For the Last Time: Stock Options

Are an Expense

by Zvi Bodie, Robert S.Kaplan, and Robert C.Merton

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 March 2003

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 Stock options are not recorded as an expense on
companies’ books.But the arguments for this special
treatment don’t stand up.Let’s end the charade.

For the Last Time:

Stock Options
Are an Expense
by Zvi Bodie, Robert S. Kaplan, and Robert C. Merton

T he time hAS come to end the debate on accounting

for stock options; the controversy has been going on
far too long. In fact, the rule governing the reporting
of executive stock options dates back to 1972, when the
forced by the opening, also in 1973, of the Chicago Board
Options Exchange. It was surely no coincidence that the
growth of the traded options markets was mirrored by an
increasing use of share option grants in executive and em-
Accounting Principles Board, the predecessor to the Fi- ployee compensation. The National Center for Employee
nancial Accounting Standards Board (FASB), issued APB Ownership estimates that nearly 10 million employees
25. The rule specified that the cost of options at the grant received stock options in 2000; fewer than 1 million did
date should be measured by their intrinsic value – the dif- in 1990. It soon became clear in both theory and practice
ference between the current fair market value of the that options of any kind were worth far more than the in-
stock and the exercise price of the option. Under this trinsic value defined by APB 25.
method, no cost was assigned to options when their exer- FASB initiated a review of stock option accounting in
cise price was set at the current market price. 1984 and, after more than a decade of heated controversy,
The rationale for the rule was fairly simple: Because no finally issued SFAS 123 in October 1995. It recommended–
cash changes hands when the grant is made, issuing a but did not require – companies to report the cost of op-
stock option is not an economically significant trans- tions granted and to determine their fair market value
action. That’s what many thought at the time. What’s using option-pricing models. The new standard was a
more, little theory or practice was available in 1972 to compromise, reflecting intense lobbying by business-
guide companies in determining the value of such un- people and politicians against mandatory reporting. They
traded financial instruments. argued that executive stock options were one of the de-
APB 25 was obsolete within a year. The publication in fining components in America’s extraordinary economic
1973 of the Black-Scholes formula triggered a huge boom renaissance, so any attempt to change the accounting rules
in markets for publicly traded options, a movement rein- for them was an attack on America’s hugely successful

Copyright © 2003 by Harvard Business School Publishing Corporation. All rights reserved. 3
For the Last Time: Sto ck Options Are an Exp ense

