The Financial Analyst: The Great Stock Option Debate

    by CFA Institute

    Proper accounting for stock options is a moving target that has challenged the accounting industry for many years, since it is a benefit that both may be exercised in the future and is based on the ever-changing value of a stock.

    The recent corporate accounting scandals like Enron, WorldCom and Tyco have publicly shed light on a long-standing flaw in the use of intrinsic value as the standard accounting method for employee stock options—typically, little or no compensation cost shows up on a company’s balance sheet. Intrinsic value recognizes only the difference between the price offered to the employee and the current market value. When the stock option price is equal to or greater than the market value, it is not recorded on the income statement as an expense. However, this valuation method does not reflect either the time value of money or the likelihood that the stock’s price will go up during the period when the employee can exercise the option.

    The Financial Accounting Standards Board (FASB) in mid-December issued new accounting standards requiring that stock options appear on income statements using a fair value–based method over the time of the employee’s service; the calculated fair value of the stock options would be deducted from net income.

    Since 1972, companies have used guidance from the Accounting Principles Board, the predecessor of the FASB, in using intrinsic value as the basis for accounting for stock options. However, the FASB recognized that this was not the best method of accounting for stock options. In 1995, the FASB implemented a new standard, where companies would use fair value–based accounting instead of intrinsic value. Nonetheless, the use of this new approach was a very divisive issue, and FASB also allowed companies a back door where they could continue to use intrinsic value as long as they disclosed their pro forma measures of net income and earnings per share as if they had used fair value.

    In 2002, the FASB issued a stop-gap measure that provided two new transition methods for companies that wanted to voluntarily switch to fair value–based accounting and also required greater and more prominent disclosure. This stop-gap measure is now superseded by the FASB’s new standard, but it has already facilitated the implementation of voluntary fair value–based accounting by many American companies.

    Prior to the accounting scandals, few companies voluntarily used fair value–based accounting, but in their wake, a significant percentage has adopted the standard. According to the FASB, by February of 2004 over 40% of the S&P 500, by market cap, had moved to fair value–based accounting.

    This change represented a huge step forward in accounting transparency, but it also created inconsistencies in adoption, as companies used different calculation methods. Furthermore, the FASB recognized that the International Accounting Standards Board (IASB) was more advanced in its work on employee stock options, issuing its own update, International Financial Reporting Standards 2, in February 2004. Beginning January 1, 2005, public corporations in European Union capital markets are required to expense employee stock options in their financial statements. The FASB and IASB have agreed in principle to converge their accounting standards quickly and cooperatively.

    The FASB’s new standard creates reporting consistency in the United States and eliminates some inconsistencies between its standards and the new IASB rule. Most importantly, it eliminates the use of the intrinsic-value method, except in the case of non-public companies. Until this standard is fully implemented, however, investors and analysts must live with inconsistencies. Large companies have until June 15, 2005, to comply, while small companies have until December 15, 2005.

    Buried Treasure: Stock Option Disclosures

    Most analysts and investment professionals use information about stock options when evaluating a firm’s performance and determining its value. Where do you find stock option disclosures in financial statements? The most direct route is to go past the financial statements and into the “Notes to Consolidated Financial Statements.” Now find the subheading that discusses employee stock options and you will likely find a lengthy disclosure that will tell you:

    1. Whether the company expenses employee stock options;

    2. If the company does expense options, what the actual impact on net income in dollars and on a per-share basis will be;

    3. If the company doesn’t expense options, what would the impact on net income have been if it did expense them; and

    4. The method under which stock option expense is calculated.
    Expensing options reduces earnings per share—sometimes dramatically. Take eBay, for instance. To find out eBay’s employee stock option accounting policy, go to page 97 of eBay’s 2003 Form 10-K [filed in March 2004] and locate the heading, “Stock-Based Compensation” (see box at end of article). In the first sentence, the company writes that most technology companies—such as eBay—use the intrinsic-value method. Under this method, companies take the difference between the employee stock option price and the current market price on the date of the grant. Since the option price and the market price on that date are usually the same, there is no compensation expense. Hence, intrinsic-value method essentially means that the company doesn’t expense options.

