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 / First Quarter 1997 / Issue 6(originally published by Booz & Company)


Stock-Based Compensation and the Cost of Capital

Accounting rules often generate opposition from corporate managers. But the opposition to a rule regarding the treatment of employee stock options has been unique in its ferocity.

A lengthy battle over the rule, which was proposed by the Financial Accounting Standards Board, ended not long ago in a victory for the managers. The issue is still very much alive, however, with backers of the proposal arguing that the current system continues to leave all but the most sophisticated investors in the dark about the true level of senior compensation -- not to mention the true state of earnings -- at many publicly held companies.

The accounting board's proposal would have required companies to estimate the present value of the options, when granted, and then account for them as a current expense.

There were dire predictions that such a change would make the awarding of options untenable at many companies, with particularly devastating consequences seen for the high-tech sector, which relies heavily on options to keep talented people on board. Even Congress and the White House joined the chorus of critics, threatening to intervene to keep the rule from going into effect.

Under the barrage of criticism, the accounting board ultimately relented, issuing a final rule in late 1995 that encourages, but does not require, the expensing of employee stock options.

While the new rule continues the tradition of allowing no expense to be recognized for the options, they are clearly of value to employees, who often take them in lieu of higher salaries or bonuses.

The accounting board's reversal permits an obvious loophole to continue as well. If a company promises employees the same future stream of cash flows as offered by a stock option, recognition of an expense is required to the extent that cash is paid out. But management can use the stock options as compensation without being accountable for them in an earnings sense. Indeed, compensation that is awarded as options in lieu of cash has the effect of inflating earnings.

Not surprisingly, the initial opposition to the proposal came from the country's largest companies, whose managers are among the principal beneficiaries of options programs. Their complaints were subsequently voiced by smaller corporations and industry associations.

The main complaint was that expensing the options would depress earnings, perhaps even pushing some smaller companies into the red. The impact on earnings would then hurt stock prices while also making it more difficult to raise outside financing, according to the doomsayers.

To see whether these fears were justified, we examined the financing habits of some 4,000 publicly traded companies. We also looked at the proxy statements and annual reports of all 348 companies that had written letters to the accounting board strongly opposing the proposed rule.

Our investigation uncovered no evidence supporting the fears about financing. For example, we found no indication that companies attempting to raise capital systematically use the options to boost accounting earnings.

We also found no evidence that stock prices reacted negatively to news of the initial proposal, even among high-tech companies that make heavy use of employee stock options.

Perhaps also not surprisingly, we found that opposition to the proposal was concentrated among companies in which top executives were rewarded with lucrative stock option grants. In fact, we found that the top executives of companies who lobbied against the proposal use options intensively for themselves, but not necessarily for employees lower down the ladder.

Our investigation suggests, therefore, that opposition to the proposal was motivated by the desire of top executives to continue to be largely unaccountable for their own compensation. (Option awards have long had to be disclosed in proxy statements, but not in conjunction with an estimate of their value.)

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