V O L U M E 1 7 | N U M B E R 4 | FALL 2005

Journal of
APPLIED COR PORATE FINANCE
A MO RG A N S TA N L E Y P U B L I C AT I O N

In This Issue: Executive Pay and Corporate Governance

Pay Without Performance: Overview of the Issues 8 Lucian A. Bebchuk, Harvard Law School, and
Jesse M. Fried, University of California at Berkeley

A Remedy for the Executive Pay Problem: 24 Jeffrey N. Gordon, Columbia University
The Case for “Compensation Discussion and Analysis”
Developments in Remuneration Policy 36 Alastair Ross Goobey, International Corporate
Governance Network and Morgan Stanley Europe

Corporate Culture and the Problem of Executive Compensation 41 Arthur Levitt, Jr., The Carlyle Group

Taking Shareholder Protection Seriously? Corporate Governance in the U.S. 44 Theodor Baums, University of Frankfurt, and
and Germany Kenneth E. Scott, Stanford Law School and
Hoover Institution

University of Rochester Roundtable on 64 Panelists: Robert Bruner, University of Virginia;

Corporate M&A and Shareholder Value Cliff Smith and Gregg Jarrell, University of Rochester;
James Owen, The Bank Street Group; Marla Sincavage,
Ernst & Young; and Matt Ostrower, Morgan Stanley.
Moderated by Mark Zupan, University of Rochester.

Takeover Defenses and Bargaining Power 85 Guhan Subramanian, Harvard Law School

Is U.S. CEO Compensation Broken? 97 John E. Core and Wayne R. Guay, University of
Pennsylvania, and Randall S. Thomas, Vanderbilt University

Top Management Incentives and Corporate Performance 105 Stephen F. O’Byrne, Shareholder Value Advisors, and
S. David Young, INSEAD

Letting Go of Norm: How Executive Compensation 115 Marc Hodak, Hodak Value Advisors
Can Do Better Than “Best Practices”
Finance, Politics, and the Accounting for Stock Options 125 Conrad Ciccotello, Georgia State University,
C. Terry Grant, California State University, Fullerton, and
W. Mark Wilder, University of Mississippi

U.S. Family-Run Companies—They May Be Better Than You Think 134 Henry McVey and Jason Draho, Morgan Stanley

The Limits of Organizational Theory and Incentives 144 Ronald Schmidt, University of Rochester
(Or, Why Corporate Success Is Not Just About Money)
Finance, Politics, and the Accounting for Stock Options

by Conrad Ciccotello, Georgia State University, C. Terry Grant, California State University, Fullerton,
and W. Mark Wilder, University of Mississippi*

O
T
n July 20, 2004 the U.S. House of Represen- rule.” In this remarkable restructuring, employees must wait
tatives passed HR-3574 by a vote of 312-111. six months and one day after the announcement of intent
This bill limits the expensing of stock options to re-price their existing stock options before receiving new
to the Chief Executive Officer (CEO) and the options reflective of the current market price. Under current
four highest-paid company employees. Further, the bill accounting, the six-month-and-one-day wait ensures that
mandates that the stock price volatility assumption in the the newly issued “replacement” options avoid expense treat-
pricing model “shall be zero.” The bill also exempts compa- ment. During this waiting period, however, the employees
nies with less than $25 million in revenues from expensing basically hold a short position in the firm. Normally, align-
of options. Similar legislation, S. 1890, was introduced in ing employee and shareholder interests would involve a long
the U.S. Senate but thus far has failed to pass. position for the employee.
The passage of HR-3574 represents yet another extraor- Following our initial discussion of the six-and-one rule,
dinary twist in the decade-long war over accounting for we present the market-adjusted performance of a sample of
employee stock options. The forces on both sides of the issue firms that engaged in this strategy in 2001. As might be
are formidable. On the “pro-expense” side are the likes of expected, market-adjusted stock prices for the sample tend
Warren Buffett, Alan Greenspan, William Donaldson, Chris- to decrease while the firm waits to set the new strike price.
topher Cox, and the late Merton Miller.1 The “don’t expense” The decline is largest when restructurings include officers
contingent includes a number of prominent executives from and directors.
high-tech firms, the U.S. Chamber of Commerce, as well as a The six-and-one strategy exemplifies why the tortured
clear majority in the U.S. House of Representatives. and inconsistent accounting treatment of stock options
The choice of accounting method for stock option under current rules has to be resolved once and for all. The
grants does not affect cash flow directly, so the fight might war has led to casualties, including the loss of simple incen-
appear pointless to an efficient market proponent.2 But tive alignment. Both the FASB and Congress are weighing
option accounting methods do appear to influence decisions in on what may be the final battle. We conclude the article
to use option compensation.3 The accounting treatment is with our proposals for the peace that needs to come to
thus a pocketbook issue for employees and a governance financial accounting for stock options.
issue for some observers.4 The politics of option accounting
crosses party lines, a mix of specific constituent support and Ten Years of Battles
a concern about power over financial standards setting. Beginning in 1972 and for a number of years thereafter,
This article offers some perspectives on the finance and stock option accounting was done without much fanfare
politics of options accounting as the war enters its second under Accounting Principles Board (APB) Opinion No.
decade. We begin by tracing ten years of the ebb and flow 25.5 Under APB No. 25, compensation expense is gener-
of actions by the Financial Accounting Standards Board ally measured when the options are issued as the excess of
(FASB) and reactions to them. We then provide some detail the market price of the stock over the exercise price. Since
on one strange example of what the decade-long battle over most options are issued at or out of the money, typically no
accounting for stock options has wrought—the “six-and-one compensation expense is ever recognized under APB No.