    But here’s where the controversy lies. Even though the intrinsic-value method says there’s no compensation, the employee has clearly received value. Assume that on June 3, 2004, an employee was granted an option to buy shares at $88—the same as the market price on that day. Although there is no compensation expense under the intrinsic-value method, the stock option has value because the employee has the right to buy the stock at $88 over a period of time when it may trade much higher.

    In the footnote, eBay indicates what the earnings impact would have been had the company selected to expense employee stock options. They determine the fair value of employee stock options using the Black-Scholes option-pricing model. In one table, eBay shows what the impact would have been had they expensed options over the past three years. In 2001, net income as reported went from $90.4 million to a loss of $117.9 million, which is a difference of approximately 230%; in 2002, it would decline almost 75% from income of $249.9 million to income of only $62 million; and in 2003, net income would decline 44% from $441.8 million to $245.5 million.

    These numbers show that expensing options would have a dramatic effect on reported income. Although the eBay footnote discloses assumptions used in the model, Black-Scholes has its critics, and different methods can produce radically different answers [see accompanying article below].

    Stock Option Accounting: The Methods to the Madness
    Intrinsic-Value Method vs. Fair-Value Method

    Currently, most employee stock options are valued for financial reporting purposes using the intrinsic-value method, which is the difference between the strike price and the market price on the date the options are granted. If the market price is above the strike price, then the option has an intrinsic value and is expensed. For example, if the strike price is $35 and the market price is $40, the intrinsic value is $5, and the $5 is expensed. That said, most employee stock options have no “intrinsic value” on the date they are granted, as the strike price is usually set at or above the market price, so the expense is zero (it can’t be negative).

    The new FASB standard requires the use of the fair-value method, which considers additional variables intended to produce a more accurate value that usually requires expensing. For this reason, fair-value methods are preferred by many equity analysts to intrinsic-value methods.

    In fact, a 2001 survey of CFA Institute members showed that 81% of analysts and portfolio managers surveyed use information about stock options when evaluating a firm’s performance and determining its value. The study adds that 66% use the information regardless of where it is found. Perhaps most telling of the importance of expensing stock options was that 85% of surveyed investors said that the firms they evaluate have stock option plans.

    Fair-Value Models

    How is fair value determined?

    The two primary methods for determining fair value are Black-Scholes and binomial.

    Black-Scholes Model

    Developed in 1973 by professors Fischer Black and Myron Scholes to price exchange-traded call options, Black-Scholes is one of the most widely accepted models in finance. It incorporates stock price, exercise price, expiration date of the option, expected stock volatility, and market interest rate to produce a theoretical option value.

    For example, using a stock price of $35, a strike price of $35, a five-year maturity, a risk-free rate of 1.2% and expected volatility of 20%, the Black-Scholes model calculates the stock option at $7.08. This is compared to $0 using the intrinsic-value method.

    Though an option-pricing standard, the Black-Scholes model has notable weaknesses. It assumes that markets are efficient, that European exercise terms apply, that no commissions are charged and that interest rates remain constant and known. In addition, variables specific to employee stock options, such as vesting, non-transferability, employee turnover, and dilution on shares outstanding, are not considered.

    Binomial Model

    To bypass some of the limitations of Black-Scholes, many analysts prefer the binomial model developed by professors J. Cox, S. Ross, and M. Rubinstein in 1976. The binomial model is similar to Black-Scholes, except it incorporates additional variables such as dividends and American exercise terms.

    And unlike Black-Scholes, which is an equation, the binomial model is an open-form or lattice that creates a tree of possible future price movements. The model determines the value of the expected option price at each node along the tree for several consecutive branches, or intervals. It then weights each outcome according to its probability and discounts the tree to its present value. Using the parameters in the previous example, the binomial model calculates the stock option at $6.84.

    Alternative Models

    In an article titled, “How to Value Employee Stock Options” for the January/February 2004 issue of the Financial Analysts Journal, John Hull and Alan White expanded the binomial model to incorporate vesting, non-transferability, employee turnover and dilution on shares outstanding to employee stock options. Commercial fair-value models based on Hull and White’s recommendations will likely soon be available.

    Despite the binomial model’s advantages, many analysts favor Black-Scholes for its ubiquity and familiarity. Which model will become the standard for valuing employee stock options for financial reporting is still unknown.

