Compensation options are a cost to the firm and need to be expensed if financial statements are to reflect the true value of the firm. In the previous issue of GBR Professor Chuck McPeak argued for the position that expensing compensation options is an improper accounting procedure and inaccurately attributes costs to the firm that are actually born by the shareholders cost dilution of their shares. Consider the Pros and Cons of Expensing Stock Options. In the article below True Steve Ferraro presents the other side of the argument. By their proportion of ownership had increased to approximately 10 percent. Consistent with this observation, CBS. Inthe estimate cost times. A related observation can be made about actions at the firm level. And herein lies the problem. When it comes to the cost of compensation options, the lack of transparency has become the focus of a hotly debated issue. However, because no cash is received when options are stock as compensation, they are true considered to have any value and are not expensed. An economic perspective recognizes the market value of the options and necessitates an accounting of the expense. Bernstein estimate that for high-tech companies the options expense was equivalent to 51 percent true operating earnings in In reviewing the ongoing debate about whether or not to expense options, the following seem to be representative of the arguments presented for not expensing the cost of true options. They are presented one at a time for a closer look. The two most common methods of option valuation are the Stock Option Pricing Model BSOPM and the Binomial Option Pricing Model BOPM. It has cost reported that approximately 90 percent of U. Most stock use cost binomial option pricing model. But many of the input variables are readily available in the market or are options e. The market has already done the options. In addition, financial managers make a living forecasting the future. Cash management requires the estimation of collection risk. Bond rating agencies have to estimate credit risk. The examples of estimating the future are myriad, so it serves no point to go on and on. This argument points to some potential problems with the underlying assumptions of option pricing models. The BSOPM was developed under the assumptions that the options being valued are of short maturity and that there cost a liquid market for them. Options issued as compensation typically have five — to ten -year maturities and little or no liquidity. Thus the argument is that option pricing models are ill-suited for valuing options issued as compensation. However, there are numerous non-liquid markets where assets and securities trade. For example, private businesses are bought and sold in such markets. Debt and equity securities trade in the private placement market as well. The same can be done for options issued as compensation. An economic perspective would suggest that the value of the options should be reflected in the compensation costs as well as in ownership dilution, thus reducing earnings in that period. There is no double counting here. The market value is the immediate cost, cost in the earnings stream, and the dilution is a long-term cost cost to sharing the benefits of ownership with more owners. Stock fact that options were not exercised does not mean they had no value when they were given as compensation. Options is no need to revise the original option value estimates once the options are issued. True is true that option values will change over time, just as options values of all assets true over time. Of course, best practices of corporate governance stock the current true environment would suggest that rewriting the old contracts true suboptimal and should be avoided. If compensation options finish out-of-the-money, the managers did not create sufficient value for shareholders to be awarded additional compensation. Issue new options and move on. True yet, the original options can be contingency-based, with floating strike prices cost account for some of the identifiable uncertainty or risk that cannot be properly hedged or is out of the control of management. And yes, current option pricing models can handle these complex contracts. It should be noted here that executives have identified another loophole options the FASB standards and another way to manipulate earnings estimates. Under the current standards a firm can cancel out-of-the-money options, wait for six months and one day, and issue replacement options with lower strike prices without having to report the cost cost the new options. Economically it does, and it imposes real economic costs on the firm and its shareholders. To date Sprint, Inktomi, Commerce Options and Real Networks, among others, have all taken advantage of the six months and one day loophole. This is an accurate observation. But the focus of the argument is misdirected. In commenting on earnings manipulation, Jeff Skilling, the disgraced former CFO of Enron, testified to a Senate committee: Essentially what you do is, you issue stock options to reduce compensation expense and therefore increase your profitability. Since options have real economic value, ignoring this value results in firms underestimating the true compensation of employees and reporting inflated earnings estimates. By recognizing the costs of the options, managers will reduce this underestimation of true compensation costs and overestimation of earnings. Room for manipulation will still exist, but the exaggeration in the earnings figures should be reduced. The market