What have we wrought? Expensing stock options was supposed to provide a clear, consistent picture of earnings that can be compared across companies and industries. But that goal may now be fading. With a June deadline for expensing options, corporations are rushing to soften the expected hit to their bottom lines. They are each making very different decisions that threaten the consistency and comparability of earnings figures. While there were grievous corporate pay abuses in the '90s due to options, reform may prove as problematic as the original problem. The Financial Accounting Standards Board should provide more guidance to make expensing options work. And auditors will have to speak up when they see bogus assumptions being made.
Putting a value on options, of course, is harder than calculating other compensation. You have to estimate future value, for example. By changing the assumptions underlying that estimate, companies can sharply reduce the expense. Take volatility. High-tech companies depend on options for a very high share of compensation. To lower the cost of expensing options, they are sharply reducing the assumed volatility of the underlying stock. While a case can be made for a secular decline in stock market volatility (the S&P 500 index traded in a very narrow range in 2004), one Silicon Valley company is cutting its volatility assumptions in half.
Others are reducing the life expectancy of options or cutting the duration of options from 10 to 7 or 6 years to lower estimated future value. Some are extending the vesting period. Others are vesting all options from previous years.
The good news is that the assumptions underlying options' value are being made more obvious to investors. The bad news is that companies are going down many paths in expensing. There is no uniform accounting standard. We may be heading back to pro forma hell.