Many Fortune 500 corporations in the United States are feeling pressure to classify stock options as an expense in the wake of the Enron Corporation and Worldcom accounting scandals. Due to the amount of money many of the executives from each of these companies made from stock options, the Securities and Exchange Commission needs to regulate stock options or force companies to expense the stock options on their annual and quarterly financial statements. Typically, an option plan gives the employees the right to buy company stock at a certain price; the strike price which is usually the market price on the date of the grant of the options. Under current U. S.
accounting rules, companies can choose whether to deduct option costs from expenses or disclose the options in the footnotes section of the financial statements. Proponents argue that if expensing stock options does not become a requirement, companies will continue to shower executives with outlandish option awards worth millions. The first major U. S. corporations to begin expensing stock were Coca-Cola, General Electric, and Proctor & Gamble.
Each of these companies announced plans to account explicitly for the cost of the options they use to compensate executives and other employees. Originally, these options were used as bonuses for executives; however, over the last three - four years, this type of payout has become more of compensation as salaries rather than bonuses without having to show this expense on financial statements. For example, the following CEO's of Fortune 500 companies received compensation in the form of salary and stock options without having to show the full expense on any of the company's financial statements, including income statements or statements of cash flows for the fiscal year 2001: Company CEO Salary Stock Option Bonus Dell Computer Corp Michael Dell $892, 308 $10, 400, 000 Hewlett-Packard Carleton S. Fiorina $1, 000, 000 $13, 519, 781 IBM Lou Gerstner $12, 000, 000 $115, 000, 000 Motorola Christopher Galvin $0 $2, 730, 000 While CEO's of these and all other major corporations make the most in salary and bonus packages, the true reflection of their compensation is not computed into the income statement. Rather, each company will list these amounts as footnotes and choose not to go into detail about the amounts they receive or how the bonus compensation is structured.
However, in November, 2002, the International Accounting Standards Board (IASB) published a proposal to require all companies to take the same route as Coca-Cola, General Electric, and Proctor & Gamble. The IASB submitted five specific principles to help boards and senior management align more closely the role of options as managerial incentives with the interests of the shareholders: 1. Explicitly tie compensation to individual value creation. In case after case, investors have seen executives reap extraordinary rewards tied to share price increases that had little to do with the management and everything to do with factors beyond its control, such as interest rate movements and changes in macroeconomic decisions.
Indexed options can be a useful tool in these cases. Unlike standard options, indexed ones make it possible to benchmark an executive against a set of his or her peers. 2. Minimize incentives to alter the company's risk profile. Investors have discovered that executives of top companies whose shares they own have ample opportunity to affect share prices by managing in ways that aren't necessarily in investors' best interest. Increasing the financial leverage of a company or the degree of business risk it bears are two prime examples.
To guard against such circumstances, the board's best response might be to reduce the weight of stock options in the CEO's compensation. 3. Favor the grant of restricted stock over stock options. As noted, indexed stock options offer one way to distinguish between value created by external forces and value arising from individual performance. Another answer would be to replace stock options with restricted stock, granted under conditions relating to executive tenure and performance. By requiring executives to invest some minimum proportion of their wealth or multiple of their salaries in the stock of the companies they run, boards can ensure that they will care about a sustained drop in share prices.
Either of these changes in compensation policy will force companies to begin to give an accurate reporting in their financial statements of CEO salary and total compensation; not just footnotes at the bottom of the page. 4. Restrict the timing stock sales. Boards can also restrict the sale of a significant portion of a CEO's stock awards for a period of time (ex: two years beyond the end of his or her tenure). This would ensure that CEO's focus on the creation of long-term value and not on short-lived bumps in stock prices.
5. Limit the potential for hedging strategies. Senior executives have many ways to hedge their holdings in the shares they own. But hedging poses a danger because it can, without shareholder knowledge, limit the real exposure to the companies without having to publically report this information on any financial statements. The major argument against expensing stock options is the reduction in earnings over the fiscal year and during each quarter. However, in a USA Today analysis of 43 of the largest corporations, earnings would be reduced by only 4.
2% on average (throughout the entire fiscal year). There are two exceptions to this study; Intel Corporation reported that earnings would have been 79% lower if it had expensed stock options, and Cisco Systems stated losses would have been nearly three times as large, if it had expensed stock options. However, General Electric's earnings would have been only 2. 9% lower in the same fiscal year 2001.
Initial research indicates that as companies begin expensing options they are almost certain to get stingier about handing them out because of the impact on the bottom line. That will have major implications for how a wide array of employees negotiate their compensation packages. Also, this will give a more accurate representation of the true compensation packages, especially for senior or executive management. Furthermore, investors will be able to see the full effect these "salaries" have on the bottom lines of these companies.
From an individual employee standpoint, expensing options may hurt when negotiating for bonuses, better overall compensation packages, or performance awards. But with executives making millions when companies are struggling or having to lay-off thousands of employees, the net result will be more beneficial for the non-management employee and investor. For example, in the case of Enron and Worldcom, the company executives may have still not completely divulged the entire stock option information; however, these filings would have been on record with the SEC as well as posted in the company's financial statements. With these changes, the collapse of each company may have been avoided and thousands of lay-offs may not have occurred. Alan Greenspan, Federal Reserve Board Chairman, predicted in Congressional testimony that the Financial Accounting Standards Board (FASB), which sets accounting rules in the Unites States, would vote in favor of the switch due to the vague rules that currently exist.
Standard & Poor announced in 2001 that they will now report earnings for companies by subtracting the footnote options expensing from income. The IASB has approved staff recommendations to establish options accounting standards and the European Union adopted the IASB standards in 2002. Currently, the SEC is studying the issue. In conclusion, with the total amount of stock options increasing each year and becoming the major incentive in CEO compensation packages, the SEC needs to follow other accounting boards initiative and begin making expensing stock options mandatory in all financial statements. With these changes, companies will begin showing more accurate earnings results while CEO's will not be able to receive outrageous compensation packages and the companies they run continue to struggle with thousands of employees lose their jobs. Works Cited Juba k, Jim.
"In Lean Times, Fat Cat CEO's Get Fatter." April 16, 2002 web > Dinan, Larry. "Who Wants to Be A Gazillion aire"? April 3, 2002 WWW. C/NetNews. com "The Job Security Double Standard." 2003.
web > "Dell Chairman Gains 198. 7 Million From Exercising Options In Fiscal 2001." May 31, 2001. web > "Getting What You Pay For With Stock Options." December 12, 2002 The Mckinley Quarterly. web > Krantz, Matt. "Firms.