Expensing Stock Options Current Briefing McIntire Investment Institute Fundamental Presented by Felise Agranoff

What is a Stock Option? A stock option is a form of compensation that gives employees the option to purchase a fixed number of shares of common stock at a given price over a given period of time. A stock option is a form of compensation that gives employees the option to purchase a fixed number of shares of common stock at a given price over a given period of time. Corporations use stock options as a method of long- term compensation. Business Week’s executive pay scoreboard (published April 17, 2000) says that options account for about 81% of the average CEO’s pay package. Options worth millions of dollars have become commonplace in today’s corporate environment. Corporations use stock options as a method of long- term compensation. Business Week’s executive pay scoreboard (published April 17, 2000) says that options account for about 81% of the average CEO’s pay package. Options worth millions of dollars have become commonplace in today’s corporate environment.

RECENT HISTORY OF EXPENSING OPTIONS 1993: FASB issued exposure draft on stock options recommending that compensation stock options should be expensed. Response: Strong opposition from businesses!! SEC was weary about supporting FASB’s proposal due to effect on economy. 1994: FASB decides to encourage, instead of require, recognition of compensation costs.

STANDARDS FOR EXPENSING STOCK OPTIONS ON FINANCIAL STATEMENTS APB Opinion No. 25: established in October 1972 Intrinsic Value Method of configuring compensation =Market Price of Stock-Exercise Price of Stock at grant date Result: Corporations do not recognize any compensation expense related to stock options because at grant date, market price and exercise price are usually the same ***This was the standard in place before FASB’s new recommendation in 1993***

SFAS 123 introduced in 1995 after Controversy Encourages, but does not require recognition of compensation cost for the fair value of stock-based compensation paid to employees for their services. SFAS 123 allows a choice between the intrinsic value method and the fair value method. Fair Value Method: Configured using option pricing models such as Block and Scholes (depends on risk-free interest rate and stock price variance)

So what have corporations actually been doing??? A majority of corporations continue to use the intrinsic value method and the grant of employee stock options does not dilute reported earnings. They are reported in footnotes of financial statements. However, such options are deductible for tax purposes. Buffet’s View: “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?”

ARGUMENTS AGAINST practicing recommendations of SFAS 123 What is being expensed is an inaccurate estimate of the “fair” value when options were granted What is being expensed is an inaccurate estimate of the “fair” value when options were granted If stock price < exercise price during ten year lifetime of option, the option will not serve as a form of compensation If stock price < exercise price during ten year lifetime of option, the option will not serve as a form of compensation Enough information about stock options are in the footnotes of financial statements Enough information about stock options are in the footnotes of financial statements The option pricing model was designed to value readily tradable stock options with short lives The option pricing model was designed to value readily tradable stock options with short lives Stock options are a valuable way to motivate long term performance and are used excessively by start-up and Tech corporations to win over top employees Stock options are a valuable way to motivate long term performance and are used excessively by start-up and Tech corporations to win over top employees

How do the scandals in Corporate America affect current practices? New PRESSURE to expense options to create more transparency to readers of financial statements New PRESSURE to expense options to create more transparency to readers of financial statements Many corporations are beginning to expense stock options: Many corporations are beginning to expense stock options:

Silicon Valley strongly oppose expensing stock options! HOWEVER…….. Chief executive said that Microsoft accepts the economic rationale for treating employee stock options as a regular business expense, though he indicated that the world's biggest software company was not willing to get ahead of its peers on the hotly debated issue. Between 1991 and 2000, Microsoft issued 1.6 billion shares as stock options and bought back 677 million shares to partly offset the equity dilution. Microsoft was able to claim a deduction on its tax return and therefore showed stock options as a great expense for tax purposes, yet it made no revelation to shareholders.

What do you think will happen? Will expensing options according to the recommendations of SFAS 123 become commonplace? Will expensing options according to the recommendations of SFAS 123 become commonplace? Will it be a legal requirement? Will it be a legal requirement? More ideas??? More ideas???

How should the MII treat a corporation’s treatment of options in making our investment decisions ?