Finance, Politics and the Accounting for Stock Options Conrad S' Ciccotello C' Terry Grant W' Mark W

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Finance, Politics and the Accounting
for Stock Options Conrad S. Ciccotello C.
Terry GrantW. Mark Wilder
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Ten Plus Years of Finance and Politics of Stock
Option Accounting

• Do Stock Options Constitute Compensation Expense?
• Raging National Debate since FASB issued Stock
  Compensation Fair Value Exposure Draft in June
  1993
• New Standard Issued December 2004
• Mandatory Expensing to begin 3rd quarter 2005
• SEC delayed effective date to first FY beginning
  after 6/15/05 (1/1/06 for most companies)

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Historical Perspective APB No. 25 Background

• Measure Compensation Expense as Excess of Market
  Price Over Exercise Price on Grant (Measurement)
  Date (Intrinsic value)
• Most Employee Stock Options Are Fixed and At the
  Money or Out of the Money on the Grant Date
• Therefore, Usually No Compensation Expense
  Recognized Under APB No. 25

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Historical Perspective SFAS No. 123

• Compensation Expense Should be Based on Fair
  Value Received using OPM (ED 6/93)
• Intense Opposition from Businesses
• Senator Lieberman sponsored bill mandating SEC to
  block reporting of option expense
• Arthur Levitt encourages FASB to Retreat
• 1995 Compromised SFAS No. 123 Issued
• Encourages Fair Value Measurement
• Most use Intrinsic Value under APB No. 25

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Re-Priced Stock Options

• Since Market Decline in 2000
• Underwater stock options no longer motivate
  employees
• Re-pricing occurs by reducing the exercise
  pricetypically to the current market price of
  the stock

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FIN 44 became Effective July 2000

• Re-priced Stock Options must be accounted for as
  Variable Stock Options
• Any market value increases above the new exercise
  price must be charged against earnings each
  accounting period until exercised

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FIN 44 Loophole

• Avoid all Compensation Expense Recognition
• cancel underwater options
• wait at least six months and one day before
  replacing the underwater options with new lower
  priced options
• e.g. Worldcom tender offer 17 January 2002
• 125 M options, exercise price range 39-45,
  closing price 16 January 2002 was 13.51

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SFAS No. 123 (R) Issued December 2004

• Expensing Required
• Similar to IASB IFRS 2 issued February 2004
• 295 pages
• Effective first interim or annual period
  beginning after 6/15/05 (SEC delayed 6 months to
  1/1/06)

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House Bill Passed July 2004

• HR-3574 passed by vote of 312-111
• Limits stock option expensing to CEO and the four
  highest compensated executives.
• Mandates stock price volatility assumption of
  zero.
• Companies with revenues lt 25 million are exempt
  from expensing stock options.
• S.1890 similar Bill in Senate
• Introduced by Senator Michael Enzi (R-WY)
• Senator Shelby (R-AL), Chairman of Banking
  Committee, vows to fight the bill in the Senate.

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Incentives Surrounding Re-Priced Stock Options

• Stock Options are intended to align interests of
  shareholders and management.
• Ironically, re-priced stock options misalign
  management and shareholder interests
• option holders have short position in company
  during 6 month waiting period.

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61 Natural Earnings Management Experiment

• Under 61, Grant Date of Replacement Options can
  be Fixed
• Previous studies show that stock prices fall
  before option grants and rise afterward
• Yermack (JF, 1997) finds less distinct CAR
  pattern when option grants are Predictable
• Predictable if option grants occur at regular
  intervals between 11-13 months during study
  period
• Can executives manage information to exert
  downward pressure on stock prices before
  re-pricing and favorably influence stock prices
  after re-pricing when grant date is known?

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Reactions to Re-Pricing

• Business Press views as a Reward for Poor
  Performance
• Academic Literature More Balanced
• Carter Lynch (JFE, 2001) (JAE, 2004)
• Re-pricing linked to employee retention efforts
• Decreases overall employee turnover
• Doesnt decrease executive turnover

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Data

• 2001 Option Re-pricing database from ISS
• Includes 121 firms employing 61 Strategy
• 92 have data availability
• 61 pinpoint the re-pricing date to exactly 6
  months one day
• 31 have flexibility
• 14 link re-pricing to an unspecified compensation
  committee meeting
• 10 specify a re-pricing window
• 7 leave the re-pricing date completely open

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CARS 12 Months prior to Announcement
Pre-Announcement CARS very negative for all
sub-samples.
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CARS 6 Months between Announcement Re-Pricing
Entire Sample -13 CARS OD included -16 CARS.
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CARS 6 Months After Re-Pricing

• Positive CARS for Low Analyst Group

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HR-3574 S.1890

• Essentially a return to Intrinsic Value
  Accounting under APB Opinion No. 25
• With a mandated stock price volatility of Zero
• Options granted at or out of the money have Zero
  Value
• No Expense Recognition
• Options in the Money are Valued at Excess of
  Market Price over Exercise Price
• Limitations Exceptions in HR-3574 are
  Irrelevant
• CEO 4 highest paid Executives
• lt 25 Million Revenues

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Similar Values Deep In or Out of Money Greatest
Difference at the Money
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Alan Greenspan comments on Stock Option Accounting

• The seemingly narrow accounting matter of
  option expensing is, in fact, critically
  important for accurate representation of
  corporate performance. And accurate accounting,
  in turn, is central to the functioning of
  free-market capitalism

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Conclusions/Recommendations

• Stock Option Accounting under SFAS No. 123/APB
  Opinion No. 25 has Serious Shortcomings
• SFAS No. 123 (R) should Proceed Unabated
• Compensation costs would be measured and
  expensed, regardless of form of compensation
• Improves Governance by Closing FIN 44 Loophole
• Better aligns Management and Shareholder
  Interests
• Consistent with IFRS 2
• Enhances Financial Statement Comparability