Stock options: End of a trend?

Accounting rule changes could make comp practice less attractive

The push to change stock option accounting rules in Canada is gaining momentum and may be unstoppable, the head of Canada’s accounting standards regulator says.

If expensing stock options was raised last fall, few people would have taken the suggestion seriously but there has been an amazing transformation in the past few months, said Paul Cherry, chair of the Accounting Standards Board (AcSB). The logic behind expensing stock options “is absolutely compelling,” he said. “In that sense, I would like to believe that it is inevitable.”

Forcing companies to recognize stock options as an expense would have the effect of making it more expensive for an organization to grant employees stock options, likely forcing many to stop or at least reduce the utilization of the practice, say compensation and accounting experts. Currently, when an employer grants stock options to employees, it does not register as an expense since there is no immediate cost to the company. For years, critics have complained the growing practice not only dilutes share value but distorts impressions of the value of a company. They have called for stock options to be included as an operational expense.

While the mandate of AcSB doesn’t include consideration of the effect such a change would have on compensation practices, Cherry acknowledged the changes would have a considerable impact on how organizations grant options.

The push to expense options comes at a time when Canadian firms are either introducing stock options or expanding current programs at a rapid rate.

A survey by compensation association WorldatWork, released last month, showed a marked increase in the number of Canadian organizations offering options to employees below the upper executive level. In 2001, about 14 per cent of organizations offered stock options to non-management hourly employees but this year that number jumped to 25 per cent.

The increased use of stock options has been dramatic, said Kay Schmitke, manager, surveys and research for WorldatWork. The practice has been gathering momentum since the dotcom boom of the last decade.

Investment guru Warren Buffett has called for stock option expensing and once explained that, “In effect, accounting principles offer management a choice: Pay employees in one form and count the cost, or pay them in another and ignore the cost. Small wonder then that the use of options has mushroomed.”

Later this month, AcSB’s Accounting Standards Oversight Council is slated to hold a meeting to discuss expensing stock options. The council gathers public input and makes recommendations to the AcSB.

Good arguments can be made on either side of the debate, said Tom Allen, chair of the council. One important consideration is whether or not stock option expensing would put Canadian organizations at a competitive disadvantage if U.S. regulators don’t introduce similar requirements.

Getting out in front of the United States is a concern but there are economists who argue the market rewards organizations that provide good information, and punishes those lacking clarity, said Cherry.

“I’m hearing a number of important people saying we have overplayed the competitive harm dimension and underplayed the competitive advantage dimension,” said Cherry.

If the accounting rules do change, “there will be drastic changes” in how stock options are used, said Schmitke. It would cut too deeply into revenues for them not to reduce the number of options being granted, she said.

If this happens, for many organizations the first response will be to reduce the number of employees who receive stock options, said Raymond Murrill, executive compensation practice leader of consulting firm Watson Wyatt. “Companies that offer options broadly will claw back on the eligibility.”

The effect will of course be a function of how much stock options have been used.

In businesses where options haven’t been a big part of the compensation strategy, expensing the options wouldn’t be a huge cost, he said.

At the other end of the spectrum, for many of the high-tech companies that rely heavily on stock options, being forced to expense stock options “would just obliterate their bottom line,” said Murrill.

Companies that do find it too expensive to issue stock options at their current rate, won’t be without alternatives, said Murrill. Rather than the standard method of stock option granting, HR departments could suggest restrictive stock units.

With a typical option the only value is in the upside appreciation in the value of the stock. But with restrictive stock units, the value is both the appreciation and the current value of the stock.

The expensing of the options is no different, but the typical non-high-tech company would only have to grant one-third the number of units to generate the same value for employees.

“It basically allows a company to deliver competitive total compensation with fewer shares then you would with stock options, he said.”

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