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By: Richard Beaumier

There is no single more important accounting issue right now in the current investor’s landscape than the unrecognized option expense. Richard Beaumier, of Sirius Capital Inc., examines the impact of this on investors, in light of new accounting rules which would require recognition of this expense.

Non-recognition of the expense associated with option-based compensation programs represents up to one quarter of the market cap in the tech sector. But, most U.S. companies in the technology sector do not recognize the cost associated with the issuance of options under the fair value method. This practice leads to the overvaluation of their profitability and, indirectly, their cash flows.

Over the past few months, the author conducted an in-depth analysis of the possible impact on profitability and cash flows of recognizing the expenses associated with options as an operating expense. He also attempted to measure the potential effect of this recognition on the market capitalization of companies in the sector.

The Financial Accounting Standards Board (FASB) is currently considering adopting a new accounting rule which, before the end of 2004, could make mandatory the recognition of expenses associated with the issuance of options.

The International Accounting Standards Board (IASB) as well as the Canadian Institute of Chartered Accountants (CICA) have already proposed the accounting change. Pressure groups, such as Congress members and certain lobbies led by technology companies like CSCO and INTC, are attempting to stop this measure. See Table 1 for an example of the impact of the stock option expense on reported net income. According to a recent Sirius Capital analysis, if this measure is adopted, technology companies will see their earnings and, indirectly, their cash flows decrease by approximately 20 per cent to 25 per cent, compared to eight per cent to 12 per cent for other companies of the S&P 500.

As of July 28, 2003, the author identified a list of 100 large companies in the technology sector which have a combined market capitalization of US$1,902 billion. The market capitalization transferred to employees via the issuance of options which are not recognized in financial statements represents US$442 billion, or 23.2 per cent. One third of the 100 companies on the list have a transfer rate greater than 50 per cent (Table 2).

The author also identified 300 nontechnology companies of the S&P 500 for a total market cap of US$5,500 billion. In the case of these companies, options which are not accounted for total US$525 billion, or 9.6 per cent. Of these 300 companies, 25 have a transfer rate greater than 30 per cent.

The difference between the tech and non-tech option cost is mainly due to the higher volatility used for the tech sector when computing the fair value of the options using the Black-Scholes model.

FASB’s Long And Winding Road…

Recognizing compensation expense relating to the fair value of employee stock options granted is the preferable approach under current U.S. accounting standards (FASB Statement No. 123, Accounting for Stock-Based Compensation). It is also the treatment supported by an increasing number of investors, including Warren Buffett. Until now, few companies elected to follow the preferable method.

In the mid-1990s, the FASB concluded that this was the best way to report the effect of employee stock options in financial statements. The FASB changed its proposal in the face of ferocious opposition from lobbyists and Congress that threatened the existence of the FASB as an independent standard setter. Consequently, it allowed the continued use of existing methods (APB 25) with disclosure in the footnotes to the financial statements of the pro forma effect on net income as if the preferable expense recognition method had been applied.

Recently, Microsoft decided to change its method of accounting for employee stock options to an approach that recognizes an expense for the fair value of the options granted in arriving at reported earnings. A number of other major U.S. companies also decided to adopt or are considering adopting this method.

The IASB recently issued a proposal that would require companies using IASB standards to recognize, starting in 2004, the fair value of employee stock options granted as an expense in arriving at reported earnings. The IASB’s approach is the same as the one the FASB is now considering.

Following the U.S. accounting scandals and pressure to improve the quality of earnings, the FASB is now revisiting its 1995 decision. The FASB is expected to issue a draft rule in the first quarter of 2004 and a final rule by the third quarter. The minutes of the recent FASB meetings suggest the board will probably recommend recognizing the stock-based compensation in the income statement as an expense using a fair value method and measuring the value of the options at the grant date. The FASB is considering various models for determining the fair value of stock options, including the widely-used but often-criticized Black- Scholes model. Value should be based on the contractual life of the option, or the time period until the option expires. Compensation cost will be recognized over the service period.

