SEC Allows Market-Based Options Expensing… Though Questions Linger

Wall Street

from the is-the-market-accurate? dept

A few years ago, there was a big debate over whether or not companies should be forced to expense stock options. Most companies did not count stock option grants as an “expense” on the income statement, even though it could impact the company’s financial situation. Some argued that this gave companies a way to hide compensation — though, that was somewhat misleading. Most of the necessary information was still in the footnotes — it just didn’t play directly into the numbers. There was some speculation that if forced to expense stock options, companies would stop using them as an incentive and it would hurt the stock of many companies as it would be harder to appear profitable (more expenses dragging down the net income number). Of course, this was silly also. Since the number of stock option grants didn’t have any real immediate impact on cash, it wasn’t impacting the actual cash position of the company. It seemed likely that the market had already calculated in the “expense” of options. Indeed, after FASB decided that companies should expense options, the impending doom many predicted failed to appear.

Of course, that doesn’t mean there still aren’t question about how you expense stock options as there’s no really good way to know how much they’re worth. The standard method for calculating the price of an option, the Black-Scholes method, isn’t really accurate for high growth companies — but it’s what is most commonly used. However, there have been some experiments to more accurately price options. Cisco kicked off the debate on this topic a couple years ago by proposing derivatives based on the options that could be publicly traded. Then, Cisco could expense the actual options based on the market price of the derivatives. The SEC rejected this plan, but it appeared that the rejection was mainly on some finer technical points. When another company, Zions Bancorp, proposed a very similar model, the SEC seemed much more willing to along with it. The latest is that the SEC has now approved Zions’ plan for options expensing based on publicly traded derivatives. The story at Gigaom provides some of the reasons why this might not actually be a very accurate way of expensing options — but it seems a lot more accurate than something like Black-Scholes. Also, again, the market has most likely already priced in the real impact of these numbers games into the stock price, so it shouldn’t have any real impact. Given the approval, though, expect many other high growth companies to jump on board with similar plans, as it’s likely to reduce the “expense” associated with options.

In the meantime, we’re still surprised that there hasn’t been more discussion about Google’s experiment with actually allowing employees with stock options to sell the options themselves to institutional traders. That seems like it could be an even more accurate way of pricing the options, since there will be a real market for them. However, it still seems like it’s being used merely as an employee perk, rather than a method for expensing options.

Filed Under: black-scholes, expensing, sec, stock options
Companies: cisco, google, zions