    Proponents of expensing say companies shouldn’t avoid recording employee stock options as an expense simply because the calculations are difficult.

    But many on Wall Street believe it doesn’t really matter whether the numbers are in a footnote or explicitly deducted from earnings because the investment community can make its own adjustments. Others argue that this disadvantages individual investors, however, who typically do not have the expertise and time to make adjustments to companies’ reported earnings.

    Still others contend that all that effort isn’t really necessary because they feel it is already embedded in company stock prices.

    Clearly, companies granting options have some idea of the resources used or cash saved by using options in lieu of cash flows for salaries. Since resources are used—for example, the shares to be issued on exercise of the options could have been sold to the public and the cash used to repay debt or for operations expenditures—it seems reasonable to expect the recognition of resources used.

    eBay Inc.: Notes To Consolidated Financial Statements Excerpt
    Stock-Based Compensation

    Consistent with predominant industry practice, we account for stock-based employee compensation issued under compensatory plans using the intrinsic-value method, which calculates compensation expense based on the difference, if any, on the date of the grant, between the fair value of our stock and the option exercise price. Generally accepted accounting principles require companies who choose to account for stock option grants using the intrinsic-value method to also determine the fair value of option grants using an option pricing model, such as the Black-Scholes model, and to disclose the impact of fair-value accounting in a note to the financial statements. In December 2002, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation Transition and Disclosure, an Amendment of FASB Statement No. 123.” We did not elect to voluntarily change to the fair value–based method of accounting for stock-based employee compensation and record such amounts as charges to operating expense. The impact of recognizing the fair value of option grants and stock grants under our employee stock purchase plan as an expense would have substantially reduced our net income, as follows (in thousands, except per share amounts):

      Year Ended December 31,
    2001 2002 2003
    Net income, as reported $90,448 $249,891 $441,771
    Add: Amortization of stock-based compensation expense determined under the intrinsic-value method 3,091 5,953 5,492
    Deduct: Stock-based compensation expense determined under the fair-value method, net of tax -211,526 -192,902 -201,775
    Pro forma net income (loss) ($117,987) $62,942 $245,488

    Earnings (loss) per share:
         Basic—as reported $0.17 $0.43 $0.69
         pro forma ($0.22) $0.11 $0.38
         Diluted—as reported $0.16 $0.43 $0.67
         pro forma 0 0 0
    We calculated the fair value of each option award on the date of grant using the Black-Scholes option pricing model. The following assumptions were used for each respective period:
      Year Ended December 31,
    2001 2002 2003
    Risk-free interest rates 0 3.00% 1.90%
    Expected lives (in years) 3 3 3
    Dividend yield 0.00% 0.00% 0.00%
    Expected volatility 81.00% 68.00% 64.00%

    The weighted average fair value of options granted in the years ended December 31, 2001, 2002 and 2003, were $11.84, $11.21 and $16.31, respectively.

    For options granted prior to our initial public offering, the fair value of option grants was determined using the Black-Scholes option-pricing model with a zero volatility assumption. For options granted subsequent to our initial public offering, the fair value of option grants was determined using the Black-Scholes option pricing model with volatility assumptions based on actual or expected fluctuations in the price of our common stock.

    We account for stock-based arrangements issued to non-employees using the fair value–based method, which calculates compensation expense based on the fair value of the stock option granted using the Black-Scholes option pricing model at the date of grant, or over the period of performance, as appropriate.

    Source: eBay’s 2003 Form 10-K.

    CFA Institute is a nonprofit professional association of financial analysts, portfolio managers and other investment professionals in 112 countries. The CFA Institute sponsors and administers the rigorous Chartered Financial Analyst® (CFA®) curriculum and examination program, sets investment performance standards, and enforces its Code of Ethics and Standards of Professional Conduct.

    This article was written by Tamiko Toland, Stuart Weiss and Stephen P. Brown, CFA. Tamiko Toland is a financial journalist with Thomson Media. Stuart Weiss is a former Business Week writer based in Portland, Oregon. Stephen P. Brown, who holds the Chartered Financial Analyst designation, is a financial writer, and the editor of two business trade publications.

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