* Much of the analysis in this article draws on our prior research over the past decade. 1. See Merton Miller and Graef Crystal, “The Case for Expensing Stock Options Against
Conrad Ciccotello and Terry Grant wrote “Employee Stock Option Accounting Changes,” Earnings,” Journal of Applied Corporate Finance, Vol. 7, No. 2 (1994), pp. 88-90.
Journal of Accountancy, Vol. 179, No. 1 (January 1995), pp. 72-77; “The Stock Options 2. Stock option exercises are expenses for income tax (as opposed to financial report-
Accounting Subterfuge,” Strategic Finance, Vol. 83, No. 10 (April 2002), pp. 37-41; and ing) purposes, and thus affect operating cash flow. See Ciccotello, Grant, and Grant
together with Gerry Grant, “Impact of Employee Stock Options on Cash Flow,” Financial (2004), cited earlier.
Analysts Journal, Vol. 60, No. 2 (2004), pp. 39-46. Mark Wilder, together with Morris 3. See Stocks and Wilder (1996), cited earlier.
Stocks, wrote “Does the FASB Decision on Stock Options Encourage Inefficient Compen- 4. See S. Gillan, “Option-Based Compensation: Panacea or Pandora’s Box?,” Journal of
sation Practices?,” Journal of Corporate Accounting and Finance, Vol. 7, No. 4 (Summer Applied Corporate Finance, Vol. 14, No. 2 (2001), pp. 115-128.
1996), pp. 123-128. 5. In 1973 the FASB replaced the APB as the primary accounting standard-setting
body.

Journal of Applied Corporate Finance • Volume 17 Number 4 A Morgan Stanley Publication • Fall 2005 125
Table 1 Timeline of Stock Option Accounting Regulatory Activities

Time Action Consequence

1972 APB issued APB Opinion No. 25. Most companies recognize no compensation expense under “intrinsic value”
measurement of APB No. 25. Expense is measured as the market price of stock
less the exercise price at measurement date.

1993 FASB Stock Option Exposure Draft issued. Proposed expensing of stock options using a “fair value” approach.

1994 Flurry of unprecedented opposition to Senator Lieberman threatens sponsorship of legislation that
Exposure Draft. would reverse mandatory expense recognition for stock options.

1995 Arthur Levitt, then Chairman of the SEC, encouraged FASB waters down stock option proposal in an effort
the FASB to back down or face possible replacement. to preserve independent standard setting.

1995 FASB issued SFAS No. 123. Compromise version of SFAS No. 123 encourages fair value expense recognition.
Most companies ignored this plea and continued to follow APB No. 25 guidance along
with pro-forma disclosure of earnings and EPS in financial statement footnotes.

2000 FASB issued FIN No. 44. Treats re-priced stock options as “variable,” requiring expensing. Loophole
permits 6-and-1 strategy to avoid expense recognition.

February 2004 IASB issued IFRS 2. Requires expensing of stock options using a “fair value” approach.

March 2004 FASB Exposure Draft issued. Proposed expensing of stock options using a “fair value” approach.

July 2004 Intense opposition to Exposure Draft. HR-3574 passed in House of Representatives. S. 1890 introduced in
Senate—still tied up in committee.

September 2004 Lobbying against FASB Exposure Draft continues. Cisco, Genentech, and Qualcomm propose alternative option valuation and
urge FASB to conduct additional analysis of valuation alternatives.

December 2004 FASB issued SFAS No. 123(R). Requires expensing of stock options using a “fair value” approach.
Eliminates loophole in FIN No. 44.

August 2005 Lobbying against FASB SFAS No. 123(R) continues. S. 1890 has the support of 31 senators but failed to emerge from the
Senate Banking Committee in the 108th Congress. A similar bill could be
introduced in the 109th Congress.