model for creating new businesses. Inevitably, most com- company and, therefore, should never be recorded as a
panies chose to ignore the recommendation that they cost on the income statement.”
opposed so vehemently and continued to record only the That position defies economic logic, not to mention
intrinsic value at grant date, typically zero, of their stock common sense, in several respects. For a start, transfers
option grants. of value do not have to involve transfers of cash. While
Subsequently, the extraordinary boom in share prices a transaction involving a cash receipt or payment is suffi-
made critics of option expensing look like spoilsports. But cient to generate a recordable transaction, it is not neces-
since the crash, the debate has returned with a vengeance. sary. Events such as exchanging stock for assets, signing
The spate of corporate accounting scandals in particular a lease, providing future pension or vacation benefits for
has revealed just how unreal a picture of their economic current-period employment, or acquiring materials on
performance many companies have been painting in their credit all trigger accounting transactions because they
financial statements. Increasingly, investors and regulators involve transfers of value, even though no cash changes
have come to recognize that option-based compensation hands at the time the transaction occurs.
is a major distorting factor. Had AOL Time Warner in 2001, Even if no cash changes hands, issuing stock options
for example, reported employee stock option expenses as to employees incurs a sacrifice of cash, an opportunity
recommended by SFAS 123, it would have shown an oper- cost, which needs to be accounted for. If a company were
ating loss of about $1.7 billion rather than the $700 million to grant stock, rather than options, to employees, every-
in operating income it actually reported. one would agree that the company’s cost for this transac-
We believe that the case for expensing options is over- tion would be the cash it otherwise would have received
whelming, and in the following pages we examine and dis- if it had sold the shares at the current market price to
miss the principal claims put forward by those who con- investors. It is exactly the same with stock options. When
tinue to oppose it. We demonstrate that, contrary to these a company grants options to employees, it forgoes the op-
experts’ arguments, stock option grants have real cash-flow portunity to receive cash from underwriters who could
implications that need to be reported, that the way to take these same options and sell them in a competitive
quantify those implications is available, that footnote dis- options market to investors. Warren Buffett made this
closure is not an acceptable substitute for reporting the point graphically in an April 9, 2002, Washington Post
transaction in the income statement and balance sheet, column when he stated: “Berkshire [Hathaway] will be
and that full recognition of option costs need not emascu- happy to receive options in lieu of cash for many of the
late the incentives of entrepreneurial ventures. We then goods and services that we sell corporate America.” Grant-
discuss just how firms might go about reporting the cost ing options to employees rather than selling them to
of options on their income statements and balance sheets. suppliers or investors via underwriters involves an actual
loss of cash to the firm.
FAllAcy 1: It can, of course, be more reasonably argued that the
cash forgone by issuing options to employees, rather than
Stock Options Do Not Represent
selling them to investors, is offset by the cash the com-
a Real Cost pany conserves by paying its employees less cash. As two
It is a basic principle of accounting that financial state- widely respected economists, Burton G. Malkiel and
ments should record economically significant transac- William J. Baumol, noted in an April 4, 2002, Wall Street
tions. No one doubts that traded options meet that crite- Journal article: “A new, entrepreneurial firm may not be
rion; billions of dollars’ worth are bought and sold every able to provide the cash compensation needed to attract
day, either in the over-the-counter market or on ex- outstanding workers. Instead, it can offer stock options.”
changes. For many people, though, company stock option But Malkiel and Baumol, unfortunately, do not follow
grants are a different story. These transactions are not their observation to its logical conclusion. For if the cost
economically significant, the argument goes, because no of stock options is not universally incorporated into the
cash changes hands. As former American Express CEO measurement of net income, companies that grant op-
Harvey Golub put it in an August 8, 2002, Wall Street Jour- tions will underreport compensation costs, and it won’t be
nal article, stock option grants “are never a cost to the possible to compare their profitability, productivity, and
return-on-capital measures with those of economically
Zvi Bodie is a professor of finance at Boston University’s equivalent companies that have merely structured their
School of Management. Robert S. Kaplan is the Marvin compensation system in a different way. The following
Bower Professor of Leadership Development at Harvard hypothetical illustration shows how that can happen.
Business School. Robert C. Merton is the John and Natty Imagine two companies, KapCorp and MerBod, com-
McArthur University Professor at Harvard Business School peting in exactly the same line of business. The two differ
and a winner of the 1997 Nobel Memorial Prize in Economic only in the structure of their employee compensation
Science. They are all based in Boston. packages. KapCorp pays its workers $400,000 in total

