Options Options

...This regime is economically wrong, too...

...Figures are in millions, except for share prices...

...If the options liability and the human capital asset they represent were on the balance sheet, we would see, for the first time, how much risk a firm is really taking by using options...

...When options are first issued, the claim on human capital that they have purchased would be recorded on the balance sheet as an intangible asset...

...Thus the solution to options abuses will be a balance-sheet solution, beginning with proper risk-disclosure on the firm's balance sheet...

...Put options and their associated human capital on the balance sheet, where they belong...

...decreases (when the firm's stock goes down or remains unchanged) would be recorded as a gain...

...And that keeps investors, analysts, regulators and boards of directors in the dark about the true risks being taken by the firm...

...On the other hand, if the option holder leaves the firm and abandons his entitlement, both the human capital asset and the option liability on the balance sheet are written down to zero...

...Economist Reuven Brenner holds the REE4P Chair at McGill University's Faculty of A11anagentent...

...The table below illustrates how IBM's balance sheet and pre-tax earnings would change by applying the balance sheet solution...

...He is the author of The Force of Finance, published this spring by Texere Publishing...

...Donald Luskin is chief investment o 'ce of Trend Macrolytics, an independent economics research firm in Menlo Park, California...

...Increases in the value of the option liability (when the firm's stock goes up) would be recorded in the income statement as an expense...

...The logic of a balance sheet solution dictates that options should be expensed...

...How does the balance sheet solution impact the issues at stake in today's debate about stock options...

...This regime is economically wrong, because it ignores the cost to the firm entailed by issuing stock at a below-market price when options are exercised, and thus fails to recognize that a true economic cost is being borne beyond the dilution that results from share issuance...

...Because an asset and liability of perfectly offsetting value are put on the balance sheet at the same time, there is no immediate impact on earnings.At this stage the asset representing human capital-the employee in question-has not yet produced anything...

...And abuses don't happen because options misalign incentives between executives and shareholders-the alignment isn't perfect and diligent boards should work to improve it, but at least options get executives working toward a higher share price...

...But on the other hand, we dismiss "options are evil" arguments that seek to impose expensing as a means of curbing options issuance...

...The corresponding income statement entries will bring the cumulative gains and expenses from the asset and the liability, taken together, to precisely the intrinsic value of the option at the time of exercise...

...We have an answer...

...At the same time, the option liability on the balance sheet is marked to market at its current Black Scholes value, reflecting the ongoing success or failure of the initiatives undertaken by the people who put their human capital at risk...

...For all the billions of dollars of options that have been issued and exercised, no one has understood options for what they really are: risky assets and liabilities that should live first and foremost on a firms balance sheet...

...Abuses don't happen because boards of directors and shareholders don't have to approve all options grants-there are loopholes, but generally grants must be duly approved...

...Enron, for example, with its massive hidden debt, was a risk-control problem...

...Such risks should appear on balance sheets and should be marked to market to reflect their current value...

...Both would be assigned the same value, estimated by a standardized options valuation algorithm such as the well-known Black Scholes model...

...Let's learn the right lesson from Enron...

...Besides creating clear-eyed accounting, this would make a vibrant reality out of the hollow slogan we've heard for years from business pundits: "People are a company's most important asset, and one that goes down the elevator at 5 o'clock every day...

...Options issued as part of compensation packages are risky derivatives.The risk profile for Cisco or Microsoft or General Electric when they issue options is the same as it would be for you if you shorted exchangetraded options on those stocks...

...But employees, owners of human capital, like them, too, because it gives them a shot at the gold ring on the upside...

...The high-flying hedge fund, Long Term Capital Management, with its levered derivatives portfolio, was a risk-control problem...

...Every investment and activity entails risk...

...The question isn't whether options are good or bad-although we believe they are often quite useful...

...First, it addresses inadequacies in the two alternative options accounting regimes available under Generally Accepted Accounting Principles...

...123 permits options to be expensed at their Black Scholes value at the time of issue, spread over their expected life...

...An option holder may labor for nothing during the bad times when the firm's stock declines-and shareholders' losses will be offset by wage savings...

...As the value of human-capital assets and option liabilities change, the inevitable results are expenses and charges on the income statement.Yes, not just charges, but credits as well-in periods when a firm's stock declines, the marked-to-market value of its options liability declines, and that will show up on the income statement as a credit to earnings...

...Specifically, if the option-holder exercises an option, whoever sold it to him has to deliver stock to him at the option's exercise price-no matter how much higher than that the stock happens to be...

...Here's how it could work...

...But at exercise, the subjective Black Scholes values converge to objective intrinsic value, and at abandonment, they become zero...

...So let the self-interested pleadings about options end-from the anti-options Old Economy companies that don't use them, pro-option New Economy companies that need them, senators seeking new revenue sources and regulators seeking new powers...

...Form matters, because it reflects reality, and brings clarity and transparency to important issues of risk...

...Accounting Policy Board Option No...

...Here's what is important about options abuses...

...This approach uses the Black Scholes value, only as an approximation, for risk signaling purposes during the option's life...

