At first blush, it seemed odd that options would not be accounted for as an expense. But issuing stock is as close as companies have to printing money. The effect of issuing new stock is the same as printing new money, that is, it dilutes the value of the currency or the stock, and the impact of issuing new stock is fully accounted for in the "diluted" earnings reported by all companies who issue options. This is the earnings per share reported as if all the options had been exercised and they had to issue new stock to cover them.

The real craziness appears when you try to figure out the implications of assessing the fair-market value of stock options. First, the options issued to employees cannot be traded on the options market, so there is no way to directly determine the market value. Second, most options are issued with vesting periods (the period you have to hold them prior to exercising or redeeming them) of typically 3 years, and an expiration (the number of years you have before they expire worthless) of 10 years. However, in the options markets, for which there are reasonable mathematical models of current value, such as Black-Scholes (http://www.google.com/search?q=black-scholes&ie=UTF-8&oe=UTF-8) most options expire in 3 years, so there isn't even a comparable free market model to use to assess the value to opitons.

The real insanity of expensing options comes when you look at options issued in falling markets. For example, I have options in the company for which I work (a Fortune 500 non-tech company, BTW) which are likely to expire worthless. If my company had been required to expense them in the year they were issued, they would have been required to report an expense which had never actually occurred. Now that's insane.

In summary, issuing stock to cover options is the equivalent to printing money for most companies and the effects are already fully accounted for in the reporting of diluted earnings. The expensing of options issues in the year they are issued leads to impossible and irrational reporting of expenses.

I know it sounds weird, but actually the way options are accounted for now makes a lot more sense than the proposed new rules.

This is a good report

But this issue is so old and has been discussed so many times that this change in rules IMHO is now a non-news event. What's at play is really an imputed expense.

Apple's so-called "options overhang" will be no greater the day after the rules go into effect than the day before. Further, the overhang has been substantially reduced over the past six months.

In the end corproations may be less apt to issue options as a compensation incentive, but the change in rules IMHO makes no difference to the fundamentals of the company as currently measured on the Street.

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In the article,

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At the same time, Apple has also said in the past that it was unfair for the company to start expensing its options when most of the compensation was not doing so. Very few companies have voluntarily agreed to do so, but the long-awaited ruling from the FASB puts all companies on an equal footing.

Should the first sentence read, "...Apple has also said in the past that it was unfair for the company to start expensing its options when most of the competition was not doing so." ??

In any case, hopefully, regardless of the above, Apple will have a level playing field, and Wall Street won't be in a panic come Apple annRpt FY 2006.

Just one clarification. The "expense" amount deducted from the earnings equals to the increase in cash hoard, right?

maybe now it will be harder for the managemetn to steal from the shareholders. if they think they deserver 150mil for their work, doggone it, be up front about it.

personally, considering that apple was in the toilet before jobs and company, i think you can actually justify the expense. but let's not pretend it's not an expense.

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Mace wrote:
Just one clarification. The "expense" amount deducted from the earnings equals to the increase in cash hoard, right?

Not exactly and the rules are not exactly clear. What's involved is imputed a fair value to the optioned shares less the cash brought in to determine the level of "expense".

Under current rules the "expense" is masked because the company books only the cash received as an increase to paid in capital. The difference between the market price and the option price does not flow through the company's books. However, the gain between the market price on the day the options are used and the share price at which the employee buys the shares is taxable income to the employee and must be reported by the employee as additional income.

For example, an employee uses options at $20 per share to buy 1,000 shares of company X. The value of the shares on that day is $40. The employee pays the company $20,000 for the shares. The employee might sell the shares the same day at $40 per share and make a net $20,000 gain. The employee must report the $20,000 net gain as taxable income.

Under current rules only the $20,000 received by the company appears on the balance sheet. The difference between the $20 option purchase price and the $40 market price under the new rules would be considered an "expense" to the company because the company "lost" $20 per share on the transaction, theoretically. Had the shares been purchased by an investor at market value, the company would have received $40 instead of $20.

