By Louis Lavelle That tick, tick, tick you hear is time running out on favorable accounting treatment for stock options, a popular employee pay perk. Come 2005, the Financial Accounting Standards Board has proposed ending the special treatment options have enjoyed for decades (see BW, 12/1/03, "Options Grow Onerous".) And on Nov. 19, Senator Michael Enzi (R-Wyo.), a former accounting manager and chairman of the Senate Banking panel's Securities & Investment subcommittee, introduced a bill in Congress that would replace the old rules with a new set of criteria for expensing stock options on corporate income statements. An identical, companion measure has been introduced in the House.
Is a solution at hand? Hardly. If anything, Enzi's bill simply replaces one accounting fiction with another. The bill, which purports to bridge the gap between expensing and antiexpensing factions, does nothing of the sort. It would require expensing only of options granted to each company's chief executive and the four other highest-paid executives -- and mandate the use of a valuation method that amounts to a cure worse than the disease.
THE VOLATILITY FACTOR. Enzi says expensing all options using current valuation methods would kill entrepreneurial activity and hurt U.S. competitiveness. Limiting expensing to options given to top executives, he says, puts the spotlight where it belongs. But his proposed solution would keep the vast majority of options off income statements, distort the true cost of even the few options that would be expensed, and do nothing to rein in out-of-control executive pay.
The fiction Senator Enzi seeks to replace is the widely used Black-Scholes option-pricing model. The formula uses information about stock and exercise prices, as well as assumptions about future dividend yield, expected option life, and other variables, to arrive at an estimated value on the day the options are granted.
One of those variables is something called "expected volatility," or the extent to which the company's stock price will rise and fall over the option's life. Every stock is "volatile," but trying to predict volatility, for mere mortals, is nearly impossible.
WORKS OF FICTION. Black-Scholes is hardly a perfect way to value options. Guesses about the future of the sort that Black-Scholes requires CFOs to make have a way of being wrong with remarkable frequency. Who's to say if 10-year options granted in 2003 are going to be exercised before they expire -- and at what price? As too many employees of failed and struggling dot-com outfits know only too well, options have a way of sinking under water, never to resurface. Employees often quit, leaving unvested options on the table.
Enzi is to be applauded for trying to deal with Black-Scholes shortcomings, but his solutions don't measure up. Instead of trying to estimate volatility for the option's life, Enzi would have companies assume zero volatility -- in effect replacing the fiction of expected volatility with the fiction of no volatility at all.
This would gladden the hearts of every tech executive in Silicon Valley, where broad-based option plans designed to retain and motivate workers -- a tech tradition for decades -- would be imperiled by expensing. By changing that one assumption, the value assigned by the Black-Scholes formula is dramatically reduced. The example of Cisco Systems (CSCO) is instructive.
ACCOUNTING MIRAGE. Under standard Black-Scholes, the nearly 200 million options Cisco awarded in fiscal 2003 were worth a staggering $1.1 billion -- a figure that would have cut 2003 net income by a third had the outfit expensed them. Yet under Enzi's scheme, those options would be worth about a third of their Black-Scholes value, about $405 million.
Furthermore, Enzi's bill would require companies to expense only the options awarded to the chief executive and the four highest-paid executives below him. At some businesses, the top five executives might account for the bulk of options awarded in a given year. But at outfits with broad-based plans -- tech companies especially -- Enzi's bill would require the expensing of a tiny fraction of annual option awards.
At Cisco, just 3% of options awarded in 2003 went to CEO John T. Chambers and the four executives below him. Those options would have been valued at just $14.5 million under Enzi's proposal. The other 194 million options would be treated just as they are now -- an accounting mirage that appears only in footnotes.
"COMPLETELY RIDICULOUS" Enzi argues that Black-Scholes "doesn't reflect the true value of options for accounting purposes," and that the "truing up" provisions in his bill will allow businesses to adjust option expenses when they're used or expire. "Companies must be able to recognize the true expense of stock options on their financial statements," Enzi said at a Capitol Hill press conference announcing his bill's introduction. "Unfortunately, the current valuation models for stock options -- Black-Scholes, binomial, Crystal Ball, and others -- are horrible indicators of the true cost to a company of stock options."
To be fair, Enzi is not alone in seeing zero volatility as a solution to the Black-Scholes dilemma. Frederic W. Cook, a New York City compensation consultant who serves on a panel working to devise new valuation methods, says it would allow for easier comparisons between companies and it wouldn't penalize outfits with high volatility, such as startups. "It's reasonable. It's simple. It's transparent," Cook says. "It's a good compromise solution."
Yet Myron Scholes, who created the Black-Scholes formula with Fischer Black and Robert Merton in the early 1970s, says volatility is the key to determining option values -- ignoring it will almost always underestimate their true value. "That's completely ridiculous," Scholes says of the zero-volatility idea. "Under any model, that's not a valid way to value options."
DOES NOT COMPUTE. At this point, Enzi's bill may be the best hope for those fighting to limit options expensing. House and Senate bills that would block expensing are both stalled, although the House bill has garnered 106 co-sponsors. And the FASB, which plans to issue a final rule next year ordering mandatory expensing in 2005, shows no signs of backing down.
The Enzi bill could gain traction on Capitol Hill in an election year, as anger over lavish executive pay packages runs white hot. His approach would hold the stock options extended to top execs up to scrutiny, while leaving those of low-level managers and employees alone. "It's a good marriage of accounting principle and political reality," says Jeffrey Peck, an anti-expensing lobbyist for the Washington (D.C.)-based International Employee Stock Options Coalition. "By expensing the top five, there's a reflection of the political reality that one has to address the subject of executive compensation."
Addressing the issue of executive pay and actually doing something to fix it are two different things, however. By limiting expensing to the options awarded to five top executives and assigning those perks the lowest possible value, Enzi's bill doesn't do anything about reforming excessive executive pay. After all, would Cisco stiff its five top managers to avoid taking a $14.5 million charge to 2003 earnings of $3.6 billion? Not likely. Do the math, Senator Enzi. Lavelle writes for BusinessWeek in New York