25. Beginning in the early 1990s, option-based compensa- They argued that expensing of employee stock options
tion started to become much more common. At that point, would level the financial reporting playing field because the
the FASB proposed a new standard that would more accu- economic value of the compensation rather than the form of
rately account for employee (and executive) stock options. the compensation would govern expense recognition.6
Table 1 provides the timeline of stock option accounting Facing a coalition of opposition, including Senator
regulatory activities. Lieberman from Connecticut (its home state), the FASB did
The FASB’s initial goal was to provide a standard that not get its wish. Fearing that the FASB’s own existence was
required stock options to be expensed. The standards-setting at risk, and in response to threatened legislation that would
organization had actually been considering how to account have overturned mandatory expensing, SEC Chairman
for stock option grants since 1984, when the topic was quietly Arthur Levitt encouraged the FASB to retract its proposal.
added to the FASB’s agenda. In 1992, Raymond Simpson and Levitt described his rationale as follows: 7
Joseph Anania, FASB project manager and board member,
respectively, explained that the FASB intended to improve I came to the conclusion that the FASB would not survive in this
financial reporting such that comparisons of reported results atmosphere. I worried that, if the group continued to push for the
of operations would be free of distortion, regardless of the form stock-option rule, disgruntled companies would press Congress to
of composition used in employee compensation packages. end the FASB’s role as a standard-setter. To me, that would have

6. E. Raymond Simpson and Joseph V. Anania, “Stock Compensation,” FASB View- 7. See Arthur Levitt with Paula Dwyer, Take on the Street (New York: Pantheon Books,
points, December 31, 1992. 2002), p. 110.

126 Journal of Applied Corporate Finance • Volume 17 Number 4 A Morgan Stanley Publication • Fall 2005
Table 2 A Six-and-One Re-Pricing Example: WorldCom
On January 17, 2002 WorldCom filed a tender offer with the SEC announcing an offer to cancel and replace 125 million existing
fixed-price options granted to employees in 1999 and 2000. The options were significantly underwater with exercise prices ranging
from $38.76 to $45.14 while the closing stock price on January 16, 2002 was $13.51. To participate in the offer, employees were
required to surrender existing options on February 14, 2002. Replacement options would have been granted to employees on
August 15, 2002—exactly six months and one day after cancellation of existing options. The replacement options would have had
favorable terms as indicated below. However, the re-pricing effort failed when WorldCom revealed a $3.8 billion accounting fraud in
June 2002 and filed Chapter 11 bankruptcy protection in July 2002.

Expiration Date of New Exercise Price Number of New Options Vesting of New Options
New Options
August 14, 2012 August 15, 2002 Same as number of 1/3 each year, for three
closing stock price canceled options consecutive years, beginning
Jan. 1, 2003

The tender offer explained the rationale for the six-month waiting period before canceled options would be replaced: “If we were to
grant the new options on any date which is earlier than six months and one day after the date we cancel the options accepted for
exchange, we would need to record a variable accounting charge against our earnings. By deferring the grant of the new options
for at least six months and one day, we will not have to record a variable accounting charge against our earnings.”