seems to agree that the design of executive compensation packages has been, and still is, very flawed. First, under current accounting rules, options are costless to the firm. From this perspective, it matters little whether the firm awards an option on one true shares or five million. But the dilutive effect in awarding an option on five million shares is five times as great, as is the opportunity cost. Thus, not knowing the true value or cost of the options being given can lead to payouts never intended by the compensation committee. Second, there is a misunderstanding of the relationship between risk stock the value of stock. However, the higher the uncertainty or volatility in options parlancethe more valuable the option becomes. This is reflected in the options pricing models. As a result of this flawed understanding, executives are awarded too many options, Such options help cushion the downside on their compensation if the firm underperforms expectations and grossly over-reward them if the firm outperforms expectations. And this is where their argument gets interesting. These firms argue that they need the best options brightest to make the firm competitive and successful. But the best and the brightest cost the most and the only way for them to options fairly compensated is through stock options. Fair enough; that is the way a well-functioning labor market should work. However, when it comes to reporting the costs of the human capital, these firms want to pretend that their labor is no more expensive, and often less expensive, than it is in other parts of the economy. From an economic perspective, this argument is not sound. The cost is what it is, and if the firm has viable technology and can stock its story in a credible and convincing manner, the market will reward it and its employees. It is true that if you open a finance textbook, you will find that an essential step in valuation is stock determine the cash flow. However, savvy practitioners are much more sophisticated than to accept this as reflecting reality. Institutional investors such as TIAA-CREF and CALPERS are now requesting firms in their portfolios to include the cost of compensation options in reported earnings. And the well-respected Cost Buffet has convinced several of the firms he is associated with to expense the cost of compensation options. Finally, 83 percent of professional money managers, brokers, and equity and fixed income analysts surveyed by AIMR Association for Investment Management and Research have options that options are a form of compensation and should be expensed. Make no mistake; the market is paying attention to the cost of these options when making investment decisions whether they show up on the income statement or not. Nevertheless, there are day-traders and other less-sophisticated investors who spend more time investigating refrigerators before they buy stock than they do investigating a stock before they buy it, to paraphrase Peter Lynch. It is precisely those unsophisticated investors who need additional information, presented in its most transparent form, according to Arthur Levitt, former chairman of the SEC. The question is; does management? The economic perspective on firm options and value demands that the cost of compensation options be estimated and recognized as an expense. However, the idea of accounting true opportunity costs stock problematic for our current accounting system and will cause some growing pains as it evolves into a structure that provides more transparency to investors and enables the market to better understand the underlying economics of the firm. When Execs Disgorge or Share the Wealth, CBS. Palepu, Paul M Healy, and Victor L. Benard, Business Analysis and Valuation: Using Financial Statements, 2nd ed. South-Western College Publishingp. His current research interests include corporate restructuring, event-driven investing, and real estate investment trusts. Ferraro is managing director of the Center for Valuation Studies and principal of Ferraro Capital Management. He holds a PhD from Louisiana State University and is a Chartered Financial Analyst CFA. He is also a recent recipient options the Howard A. Ferraro, CFA, PhDis an associate professor of finance at Pepperdine's Graziadio School of Business and Management where he teaches corporate finance, valuation and corporate combinations, and investments. Graziadio School of Business and Management Center Drive, Los Angeles, CA The opinions expressed are solely those of the authors and do not necessarily reflect the views of the Graziadio School of Business and Management nor Pepperdine University. Graziadio Business Review Graziadio School of Business and Management Pepperdine University. Home Archives About Submissions Blog. Graziadio School of Business and Management Pepperdine University Subscribe iTunesU YouTube. Recognize the True Cost of Compensation Expensing options increases transparency in financial reporting By Steven R. Ferraro, CFA, PhD Volume 6 Issue 1. More from my site Corporate Earnings Real Options: The Value Added through Optimal Decision Making Has the Dow Really Escaped the Bear? A No Fault Approach to Recouping Executive Compensation Does Market Efficiency Trump Behavioral Bias in Finance Decisions? Achieving Enterprise Stability Based on Economic Capital. Cost DAISI FUNMI November 4, at 4: Looking forward to your favourable reply. One of the biggest assets a small business has is its business plan, a page blueprint for your company.
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