Stock Option Studies and Options Expensing

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Two studies have found connections between lucrative stock options and grants paid to chief executives as compensation and companies that report accounting irregularities, flawed accounting practices, or engage in risky business strategies. These studies were undertaken by Brigham Young University and the University of Minnesota.

The Brigham Young study found that companies who compensate their executives with large stock packages tend to engage in potentially dangerous business strategies leading toward larger capital spending or growth by acquisition.

"Such risk-taking does sometimes pay off, but more often than not it results in underperforming expectations," wrote Professor William Gerard Sanders writing in his study. He teaches business management at Brigham Young.

"The concern about stock options is that they can encourage companies to make short-term business decisions that are not in the best interests of the shareholders," said Brandon Rees speaking with Reuters. Rees is a research
analyst for the Office of Investment at the AFL-CIO Federation of Labor Unions in Washington, DC.

"The reason people still give options is the reason they gave them before -- they have no value unless you make the stock price goes up. There is a legitimate reason for giving out options. It's not like they went from good
to bad overnight," said Mike Melbinger speaking with Reuters. Melbinger is chair of the executive compensation and employee benefits practice at the law firm Winston & Strawn in Chicago.

The University of Minnesota study examined companies that restated their financial results between January 1997 and June 2002. The study found that these companies were more likely to report accounting problems or faulty accounting practices that might have lead to these irregularities were mainly by CEOs who were highly compensated using stock options or grants.

This study has its detractors though. Charles Peck, a compensation expert at the Conference Board told Reuters, "Accounting restatements may correlate with the use of CEO stock options, but it does not necessarily mean that one is driving the other."

But flawed compensation or not, stock options and grants are still used by companies to attract and retain their valuable employees. With new accounting rules coming from the FASB and FSB aimed at U.S. companies to treat options as expenses, offering of stock options may change.

All stock options and grants will be accounted for as a compensation expense against the company's income in the future. The Securities and Exchange Commission (SEC) will enforce this generally accepted accounting practice
(GAAP). Most companies do not need to comply with this rule until January 1, 2006 although companies ending their fiscal year in June will start expensing options against income in their next quarter.

Microsoft now gives restricted stock to its employees instead of outright option grants. The company is a proponent of expensed options. "We firmly believe that stock-based compensation is a true expense of our business," said Chris Liddell, Microsoft's CFO, speaking with the International Herald Tribune. He went on to say "and expect that analysts and investors will begin to include the impact of compensation in the financial statements in their models."

With the deadline coming, some companies still tinker with the presentation of reduced earnings before being forced to expense their options. Investors are ultimately being deceived in their exercise. Some companies are lowering already low “volatility” assumptions in their options expense calculations. Some analysts and companies believe they can sidetrack investors attention away from the real cost of options.

Some earnings compilers only publish “consensus” or Ebitda (earnings before interest, taxes, depreciation, and amortization) numbers although quite different from GAAP measured earnings. “We're following the protocol established by the marketplace,” declared Mike Thompson speaking to the International Herald Tribune. Thompson is the director of research for Thomson Financial.

On the right side of options expensing, companies like UBS have established policies requiring their analysts to account for the cost of options in their earnings estimates. David Bianco is UBS' head of U.S. valuation and accounting. “We're trying to take some leadership here. It's important,” he said to the International Herald Tribune.

"The real point should be that you should be careful about how you motivate people," said Alan Johnson speaking with Reuters. Johnson is a compensation consultant and managing director of Johnson Associates based in New York. "If you are inappropriately motivating people, that's a problem."

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