4 hArvArD busIness revIEw

 For the Last Time: Sto ck Options Are an Exp ense

compensation in the form of cash dur- employee stock options, which are
ing the year. At the beginning of the private contracts between the com-
year, it also issues, through an under- How legitimate is an pany and the employee for illiquid
writing, $100,000 worth of options in instruments that cannot be freely
the capital market, which cannot be accounting standard sold, swapped, pledged as collateral,
exercised for one year, and it requires or hedged.
its employees to use 25% of their com- that allows two It is indeed true that, in general, an
pensation to buy the newly issued op- instrument’s lack of liquidity will re-
tions. The net cash outflow to KapCorp economically identical duce its value to the holder. But the
is $300,000 ($400,000 in compensation
expense less $100,000 from the sale of
transactions to produce holder’s liquidity loss makes no differ-
ence to what it costs the issuer to cre-
the options). radically different ate the instrument unless the issuer
MerBod’s approach is only slightly somehow benefits from the lack of liq-
different. It pays its workers $300,000 in numbers? uidity. And for stock options, the ab-
cash and issues them directly $100,000 sence of a liquid market has little ef-
worth of options at the start of the year fect on their value to the holder. The
(with the same one-year exercise re- great beauty of option-pricing models
striction). Economically, the two positions are identical. is that they are based on the characteristics of the under-
Each company has paid a total of $400,000 in compensa- lying stock. That’s precisely why they have contributed to
tion, each has issued $100,000 worth of options, and for the extraordinary growth of options markets over the last
each the net cash outflow totals $300,000 after the cash 30 years. The Black-Scholes price of an option equals the
received from issuing the options is subtracted from the value of a portfolio of stock and cash that is managed dy-
cash spent on compensation. Employees at both compa- namically to replicate the payoffs to that option. With
nies are holding the same $100,000 of options during the a completely liquid stock, an otherwise unconstrained
year, producing the same motivation, incentive, and re- investor could entirely hedge an option’s risk and extract
tention effects. its value by selling short the replicating portfolio of stock
In preparing its year-end statements, KapCorp will and cash. In that case, the liquidity discount on the op-
book compensation expense of $400,000 and will show tion’s value would be minimal. And that applies even if
$100,000 in options on its balance sheet in a shareholder there were no market for trading the option directly.
equity account. If the cost of stock options issued to em- Therefore, the liquidity– or lack thereof – of markets in
ployees is not recognized as an expense, however, MerBod stock options does not, by itself, lead to a discount in the
will book a compensation expense of only $300,000 and option’s value to the holder.
not show any options issued on its balance sheet. Assum- Investment banks, commercial banks, and insurance
ing otherwise identical revenues and costs, it will look as companies have now gone far beyond the basic, 30-year-
though MerBod’s earnings were $100,000 higher than old Black-Scholes model to develop approaches to pricing
KapCorp’s. MerBod will also seem to have a lower equity all sorts of options: Standard ones. Exotic ones. Options
base than KapCorp, even though the increase in the num- traded through intermediaries, over the counter, and on
ber of shares outstanding will eventually be the same for exchanges. Options linked to currency fluctuations. Op-
both companies if all the options are exercised. As a result tions embedded in complex securities such as convertible
of the lower compensation expense and lower equity po- debt, preferred stock, or callable debt like mortgages with
sition, MerBod’s performance by most analytic measures prepay features or interest rate caps and floors. A whole
will appear to be far superior to KapCorp’s. This distortion subindustry has developed to help individuals, compa-
is, of course, repeated every year that the two firms choose nies, and money market managers buy and sell these
the different forms of compensation. How legitimate is an complex securities. Current financial technology certainly
accounting standard that allows two economically identi- permits firms to incorporate all the features of employee
cal transactions to produce radically different numbers? stock options into a pricing model. A few investment
banks will even quote prices for executives looking to
FAllAcy 2: hedge or sell their stock options prior to vesting, if their
company’s option plan allows it.
The Cost of Employee Stock Options
Of course, formula-based or underwriters’ estimates
Cannot Be Estimated about the cost of employee stock options are less precise
Some opponents of option expensing defend their posi- than cash payouts or share grants. But financial state-
tion on practical, not conceptual, grounds. Option-pricing ments should strive to be approximately right in reflecting
models may work, they say, as a guide for valuing pub- economic reality rather than precisely wrong. Managers
licly traded options. But they can’t capture the value of routinely rely on estimates for important cost items, such

mArch 2003 5
For the Last Time: Sto ck Options Are an Exp ense

as the depreciation of plant and equipment and provi- mating the cost of options granted. For example, John
sions against contingent liabilities, such as future envi- DeLong, in a June 2002 Competitive Enterprise Institute
ronmental cleanups and settlements from product liabil- paper entitled “The Stock Options Controversy and the
ity suits and other litigation. When calculating the costs New Economy,” argued that “even if a value were calcu-
of employees’ pensions and other retirement benefits, lated according to a model, the calculation would require
for instance, managers use actuarial estimates of future adjustment to reflect the value to the employee.” He is
interest rates, employee retention rates, employee retire- only half right. By paying employees with its own stock
ment dates, the longevity of employees and their spouses, or options, the company forces them to hold highly non-
and the escalation of future medical costs. Pricing models diversified financial portfolios, a risk further compounded
and extensive experience make it possible to estimate the by the investment of the employees’ own human capital
cost of stock options issued in any given period with a in the company as well. Since almost all individuals are
precision comparable to, or greater than, many of these risk averse, we can expect employees to place substan-
other items that already appear on companies’ income tially less value on their stock option package than other,
statements and balance sheets. better-diversified, investors would.
Not all the objections to using Black-Scholes and other Estimates of the magnitude of this employee risk dis-
option valuation models are based on difficulties in esti- count – or “deadweight cost,” as it is sometimes called –

