Are Stock Options Compensations? Yes, But So What? - 16 Nov 2008

Sunday, November 16, 2008

Are Stock Options Compensations? Yes, But So What?

http://painting-with-numbers.blogspot.com/2008/11/are-stock-options-compensations-yes-but.html

Well, are they? Should stock options be valued, and treated as an
operating expense to be run through the company’s income statement? The
accounting issue was “settled” a few years ago by GAAP statement FAS
123R, which requires companies to “expense” stock options. But it’s
still up in the air: most securities analysts will tell you that more
investors would rather see the pro forma income statements, with stock option expense backed out, than the GAAP financial statements.

First of all: Are stock options compensation?
Well, company stock is a scarce and valuable resource – just like cash,
or cars, or health insurance – that companies offer to prospective or
current employees to get them to accept a job offer. Or reward them for
a job well done. Or keep them from going to work somewhere else. Hello?
Of course stock options are a compensation expense!

So why do
so many people want income statements without the stock option expense?
Is this a paradox? No, not if you ask this question first: What is the income statement for?

Back up one more step: How much is a company’s stock worth?
As every MBA will tell you, it’s the discounted net present value of
the company’s future cash flow. Obviously, that’s very hard to
estimate, but if you can do that accurately, it’s the only
thing you need to do to determine if a stock is worth more or less than
its current price. And a company’s historical income statements are one
of the few objective tools for assessing its cash-generating potential.


So now the question becomes: Does expensing stock options make easier to use income statements as a tool for forecasting future cash flow? Or harder? If you believe what the analysts are saying, investors are voting against expensing stock options.

Does
this mean we should “repeal” FAS 123R? No. Stock options are a
compensation expense, and there are plenty of investors who want to see
them expensed in the income statement. But it appears that even more
investors prefer income statements that don’t expense options. Rather
than “fixing” the accounting standards, accounting firms and their
regulators need to focus on making sure that investors get the
information they need. So get over it – pro forma statements aren’t always so bad.


“Painting
with Numbers” is my effort to get people talking about financial
statements and other numbers in ways that we can all understand. I
welcome your interest and your feedback.