If it’s not an expense, what is it?
Let me elaborate.
A typical accountant-prepared financial statement contains a balance sheet and a income statement. The balance sheet shows all the company’s assets (real estate owned, inventories, accounts receivables,* etc.) and liabilities (loans, accounts payable,** etc.) The income statement shows how much money the company has paid out and how much money they were paid.
The balance sheet and the income statement provide varying levels of detail depending on how the accountant chooses to present numbers, but they usually summarize the company’s entire standing, and they usually occupy one or two pages each, whether it’s for a mega-corporation like Coca Cola, or a mom-and-pop grocery store. (Assuming Mom & Pop bother to prepare one at all).
In addition to the balance sheet and income statement, the financial statement may contain assorted other disclosures, the company’s statement of purpose, expectations for coming years, rah-rah-cheerleading, and footnotes. How much space this stuff takes up varies from company to company. Coca Cola’s year-end 2000 statement was 64 pages, and that’s not an unusual length. (You can see it for yourself here but don’t blame me if it causes your brains to leak out of your ears.)
When investors look at a company’s financial statement, they flip through until they get to the balance sheet and income statement, maybe look over the cash-flow numbers if those are separate, maybe do a little number-crunching of their own to examine various ratios. Few people—even among analysts, professional stock brokers, and financial journalists—even glance at the rest of it. Some do. One of the men from The Motley Fool emphasized, among his reasons for not investing in Yahoo!, an intense distrust for their free-wheeling handling of stock options. (Sorry for the lack of a specific link; I got the article some weeks ago via email and don’t know where it is in the site archives.)
My point is this: companies, especially high-tech companies, offer their employees in some cases the majority of their compensation in the form of stock options. CEOs get millions of dollars in stock options. And this is a footnote on the financial statement? Microsoft to investors: “Oh, and, by the way, we gave out two billion dollars in stock options, too. But that’s nothing you need to worry your pretty little head about.”
Further, this accounting practice distorts the use of stock options. Think about it. CEO looks over his books, thinks to himself: “Hmm, if I give all my employees 5% raises, that’ll lower my net income by 20%. But if I give them all 100 stock options, that doesn’t effect my bottom line at ALL. Hey, I can give out 200 stock options each, or 2,000! What difference does it make? Stock options are FREE! Stock options for everyone!”
The issue of stock option abuse is both real and serious, and much too close to my facetious example above. The Congressional accounting reform bill pushed through the Senate on Monday declined to address it (though it may yet come up when the House and Senate reconcile their versions, I don’t know.) There are honest reasons for not wanting to treat stock options as an expense. Mostly, it’s just that they’re hard to value. If you’re going to expense them, you need to do so when they vest—when the employee first becomes able to use them-- not when they’re exercised. (Otherwise they could hugely distort your company’s financial picture. “Our stock rose 70% this year! Then all our employees cashed all their accumulated stock options, causing us to have paper losses of 2.5 billion. Now our stock has plummeted 85%.”)
At the point at which options vest, the company has no idea how much they’re going to end up worth to the employee. It may become worth thousands, or they may be completely worthless, depending on what the market does. Further, there’s no direct exchange of money at this point, either. It’s not like the company has cut a check to the employee. There’s no “accounts payable” holding funds to cover the “cost” of the options. Those against expensing stock options contend that it will make the financial statement more “opaque”--harder for the average person to understand.
However, the market is expert at valuing all kinds of risks, bets, hedges, derivatives, and whathaveyou. Companies already use formulas to tell their employees how much those options they haven’t used are going to be worth. They can evaluate what they’re worth. And they can tell their stockholders how much it’s cost them.
And, in my not-so-humble-opinion, they should.
Monday, Coca-Cola joined a handful of other companies in announcing that they would to do so. Coca-Cola’s decision is particularly noteworthy because the other companies (like Boeing) aren’t nearly as big or influential as Coke, who has the potential to start a trend, forcing other companies to join them or risk being snubbed by investors.
Moreover, as a libertarian, I am particularly pleased to see a large company recognize the value in doing the right thing. Being honest with your investors is good for business. Congress shouldn’t have to tell you that. And in Coca-Cola’s case, they didn’t.
So, here’s to you, Coca-Cola.
I’ll have a Coke and a smile.
* Accounts receivable is a fancy way of saying “Money others owe me and haven’t paid yet.”
** Accounts payable is “money I owe others but haven’t paid yet.”