The Real Impact of Forfeiture and Early Exercise

Unlike cash salary, stock options cannot be sured by financial models to reflect the strong
transferred from the individual granted them to likelihood of forfeiture and early exercise. Cur-
anyone else. Nontransferability has two effects rent proposals put forth by these people to
that combine to make employee options less FASB and IASB would allow companies to esti-
valuable than conventional options traded in mate the percentage of options forfeited during
the market. the vesting period and reduce the cost of option
First, employees forfeit their options if they grants by this amount. Also, rather than use the
leave the company before the options have expiration date for the option life in an option-
vested. Second, employees tend to reduce their pricing model, the proposals seek to allow com-
risk by exercising vested stock options much panies to use an expected life for the option to
earlier than a well-diversified investor would, reflect the likelihood of early exercise. Using an
thereby reducing the potential for a much expected life (which companies may estimate
higher payoff had they held the options to ma- at close to the vesting period, say, four years)
turity. Employees with vested options that are instead of the contractual period of, say, ten
in the money will also exercise them when they years, would significantly reduce the estimated
quit, since most companies require employees cost of the option.
to use or lose their options upon departure. In Some adjustment should be made for forfei-
both cases, the economic impact on the com- ture and early exercise. But the proposed method
pany of issuing the options is reduced, since the significantly overstates the cost reduction since
value and relative size of existing shareholders’ it neglects the circumstances under which op-
stakes are diluted less than they could have tions are most likely to be forfeited or exercised
been, or not at all. early. When these circumstances are taken into
Recognizing the increasing probability that account, the reduction in employee option costs
companies will be required to expense stock op- is likely to be much smaller.
tions, some opponents are fighting a rearguard First, consider forfeiture. Using a flat per-
action by trying to persuade standard setters to centage for forfeitures based on historical or
significantly reduce the reported cost of those prospective employee turnover is valid only
options, discounting their value from that mea- if forfeiture is a random event, like a lottery,

6 hArvArD busIness revIEw

 For the Last Time: Sto ck Options Are an Exp ense

range from 20% to 50%, depending on the volatility of the deadweight cost influence the way companies record the
underlying stock and the degree of diversification of costs of the packets. Financial statements reflect the eco-
the employee’s portfolio. The existence of this deadweight nomic perspective of the company, not the entities (in-
cost is sometimes used to justify the apparently huge scale cluding employees) with which it transacts. When a com-
of option-based remuneration handed out to top execu- pany sells a product to a customer, for example, it does
tives. A company seeking, for instance, to reward its CEO not have to verify what the product is worth to that indi-
with $1 million in options that are worth $1,000 each in vidual. It counts the expected cash payment in the trans-
the market may (perhaps perversely) reason that it action as its revenue. Similarly, when the company pur-
should issue 2,000 rather than 1,000 options because, from chases a product or service from a supplier, it does not
the CEO’s perspective, the options are worth only $500 examine whether the price paid was greater or less than
each. (We would point out that this reasoning validates the supplier’s cost or what the supplier could have re-
our earlier point that options are a substitute for cash.) ceived had it sold the product or service elsewhere. The
But while it might arguably be reasonable to take dead- company records the purchase price as the cash or cash
weight cost into account when deciding how much equity- equivalent it sacrificed to acquire the good or service.
based compensation (such as options) to include in an ex- Suppose a clothing manufacturer were to build a fit-
ecutive’s pay packet, it is certainly not reasonable to let ness center for its employees. The company would not do

