Why Expensing Options Is No Cure
By Aaron Bernstein
On Mar. 12, the Financial Accounting Standards Board (FASB) finally decided to consider whether to require companies to deduct the cost of stock options from their earnings. While the board won't finish its deliberations for months, the move was welcomed by angry investors who have been agitating for curbs on runaway executive options grants.
Too bad expensing options isn't the solution advocates think it is. Sure, CEOs across Corporate America have abused options, taking far more value from shareholders than they possibly can justify. But little will be achieved by simply delineating how much they've taken, which is really all that expensing options accomplishes. "People who argue that expensing will rein in executive pay are deluded," says Corey Rosen, executive director of the National Center for Employee Ownership and the editor of a forthcoming book, Equity Compensation in a Post-Expensing World.
Here's a crude analogy: Expensing is sort of like the owners of a shop putting up a sign in the window that says: "Help, the manager we hired to run this joint is raiding the till." The idea is that when the stock market realizes how shareholders are being ripped off, it will knock down the offending company's share price and force management to curtail the option plan.
However, there's good reason to think that nothing of the sort will occur. For one thing, cutting reported profits by some estimate of the future cost of the options the company has issued doesn't change its actual profits. The company will still make the same amount of money every year. The only difference is that the earnings will be reduced by a projection of how much cash it would take to buy back the shares underlying the options, should they be exercised when they vest a few years down the road.
In addition, expensing options likely won't impose much discipline on greedy execs because the stock market has probably already discounted the option costs at most companies. For example, the share prices of 103 companies that announced last summer that they would expense their options, such as Coca-Cola (KO ) and General Electric (GE ), didn't take much of a hit vs. the market in general during the 120 days before and after the announcements, according to a study by consultants Towers Perrin. "This study would suggest that investors on balance are insightful enough to have baked in the impact of expensing," says Gary Locke, a practice leader at Towers Perrin.
Many B-school finance professors seem to think the market would react with the same indifference if FASB does eventually require all public companies to deduct option expenses. More than 80% say expensing would have little or no significant impact on stock prices, according to a survey of 37 finance professors done in January by Rosen's group. As Rosen puts it, expensing would likely turn out to be the Y2K problem of stock options: much feared but of little consequence when it actually happens.
Unfortunately, the still-too-timid Securities & Exchange Commission has missed yet another opportunity to intervene in this issue on the side of beleaguered investors. It has failed to institute a rule proposed by the New York Stock Exchange and Nasdaq at the height of the corporate scandals last summer that would require companies to submit option plans to shareholders for approval. As a result, CEOs remain free to grab as much as they can get their boards to rubber stamp.
At this point, shareholders have little choice but to take matters into their own hands. They can and should mount major lobbying campaigns to goad the SEC into action. But while they're waiting for a response, they can also submit proxy resolutions calling on companies to curb options for top execs or even ban them altogether, as a handful of brave souls have done at companies such as American Express (AXP ) and Verizon (VZ ).
Of course, proxy resolutions aren't binding on management, so CEOs can brush them off just the way most have largely ignored the public outcry against their excessive pay. But until the SEC or Congress can be prodded to do something, that's a better bet than wasting energy on futile expensing measures.
Bernstein is a BusinessWeek senior writer in Washington, D.C.
Edited by Thane Peterson