been worse than going without the stock-option rule. At a private Compensation—an Interpretation of APB Opinion No. 25.”
meeting with the FASB in Norwalk, I urged them to retreat. I Under FIN No. 44, which became effective in July 2000,
warned them that, if they adopted the new standard, the SEC companies must expense options that are re-priced. Typically,
would not enforce it…In retrospect, I was wrong. I know the re-pricings occur after stock price declines.8 Under FIN No.
FASB would have stuck to its guns had I not pushed it to surren- 44, any lowering of the exercise price of existing options forces
der. Out of a misguided belief that I was acting in the FASB’s companies to account for those options as “variable” stock
best interests, I failed to support this courageous and beleaguered options. This means that increases in the stock price above
organization in its time of need, and may have opened the door the new, lower exercise price must be recalculated and charged
to more meddling by powerful corporations and Congress. The against earnings each quarter for the entire life of the options.
last thing I wanted was to politicize the FASB, which can’t func- No longer can companies automatically avoid expensing the
tion if it must please every last CEO and deal with the whims of value of re-priced options when lowering the exercise price.
Washington lawmakers. But FIN No. 44 has loopholes. By canceling “underwa-
ter” options whose exercise price is well above the company’s
As a political compromise, in 1995 the FASB issued stock price, and then re-pricing and re-granting those options
Statement of Financial Accounting Standards (SFAS) No. to be effective more than six months later, companies are able
123, “Accounting for Stock-Based Compensation.” SFAS to defeat the intent of FIN No. 44. That is, all compensation
No. 123 only recommends that companies charge the fair expense recognition for the re-priced options is avoided. World-
value of options as compensation expense. The standard Com provides an illustrative example as shown in Table 2.
permits companies to continue to use APB No. 25’s intrin- The six-and-one strategy exposed a loophole in stock
sic value method (typically resulting in no compensation option accounting that remains in effect to the present.
expense), along with additional footnote disclosures. Uncomfortable with the loophole, the FASB waited for
Although some 750 companies have recently decided to an opportunity to address it. In February 2004, the Inter-
begin expensing stock options, most—and especially technol- national Accounting Standards Board (IASB) passed
ogy firms—still do not. Instead, they follow SFAS No. 123’s International Financial Reporting Standard 2 (IFRS),
alternative of disclosing in a footnote what net income and “Share-Based Payment.” IFRS 2 requires fair value expens-
EPS would have been if the fair value of employee stock ing of stock options. Sensing the opportunity, in March
options had been booked as compensation expense. 2004 the FASB issued an exposure draft of a proposed new
Stopped short of its broad goal for SFAS No. 123, the standard that, like IFRS 2, would require fair value expens-
FASB subsequently issued FASB Interpretation No. 44 (FIN ing of stock options and would eliminate the loophole in
No. 44), “Accounting for Certain Transactions Involving Stock FIN No. 44. In December 2004, the FASB issued SFAS
8. Re-pricings tend to occur after poor performance. See B. Moore, “Investor Advo- and Impression Management in Re-Pricing Executive Options,” Academy of Management
cates Press Companies to Curb Stock Option Re-Pricings,” Wall Street Journal, March 10, Journal, Vol. 45 (2002), pp. 1172-1182. But there is also literature linking re-pricing with
1999, p. C2; A. Bryant, “Stock Options that Raise Investors’ Ire,” New York Times, March employee retention. See M. E. Carter and L. Lynch, “Effect of Stock Option Re-Pricing on
27, 1998, p. D1; J. Reingold, “Slimmer Rewards for a Job Poorly Done,” Business Week, Employee Turnover,” Journal of Accounting and Economics, Vol. 17 (2004), pp. 91-112.
February 15, 1999, p. 38; and T. Pollock, H. Fischer, and J. Wade, “The Role of Politics

Journal of Applied Corporate Finance • Volume 17 Number 4 A Morgan Stanley Publication • Fall 2005 127
Figure 1 Pre-Announcement CARS

10%

0%

-10%
Median CAR Whole Sample

-20% Low Analyst Group

High Analyst Group

-30%
O&D Excluded
-40%
O&D Included

-50%

-60%

-70%

-12 -11 -10 -9 -8 -7 -6 -5 -4 -3 -2 -1

Month Relative to Announcement

No. 123(R), which requires expensing of stock options for WY). As of February 25, 2005, S. 1890 had 30 bipartisan
periods beginning after June 15, 2005.9 cosponsors.11 In November 2003, S. 1890 was referred to the
Similar to the reactions a decade earlier, the FASB’s Committee on Banking, Housing, and Urban Affairs. It failed
2004 exposure draft brought an intensively negative to emerge, probably because Committee Chairman Senator
response from a number of technology firms and politi- Richard Shelby (R-AL) fought its passage. A similar Senate
cians. Several members of the U.S. Congress have been bill could be introduced in the 109th Congress in 2005.
quite vocal in expressing their views on this issue. Support-
ers and opposition cannot be distinguished by their political Re-Pricing with the Six-and-One Strategy
affiliation. Although Rep. Richard Baker (R-LA) is the Stuart Gillan has described option-based compensation as a
primary sponsor of HR-3574, bi-partisan support is strong “Pandora’s box” with enormous potential to transfer wealth
and the bill passed by an overwhelming majority. Believ- from shareholders to employees.12 To obtain a glimpse
ing Congress to have an important role in this debate, Rep. inside that box, we compiled a sample of six-and-one option
Michael Oxley (R-OH) has been quoted as follows: re-pricings identified from a database maintained by Insti-
tutional Shareholder Services (ISS).13 We initially focused
You have an unelected body called FASB that nobody has on the 121 companies we identified as engaging in some
ever heard of that could very well make decisions that have an form of the “six-and-one strategy” in the year 2001. After
enormous impact on our overall economic picture…We could screens for data availability, we were left with 92 firms.
be, in my estimation, foolhardy to sit back and simply allow To avoid expense recognition, stock option replace-
it to happen just because some people think this is a real silver ment must not occur before a minimum six-month waiting
bullet in dealing with corporate governance.10 period. Sixty-one companies complied exactly with this
requirement, stating that the replacement options would
In the U.S. Senate, option expensing is still under the have a strike price equal to the market price six months
microscope with strong proponents on both sides of the and one day later. The following language extracted from
issue. Senate bill S. 1890 is very similar to HR-3574 and was Centillium Communications’ October 22, 2001 Tender
introduced in November 2003 by Senator Michael Enzi (R- Offer Statement is representative:

9. In April 2005, the SEC delayed the effective date for SFAS No. 123(R) until the first chive/2004/20040422_headlines07_Staff.html.
quarter of the fiscal year that begins after June 15, 2005. This effectively postpones 11. See “Bill Summary & Status for the 108th Congress,” last retrieved February 26,
mandatory expensing of stock options for six months for many companies. For example, 2005 at http://thomas.loc.gov/cgi-bin/bdquery/z?d108:SN01890:@@@P.
those companies with a calendar year fiscal year-end will not be required to expense stock 12. See Gillan (2001), cited earlier.
options until January 1, 2006. 13. We are very grateful to Patrick McGurn of ISS and Floyd Norris of The New York
10. See “Oxley: Congress Belongs in Stock Option Debate,” AccountingWeb.com, April Times for data assistance.
22, 2004, last retrieved February 26, 2005 at http://securities.stanford.edu/news-ar-

128 Journal of Applied Corporate Finance • Volume 17 Number 4 A Morgan Stanley Publication • Fall 2005
Figure 2 CARS Between Announcement and Re-Pricing

10%

5%

0%

Whole Sample
Median CAR

-5% Low Analyst Group

High Analyst Group

-10%
O&D Excluded

O&D Included
-15&

-20%

-25%

1 2 3 4 5 6
Month Relative to Announcement

Centillium Communications, Inc. is offering eligible employ- Results

ees the opportunity to exchange certain stock options defined Figure 1 shows the abnormal returns for the 12-month period
below as Eligible Options and Required Options for an equal preceding the six-and-one announcement for the sample of 61
number of new options to be issued after a six-month-and one- firms engaging in the exact “six month and one day” strategy.
day waiting period. Similar to previous research, we calculated cumulative abnor-
mal returns (CARs) as the cumulative difference between the
The remaining 31 firms left some flexibility in the re-pric- company return and a value-weighted market index.14 Consis-
ing date. Some (ten firms) specified a window after the end tent with prior research, we found (as shown in Figure 1) that
of the six months. Macromedia, for example, defined the six-and-one option re-pricing is associated with prior poor
grant date for the replacement options in its May 4, 2001 performance. The pre-announcement CARs for the sample of
Tender Offer Statement as “a date between December 61 firms were very negative. Some 80-90% of the individual
5, 2001 and January 21, 2002.” Some (14 firms) speci- company CARs were less than zero, and the pre-announcement
fied that the re-pricing would be linked to a meeting of CARs were also very negative for each of the subgroups.15
the compensation committee following the expiration of Figure 2 shows the CARs for the sample of 61 companies
six months. Selectica, for example, stated in its April 27, during the six-month waiting period between the announce-
2001 Tender Offer Statement that “we will grant the new ment and the re-pricing. The announcement occurs at time
options on the date of the first meeting of the compen- zero, and these 61 re-pricings are set to occur exactly six
sation committee of the Selectica board of directors held months and one day later. Figure 2 shows that the median
more than six months and one day following the date we CAR for the entire six-month sample was a negative 13%.
cancel the options accepted for exchange.” Some (seven The subsamples, however, show varying patterns. Interest-
firms), like Spherion Corporation, left the re-pricing date ingly, the median CAR for re-pricings that include officers
open by stating the following in its December 21, 2001 and directors was the most negative of all subgroups—about
Tender Offer Statement: “The grant date will be at least –16% during the six-month period. Counter to the prevailing
six months and one day after the date we cancel the options tendency, the median CAR for the re-pricings that exclude
accepted for exchange.” officers and directors was actually a positive 3.2%.16
14. For example, see D. Aboody and R. Kasznick, “CEO Stock Option Awards and the of Financial Economics, Vol. 57 (2000), pp. 129-154. Note that high and low analyst sub-
Timing of Corporate Voluntary Disclosures,” Journal of Accounting and Economics, Vol. groups are defined relative to the median number of analysts following sample firms.
29 (2000), pp. 73-100. 16. Analyst following appears to have had little relationship to the abnormal return
15. See M. Brenner, R. K. Sundaram, and D. Yermack, “Altering the Terms of Execu- pattern during the six-month waiting period. The median number of analysts following the
tive Stock Options,” Journal of Financial Economics, Vol. 57 (2000), pp. 103-128; and D. sample firms was five.
Chance, R. Kumar, and R. B. Todd, “The Re-Pricing of Executive Stock Options,” Journal

