Stock options should count as expense

By DAVID MOON, Moon Capital Management
April 11, 2004

There is an accounting battle being waged over the treatment of stocks options. The details would bore (or confuse) most people. The resolution will have no impact on the profitability or operations of a single company.

Many companies include as a part of certain employees' compensation an option to purchase the company's stock. If the price of the stock later increases, the employee has the ability to buy the stock at a price below the market price, then simultaneously sell it, realizing a risk-free profit on the transaction. It is not uncommon for stock options to account for much, if not most, of some executives' total compensation.

Companies that give their employees stock options deduct the value of the options as an expense on their tax return. But when you look at the financial statements they present to investors, the options are not treated as expenses. This will come as a surprise to some readers, but companies do keep at least two sets of books, one for the IRS and one for their shareholders.

When a CEO like Intel's Craig Barnett argues that options are 'imaginary expenses' (as he did in a March 31 Wall Street Journal editorial), how can his opinion not be clouded by the amount of his personal wealth that result from those options? Barnett exercised 384,000 options in January, netting him about $10 million in cash. Was this an 'imaginary cash?' I suspect neither his banker nor his wife would think so.

Opponents of expensing options are quick to point out that when an option is granted, estimating its then-current market value is an inexact process. That is true. But companies make estimates all of the time on their financial statements. Loan loses, inventory valuation and shrinkage, pension expenses, medical expenses, mortgage prepayments - all of these items require companies to make estimates.

Others argue that since options are so widely used in certain industries (startup businesses and technology companies, for example), expensing options would create a heavy burden on the reported earnings of those companies, resulting in a decrease in the values or prices of those stocks. If that's true, then investment analysts must be shallow. How an option is reported has zero impact on a company's value. Expensing options simply more properly describes the nature of the transaction.

Expensing options would ultimately lead to less volatility for stock prices because reported earnings would more closely reflect economic reality, rather than some accountant's executive-inspired fiction. Simply saying than an option doesn't have a real economic cost doesn't make it true. If you have two dogs and call one of them a cat, how many cats do you have? None, because calling a cat a dog doesn't make it a cat.

As with other financial scandals, the root of the problem is that people are willing to take short cuts and ignore real issues when those issues stand in the way of some desired outcome, like putting another $10 million in your bank account.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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