Expensing Options Is Bad Accounting?

Just when I thought the debate was over, it has been re-opened as several accounting experts have claimed that expensing options is bad accounting. Here is the logic:

  • An Employee Stock Option (ESO) is a "gain-sharing instrument" in which shareholders agree to share their gains (stock appreciation), if any, with employees;
  • A gain-sharing instrument, by its nature, has no accounting cost unless there is a gain to be shared;
  • The cost of a gain-sharing instrument must be located on the books of the party that reaps the gain;
  • In the case of an ESO, the gain is reaped by shareholders and not by the enterprise; so the cost of the ESO is borne by the shareholders;
  • This cost to shareholders (which, coincidentally, exactly equals the employee's post-tax profit) is already properly accounted for under the treasury stock method of accounting (described in FAS 128, entitled "Earnings per Share") as a transfer of value from shareholders to employee option holders;
  • Neither the grant nor the vesting of an ESO meets the standard accounting definition of an expense. Moreover, ESOs can be granted only to employees, are not transferable, and are cancelable at the will of the company (by terminating the employee). Consequently they cannot be sold on the open market. And to sell them to employees defeats their purpose. Thus, companies do not forgo any cash when they grant ESOs, so their issuance cannot be an opportunity cost.

I don't get it. If I give an option to my employee at a $15 strike price and six months from now he cashes it in when the shares are $20, all I've done is raise capital in an inefficient way. How is that good for anybody other than the employee? That $5 difference is a real economic expense.

  • Elmar

    If you raise capital in an inefficient way, you leave money on the table – That $5 difference could have gone to the owners of the company, so it is a “cost/loss” in the sense of “I, the shareholder, have less money”.

    The point here, though, is that it is a cost to the *shareholders*, not the company. It doesn’t affect the company’s bottom line, since it doesn’t have to spend those 5 bucks.

    The problem is that if you pay someone with options, you take something that *is* a cost to the company (that person’s salary), which means lower profits, and therefore lower shareholder value, and convert it to something that is a direct loss to the shareholders.

  • A fundamental problem with options expensing is that it tries to convert *division* into *subtraction*, which is not possible.

    If a company pays someone $50000, that $50000 is a definite amount subtracted from cash. If the company pays someone with options, the effect is to potentially dilute the shares and hence reduce EPS for the existing shareholders. Since dilution increases the denominator on the EPS calculation, the “cost” of that dilution to the existing shareholders is not a constant knowable at the present time, but is rather a function of future earnings.

  • Don Lloyd

    If your company takes in $5 in revenue every day and spends $4 in cash a day for all of its inputs, it will accumulate $1 per day, every day. Even if you give away half of the remaining company every day, that $1 a day will still be accumulating. It is only who has how much of a claim on that $1 per day that is affected.

    A business and its owners are distinct entities.

    Regards, Don

  • Rob

    I agree. Options are usually a form of compensation. In many cases, they are given in lieu of a higher salary.

  • …my point being not only that options are a form of compensation, but that it is misleading to show them on the books as a contrived expense item.