independent of the stock price. In reality, how- investment bank to hedge their option posi-
ever, the likelihood of forfeiture is negatively tions without exercising prematurely. As with
related to the value of the options forfeited and, the forfeiture feature, the calculation of an
hence, to the stock price itself. People are more expected option life without regard to the mag-
likely to leave a company and forfeit options nitude of the holdings of employees who exer-
when the stock price has declined and the op- cise early, or to their ability to hedge their risk
tions are worth little. But if the firm has done through other means, would significantly un-
well and the stock price has increased signifi- derestimate the cost of options granted.
cantly since grant date, the options will have Option-pricing models can be modified to
become much more valuable, and employees incorporate the influence of stock prices and
will be much less likely to leave. If employee the magnitude of employees’ option and stock
turnover and forfeiture are more likely when holdings on the probabilities of forfeiture and
the options are least valuable, then little of early exercise. (See, for example, Mark Rubin-
the options’ total cost at grant date is reduced stein’s Fall 1995 article in the Journal of Deriva-
because of the probability of forfeiture. tives, “On the Accounting Valuation of Employee
The argument for early exercise is similar. It Stock Options.”) The actual magnitude of these
also depends on the future stock price. Employ- adjustments needs to be based on specific com-
ees will tend to exercise early if most of their pany data, such as stock price appreciation and
wealth is bound up in the company, they need distribution of option grants among employ-
to diversify, and they have no other way to re- ees. The adjustments, properly assessed, could
duce their risk exposure to the company’s stock turn out to be significantly smaller than the
price. Senior executives, however, with the proposed calculations (apparently endorsed by
largest option holdings, are unlikely to exercise FASB and IASB) would produce. Indeed, for
early and destroy option value when the stock some companies, a calculation that ignores for-
price has risen substantially. Often they own un- feiture and early exercise altogether could come
restricted stock, which they can sell as a more closer to the true cost of options than one that
efficient means to reduce their risk exposure. Or entirely ignores the factors that influence em-
they have enough at stake to contract with an ployees’ forfeiture and early exercise decisions.

mArch 2003 7
For the Last Time: Sto ck Options Are an Exp ense

so to compete with fitness clubs. and costly to do for a large group of

It would build the center to gener- companies that had put different
ate higher revenues from increased The people claiming sorts of data in various nonstandard
productivity and creativity of health- formats into footnotes. Clearly, it is
ier, happier employees and to reduce that options expensing much easier to compare companies
costs arising from employee turn- on a level playing field, where all com-
over and illness. The cost to the com- creates a double- pensation expenses have been incor-
pany is clearly the cost of building porated into the income numbers.
and maintaining the facility, not the counting problem are What’s more, numbers divulged in
value that the individual employees footnotes can be less reliable than
might place on it. The cost of the fit-
themselves creating a those disclosed in the primary finan-
ness center is recorded as a periodic smoke screen to hide the cial statements. For one thing, exec-
expense, loosely matched to the ex- utives and auditors typically review
pected revenue increase and reduc- income-distorting effects supplementary footnotes last and de-
tions in employee-related costs. vote less time to them than they do
The only reasonable justification of stock option grants. to the numbers in the primary state-
we have seen for costing executive ments. As just one example, the foot-
options below their market value note in eBay’s FY 2000 annual report
stems from the observation that many reveals a “weighted average grant-
options are forfeited when employees leave, or are exer- date fair value of options granted during 1999 of $105.03”
cised too early because of employees’ risk aversion. In for a year in which the weighted average exercise price of
these cases, existing shareholders’ equity is diluted less shares granted was $64.59. Just how the value of options
than it would otherwise be, or not at all, consequently re- granted can be 63% more than the value of the underly-
ducing the company’s compensation cost. While we agree ing stock is not obvious. In FY 2000, the same effect was
with the basic logic of this argument, the impact of for- reported: a fair value of options granted of $103.79 with
feiture and early exercise on theoretical values may be an average exercise price of $62.69. Apparently, this error
grossly exaggerated. (See the sidebar “The Real Impact of was finally detected, since the FY 2001 report retroac-
Forfeiture and Early Exercise.”) tively adjusted the 1999 and 2000 average grant-date fair
values to $40.45 and $41.40, respectively. We believe ex-
FAllAcy 3: ecutives and auditors will exert greater diligence and care
in obtaining reliable estimates of the cost of stock options
Stock Option Costs Are Already
if these figures are included in companies’ income state-
Adequately Disclosed ments than they currently do for footnote disclosure.
Another argument in defense of the existing approach is Our colleague William Sahlman in his December
that companies already disclose information about the 2002 HBR article, “Expensing Options Solves Nothing,”
cost of option grants in the footnotes to the financial has expressed concern that the wealth of useful infor-
statements. Investors and analysts who wish to adjust in- mation contained in the footnotes about the stock op-
come statements for the cost of options, therefore, have tions granted would be lost if options were expensed.
the necessary data readily available. We find that argu- But surely recognizing the cost of options in the income
ment hard to swallow. As we have pointed out, it is a fun- statement does not preclude continuing to provide a foot-
damental principle of accounting that the income state- note that explains the underlying distribution of grants
ment and balance sheet should portray a company’s and the methodology and parameter inputs used to cal-
underlying economics. Relegating an item of such major culate the cost of the stock options.
economic significance as employee option grants to the Some critics of stock option expensing argue, as venture
footnotes would systematically distort those reports. capitalist John Doerr and FedEx CEO Frederick Smith
But even if we were to accept the principle that foot- did in an April 5, 2002, New York Times column, that “if
note disclosure is sufficient, in reality we would find it a expensing were … required, the impact of options would
poor substitute for recognizing the expense directly on be counted twice in the earnings per share: first as a po-
the primary statements. For a start, investment analysts, tential dilution of the earnings, by increasing the shares
lawyers, and regulators now use electronic databases to outstanding, and second as a charge against reported earn-
calculate profitability ratios based on the numbers in com- ings. The result would be inaccurate and misleading earn-
panies’ audited income statements and balance sheets. An ings per share.”
analyst following an individual company, or even a small We have several difficulties with this argument. First,
group of companies, could make adjustments for infor- option costs only enter into a (GAAP-based) diluted
mation disclosed in footnotes. But that would be difficult earnings-per-share calculation when the current market