Journal of Applied Corporate Finance • Volume 17 Number 4 A Morgan Stanley Publication • Fall 2005 129
 Researchers have long recognized that options can create Former SEC Chairman William Donaldson has been a
incentives for executives to take certain actions that might defender of independent standard setting by the FASB. In
not necessarily be in the interests of shareholders.17 The a letter addressed to 16 senators, including Senate Majority
issue at hand, however, is not whether having stock options Leader Bill Frist, Donaldson expressed concerns over the
influences managerial behavior but whether the accounting passage of HR-3574 and its potential to disrupt the account-
treatment for options does the same trick. ing standard-setting process. He stated that the FASB’s
Six-and-one re-pricing is the result of efforts to avoid work on stock option accounting “should be allowed to run
expense recognition for re-priced options. While the patterns its full course.”20
shown in Figure 2 do not prove anything about manage- In a September 2004 letter addressed to Senator Shelby,
rial behavior, the negative abnormal returns between the Chairman of the Senate Banking, Housing, and Urban
announcement and re-pricing date raise troubling questions. Affairs Committee, Mr. Thomas Bowman, President and
Aren’t such stock price declines exactly what these (officer CEO of the CFA Institute (a professional association of
and director) option holders would have wanted? 71,000 security analysts), stated, “I am writing to ask you
to vigorously oppose S. 1890, the so-called Stock Option
Moving Forward Reform Accounting Act.”21 He argued that “FASB supports
Having illustrated the distortion of incentives by six-and- reality over fantasy, and the investor’s right to know over
one restructurings, we now address the following question: management’s right to hide.”
what should be done about accounting for stock options? During his July 2005 Senate confirmation hearings,
Before providing our thoughts, we summarize the two recently appointed SEC Chairman Christopher Cox pledged
main positions. his support for the new FASB option expensing rule.22 Like
former SEC Chairman William Donaldson, Cox seems
Pro-Expense supportive of independent accounting standard setting.
Alan Greenspan has described stock options as “a unilateral
grant of value from existing shareholders to an employee…a Don’t Expense
transfer through the corporation of part of the market capi- Many of the arguments against stock option expensing empha-
talization owned by existing shareholders.”18 And he views size the difficulty of estimating the value of option grants.
stock option expensing as a critical step toward greater real- For example, in January 2003, 40 members of the House of
ism in financial statements: Representatives sent a letter to the FASB questioning the abil-
ity to accurately forecast the value of stock options.
The seemingly narrow accounting matter of option expensing is,
in fact, critically important for accurate representation of corpo- [P]ricing models currently available, such as Black-Scholes
rate performance. And accurate accounting, in turn, is central or slight variations on it, were designed for entirely different
to the functioning of free-market capitalism—the system that kinds of options that have little in common with employee
has brought such a high level of prosperity to our country. stock options. The same model can produce widely differing
results depending on the particular guesstimates a company
Warren Buffett, also a staunch supporter of stock option decides to use. Highly subjective numbers that are not reliable
expensing, argues that the current accounting for stock or meaningful are of no use to investors, and in fact, hurt their
options represents one of the “most flagrant deceptions” in ability to make informed decisions.23
financial reporting:
In a January 15, 2004 letter addressed to President
Options are a huge cost for many corporations and a huge benefit Bush, Carl Feldbaum, President of Biotechnology Industry
to executives. No wonder, then, they have fought ferociously to Organization (representing more than 1,000 biotechnol-
avoid making a charge against their earnings. Without blush- ogy companies) expressed concerns over possible required
ing, almost all CEOs have told their shareholders that options expensing of stock options. The letter states,
are cost-free.19
17. One example is dividend policy. See R. Lambert, W. Lanen, and D. Larcker, “Execu- August 30, 2004, The Wall Street Journal, last retrieved August 30, 2004 at http://online.
tive Stock Option Plans and Corporate Dividend Policy,” Journal of Financial and Quantita- wsj.com/article_print/0,,SB109383177932204272,00.html.
tive Analysis, Vol. 24 (1989), pp. 409-425. 21. See Mr. Bowman’s letter, September 13, 2004, last retrieved February 26, 2005
18. Remarks by Chairman Alan Greenspan at the 2002 Financial Markets Confer- at http://www.cfainstitute.org/pressroom/techletter.html.
ence of the Federal Reserve Bank of Atlanta, Sea Island, Georgia, May 3, 2002, last 22. See Deborah Solomon, “Cox Pledges to Leave Stock-Options Rule Alone,” July
retrieved February 26, 2005 at http://www.federalreserve.gov/boarddocs/speech- 27, 2005, The Wall Street Journal, last retrieved August 22, 2005 at http://online.wsj.
es/2002/20020503/default.htm. com/article/0,,SB112238959931896156,00.html.
19. Warren E. Buffett wrote “Who Really Cooks the Books?,” The New York Times 23. See Letter from Members of Congress to the Financial Accounting Standards
on the Web, last retrieved February 26, 2005 at http://www.j-bradford-delong.net/mov- Board, January 30, 2003, last retrieved March 1, 2005 at http://www.techlawjournal.
able_type/2003_archives/000668.html. com/cong108/stockoptions/20030130.asp.
20. See Deborah Solomon, “SEC Asks Congress to Defer to FASB in Options Debate,”

