Qualiport

[ July 21, 2000 ]

Accounting for Options

By Maynard Paton (TMFMayn)

Carburton Street, London -- Companies are overstating their profits! That's the impression given by an article on the front page of yesterday's Financial Times. The feature described how the Accounting Standards Board is set to introduce a "radical plan" to alter the reporting of share options in company accounts.

As Sir David Tweedie, the chairman of the ASB, declared in the FT: "These things (share options) have value and they are not being charged (against profits). In some industries it is going to reveal exactly what is going on."

Strong words. So, should investors be concerned over the current "hidden" effects of share options? Are profits overstated? Or is this just a cosmetic accounting argument that should be left for the clever bean counters to resolve?

The basics

Share options are granted to company management and employees to help align their interests to those of the shareholders.

They give the owner the right, but not the obligation, to convert the options holding into an equivalent number of shares. The transaction is performed by the company converting the options into newly issued shares, with the shares then being purchased by the option holder at a predetermined "exercise" price.

If the exercise price is below the current market value of the shares, then the option is deemed to be "in the money". If the price is above the current market value, the option is described as "out of the money". And if both prices are equal, then the options are said to be "at the money". Companies normally grant "out of the money" options.

Of course, the option-holder will only take up, or "exercise", the options when they are "in the money". Typically, a holder will exercise the options and then immediately sell the newly created shares on the open market. The holder's financial reward will be the difference between the price paid for the option-to-share "conversion" and the market value of the shares sold. With the reward being ultimately based on the company's share price performance, the "alignment" between the option-holding employee and the shareholder is created.

Options are usually only exercised when certain predefined performance criteria have been met, although non-performance related options can be granted. Share options also have a limited lifespan. Options are normally only exercisable between three and ten years after the initial grant. If the performance criteria aren't met, or the holder fails to exercise them in the set timescale, then the options are said to have "lapsed".

An example

As with most aspects of investment, these basics are best explained with an example.

Company A has 20m shares in issue and each share is worth 100p. In an attempt to increase shareholder returns, the company decides to grant a total of 1m share options to incentivise its key members of staff. Company A sets a simple performance criterion -- if the shares are above 200p after three years, then all the options can be exercised. The exercise price is set at 150p.

Three years later, and the staff have worked wonders. Company A shares stand at 260p and all the staff exercise their options. Thus, they collectively convert their options by purchasing 1m shares at 150p from Company A. Company A receives £1.5m (1m x 150p) from the staff and it now has 21m shares in issue. The staff promptly sell all of their newly acquired shares in the market and receive £2.6m (1m x 260p), giving a net "bonus" of £1.1m (1m x (260p - 150p)).

So what's the problem?

First impressions suggest there aren't too many problems for the shareholder. The market effectively pays for all of the additional employee remuneration. There are real benefits in the use of share options for quoted companies. Certainly those enterprises that have limited financial resources, but rely heavily on talented employees, do find that "locking in" staff through lucrative shares options can be a more "cost effective" route than the ordinary cash bonus.

But there is an economic cost attached to options. Firstly, there is the obvious shareholding dilution effect. But also, the company issues shares at a discount to the eventual market price, a discount that could be quite significant over the long-term. This "opportunity cost" has to be taken into account. In the above example, instead of selling 1m shares at 150p, Company A could raise up to £2.6m by issuing the shares nearer to the 260p market price. In other words, shareholders are essentially waiving their right to the difference between what the option holders are to pay for the shares and what the market could pay. In Company A's case, the £1.1m is essentially foregone, to be instead given to the company's staff.

Thorny accounting

Trying to account for share options and their rewards is a thorny subject. At the moment, the benefits are not expensed in a company's main profit and loss account. "And why should they be expensed?" most company directors would retort, suggesting that any reward from options is not a tangible cash cost to the company.

But business perspective investors take a different view. Warren Buffett has voiced his concerns over share option accounting in the past. Unsurprisingly, Buffett sides with the aforementioned views expressed by Sir David Tweedie.

Buffett: "It seems to me that the realities of stock options can be summarised quite simply: If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?"

Just like Buffett, the business-focused private investor should imagine becoming the full owner of a business when making part-ownership investment decisions. If you visualise taking private a quoted company that has a large number of options outstanding, then it's going to be you who has to compensate the option holders. As your purchased company wouldn't have marketable shares any more, you'd have to offset the loss of future options through simple cash bonuses. And these cash bonuses would obviously cause cash flow and profits to suffer.

Private Dell

Imagine you're the private owner of Dell Computer Corporation (Nasdaq: DELL). If you didn't have the benefit of share options, your cash incentive alternatives would heavily weigh on your company's profits.

Taken from Dell's 10-K covering the year to January 2000: "Had the Company accounted for its Incentive Plan and employee stock purchase plan by recording compensation expense based on the fair value at the grant date on a straight-line basis over the vesting period, stock-based compensation costs would have reduced pretax income by $329m ($224m, net of taxes), $194m ($136m, net of taxes) and $100m ($69m, net of taxes) in fiscal years 2000, 1999 and 1998 respectively."

As I mentioned in a recent review of Dell, "In other words, had Dell employees been working for a private company and been given cash instead of exercising their options, post-tax profits would have decreased by 13%, 9% and 7% in the fiscal years 2000, 1999 and 1998 respectively."

I guess it all boils down to this. Say there are two identical companies: same turnover, same assets, same everything. One is private, one is quoted. Should they be valued differently because one has access to "cost free" options that don't affect their reported profits?

Just from looking at Dell, accounting for share options is certainly no cosmetic presentation issue for the accountants to settle. On Monday, I'll continue on the topic of share options, touching upon what the ordinary investor should look out for. Specifically, I'll be considering the seven Qualiport companies and their activities in this area. Will there be anything for the "business perspective" Qualiport managers to worry about?

In the meantime, any comments about this feature or share options in general can be directed to the Qualiport discussion board, in the Resources section below.

Where Next?

• Review the US Fool's take on Optionmania