Option Expensing

Incentive stock options have been in the news again with the "backdating" scandal. The issue is whether various companies' executives manipulated option grants by backdating them to a time when their stock price was near a low and therefore guaranteeing themselves a profit. I haven't followed this scandal that closely because frankly, I don't see that it's a big deal. Shareholders were told the quantity and price of the option grants and if they had a problem with it, they could sell the stock. Furthermore, if the executive had something to do with the subsequent rise in the stock price, maybe he/she should be compensated through a bonus scheme. Giving the bonus in the form of a backdated option merely makes the bonus taxable as a capital gain rather than regular income. And I never have a problem with anyone paying less in taxes.

My greatest concern about options has been the accounting treatment that now requires all options to be expensed through the income statement. This change was supposed to make more obvious the true cost of the options that were being granted to top executives and was pushed by the class warriors who are concerned about CEO pay. It all smacks of envy to me, but nevertheless, the FASB (Financial Accounting Standards Board) caved in to the political pressure and decreed that all options must be expensed. Here's my problem with it; there is no way to accurately value the option at the time it is granted and forcing expensing just provides unethical executives another way to manipulate reported earnings. Furthermore, the "cost" of the options are already reflected in the balance sheet. If the options are exercised, existing shareholders will be diluted. The real problem was that investors were just too lazy to actually look at the balance sheet and all the footnotes.

Now, because of expensing, several questions arise:

1. What if the value placed on the option at the time of grant is wrong (as it is likely to be)? Will companies be forced to restate earnings from previous quarters or will there be adjustments in future quarters? Doesn't that make evaluating the company even harder than it was before expensing?
2. If the "cost" of the option is reflected in the income statement and through changes in the number shares outstanding, aren't the costs overstated?
3. What if the options are never exercised because the stock price declines? Will the companies add back the "expense" in a later quarter?
4. Since the "cost" of incentive options involves no outlay of cash, why should current earnings be penalized? Isn't it more like a future liability and therefore more properly reflected on the balance sheet?

The Wall Street Journal has an OpEd today about a group of economists and others who are pressing to end the expensing of options. The group includes Nobel Prize winners Milton Friedman and Harry Markowitz. Click on the title to read the entire story. Here's an LA Times article about the group. And here's a press release from UC Berkeley, where the position paper was published.