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Accounting Stock Options

In the summer of 2002 Congress was debating what to do about the accounting rules governing stock options. On one side were people who felt that the current rules — in which the liabilities associated with options did not appear in the balance sheet, but were merely noted as a footnote in the annual report — allowed companies to exaggerate their value by “hiding” those liabilities from investors. On the other side were those who felt that forcing companies to account for options as regular “expenses” — the rule change under discussion — would put options on the same financial footing as salaries and thereby kill their utility both as a mechanism for allowing employees to share in the fortunes of a company and as a low-cost way for startup companies to attract the talented employees to their high-risk and volatile work environment.

The San Jose Mercury News, as the major newspaper of the Silicon Valley where the debate was fundamental to the local economy, invited its readers to weigh-in on the topic. This was my take, published on 2 June 2002.

29 May 2002

As both an option-holder and a shareholder in various companies I agree that options should be reported in some manner other than a footnote, but I vehemently disagree that calling them an “expense” — on a par with cash outlays like salaries — is the correct accounting form.

Options do not represent a cash outlay. In some ways they are more like the accrued obligation of a pension plan; in some ways they are more along the lines of a stock split; in other ways they are incomparable.

The whole issue is made even more complex by the fact that options are frequently awarded from a pool which was already accounted for when share prices were set — that is, the total of shares outstanding that goes into calculating a per-share price includes an option pool that may or may not have been awarded. In that case, is the awarding of options from a previously-existing pool even an accountable event? It depends, I suppose, on whether the shareholders assumed, when they bought their shares, that the pool would or would not eventually be awarded.

In short, the issue is much more complex than any commentary I’ve heard would indicate and, I suspect, much more complex than any politician proposing accounting rule changes has considered.

© Copyright 2002, 2005, Augustus P. Lowell

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