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By John Lorinc Illustration: Gérard Dubois THE STOCK OF EXECUTIVE OPTIONS HAS FALLEN HARD GIVEN ALL OF THE RAMPANT ABUSES. BUT IT MAY RISE AGAIN ONCE FIRMS BEGIN TO CHARGE STOCK COMPENSATION TO THEIR INCOME STATEMENTS In a recent letter to Berkshire Hathaway shareholders, CEO Warren Buffett pointedly asked: "If 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 should they go?" It would be hard to think of another business idea whose value has plunged quite as precipitously. Barely four years ago, few investors — with the possible exception of accounting purists, pension fund managers and the likes of Buffett — would have quibbled with a key component of the received wisdom about the 1990s' tech boom: that growth-oriented new economy firms can attract a higher caliber of executive by using stock options as a motivator. And with the soaring stock prices on Nasdaq, there was little reason to question the compensation strategies of high-flying tech firms such as JDS Uniphase, Cisco Systems and Microsoft. But since the tech bubble burst, and rampant accounting abuses by such companies as Enron became public knowledge, no one is putting much stock in employee stock options anymore. Indeed, the experience of the past two years has shown that option-heavy executive compensation packages do not necessarily lead to improved profits. In fact, it's quite the opposite. A recent study by New York's Sanford Bernstein & Co. found that while Fortune 500 companies saw average annual profit growth of 9%, that figure would drop to 6% if the cost of executive options packages was taken into account. A 2000 study by London's Smithers & Co. surveyed 167 firms and concluded that 25 of them would see profits entirely eliminated once options costs were added in. In Microsoft's case, its 1998 US$4.5-billion profit would have been a US$17.8-billion loss if Microsoft had to purchase the options it issued on the open market. Then there are the individual cases. To choose one of the most notorious Canadian examples, Jozef Straus, CEO of JDS Uniphase, pocketed more than US$150 million (before tax and brokers' fees) by exercising his stock options in 2001, even though JDS's fortunes were plummeting. The problem was companies did not have to expense the value of these executive options packages, and that particular practice led directly to overstated profits, diluted shareholder value and rampant executive greed. "My experience," says accounting analyst Patricia McConnell of Bear Stearns in New York, "is that companies don't control costs that they don't have to charge to their income statement." All that is about to change. Last fall, accounting standard-setting bodies in Canada and Europe came forward with policy proposals that would require public companies to estimate and then report the costs of their employee options compensation packages on their financial statements. London-based International Accounting Standards Board (IASB) released its exposure draft in November 2002, just weeks after Canada's Accounting Standards Board (AcSB) issued its intent to develop a tougher standard on expensing options. "These proposals are very timely, given the demand for greater transparency in financial reporting, particularly with regard to employee share options," says Sir David Tweedie, IASB chairman. "Typically, transactions in which share options are granted to employees are not recognized in an entity's financial statements. As a result, the entity's expenses are understated and its profits are overstated. The time has come to close this gap in accounting standards." The Canadian accounting profession has moved aggressively on the option issue, responding to a relatively high degree of consensus about the solutions. In 2001, the AcSB put out its standard on accounting options and then released another exposure draft shortly before the New Year, requiring companies to report stock options. The draft asks for feedback on the differences between the proposed Canadian rules and the IASB standards. By contrast, in the US the issue of options accounting continues to be controversial. In the wake of Enron, the idea of requiring companies to expense options has been taken up by various prominent federal legislators who have jumped on the political bandwagon of prosecuting corporate malfeasance. US-based Federal Accounting Standards Board (FASB) put a preface on the IASB exposure draft and released it for comment by February 1, but there are still large pockets of opposition to the idea, from sectors such as high tech and biotech. (As one Cisco Systems vice-president said to the San Francisco Chronicle: "Why do you think employees are so motivated? The answer is because they are shareholders of the company.") FASB had tried to do this in the mid-1990s but the draft standard was met with fierce opposition by Silicon Valley executives and politicians such as Senator Joseph Lieberman. But with more than 100 major US firms — including Coca-Cola, Ford, Wal-Mart and Morgan Stanley — moving toward accounting for options expenses, the trend seems to be pointing in one direction: that the days of the fine-print note disclosure are gone. In the mathematically complex world of financial derivative instruments, employee stock options represent a particularly vexing problem for accountants, analysts and the employee investors who hold them. Unlike the so-called "plain vanilla" options that trade on derivatives markets, employee stock options tend to come loaded with a range of conditions and restrictions that make them more difficult to measure. For example, they can't be sold or traded, and most firms require employees to forfeit their unexercised options if they leave the firm or they must exercise them immediately before leaving, assuming they have vested. European-style employee stock options may only be exercised on their expiry date. American-style options, by contrast, can be exercised at any point up to the expiry date. But in all cases, if an employee exercises his or her options when the share price is above the exercise price, then the company must issue more stock, which the employee may then sell or trade in order to realize a financial gain or diversify his or her portfolio. All these variables make them elusive from a valuation perspective. The first bid to come up with a formula dates back to the early 1970s, when two economists, Canadian Myron