Expensing Options

Interesting observation - anyone wish to comment ?

21/5/2002
Executive Options should be Expensed

It is very likely the US President and the Chairman of the US Federal Reserve occasionally have their little differences. But when they clashed quite publicly recently over the treatment of share options, shareholders could applaud from the sidelines that this apparently esoteric subject was at last getting the attention it deserves.

At stake in the US is a hefty 15% of the capital of the Standard & Poor’s 500 firms: a massive fortune for large numbers of US executives. This windfall has been surreptitiously appropriated from shareholders under the guise of share options.

Last month, Cisco’s CEO, John Chambers, was in Australia publicly opposing the expensing of options. With good reason; while Mr Chambers had previously acquiesced in a stunt that saw his salary cut to $1 per annum, at the same time regulatory filings showed that he made a cool US$150 million by exercising stock options. Who needs a salary of $1 or even $268,000 (his previous salary) when you can take home serious money?

And Cisco is just one of many. Had share options for example been expensed by Microsoft last year its earnings would have been slashed by almost 80% or a whopping A$13.4 billion. Most shareholders are just not aware of the hidden cost of options nor that company earnings are being artificially inflated.

Alan Greenspan describes the failure to expense stock options as introducing a "significant distortion in reported earnings" and argues the Black-Scholes methodology should be used to value options and they should be recorded in the same way as other forms of compensation.

Mr Greenspan echoes the views of Warren Buffett who recently depicted American CEOs as "top dogs", fighting to retain the status quo, in a "survival of the fattest" contest.

In an article which will be republished in the next issue of the ASA’s monthly newsletter , Mr Buffett poses the questions: 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?

US corporations at least have to provide footnotes to financial statements to enable analysts to calculate reasonable estimates of the effect of these lucrative perks on earnings.

But here in Australia the corporate community tries to ensure that the golden pot is not stirred and the lid is kept firmly in place. Others with vested interests such as remuneration consultants collude in this endeavour.

Any suggestion that options be expensed is rejected on the grounds that their value can’t be estimated, that existing disclosures are adequate or that issuing options is a change in proprietorship rather than a cost to the entity.

These arguments are spurious. As Dr Greenspan observed, other important items such as depreciation, stock revaluations and bad-loan provisions are all estimates. And while Black-Scholes may have deficiencies there are alternatives – some Australian actuaries for instance have developed a methodology for valuing options that takes account of performance hurdles.

Existing disclosures might be acceptable to professional analysts but they are totally inadequate for shareholders who should be properly informed of the true cost of remunerating executives.

And shareholders should also be apprised of the dilutionary impact of options instead of seeing their value shifted almost furtively to greedy executives.