130 Journal of Applied Corporate Finance • Volume 17 Number 4 A Morgan Stanley Publication • Fall 2005
Figure 3 Value at Date of Option Grant

Value of Options ($)

FASB 123 (R)

House Bill

Difference

$0
(out of the money) (at the money) (in the money)

BIO opposes stock option expensing because it would force biotech ment (grant) date—exactly the same result as under APB
companies to reduce the number of stock options issued to rank- No. 25.27
and-file employees in order to maintain growth in reported Few (if any) employee stock options are issued in the
earnings or control losses. Further, many of the accounting options money. So under the House bill, expensing of option grants
for expensing are inappropriate for valuing employee stock options would virtually disappear. This renders irrelevant the limita-
issued by emerging companies with volatile stocks.24 tions and exceptions in HR-3574 related to mandatory
expensing for the CEO and the four highest-paid company
As an additional example, a coalition of technology employees, as well as the expensing requirement exemption
companies (Cisco, Genentech, and Qualcomm) presented for companies with less than $25 million in revenues.
an alternative option valuation approach to the FASB in Figure 3 depicts the valuation of options for estimating
September 2004, apparently in an effort to eliminate, delay, expense (at option grant) under the FASB rule and House
or decrease expense recognition for options.25 Their proposal bill, respectively. The kinked straight line translates to the
primarily affects the input assumptions to the Black-Scholes intrinsic value of the option—the House bill. Since the
estimation model. assumed volatility of the stock price under the House bill
is zero, any option issued at or out of the money has zero
How Should the War over Stock Options End? value. Any option issued in the money has a value equal
Finance Considerations to the market price of the stock less the strike price of the
The House bill (HR-3574) is essentially a return to the option. The curved line FASB proposal represents a fair
intrinsic value accounting method under APB No. 25.26 value of an option similar to what would be calculated using
Since the bill forces stock price volatility to be zero, options a Black-Scholes (binomial) type option pricing method.
issued at or out of the money would have zero value and not The fair value (FASB rule) and intrinsic value (House
trigger any expense recognition. If the option is issued in the bill) of an option are very close if the option is deep in or out
money, its value would be equal to the excess of the market of the money. At the money, however, is where the differ-
price of the stock over the exercise price on the measure- ence between the intrinsic and fair value of an option is the

24. See Biotechnology Industry Organization letter to President Bush, January 15, 26. Proposed Senate bill S. 1890 produces the same result as it mirrors the provisions
2004, last retrieved March 1, 2005 at http://www.bio.org/news/features/2004Letter_ of HR-3574.
to_PresBush.pdf. 27. The intuition is that since the volatility of the stock is zero, the stock price does not
25. See the coalition presentation to the FASB, “Employee Stock Option Valuation: A Pro- move. If the option is out of or at the money, the value of the stock cannot move into the
posed Fair Value Method,” September 15, 2004, last retrieved February 26, 2005 at http:// money. If the option is issued in the money, the value is the difference between the (fixed
www.qualcomm.com/ir/ppt/fasbpresentation_091504.pdf as well as the “Appendices” to by assumption) stock price and the exercise price. No publicly traded stock has zero
the presentation at http://www.qualcomm.com/ir/ppt/fasbappendices_091504.pdf. volatility, so this is an extreme assumption.