Scholes and American Fischer Black, developed an approach for measuring European-style options. In 1979, three US derivatives experts, John Cox, Stephen Ross and Mark Rubinstein, came up with a "binomial tree" model to price US-style employee stock options, which, because they can be exercised early, must be estimated by using methods to project stock price fluctuations. These models, however, were for the most part moot because of Opinion 25, from the US accounting handbook. Known as the intrinsic value-based method, this rule pegged the value of an option as the "excess, if any, of the market price of the stock over the exercise price on the date the option is granted," according to John Hull, professor of finance at the Joseph L. Rotman School of Management at the University of toronto. The rub was that the strike price for most employee stock options was the stock price on the date they were granted, meaning the value was seen to be zero. Which, as the late 1990s proved, turned out to be an accounting fiction. "The key issue," says Ontario Securities Commission chief accountant John Carchrae, "is that their value is not zero." In 1994, FASB began preparing an approach to valuing stock options based on a fair value method. The idea was to come up with a valuation that reflected the actual cost to the shareholder. The process was to estimate the expected life of the option, use one of the available pricing models to value the option, and then adjust the calculation to reflect the chance that the employee may leave the company and forfeit his or her options. Each step leads to a host of computational headaches. Take the issue of expected option life. Hull, who has been researching this on behalf of the Ontario Teachers' Pension Plan, says the trick is to find a way of modeling an "optimal exercise strategy" — a stock price threshold, or ratio between the stock price and the exercise price that the employee would be seeking before exercising the options. There are only a few studies on this to date. They show senior executives hold their options longer than mid-level managers. The research also shows that employees in different sectors demonstrate different exercise strategies. One US study, conducted between 1979 and 1994, showed that executives at 40 firms tended to exercise options about six years into a 10-year option, and that the stock price was approximately 2.8 times higher than the exercise price.     Impact of employee stock options on earnings and dilution       The reduction in operating income of the S&P 500 when employee stock-based compensation is included, using the fair value measurement method in FASB 123:     1999 2000 2001     S&P 500 total 5% 8% 12%     Networking equipment (2)* 25% 41% 794%     Semiconductors (18) 16% 23% 510%     Application software (9) 69% 102% 216%     Electronic equipment & instruments (10) 11% 23% 101%     * Number of companies in sector     In 2001, the total diluted EPS of the S&P 500 drops by 20% when ESO are included. Pre-tax stock-based compensation increased by 30%, from US$61.3 billion in 2000 to US$80 billion in 2001. There were 13 S&P 500 companies with pre-tax stock-based compensation exceeding US$1 billion.     (Source: Bear Stearns, July 2002)     Average options outstanding as a percentage of average shares outstanding:     S&P 500 total 7.2% 8% 8.7%     Information technology 13.3% 13.6% 14.4%     Healthcare 8.1% 9% 9.8%     (Source: The Analyst's Accounting Observer, June 2002)       Another calculation problem involves projecting the volatility of the stock price, a notoriously tricky exercise, as well as the turnover rate in the company and the probability that executives will leave before the vesting period expires. This, too, presents a moving target to analysts because the departure of senior executives can depress a company's stock, thus affecting other variables in the pricing model. Some critics say the main problem with expensing options has to do with the complexity of valuing them. Carchrae considers this something of a red herring raised by firms that want to hold on to the intrinsic value method that has been on the books for almost three decades. As Hull points out, lots of numbers in a financial statement are the result of estimates, for example, reserve accounts. "This is a fact of life, that you're not 100% certain about the things you estimate. An approximate estimate of options expenses is better than ignoring them." The FASB exposure draft, which proposed the mandatory expensing of stock options calculated using the fair value method, met with a solid wall of political and corporate opposition. On May 3, 1994, as Mark Rubinstein, the Paul Stephens professor of applied investment analysis at the Haas School of Business at the University of California at Berkeley, noted in a 1995 essay in the Journal of Derivatives, "The United States Senate for the first time in its history conducted a debate over external [not tax] accounting standards." The result: an 88 to nine vote against FASB 123. The board withdrew its draft standard, leaving individual corporations to decide on how to value their options. Most corporations continued to use the intrinsic value method — although a few, such as Coca-Cola, recently made the change. The hypercharged trajectory of the latter 1990s serves as a testament to how few companies behaved like the pop bottler. "Silicon Valley managed to beat it back the first time, but it's a different environment now," Joseph Doherty, a Lehman Brothers analyst, told BioWorld Financial Watch last April. While the Sarbanes-Oxley Act didn't deal with options expensing, several prominent US lawmakers have put forward bills pertaining to the stock option question — one of which proposed denying certain types of tax credits to companies that failed to report their options expenses. Robert Herz, FASB chairman, said in an interview with Business Week in August that the standard-setting body is trying to give companies some guidance in shifting from the intrinsic value method to the fair value approach. It's also pushing for better disclosure of stock options. But when asked about the issue of mandatory expensing, Herz admitted, "Our current proposal still doesn't deal with that fundamental question."   