All this is an oversimplification but illustrates some of the issues. Under the new rules the FASB is pretending the employees did nothing to increase the value of the shares through hard work and a desire to grow the share price of the company for themselves and all other shareholders. Would people work as hard if options aren't available? Would the company be able to keep top talent if it didn't offer options?

One of the benefits of options is the employee has some say in when they take their gain as opposed to higher salaried compensation which is taxed every period.

Further, firms have argued options allow them to keep a lid on salary expense because in theory salaries might be lower today becuase employees share in the risk of building the company through a potentially greater reward in which they only benefit when all shareholders benefit from a higher stock price.

Now the difficult question: How does the FASB expect companies to account for the "expense" on options that haven't been used yet?

Apple executives have benefited from options. Becuase of their hard work that has added more than $20 billion to shareholder value since the return of Steve Jobs the company may face a higher "expense" because the gap between option price and market price is greater. On the flip side a company that hasn't seen its stock price move anyway but sideways for years might realize no "expense" at all from its option plan because shareholders haven't seen an increase in their investment value.

In a way it forces companies to "expense" their success.

Thanks, Dawn.

Issuing options ultimately lead to dilution of share price which should be accounted for. Whether expensing is the best way I am not sure.

Is there a maximum limit to the number of options issued e.g. not more than certain % of issued shares? My concern is whether there is a mechanism to prevent over dilution of share price?

I wonder what how the government will feel about the loss in tax revenue.

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mrmgraphics wrote:
Should the first sentence read, "...Apple has also said in the past that it was unfair for the company to start expensing its options when most of the competition was not doing so." ??

Yes, yes it should.

The typo has been corrected, and thanks for the note!

Bryan
Editor
TMO

Say a company issues a total of 100,000 shares at $50 per share and expenses the $5,000,000 "expense". Under the new rules they take the $5,000,000 hit on earnings - and, by the way, reduce their income tax payments by about 1.5 million.

Now say over the time the stock drops in value so no one with an option is going to exercise it.

Since the expense when given was expenses does the company then reverse the expense out - thus overstating the profit or loss of the new period?

Gets more complicated when the period for exercising is over a few years. At what point does the company take the income? If the company has tanked - out of business - do they post the $5,000,000 expense reversal just as they are turning out the lights? And that $1.5 mil they saved in income taxes . . .

Apple, and other companies, are going to be loud and clear about the "revised" earnings and earnings per share and make sure comparisons with the previous treatments are well understood.

Thank you FASB for the 20% pay cut I just received. I got notified that effective today all stock options for "highly compensated" employees have been cancelled due to the FASB action. This equates to a 20% loss in pay for me since the stock options were granted after the company enforced a 20% pay cut for all "highly compensated" three years ago.

To answer Mace's question, the number of shares a company can issue as options is governed by the company's stock option plan. The plan sets the maximum number of shares the company may issue as options, and the plan must be approved by the shareholders. The company I work for has approx 30M shares outstanding, and 2.5M shares in the stock option plan.

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Guest wrote:
I wonder what how the government will feel about the loss in tax revenue.

It's not going to be that significant. According to a Yahoo! financial quiz, 61% of US corporations paid NO federal tax between '96 and 2000, and that only 7% of tax revenue in 2003 was paid for by corporations. The U.S. citizen pays the largest chunk, 43%.

So even if reported earnings are reduced as a result, the impact to what the government receives will be minimal since corporations were paying such a small slice to begin with.

note: It seems Yahoo is redirecting back to the referrer for that link, so if you want to read the reference, copy-and-paste this URL rather than click on it: http://polls.yahoo.com/public/archives/57019568/p-quote-374

I wonder what constitutes the "U.S." Citizen sector. (the Yahoo article does not make it clear) If it includes the LLC's and S-Corps (the owners of both take business profits as personal income each year) then, the 43% seems reasonable (Small business; DBA's, S-Corps and LLC's are the lifeblood of the US economy, not the large C-corps, as is the popular notion) If not, then the 43% figure seems dubious (as well as the 7% corp figure, if it includes S-Corps)