## Employee Stock Options - Expense Them or Eliminate Them!

### by Fred E. Foldvary, Senior Editor

A stock option is a contract that enables the owner to buy or sell a number of shares of stock at a particular "strike price" during some time interval. If the contract is for buying the shares, it is called a "call" option; if it is for selling shares, it is a "put" option.

For example, suppose you pay \$200 to buy a call option for 100 shares of the Menger corporation at a strike price of \$50 with an expiration date of December 31, 2002. Until that date, the holder can buy 100 shares at \$50 regardless of the market price. If one bought the option when the share price was \$40 and the price rises above \$50, the option is "in the money." If the owner exercises the option, he buys the shares. If the market price is \$60, he pays \$5000 (100 times \$50) for shares with a market price of \$6000, for a profit of \$800 (\$6000 minus \$5000 minus \$200).

If the stock rises in value, the call options rise at an even greater percentage. If a call option expires when the stock is below the strike price, the option becomes worthless. Call options therefore allow the investor to benefit from a rise in price, with a limited risk, since one can lose no more than the cost of the option. Put options allow one to profit from the fall in price of a stock, and therefore lets those who own shares hedge against a fall in the price.

Stock options are therefore a great way to shift and spread risk or to speculate on share prices. They help create a more fluid and efficient financial market. The problem with options comes when they become wages paid to employees, and the cost is not properly recorded.

Suppose we have Carl, an employee at the Menger corporation. The company could pay him \$60,000 in money, or it could pay him \$50,000 and pay the other in shares of stock. Where would these shares come from? If the company already held the shares, then this is like paying him cash; the payment comes from the assets of the company. But if the firm did not own the shares but simply created the shares, then this would dilute the shares of all the other shareholders, reducing the value of the shares of stock. As a simple example, suppose Menger had 1 million shares of stock, and issued another million shares as payment to employees. The market price of all the shares would be cut in half. In economically proper accounting, if the firm issues more shares of stock, it should be counted as an expense, reducing the net worth of the firm, just as payments of cash would.

Options operate similarly, except with a time lag. Suppose Carl gets paid \$50,000 plus call options. The economically honest and proper way to account for this is for the firm to already have \$10,000 worth of shares and then "write" or issue call options based on those shares, so that if the options are exercised, those shares would be bought. The firm would then expense the options, subtracting the current market value of the options from its net worth. To calculate the expense, the options paid to employees should be the same as those currently in the market.

But this is not the usual practice today. Firms now issue options without recording them as an expense and without holding the underlying shares of stock. At that moment, no cash is withdrawn from the firm's treasury, so superficially there is no money cost. But the implicit reality is that the firm has created a liability, a potential loss of asset value. The options are not expensed, which makes it look like the company is earning more money, since these costs have not been subtracted from revenues. This in actuality dishonest. It is doubly dishonest when the shares of stock obtained are newly issued rather than already existing.

Because of the recent financial scandals and the realization that many firms are amassing huge option liabilities, a few firms, such as Coca-Cola, have begun expensing their employee stock options. Coca-Cola will also sell these options to investment banks to help determine a market price. Otherwise, the options need to be priced by a "Black-Scholes" formula involving expected interest rates and stock volatility, which may differ from a market price.

The International Accounting Standards Board (IASB) has proposed that companies account for the value of stock options. U.S. companies are not required to follow this standard, but many companies world-wide will do so in the coming years and there will be pressure, if not legal requirements, for U.S. firms to do so.

Some argue that the stock options are not a payment for past work, but an incentive for future good performance. But in fact, when an employee is paid or given a stock option, this is an asset he gets at that time, not in the future. The market price of the option already includes expectations about the future price of the shares. If the firm wants an incentive for the future, it should instead promise a bonus based on the performance of the employee and of the firm.

If options are going to be expensed, then it is more straight-forward to instead pay the employee in shares of stock. It is better for the employee, since if the shares fall in price, they would still have some value, rather than having worthless options. It is better for the shareholders, since they would know the true cost of the employee compensation.

If options there must be, let them be expensed when issued. Better yet, don't pay employees in options. Pay them a cash bonus. If the firm pays in shares of stock, then it should buy the shares in the market rather than issue new shares, so that the investors will know the true cost.

The pure free market requires honesty in accounting. When firms may incur expenses and not disclose them, this is legalized deception, and a violation of market ethics. There is no option in a true free market other than to tell the truth.

Copyright 2002 by Fred E. Foldvary. All rights reserved. No part of this material may be reproduced or transmitted in any form or by any means, electronic or mechanical, which includes but is not limited to facsimile transmission, photocopying, recording, rekeying, or using any information storage or retrieval system, without giving full credit to Fred Foldvary and The Progress Report.