Options for stock compensation The growing number of criminal and civil cases pending against companies and their executives has led to more stringent regulation in both Canada and the United States. Little, however, has been done to address the underlying causes: the demands placed on executives and the way they are paid. Steps taken by executives to hide losses and overstate revenue appear to have been motivated by a desire to maximize their base salaries and bonuses and cash-in their stock options before the signs of declining corporate performance became apparent. Past abuses and the large number of outstanding shares currently under water have led many organizations to reconsider the attractiveness of stock options as a form of compensation. Yet, options may be the best way to tie together executive and shareholder interests — especially in today's climate. Here are six ways of achieving this very legitimate objective without encouraging the excesses of the past: Limit the number of options granted — shareholders and regulators will no longer tolerate high levels of share dilution. Focus on key drivers of share value and tie the granting of future stock options to achievement of key performance targets. Require options be held for at least three years before they vest. Tie the vesting of options to the achievement of predefined and challenging performance targets. Limit the number of options that can be exercised at any one time (no individual can exercise more that 20% of options held in the same year). Rethink both base and incentive pay. To find out more about how to provide a stronger link between executive pay and long-term sustained company performance, please access the full article at www.CAmagazine.com/expenseit Nadine Winter, president, Winter Consulting Group   While the Canadian profession is closely watching what's playing out in the US, it has moved quickly with new rules. In January 2002, the AcSB issued CICA Section 3870, a standard for calculating stock options using the fair value method, but falling short of requiring companies to record the cost of plain vanilla stock options on their financial statements. "The AcSB thought the [intrinsic value method] was intrinsically flawed because it didn't take into account the time value of an option," says board principal Harry Klompas. By September, however, the Accounting Standards Oversight Council called on the AcSB to revisit the standard with an eye to making such expensing mandatory. Within three weeks, the AcSB announced it was commencing the project. In November 2002, the IASB exposure draft was released for comment, thus setting the terms of the debate worldwide. It proposes mandatory recognition of all share-based payment transactions, using the fair value method, with no exceptions. The value should be estimated at the grant date, but the exposure draft doesn't specify which pricing model should be used. As with most of the post-Enron regulatory changes, the process has been far less politicized in Canada than in the US. OSC chairman David Brown has indicated he is happy to leave the options expensing problem to the accounting profession, rather than stepping in to push for changes in the regulatory environment. He is, however, monitoring the situation. There has been little official criticism from corporate Canada, although the timing of the implementation of new standards, as well as harmonization with the US, is sure to become an issue. Hull feels it is a good time for Canada to be taking the lead — a view shared by Carchrae, who argues that Canadian companies may turn tougher accounting standards to their advantage because the markets will recognize that their reporting processes yield more credible numbers than those put out by firms that keep options expenses off the income statement. Says Carchrae: "I think the markets will be able to adjust to the difference." The opinions of investment industry insiders are mixed. John Kinsey, portfolio manager with Caldwell Securities Ltd., in Toronto, feels there needs to be a level playing field so that analysts and investors can make apples to apples comparisons between the financial statements of competing firms. This, he says, will only happen if everyone begins expensing stock options using the same valuation method. Indeed, he argues there could be an investor backlash against companies, such as Cisco, that insist on sticking to the intrinsic value method. "It may hurt the companies that are issuing options because investors prefer companies that are adhering to the rules." Paul Hand, a managing director for RBC Capital Markets, doesn't need to be convinced that the executive compensation packages of the late 1990s had gotten out of hand. "We got carried away," he agrees. But he is less persuaded by the proposition that Canada should be creating a tougher accounting standard than the US. "I don't see the urgency to move ahead. What do we have to gain by getting out on the edge?" The AcSB's Klompas, who is overseeing the new options standard project, lays out the situation this way: the AcSB has a policy that stresses harmonization with best standards. At the moment, it can take one of three routes: update the existing standard, scrap it and adopt the IASB document, or wait to see what FASB comes up with. While Bear Stearn's Patricia McConnell points out that FASB's new standard is very similar to the IASB version, Klompas says it still has to come through the crucible of the consultation process, which is expected to take at least a year. "We don't know what's going to happen." What is evident, however, is that the uncertainty of the standard-setting process hasn't managed to obscure the long-term goal, which is to create a reporting environment that is not only more comprehensive, but that also discourages the abuses of the late 1990s. McConnell says it is highly likely that once companies are required to expense stock options, executive compensation packages will become more frugal, by comparison to the astronomical amounts being pocketed by CEOs who were paying more attention to stock prices than corporate operation. In fact, John Hull is hoping to see a more rational approach to stock-based compensation schemes, whereby non-salary executive pay is tied to sectoral indices or other indicators that provide a clearer reflection of the firm's financial performance. And once such compensation policies, supported by new reporting standards, become commonplace among Nasdaq or TSX firms, it's possible the stock of stock-option compensation may once again rise. John Lorinc is a freelance writer based in Toronto.