demonstrate, expensing options provides more complete and surely more transparent information to investors regarding what is being done with their money. Technology companies, however, say that expensing hurts their earnings, their stock price, and their ability to compensate employees. This is only half true.
After the stock market crash of 2000, a new way to make a living in Silicon Valley has been equity-onlyjobs. Employees and workers received stock options and a let- ter of intent to hire them in the future, rather than wages and benefits. This sort of employer–employee relation has been on the rise, especially among laid-off infor- mation technology workers who no longer want to wait indefinitely for paying jobs.
The San Francisco Chroniclewrote on 22 December 2002 that equity-only jobs are often with start-up IT companies. One, however, should not confuse the start-ups that try to survive by paying in equity share, with the pillars of technology, like Intel, lavishly awarding options beyond fat salaries and other benefits. Moreover, California officials have warned that:
● Equity-only agreements violate state labour laws, and
● Labour laws stipulate that all workers must be paid at least the minimum wage.
There are evident reasons why big outfits fought the expensing of options tooth and nail. In 2003, communications equipment companies would have seen a 117% drop in net income had they expensed executive options, and the income of semiconductor firms would have dropped 102%, while the S&P 500 overall went south by 8%.
It needs no explaining why, in the United States, fearing they would have to write such figures in their income statement, instead of inflated current profits, companies put their lobbyists in motion. On 20 July 2004, the US House of Representatives voted 312–111 to block the proposed FASB rule that would require the accounting of employee stock options as corporate expenses. Instead, expensing would be limited to stock options for:
● The chief executive, and
● The next four highest-paid officers of a company.
Among the dissenting voices to this legal sustenance of stock options greed at the expense of shareholders has been Rep. Paul Kanjorski (D–Penn.), who argued that this lop-sided vote threatens the independence of the FASB.
Moreover, Kanjorski said, stock options have contributed to recent financial storms on Wall Street, noting that a decade ago the Congress strong-armed FASB into abandoning an effort to adopt a rule requiring stock option expens- ing. It is to the credit of IASB that expensing stock options became a rule with IFRS.