From Concept To Practical Considerations

Let’s start with a simple example. ABC Inc. allows its employees to acquire 10 million shares of its common stock at $50 per share when the market is also at $50 per share. The options vest over four years and expire seven years from the grant date. The weighted average expected life is five years. The risk-free rate is five per cent. The stock is expected to pay dividends of $1 annually. The volatility of the stock is 33 per cent. The compensation cost is recognized rateably over the vesting period. The company buys back the stock when the options are exercised at a cost of $85 per share. For purposes of this example, we will not consider the taxes.

What is the fair value of the deferred compensation? What is the annual expense using the fair value method?

To measure the cost of these options, we will apply three different methods:

Application of a Simplistic Method

Under this method, known as the ‘minimum value method,’ we will consider only the time value of money in measuring the value of the options. To obtain the fair value of the options, we subtracted from the actual market value of the stock (at the grant date):

Application of the Black-Scholes Model

The Black-Scholes model incorporates the volatility of the underlying stock and provides a better measure of the fair value of the options. The fair value of the options is $147 million (Table 4).

Some critics claim that the Black- Scholes model is appropriate only for options having an expiry date of nine months or less. The significant difference between the simplistic valuation ($65 million) and the Black-Scholes model ($147 million) arises from the volatility impact, not from the timeframe. The Black-Scholes model provides a more realistic and useful valuation than the simplistic method.

The impact of the volatility is significant. The value of the option more than doubles if a volatility of 80 per cent is used instead of 33 per cent. The fair value of the options would then reach more than $300 million.

The investor should carefully consider the volatility used.

The Buyback Method

Some claim that the cash outflow paid by the company to buy back the shares is a good measure of the cost of an option plan. In this case, the cost would be:

Proceeds $500M
Buyback Outflow ($850M)
Net cost (Outflow) ($350M)

The amount of $350M should be analyzed and allocated according to the nature of the various transactions. The buyback method is not appropriate for measuring the stock-based compensation expense because the amount contains an operating component ($147 million) AND a capital component ($350 million – $147 million = $203 million).

Which Method Should Be Used?

In addition to the Black-Scholes model, the minimum value method, and the buyback method, other methods can be used to measure the value of an option such as the binomial method and the intrinsic method. The FASB is looking for a practical method of determining the fair value of an option. It is still too soon to determine exactly which method will finally be recommended. We think that the Black-Scholes model is still the best one.

There are other problems associated with options which have not yet been addressed.

For instance, under the current accounting rules, companies must state the tax benefits associated with options in the operating section of the cash flow statement even if the company has no expenses associated with options. The effect of this is to artificially overstate cash flows from operations.

In addition, tax benefits are also calculated for U.S. tax purposes using the market value of the stock at the time of exercise, but the accounting expenses associated with the option are calculated at the time of allocation and on a different basis (using the exercise price and a model based on the fair value such as the Black-Scholes model). Investors must also take these issues into consideration.

There is no single more important accounting issue right now in the current investor’s landscape than the unrecognized option expense. According to an internal study conducted at Sirius Capital, non-recognition of this expense represents 23.2 per cent of the market cap in the tech sector and 9.6 per cent of the market capitalization of 300 non-technology companies listed on the S&P 500.

Current GAAP (Generally Accepted Accounting Principles) allow companies to inflate their earnings reports. Better accounting practices are needed to give a true picture of financial position and performance.

Theoretically, recognition of the option expense should not have an impact on the market according to the efficient market hypothesis. In practice, however, the impact will probably be negative, as it was when the SFAS 142 on goodwill was applied by AOL Time Warner or JDS Uniphase.

As an investor and a portfolio manager, I see no justification for excluding the cost of employee stock options from the determination of net income.

The fair value method of accounting for stock options should be a requirement. Cash flow from operations should also be adjusted to reflect the after-tax cost of this expense. The impact on earnings will probably be negative for some S&P 500 companies and bad for more tech companies. The only uncertainty is the degree of the impact on the market capitalization of these companies.

Investors should be ready before the new rules become applicable, probably as soon as the third quarter of 2004. The first financial results to be published in October 2004 might be challenging.

Investors must understand the very nature of the situation in order to take appropriate action to reduce the risk associated with the eventual implementation of such an accounting rule. An arbitrage strategy could be developed to benefit from this issue in the coming months.

Richard Beaumier is president and CEO of Sirius Capital Inc., a Montreal-based portfolio management firm specializing in the eTechnology sector.

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