Commentary: Options: A Modest Proposal

Why not expense part of the cost at grant and the rest at expiration?

Like heavyweight boxers at the end of a round, the warring sides in the debate over expensing employee stock options have retreated to their respective corners. In this corner: the supporters, who say options are an expense like any other and should be treated as such on the financial statement. In the far corner are those who claim that doing so would cripple technology companies that make generous option grants to the rank and file, and that it would kill innovation by making it impossible for new companies to recruit high-priced talent. Ultimately, they say, expensing options would make the U.S. economy less competitive.

While the positions seem well-entrenched, there is a solution -- and a fairly simple one, at that. The elements are not new to anyone who has followed the expensing debate; credit goes to legislators, accounting experts, and partisans in the expensing war. But combining them in a novel way creates something that has so far eluded policymakers: a workable plan. The Financial Accounting Standards Board (FASB) should consider it as part of its review of proposed expensing rules to be released in March.

To answer the complaint of techies that FASB would force them to take a larger expense than they need to, companies should be allowed to reduce the upfront expenses listed on the income statement by as much as half when options are granted. Then all companies -- those that choose to make a reduction and those that don't -- should be required to adjust the expenses when the options expire, so that ultimately they reflect an amount equal to the value received by employees.

The result: The true value of every option granted would be reported on the income statement, yet companies would retain the flexibility to minimize the upfront impact on earnings. "It's a reasonable approach," says Charles W. Calomiris, a finance and economics professor at Columbia University. "It's certainly an improvement over [current expensing] proposals."

BEYOND BLACK-SCHOLES. One of the biggest drawbacks to the present FASB position is its reliance on the Black-Scholes option-pricing formula. Developed in the 1970s to price publicly traded options, it has become the primary means for valuing employee stock options, even though it routinely underestimates their value in a bull market and overestimates their value in a bear market. Opponents of expensing rightly claim that using Black-Scholes is a little like using a wheel of fortune to figure your taxes; you may get it right, but you may end up overpaying Uncle Sam.

The solution is simple. After calculating the Black-Scholes value of the options they grant, companies should be permitted either to expense that amount as the options vest, as FASB would have it, or reduce the amount they expense by up to half, depending on the company's view of its likely stock performance and other factors like volatility that affect option values. When the options expire years later, companies should be required to tally up the value received by employees, taking into account options that never vested because employees quit, those that expired underwater, and those that were exercised for gains that far exceeded their Black-Scholes value -- and adjust expenses accordingly.

Under such a reconciliation, companies with cyclical businesses or highly volatile stocks would not pay dearly, as they would under the FASB proposal, for millions of options that expire underwater. Says Jim J. Guilfoyle, director of accounting at Cummins Inc.: "You won't over-expense your earnings in the years when you recorded the options. You'd get higher-quality earnings."

No expensing plan is perfect, of course. In this case, companies that reduce upfront option expenses would be taking a huge risk. A runup in the stock could result in a massive hit to earnings down the road as the value of the options soared. That risk could be mediated by allowing companies to take an additional charge to earnings before the options expire. That's not enough for the purists, who say that the process of matching the expense of options with their ultimate value -- called "truing up" -- muddies corporate financial statements. They look at options as payment for services rendered during the vesting period, and say that subsequent changes in value have no place on the income statement.

Finally, there is a practical consideration: Will companies that choose to reduce upfront option costs send a signal to the markets that their stock price might be headed for a fall, triggering a rush to the exits? Under the FASB method, that's not a problem. Says Phil Ameen, the comptroller at General Electric Co. (GE ), which began expensing in 2002: "I personally think the best method is the one we have right now."

But the fact is, companies do this sort of reconciliation all the time -- in accounting for pension-fund returns, goodwill, and private equity, for instance -- and with FASB's blessing. It makes eminent sense for options, where the true value cannot be known until long after they've been issued. Even those who oppose option expensing agree such a system could work, although they say financial statements would still reflect unrealistic Black- Scholes values until the adjustments are made. Says Jeffrey Peck, the lead lobbyist for tech companies that oppose expensing: "It still doesn't begin to address the pollution of the financial statement that occurs at grant date."

Maybe so. But the pollution that occurs now-the omission of option costs from the financial statements entirely -- is far worse. A compromise that corrects that is well worth considering.

By Louis Lavelle

    Before it's here, it's on the Bloomberg Terminal.