Journal of Applied Corporate Finance • Volume 17 Number 4 A Morgan Stanley Publication • Fall 2005 131
greatest—and this, of course, is where most employee stock Political Considerations
options are granted. Along with the economic arguments, the final battle over
Figure 3 also visually highlights the impact of option option accounting also has implications for the politics of
re-pricing. Under the six-and-one strategy, deep out-of- standard setting. Congressional interference in the standard-
the-money options are replaced with options near or at the setting process could mark the demise of the FASB. Former
money. The story accompanying re-pricing is that deep SEC Chairman Arthur Levitt argues, “The true test of a
out-of-the-money options don’t motivate employees very democratic institution is whether it is respected even by
effectively. Consider the price declines shown in Figure 1. those who disagree with its decisions. If we don’t abide by
The FASB fair value line in Figure 3 shows how re-pricing FASB’s decisions when they go against our interests, then
transfers value to option holders by moving them back to we will seriously undermine, and ultimately destroy, the
the money, thus increasing their motivation. The House institution.”30
line shows no valuation impact so long as the option is re- Consider the perspective of John “Neel” Foster, who
priced at or below the money. If the re-pricing does not served two terms (1993-2003) on the FASB board. He
transfer value to employees, then why do it? has expressed concern for the efficient functioning of the
Another economic challenge to the accounting under U.S. capital markets as well as the importance of preserving
the House bill is evident when option exercise is considered. the FASB’s independence to achieve neutral accounting
Regardless of how the accounting for stock option grants is standards.31 In agreeing with Levitt’s assessment, Foster
done, at the point of exercise value (cash and or stock) must stated, “If a group of constituents that is dissatisfied with a
be transferred to satisfy an in-the-money option exercise. proposal or a standard issued by the FASB has the ability to
Depending upon the number of options granted, and their successfully appeal to Congress to overrule that standard, the
depth in the money, the value transferred from the firm to authority and the viability of the FASB will soon vanish.”
the option holders could be significant.28 If the value of the With the political override of SFAS No. 123(R), the
options were indeed zero, why would firms grant them to future of accounting standard setting could be changed
employees in the first place? dramatically. One direction might be the creation of
The main objection to the FASB rule is the difficulty a new private sector body even more insulated from
in estimating fair value. The difficulty relates principally political interference. Or, U.S. GAAP could be replaced by
to estimating stock price volatility as well as the effect of international standards passed by the IASB (which already
the “non-marketability” of employee stock options. But require fair value expensing of stock options). Alternatively,
even if the option valuation method is not perfect, it should the SEC or some other governmental entity could take on
provide a better estimate than zero value. No stock has zero this responsibility. This alternative could lead to suboptimal
volatility, as the House bill mandates. financial reporting due to extreme political interference.
We recognize that SFAS No. 123(R) affects some As Foster argues, “I don’t believe anyone would want
companies more than others. A decade ago, we estimated the accounting standards to continually tack with every change
relative effects on various types of firms.29 Stock volatility in the political winds, or to be determined by social policy
estimates matter, as does the size of the grant relative to the or the special interests that others have—think about the
size of the firm. But these factors should be evaluated when tax code.”32
a board of directors considers stock option grants in the first
place. They reflect the value of the compensation given. Summary
Thus, it appears to us that the FASB rule improves As the dispute over accounting for employee stock options
relevance and reliability since it more faithfully represents enters its second decade, we offer some perspectives on the
the underlying economic substance of stock option transac- current situation. Recent actions by the U.S. House seek
tions than the House bill. Moreover, SFAS No. 123(R) will to reverse the FASB’s new rule requiring expensing of stock
simplify the current accounting mess by eliminating excep- options. An accompanying bill has yet to pass the Senate,
tions and loopholes like the six-and-one rule. Finally, SFAS however. In the meantime, efforts to avoid expense recognition
No. 123(R) will improve comparability with financial state- under the existing rules are creating some strange incentives.
ments prepared under international accounting standards One example is an accounting loophole called the
since SFAS No. 123(R) is similar to IFRS 2 passed in six-and-one re-pricing strategy, which is undertaken to
February 2004 by the IASB. avoid expense recognition of re-priced options. Managers

28. See Ciccotello, Grant, and Grant (2004), cited earlier. 31. Ibid.
29. See Ciccotello and Grant (1995), cited earlier. 32. Ibid.
30. See John “Neel” Foster, “The FASB and the Capital Markets,” last retrieved
February 27, 2005 at http://www.fasb.org/articles&reports/Foster_FASBReport.pdf.

132 Journal of Applied Corporate Finance • Volume 17 Number 4 A Morgan Stanley Publication • Fall 2005
essentially hold a short interest in the firm during the six- contemporary philosopher Yogi Berra, “When you come to
month-and-one-day waiting period before the strike price a fork in the road, take it.” We prefer the FASB approach.
on their options is reset to market. We observe abnormal From a finance perspective, fair value estimates are more
stock price declines during that timeframe for a sample of relevant and reliable than intrinsic value estimates. From a
61 companies. The stock price decline is greatest for re- political perspective, a Congressional override of the FASB
pricings that include officers and directors. Stock option sets a dangerous precedent.
accounting, as it now stands, sorely needs to be fi xed.
SFAS No. 123(R) would remove loopholes and put an
end to the options accounting war by requiring all options conrad ciccotello is Associate Professor of Risk Management
to be expensed at fair value. In stark contrast, the recently and Insurance in the Robinson College of Business at Georgia State
passed House bill (HR-3574) would effectively eliminate University.
any expensing of options since it requires the assumption of
zero stock price volatility in option pricing models. Under terry grant is Professor of Accounting at California State Univer-
the House bill, options issued at or out of the money have sity, Fullerton.
zero (intrinsic) value and zero expense.
Although the House bill is dressed up to look like it mark wilder is Associate Professor of Accounting at the University
would trigger option expensing, its approach is clearly of Mississippi’s Patterson School of Accountancy.
different from that of SFAS No. 123(R). In the words of

Journal of Applied Corporate Finance • Volume 17 Number 4 A Morgan Stanley Publication • Fall 2005 133
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