8 hArvArD busIness revIEw

 For the Last Time: Sto ck Options Are an Exp ense

price exceeds the option exercise price. Thus, fully diluted value gained from the sale of the shares is not reported
EPS numbers still ignore all the costs of options that are in net income, but its EPS denominator has increased
nearly in the money or could become in the money if the from 8,000 to 10,000. Consequently, KapCorp now re-
stock price increased significantly in the near term. ports an EPS of $1.00 to MerBod’s $2.00, even though
Second, relegating the determination of the economic their economic positions are identical: 10,000 shares out-
impact of stock option grants solely to an EPS calculation standing and increased cash balances of $20,000. The
greatly distorts the measurement of reported income. people claiming that options expensing creates a double-
Such fundamental profitability and productivity mea- counting problem are themselves creating a smoke
sures as return on investment, return on capital employed, screen to hide the income-distorting effects of stock op-
and economic value added, which are based on account- tion grants.
ing income, would not be adjusted to reflect the economic Indeed, if we say that the fully diluted EPS figure is the
impact of option costs. These measures are more signifi- right way to disclose the impact of share options, then we
cant summaries of the change in economic value of a should immediately change the current accounting rules
company than the prorated distribution of this income to for situations when companies issue common stock, con-
individual shareholders revealed in the EPS measure. This vertible preferred stock, or convertible bonds to pay for
becomes eminently clear when taken to its logical absur- services or assets. At present, when these transactions
dity: Suppose companies were to compensate all their occur, the cost is measured by the fair market value of the
suppliers – of materials, labor, energy, and purchased ser- consideration involved. Why should options be treated
vices – with stock options rather than with cash and avoid differently?
all expense recognition in their income statement. Their
income and their profitability measures would all be FAllAcy 4:
so grossly inflated as to be useless for analytic purposes;
Expensing Stock Options
only the EPS number would pick up any economic effect
from the option grants. Will Hurt Young Businesses
Our biggest objection to this spurious claim, however, Opponents of expensing options also claim that doing so
is that even a calculation of fully diluted EPS does not will be a hardship for entrepreneurial high-tech firms that
fully reflect the economic impact of stock option grants. do not have the cash to attract and retain the engineers
The following hypothetical example illustrates the prob- and executives who translate entrepreneurial ideas into
lems, though for purposes of simplicity we will use grants profitable, long-term growth.
of shares instead of options. The reasoning is exactly the This argument is flawed on a number of levels. For
same for both cases. a start, the people who claim that option expensing will
Let’s say that each of our two hypothetical companies, harm entrepreneurial incentives are often the same peo-
KapCorp and MerBod, has 8,000 shares outstanding, no ple who claim that current disclosure is adequate for com-
debt, and annual revenue this year of $100,000. KapCorp municating the economics of stock option grants. The two
decides to pay its employees and suppliers $90,000 in positions are clearly contradictory. If current disclosure is
cash and has no other expenses. MerBod, however, com- sufficient, then moving the cost from a footnote to the
pensates its employees and suppliers with $80,000 in cash balance sheet and income statement will have no market
and 2,000 shares of stock, at an average market price of effect. But to argue that proper costing of stock options
$5 per share. The cost to each company is the same: would have a significant adverse impact on companies
$90,000. But their net income and EPS numbers are very that make extensive use of them is to admit that the eco-
different. KapCorp’s net income before taxes is $10,000, nomics of stock options, as currently disclosed in foot-
or $1.25 per share. By contrast, MerBod’s reported net notes, are not fully reflected in companies’ market prices.
income (which ignores the cost of the equity granted to More seriously, however, the claim simply ignores the
employees and suppliers) is $20,000, and its EPS is $2.00 fact that a lack of cash need not be a barrier to compen-
(which takes into account the new shares issued). sating executives. Rather than issuing options directly to
Of course, the two companies now have different cash employees, companies can always issue them to under-
balances and numbers of shares outstanding with a claim writers and then pay their employees out of the money
on them. But KapCorp can eliminate that discrepancy received for those options. Considering that the market
by issuing 2,000 shares of stock in the market during systematically puts a higher value on options than em-
the year at an average selling price of $5 per share. Now ployees do, companies are likely to end up with more cash
both companies have closing cash balances of $20,000 from the sale of externally issued options (which carry
and 10,000 shares outstanding. Under current account- with them no deadweight costs) than they would by
ing rules, however, this transaction only exacerbates the granting options to employees in lieu of higher salaries.
gap between the EPS numbers. KapCorp’s reported in- Even privately held companies that raise funds through
come remains $10,000, since the additional $10,000 angel and venture capital investors can take this approach.

