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The Accounting Cycle
Accounting for Stock Options (Part Two): Expense, Expense, and Expense
Op/Ed

November 2006Kip Hagopian recently wrote the essay "Point of View: Expensing Employee Stock Options is Improper Accounting," which was published in California Management Review. He pooh-poohs the Financial Accounting Standards Board's standard because he thinks that employee stock options are not expenses, according to FASB's own definition. He also thinks that employee stock options are not an opportunity cost.



Accounting for
Stock Options
 
Part One
Reasoning By Authority
 
Part Two
Expense, Expense, and Expense
 
Part Three
Why CEOs Fight Stock Option Accounting

 


 

In contrast with Hagopian, Boston University's Zvi Bodie, a finance professor, Harvard's Robert Kaplan, an accounting professor, and Robert C. Merton, a Harvard economist wrote an op-ed piece "Stock Options: To Expense or Not to Expense" that appeared in the Wall Street Journal on August 12, 2002. They claimed that employee stock options are indeed an expense.

Let's compare and contrast Hagopian's arguments with those of Bodie, Kaplan, and Merton. For my money, Bodie, Kaplan, and Merton easily win the debate with Hagopian.

To begin, FASB defines expenses as "outflows or other using up of assets or incurrences of liabilities … from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major or central operations." Hagopian states that the issuance of stock options cannot be an expense because the entity does not credit any asset or liability account as the definition requires.

Bodie, Kaplan, and Merton counter that such arguments ignore the essence of accrual accounting that permits the recognition of an expense even though the cash disbursement occurs later. They see no difference between the issuance of stock options and compensation by "outright grants of stock or promising future pension benefits." As it is generally accepted to expense these amounts—Hagopian says nothing to the contrary in his paper—logic dictates that like treatment be given to the accounting for stock options.

When organization costs are paid for with shares of stock, the company still expenses these organization costs. One can conceptualize this transaction as two parts: the issuance of the stock for cash and then using the cash to pay for the legal and accounting fees and promotional costs to set up the firm. In the same way, stock options can be conceptualized as the granting of stock options for cash and the cash utilized to pay the employees.

Hagopian next asserts that the stock option does not constitute an opportunity cost. He holds this position because the business enterprises cannot sell similar options to others. Hagopian conveniently forgets that managers generally do whatever they can to make the option valuable to themselves. If the stock market doesn't cooperate and stock prices drift downward, the management team simply reloads the stock option with a smaller strike price. Some managers even illegally backdate the options. The point is that we should compare the stock option with the entity's best alternative, which is issuing new stock to the market, and this is an opportunity cost. As Bodie, Kaplan, and Merton say, "the value of the stock option to the company is its costs—the cash foregone by granting the options to an employee rather than selling them to external investors—not its value to the person who receives it."

Hagopian and the paper's signatories inject the term gain-sharing instrument into the debate. (I guess if you can't win an argument with terms, concepts, and principles in the accounting discipline, you can introduce new ones to change the discourse.) Specifically, Hagopian describes employee stock options as a gain-sharing instrument. In this case, "it is the shareholders that reap the gain. Logically, therefore, it is the shareholders that must bear the cost." Not only has he inserted a new term, he also invents a new accounting principle that costs attach to those who benefit from the gain. I guess firms can stop expensing cost of goods sold, for managers can argue that the customers gain from the goods sold to them! Worse, as Bodie, Kaplan, and Merton pointed out, this line of reasoning completely ignores the entity principle. "But a firm's financial report reflects the perspective of the firm and its shareholders, not the entities with which it contracts. This principle is so fundamental that it is usually taught on the first day of an introductory accounting course." The gain of the person receiving the option and his or her costs are irrelevant. What is important are the costs to the business enterprise.

Hagopian also resurrects the idea that Statement No. 125 already accounts for stock options by measuring their dilutive effects. True, the printing of stock options has an inflationary impact like the government's printing too much money. But there is still a cost to the granting of stock options. Bodie, Kaplan, and Merton point out that if there were no cost, the firm could then just issue stock or stock options to all their employees and not recognize any expense. For that matter, the firm could issue stock to vendors and others for whatever resources the company uses; in this manner, the firm would never expense anything! I enjoy the comment by Bodie, Kaplan, and Merton: "Curious reasoning!"

Summing up, Hagopian's reasoning is faulty. He and his signatories ignore basic principles of accounting such as the accrual principle and the entity principle. They then go on to invent terms and principles that have never been a part of the accounting standard setting process. As such, Hagopian has not even dented the reasoning by FASB; therefore, FASB's arguments for expensing stock options still stand.

Return to The Accounting Cycle

J. EDWARD KETZ is accounting professor at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals. He also has edited Accounting Ethics, a four-volume set that explores ethical thought in accounting since the Great Depression and across several countries.

2006 SmartPros Ltd. All Rights Reserved.

Editorial and opinion content does not represent the opinions or beliefs of SmartPros Ltd.

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