What stock options are and why they should be expensed

What are stock options?

Stock options are offered to managers and employees as a way to tie their compensation to the success of the company. A stock option gives the holder the right to buy a stock from the company at a certain price (“strike price”) at a future date. If the stock values goes up above that price, the holder gains additional profit from the sale of the options.

In the last decade the use of options has grown exponentially. In 1992, one million employees received options. Today 10 million do, though the vast majority of actual options are concentrated heavily at the top. Business Week estimates that 16.3% of all outstanding shares at large companies are in the form of options.

Stock options have fueled reckless behavior by management

Stock options were introduced in the early ‘90s as a way to tie the compensation of managers and executives more closely with share price and thus the interest of shareholders. In reality, widespread stock options facilitated reckless greed that harmed many shareholders.

According to the Economist, stock options accounted for 58% of the pay of U.S. CEOs in 2001. That year, the average CEO earned an outrageous $10.83 million – or 411 times the average worker.

Since stock options are not counted as expenses and are also tax-deductible, it makes perfect sense that corporations would pay their executives with boatloads of stock options. Executives get filthy rich, the company lowers its taxes, and everybody is happy.

The only problem is that with boatloads of options, executives became so focused on the stock price that they cooked up whatever accounting tricks they could think of to keep profits high and the stock price rising. Executives could then cash in on their millions of options when the stock price was artificially high – deceiving millions of investors for their own profit in the process.

As Senator Carl Levin (D-Mich.) put it: “Virtually every corporate disaster that has struck in recent years has had a stock option component.”

At Enron, for example, Chairman Ken Lay cashed in $123 million in stock options in 2000. CEO Jeffrey Skilling took home $60 million. At Qwest, chairman Philip Anschutz made $1.9 billion in options and CEO Joe Nacchio made $232 million. At Global Crossing, Gary Winnick cashed in $735 million. At Oracle Corp., CEO Larry Ellison exercised a whopping $706 million in options while his company’s stock dropped 50%.

How do they get away with it? One reason is that options don’t show up as an expense

Almost all stock options go to top executives and managers

Broad-based options are potentially an effective management tool to reward hard-working employees with a piece of company ownership. But unfortunately, the vast majority of stock options go to a handful of top greedy executives.

According to the Bureau of Labor Statistics, only 1.7% of non-executive workers got any stock options in 2000, a banner year for options. According to professors Joseph R. Blasi and Douglas L. Kruse, the authors of “In the Company of Owners: The Truth about Stock Options,” about 30% of options go to the top five employees, and the other 70% are “spread narrowly among other executives and managers.” From 1992 to 2001, the top five executives of the largest 1,500 U.S. companies made $67 billion in stock-option profits, according to Blasi and Kruse.

Not expensing options gives a misleading financial picture of the company

Technically, the options appear as nothing more than footnotes in the company’s financial statements. Fixed-price stock options are the only form of compensation that companies do not have to book as an expense at any time. But corporations receive tax deductions based on the compensation executives received from cashing in their options. The only thing that adds up is a colossal distortion of a company’s financial health.

A Federal Reserve study found that if stock options had been expensed between 1995 and 2000, annual corporate earnings growth would have been just 5%, not the 8.3% reported. Merrill Lynch has estimated that had options been expensed, earnings for the S&P 500 would have been 21% lower in 2001, and 39% lower in the information technology sector.

Yahoo reported a profit of $71 million for 2000, but adjusting for employee stock options it should have been a loss of $1.3 billion. Cisco reported $4.6 billion in profits – which should have been a $2.7 billion loss. As the Washington Post concluded in an editorial, “By reporting make-believe profits, companies may have conned investors into bidding up their stock prices.” (see “Money Talks” April 18, 2002) This hurts investors and it hurts the economy as a whole.

Opponents of expensing argue that options should not be expensed because granting them doesn’t have a direct cost. But as investing guru Warren Buffett explains it: “If stock options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world do they go?”

If options do not have any value, why do executives and employees want them so much? Every option given to an executive is an option that the corporation could have sold on the open market, raising money for the corporation. Since options could fetch a value on the open market, they do have a value.

Corporations list options as expenses for tax deduction purposes

Companies regularly deduct the cost of exercised stock options when filing their tax returns. Yet, if options are considered an expense for tax purposes, why are they not also considered an expense when it comes to financial statements?

This disparity allowed U.S. corporations to deduct a remarkable $56 billion for stock options in 2000, according to Tax Notes, up from $42 billion in 1999 and $28 billion in 1998.

Enron, for example, took a whopping tax deduction of $1.4 billion in 2000 alone for stock options given to top executives. This was one of the key accounting loopholes that the corporation utilized to paint a grossly inaccurate picture of its finances. But Enron was not alone. Microsoft took a stock options tax deduction of $5.54 billion in 2000. Cisco took $3.08 billion. Citigroup took $1.4 billion. Pfizer took $1.3 billion. Lucent took $1.1 billion.

To make matters worse, in 2001 the IRS issued Revenue Ruling 2001-1. This states that the alternative minimum tax, which requires corporations with extensive deductions to pay a minimum tax, did not apply to companies who reduced their taxes using stock options deductions.

With tax deductions like these, it’s no wonder that corporations are giving out boatloads of options. But there’s no such thing as a free lunch. These disparities create a misleading picture of the company’s financial health, which results in bad investments. Bad investments turn unprofitable and/or inefficient companies into overvalued companies, which may be good for CEOs, but bad for the workers, the investors, and ultimately, the economy as a whole.

Options dilute the value of company stock

The more company shares are printed, the less each share will be worth because the earnings per share will be reduced. So every time options are issued, the value of outstanding shares declines. In other words, the value of executive stock options comes partly at the expense of all other shareholders. Business Week estimates that 16.3% of all outstanding shares at large companies are in the form of options.