April 6, 2004                         Stock Option Debate

The following was an article written by www.2ndopinionresearch.com  .  We enjoyed the article and with permission from 2nd Opinion Research  have placed it on our site. 

Stock Option Debate FASB is gearing up to mandate stock option expensing. In this regard, interesting quotes are appearing in the media, some of which support our ongoing efforts to highlight the cash consequences of stock options as evidenced by stock repurchases. Recently a FORTUNE reported told NPR’s Market Place, in an effort to play down the effect of recognizing the stock option expense, that the accrual implies no cash consequences.

Contrast that against a Sanford Bernstein analyst quoted on The Street.com: “I believe it will significantly raise people’s awareness of the fact that cash flows that normally accrue to shareholders or bondholders or go towards capital spending are in fact committed to offsetting dilution.” In the same article, a manager of Parnassus Equity Income said that his firm already pays careful attention to whether a company’s stock buyback plan actually reduces its net shares outstanding, or merely offsets the dilution from generous stock option grants.

We responded to a letter published in the Wall Street Journal in which the writer claimed that stock option expense accruals bore no cash consequences. The editor decided not to publish.

We wrote: Geoffrey P. Sanders points out (March 18, 2004) in a letter to the editor that Jonathan Weil is wrong to include the stock option expense among the many estimates found in financial statements. Sanders observes that with accounting estimates like bad debt allowances there is “always a day of reckoning where shareholders can compare the estimate that management originally recorded to what the particular transaction actually cost the company; to the amount of cash that left the business.” Apparently, according to Sanders, the stock option expense estimate is irrelevant to future cash outflows.

Examine this notion with what we find in the financial statements of Maxim Integrated Products, a prolific user of stock options. At the beginning of fiscal 2001, Maxim had 322 million basic shares of common stock outstanding. During the ensuing three years, employees received 31 million shares in lieu of cash compensation. According to FASB 123 footnote disclosures the estimated cost associated with these “coupons” was $440 million.

For those still suffering under the illusion that the $440 million estimate is not a reflection of future cash outflows, consider the following: During the three-year period under review, Maxim redeemed 29 million of the said “coupons” at a gross cash cost of $1.269 billion. Employee contributions in the form of strike price payments and the IRS’ tax benefit subsidized $799 million of these outlays, bringing the net cash that left the business to $470 million. Management could have spent another $100 million on stock repurchases and the share count would have been back at 322 million where it stood at the beginning of fiscal 2001.

Normally, stock repurchases are capital transactions that benefit all shareholders. Redeeming “IOU’s” issued to employees to keep compensation costs out of the income statement leaves non-employee shareholders no better off than they were before the “coupon” exercise commenced. This roundabout way of compensation fools many into believing that the Black-Scholes estimate is a figment of FASB’s imagination. More to the point, the lack of transparency allows for executive compensation packages that hugely exceed any amount management could ever have persuaded the board to authorize in the form of a cash transaction.”

The following link leads to an article published in the CPA Journal by Professor Abe Briloff, in which Briloff refers to SFAS 123’s valuation methodology as a “convoluted mathematical configuration that has met universal condemnation… SFAS 123 rules are essentially devoid of economic and accounting logic.” Ronald J. Murray, a former member of EITF, a FASB creation that makes accounting rules on the run as a special favor to management, quickly responded by arguing certain theoretical constraints, which might be correct, but are wholly unhelpful to investors. Murray objects to Briloff’s suggestion that options should be marked to market, a practice followed by TSX without auditor objections. To argue his point he notes that such mark to market practice is not allowed when securities are issued in business combinations, as if the two are comparable. A business combination is a one-time distinct event or transaction, without ongoing uncertainties as to the true value of the transaction. The services of an employee are an ongoing expense, a transaction only fully settled once the employee exercises his or her options. Briloff has transparency and investor interests at heart; Murray tries to defend the indefensible.

Here is the link: http://www.nysscpa.org/cpajournal/2003/1203/nv/nv4.htm