mArch 2003 9
For the Last Time: Sto ck Options Are an Exp ense

The same procedures used to place a value on a privately the supposed accounting benefits from not having to re-
held company can be used to estimate the value of its op- port a portion of their compensation costs no matter
tions, enabling external investors to provide cash for what form that compensation might take.
options about as readily as they provide cash for stock.
That’s not to say, of course, that entrepreneurs should
never get option grants. Venture capital investors will al-
What Will Expensing Involve?
ways want employees to be compensated with some stock Although the economic arguments in favor of reporting
options in lieu of cash to be assured that the employees stock option grants on the principal financial statements
have some “skin in the game” and so are more likely to be seem to us to be overwhelming, we do recognize that ex-
honest when they tout their company’s prospects to pensing poses challenges. For a start, the benefits accruing
providers of new capital. But that does not preclude also to the company from issuing stock options occur in future
raising cash by selling options externally to pay a large periods, in the form of increased cash flows generated by
part of the cash compensation to employees. its option motivated and retained employees. The funda-
We certainly recognize the vitality and wealth that en- mental matching principle of accounting requires that
trepreneurial ventures, particularly those in the high-tech the costs of generating those higher revenues be recog-
sector, bring to the U.S. economy. A strong case can be nized at the same time the revenues are recorded. This is
made for creating public policies that actively assist these why companies match the cost of multiperiod assets such
companies in their early stages, or even in their more as plant and equipment with the revenues these assets
established stages. The nation should definitely consider produce over their economic lives.
a regulation that makes entrepreneurial, job-creating In some cases, the match can be based on estimates of
companies healthier and more competitive by changing the future cash flows. In expensing capitalized software-
something as simple as an accounting journal entry. development costs, for instance, managers match the costs
But we have to question the effectiveness of the cur- against a predicted pattern of benefits accrued from sell-
rent rule, which essentially makes the benefits from a ing the software. In the case of options, however, man-
deliberate accounting distortion proportional to compa- agers would have to estimate an equivalent pattern of
nies’ use of one particular form of employee compensa- benefits arising from their own decisions and activities.
tion. After all, some entrepreneurial, job-creating compa- That would likely introduce significant measurement
nies might benefit from picking other forms of incentive error and provide opportunities for managers to bias
compensation that arguably do a better job of aligning ex- their estimates. We therefore believe that using a standard
ecutive and shareholder interests than conventional straight-line amortization formula will reduce measure-
stock options do. Indexed or performance options, for ment error and management bias despite some loss of ac-
example, ensure that management is not rewarded just curacy. The obvious period for the amortization is the
for being in the right place at the right time or penalized useful economic life of the granted option, probably best
just for being in the wrong place at the wrong time. A measured by the vesting period. Thus, for an option vest-
strong case can also be made for the superiority of prop- ing in four years, 1/48 of the cost of the option would be
erly designed restricted stock grants and deferred cash expensed through the income statement in each month
payments. Yet current accounting until the option vests. This would
standards require that these, and vir- treat employee option compensation
tually all other compensation alter- costs the same way the costs of plant
natives, be expensed. Are companies
It is not the proper role and equipment or inventory are
that choose those alternatives any of accounting standards treated when they are acquired
less deserving of an accounting sub- through equity instruments, such as
sidy than Microsoft, which, having to distort executive in an acquisition.
granted 300 million options in 2001 In addition to being reported on
alone, is by far the largest issuer of and employee the income statement, the option
stock options? grant should also appear on the bal-
A less distorting approach for de- compensation ance sheet. In our opinion, the cost of
livering an accounting subsidy to en- options issued represents an increase
trepreneurial ventures would simply by subsidizing one in shareholders’ equity at the time of
be to allow them to defer some per- grant and should be reported as paid-
centage of their total employee com-
form of compensation in capital. Some experts argue that
pensation for some number of years, relative to all others. stock options are more like contin-
which could be indefinitely– just as gent liability than equity transactions
companies granting stock options do since their ultimate cost to the com-
now. That way, companies could get pany cannot be determined until

