Keeping Options Under Wraps
The economic logic seems unassailable: Since the pay and fringes received by rank and file workers are a business cost that is recognized as an expense item on income statements, so too should the big chunk of top executives' compensation made up of stock options.
Now that option pricing models have made it relatively easy to place a value on options, however, corporations argue that expensing options would have harmful economic effects. By reducing reported earnings, they say, the practice would cause stock prices to fall and thus raise the cost of capital.
Such views were the gist of the 1,700 or so comment letters received in 1993 by the Financial Accounting Standards Board (FASB) when it finally dropped the other shoe and unveiled a proposal to make companies recognize the cost of employee options as an expense. As a result of the firestorm of resistance, the FASB backed off, and companies will now be required merely to disclose the estimated costs of options in a footnote.
In a new study, Patricia M. Dechow and Richard G. Sloan of the Wharton School and Amy P. Sweeney of the Harvard Business School have assessed the validity of corporate objections to the FASB proposal. They find no evidence that companies dependent on external financing make especially intense use of stock options as compensation. More important, they find that the stock prices of companies making heavy use of options did not react negatively when the news of the FASB proposal broke.
The three accounting professors also looked at the companies registering written objections to the expensing proposal. On average, they found that the top five executives in each of the companies heard from received both much higher total compensation ($1.2 million vs. $880,000) and a higher fraction of their pay in the form of stock options (28% vs. 21%) than the top brass of a matched sample of companies that registered no complaints.
The study's bottom line: The concerns expressed about the impact of expensing options on stock prices and borrowing costs seem to have been a smoke screen to avoid publicizing bosses' high pay.