Alan Reynolds

 The Financial Accounting Standards Board (FASB) recently proposed requiring U.S. companies to "expense" all employee stock options starting next year. Public companies would be required to first estimate the "fair value" of such options at the time they are granted, and then subtract that estimate from revenues as if it were a known and current expense (rather than an unknown and future expense). Even though the estimated value of those options changes every day, the estimate at the time they were granted would nonetheless remain the amount deducted over several years of vesting.
The business press has generally reported about this issue in a naive and moralistic way. Crusaders for expensing are said to be advocating an obviously more honest measure of earnings, while opponents are said to be niggling over trivial estimating difficulties. A recent Congressional Budget Office (CBO) paper on the topic is not much better.

 Critics of expensing often get bogged down in the difficulty of estimating the value of options when granted. But a much more critical point follows from the fact that, as the CBO inadvertently remarks, "An option's value at the end of the exercise period is almost always different from its value when it was granted." If the correct definition of cost is the actual value when options are exercised, then deducting the estimated value when options are granted must be incorrect.

 The fair value of options to an employee on the day they are granted is an entirely different concept (and dollar amount) from the actual cost to an employer if and when those options are later exercised. So, what is the cost of employee stock options to corporate shareholders, and when does that cost occur?

 The cost of options has heretofore been thought to occur after they are vested and exercised, typically three to five years after they were granted. That is, for example, the official IRS definition of the options' cost -- the date when employees receive taxable income from exercising options and the employer receives a matching deduction. Assuming the stock price has risen, the firm must sell shares to employee at the lower strike price and either buy or issue shares at the higher exercise price. Companies do that by issuing more shares or by using cash or debt to repurchase existing shares. And, contrary to numerous erroneous news reports, the cost of exercised options is certainly not hidden from shareholders.

Alan Reynolds

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