10 hArvArD busIness revIEw

 For the Last Time: Sto ck Options Are an Exp ense

employees either exercise or forfeit their options. This ar- leaving the company before vesting or if their options ex-
gument, of course, ignores the considerable economic pire unexercised. But if companies were to mark com-
value the company has sacrificed at time of grant. What’s pensation expense downward when employees forfeit
more, a contingent liability is usually recognized as an ex- their options, should they not also mark it up when the
pense when it is possible to estimate its value and the lia- share price rises, thereby increasing the market value of
bility is likely to be incurred. At time of grant, both these the options? Clearly, this can get complicated, and it
conditions are met. The value transfer is not just proba- comes as no surprise that neither FASB nor IASB recom-
ble; it is certain. The company has granted employees an mends any kind of postgrant accounting revisions, since
equity security that could have been issued to investors that would open up the question of whether to use mark-
and suppliers who would have given cash, goods, and ser- to-market accounting for all types of assets and liabilities,
vices in return. The amount sacrificed can also be esti- not just share options. At this time, we don’t have strong
mated, using option-pricing models or independent esti- feelings about whether the benefits from mark-to-market
mates from investment banks. accounting for stock options exceed the costs. But we
There has to be, of course, an offsetting entry on the would point out that people who object to estimating the
asset side of the balance sheet. FASB, in its exposure draft cost of options granted at time of issue should be even less
on stock option accounting in 1994, proposed that at time enthusiastic about reestimating their options’ cost each
of grant an asset called “prepaid compensation expense” quarter.
be recognized, a recommendation we endorse. FASB, •••
however, subsequently retracted its proposal in the face We recognize that options are a powerful incentive, and
of criticism that since employees can quit at any time, we believe that all companies should consider them in de-
treating their deferred compensation as an asset would ciding how to attract and retain talent and align the in-
violate the principle that a company must always have terests of managers and owners. But we also believe that
legal control over the assets it reports. We feel that FASB failing to record a transaction that creates such powerful
capitulated too easily to this argument. The firm does effects is economically indefensible and encourages com-
have an asset because of the option grant – presumably a panies to favor options over alternative compensation
loyal, motivated employee. Even though the firm does not methods. It is not the proper role of accounting standards
control the asset in a legal sense, it does capture the ben- to distort executive and employee compensation by sub-
efits. FASB’s concession on this issue subverted substance sidizing one form of compensation relative to all others.
to form. Companies should choose compensation methods ac-
Finally, there is the issue of whether to allow compa- cording to their economic benefits – not the way they are
nies to revise the income number they’ve reported after reported.
the grants have been issued. Some commentators argue
that any recorded stock option compensation expense Reprint r0303D
should be reversed if employees forfeit the options by To place an order, call 1-800-988-0886.

mArch 2003 11