...So are stock options, which entail elements both of hidden debt and of derivative securities...

...A balance sheet solution provides all the information necessary for informed evaluation of incentives by boards of directors and shareholders...

...Options abuses happen for precisely the reason that Enron blew up: because accounting rules permit them to be kept of} a firm's balance sheet-despite the fact that they represent material risks...

...And the option liability reflects the obligation to pay if the human capital is eventually transformed into something tangible: a commercially successful new technology, drug, movie, product or service...

...Companies both take risk and use strategies to hedge against-or control-risk...

...But first, let's set aside what's not really important about options: Abuses of stock options don't happen because their costs fail to show up on company income statements-a helpful if imperfect version of this has been a mandatory part of the notes to consolidated financial statements for years...

...OPTIONS OPTIO ENRON'S LESSON: PUT THEM ON THE BALANCE SHEET BY REUVEN BRENNER AND DONALD LUSKIN J n the wake of the Enron debacle, the firelight over reforms to prevent abuses in executive stock options has proved only one thing: that no one has learned the lessons of Enron...

...They don't always succeed, especially when risk is not well disclosed...

...The willingness of an employee to forego wage income in order to get options of unknown future value is an off-balance-sheet risk, in which the employee trades his own "human capital" for the option...

...Until that kind of information is available, it will do no good to pass new regulations requiring new board committees and ever-longer proxy statements...

...Naturally, some simplifying assumptions have been made, considering that not all necessary data is publicly available in sufficient detail...

...Even though the asset and liability perfectly offset each other, the now-larger balance sheet sends an important signal to investors:The firm 30 THE AMERICAN SPECTATOR • MAY/JUNE 2002 sends an important signal to investors: The firm has become more levered and is taking more risk...

...The stock surges_ options IiahiIit ies swell, and earnentis are impaired The IBM Example First warning: options ]tabo]itoes begin to exceed human capital assess 2' It4 3790 ;o 92 tq 107 88 Hs 00 I o qb i ne stock nropsu options nanuutes collapse, and earnings get a bOOST ine stucK runs to new nigns as more options Lire issued-liability lit nwss Imkghts- too, and earniosss suffer MAY/JUNE 2002 • THE AMERICAN SPECTATOR 31...

...The question is simply how to best reflect this risky form of compensation in financial statements...

...The adversarial prejudices of the politicians, pundits and big-business spokesmen have focused the debate on isolated symptoms-deceptive earnings reporting, tax breaks, fat-cat compensation, lax corporate governance-and ignored the underlying disease: a fundamental misunderstanding of the nature of options...

...We dismiss the typical op-ed columns that rail against expensing options under the banner of "options are good for the economy," no matter how they accounted for...

...It has acquired a risky asset in the form of human capital and has committed to a risky liability in the form of the option...

...On the income statement, the cumulative expenses and gains go to zero...

...This risk-bearing by employees is thus an asset of the firm-the crystallization of human capital-and should be carried on the firm's balance sheet as such...

...And we would have an analytical framework that would lead straightforwardly to robust solutions for all the other concerns that have so far dominated the debateexpensing, taxation, incentives and shareholder rights...

...The option liability is marked at its intrinsic value-the difference between the exercise price at which the employee can buy the firm's stock and the stock's market value...

...The balance sheet solution also resolves the debate about taxation of options expenses.The cumulative expenses recorded on the income statement would correspond exactly to the tax deduction to which the firm is entitled, ending the socalled "double standard" between expensing rules and tax deduction calculations targeted by Senators Carl Levin and John McCain in Senate Bill 1940...

...Abuses don't happen because companies' option expenses are tax-deductible-the current tax code fairly allows deductions based on options' true economic cost...

...The balance sheet solution would also apply perfectly to new generations of incentive arrangements-not just today's simple stock options...

...On the other hand, Financial Accounting Standards Board Statement No...

...At the same time, the options themselves would be recorded as a financial liability on the balance sheet...

...and people are assets, not labor-everything else falls into place...

...25 permits options to be expensed at zero because they have no cash value at issue and consume no cash at exercise...

...Over the life of the option, the value of the human capital asset on the balance sheet depreciates toward zero, as the claim on human capital runs off...

...Right now, options are an off balance-sheet risk, just like Enron's famous partnerships...

...Under our approach, expenses flow naturally from the balance sheet to the income statement...

...When the firm's stock is higher, employee option-holders get a piece of the upside, while shareholders keep the lion's share...

...It enshrines a highly subjective Black Scholes estimate forever-too low if the options are eventually exercised at a price higher than their value at issue, too high if either the intrinsic value goes lower than at issuance, or the option is abandoned altogether...

...When the option is exercised, the human capital asset is depreciated all the way to zero...

...Other than an executive's fantasy of not having to disclose expenses, we don't see any arguments against this approach...

...So options are a heads-I-win, tails-I-win deal for shareholders-owners of financial capital...

...And let Warren Buffet ask yet again, "If options expenses shouldn't go into the calculation of earnings, where in the world should they go...

...If you get the definitions right-options are liabilities, not wages...