Taking stock of options: AICD Review

Giving executives stock options was all the rage. But the system was abused and there is a view that options should now be expensed in the accounts. Owen Thomas* argues that in expensing options, shareholders are not necessarily better informed.

There is little doubt that the process of enforcing the inclusion of an expense for remuneration options in the accounts of companies is well and truly underway. However, the wisdom of this is not clear.

Shane Oliver, chief economist and strategist at AMP Henderson, argues that the horse has bolted. "I had traditionally thought they should be expensed, but now I'm not entirely convinced that it's going to do anything in the US if they expense them now – except confuse everybody," Oliver told Australian Financial Review. In the US, the International Accounting Standards Board decided unanimously to require that executive stock options be treated as expenses, according to the Washington Post. The new accounting rule will be mandated for corporations in the EU by 2005, as well as for Australia and other developing nations that follow IASB regulations. The question that should be asked is "What increase in information is given to investors by expensing remuneration options?" Options issued for remuneration purposes have traditionally been listed in the "notes to the accounts" of Australian companies and in most cases also listed in the remuneration of the board and top five executives disclosure requirements.

In general, the notes to the accounts of annual reports include the number of options and a brief listing of the terms and conditions of these options (full terms and conditions are usually available upon request). In some cases, boards have included valuation estimates of these options as additional information for shareholders. These estimates have predominantly been based on a variation of the Black-Scholes options pricing model. Recently the issue of stock options as a remuneration benefit has come under the spotlight. This interest in executive remuneration has been generated through the significant benefits being realised by executives through executive option packages (Microsoft, Macquarie Bank etc) and recent executive fraud and corporate collapses (Worldcom, etc). In fact the remuneration options themselves are being linked to the fraud committed. Within this environment the call to expense options has risen seemingly without significant consideration as to what value is to be expensed and whether there is an improvement in shareholder information by such a change to reporting requirements.

How is an executive remuneration option valued? Most remuneration options have performance hurdles such as: 1) Tenure requirements (No exercise of the options until a period of service is satisfied); 2) Corporate performance hurdles (No exercise of the options until a performance hurdle is satisfied), such as;

a. A total shareholder return (TSR) performance against an index or group of companies;

b. A quantifiable performance against other auditable items such as NPAT, revenue;

c. An event such as the commissioning of a new mine, the attainment of a level of market share or the ASX listing of the company; and

d. A certain share price level.

These performance hurdles are often coupled with forfeiture if the executive:

1) Mortgages, hedges or effectively deals with the option as if the executive "owned" the option; or

2) If, in the opinion of the board the executive engages in conduct that brings the company into disrepute.

What is an appropriate value to disclose to shareholders for these instruments?

Consider the following example:

"The Coca-Cola company announced today that it will expense the cost of all stock options the company grants ... Management has concluded that stock options are a form of employee compensation expense and therefore it is appropriate that these costs be reflected in our financial results. 'I am pleased that our company's board of directors agrees,' said Doug Daft, chairman and chief executive officer ... To determine the fair value of the stock options granted, the company intends to use quotations from independent financial institutions. The option value to be expensed will be based on the average of the firm's quotations received from the financial institutions to buy or sell Coca-Cola shares under the identical terms of the stock options granted." – Coca-Cola

Independent financial institutions will value the options based on estimates of potential outcomes and varying calculations. But in general, assuming the Coca-Cola company options have terms and conditions similar to those outlined above, the valuation of these options will require estimates of various elements.

Firstly, the valuation will be dependent upon the estimated volatility (the probability of movement) of the underlying stock value. This volatility will be used to estimate the potential future price outcomes of Coca-Cola stock at exercise and as such the expected future value of the options. Secondly, a volatility of the outcome of any performance hurdles will be estimated. This volatility will be used to estimate the potential outcomes of the performance hurdles within the time constraints of the option term. Thirdly, the tenure requirement of the options will, in most cases, be assumed away. Finally, using these estimates and outcomes the financial institution will use a variance on the Black-Scholes options pricing model to estimate the current value of the options issued to executives. Given all the estimation going on in this calculation, a large variance in the independent results would be expected. This expectation is confirmed in part by Coca-Cola which implies variance in the valuation of the options as they expect to "average" the results.

Using the "estimated value" of the options from the above calculations it is proposed that the shareholders will be better informed if this "estimated value" is expensed. The argument against expensing this "estimated value" is in general based on disputing the valuation. However, this does not seem to present a problem to accountants such as the executive vice-president of the US Financial Accounting Foundation, Joe LaGambina who told the AFR on August 5 that "the world of accounting is full of estimates". Will shareholders be better informed? In most cases no. The expensing of this estimated value will not increase the knowledge to shareholders as the information is, in most cases, already in the notes to the accounts. Are the estimated values of the options fair? The estimated values are, in general, the best mathematical valuation available. However, without a market for the remuneration options to provide a price search process we will never know whether the estimates are fair or not. The question that should be asked is whether the "estimation" and expense of remuneration options improves company reporting? As above, in general, the information is already in the market place and as such I do not believe that expensing the options improves shareholder information.

Will the expensing of options change the share price of the stocks involved? Hard to say, but I think not. As the knowledge is in most cases already public, "efficient markets" should have incorporated the effect into the current price. Yes the "horse has bolted" and we will probably expense remuneration options in the future. But, this amendment to corporate reporting does little to increase the knowledge of shareholders and will not reduce potential fraud. However, it should give analysts plenty of work recalculating historical comparative data.

* Owen Thomas is director, executive remuneration, shares and option plan with RPC Group

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