Corey Rosen
Executive Director, National Center for Employee Ownership
Excerpted from the forthcoming Equity Compensation in a Post-Expensing World, March 2003, NCEO (www.nceo.org)
An underlying assumption of the concern about expensing options is that if expensing were required, companies with significant options programs would see their stock price decline in response to showing the cost of the options on their income statements. Of course, this is just an assumption. Others have argued that there won’t be much effect at all, because this information already exists on the footnotes. Markets would already have factored it into a company’s stock price. Kaye Thomas, author of Consider Your Options, one of the leading text on stock options, puts this argument well:
"Treating options as an expense will reduce reported earnings: the number the company officially reports each quarter. Option expensing won't affect the actual earnings of any company. A company's actual earnings are what they are. We could have a rule that requires every company to divide its earnings by the square root of pi before reporting them to the public and actual earnings would not be affected. What's more, the public's perception of earnings would not be affected by such a rule, provided that everyone knew how the company arrived at its numbers. Changing the rule shouldn't make a difference in a situation where there has been full disclosure.
That is precisely the situation for stock option expenses. It's easy to learn the amount of the stock option expense for any publicly traded company. They're required to reveal this information in their financial statements, so anyone who's interested can look it up. Changing the way they reveal the information won't be a big deal." (from Fairmark Options Resource Center, www.fairmark.com, Oct. 10, 2002).
In "Deducting Options: Much Ado About Nothing," in the October 2002 issue of Strategic Finance, authors Sanjay Deshmukh, CFA; Keith M. Howe; and Carl Luft make much the same point. Markets, they say, already have this information, so little will happen when expensing is required.
A more nuanced argument contends that companies with options programs that do not seem well targeted or well justified in terms of compensation strategies would suffer, but others would not, or that only companies with options programs well outside the industry norm would suffer.
To assess these arguments, we first looked to see what research has been done on this issue. We found only two studies so far, although no doubt many will be done now that a large enough number of companies have voluntarily decided to expense options. In a study of the market’s reaction to announcements that companies were going to expense options, Towers Perrin found that in the 120 days surrounding the announcement by 103 companies in the summer of 2002 that they were going to expense options, stock prices at these companies did not go up or down more than would have been expected based on normalized comparative results for the market in general. "Markets are very good at reflecting available information in security prices and were already awash in information about option grants and their economic costs," said Scott Olsen, co-leader of Towers Perrin's Executive Compensation consulting practice. "The study notes that in similar past situations, stock markets have ignored accounting and have paid attention to economics when examining company accounting choices in areas like inventory, depreciation or business combinations." (Source: Announcement of Option Expensing Has No Impact on Share Price, Towers Perrin Study Finds, Nov. 21, 2003, ).
In Expensing Employee Stock Options: Lifting the Fog by Norbert Michel and Paul Garwood of the Center for Data Analysis of the Heritage Foundation (report 02-06, October 18, 2002), the authors conclude that the stock market would react with indifference to expensing stock options. The conclusion is based on a study of the market’s reaction to six events from 1993 through 1995 surrounding the announcement by the FASB that it would consider requiring stock options expensing and, eventually, its announcement that it would only require expensing to appear in footnotes. The authors used a common technique in stock market research called an "event study." Event studies focus on the market’s immediate reactions over one or two days to a particular announcement. The authors hypothesized that if the market "cared" about expensing, prices for companies with the highest percentage of overhang would decline relative to those with the lowest. So when announcements were made suggesting expensing would be required, the prices of companies with a lot of overhang should have gone down, and they should have gone up when the news suggested expensing might not have been required. In fact, the authors found no evidence that this happened. Instead, the market appeared indifferent to the announcements.
To probe further, we conducted an e-mail survey of business school finance professors at 30 leading business schools. We received 37 responses. The professors were asked two questions. The questions and the introductory material appear below:
"As you know, there have been recent proposals to require companies to expense the present value of option grants to employees as a compensation cost on their income statements. Current rules require companies to show this expense in their footnotes or on their income statements (over 95% choose footnotes). This two-question survey is intended to find out what, if any, impact on stock prices economists expect this change to have."
1. Which of these statements comes closest to representing your views about the short-term impact on stock prices of requiring companies to expense the present value of option grants to employees as a compensation cost on their income statements?
2. Do you think companies should expense options?
On question one, 14 people answered a, seven answered b, two answered c, 10 answered d, and four answered e. In other words, only six of the respondents expected that expensing will have a substantial impact on stock prices for any of the companies with options. The remaining 31 respondents expected either no impact or a small impact. The respondents did, however, think companies should expense options. Twenty-eight respondents chose a, five chose b, three chose c, and one chose d.
So what can we make of this limited research? From what data there are, it appears that expensing might turn out to be the "Y2K" problem of stock options, much feared but of little consequence. Of course, it is impossible to predict how the market will respond with any precision, but, at this point, it seems that it would be safer to bet that the impact will be nominal. If this is the case, companies should certainly not make wholesale changes in their plans just to respond to a non-existent problem. Instead, they should design their equity compensation so that it serves their real economic and human resource needs, not their accounting convention needs.