Many firms, particularly startups, give their higher level employees stock options as a form of compensation. Stock options also give executives incentives to increase stock price, thereby bringing the goals of the executives in line with the interests of the stock holders. The problem of stock options has to do with the accounting. Employee stock options are not counted as an expense and thus do not reduce reported profits. Under present practice corporation take a tax deduction for the stock options given to employees and thereby reduce their tax liability without their showing up as a cost on the stockholder reports.
Warren Buffett, in a letter to Berkshire Hathaway shareholders, summed the situation up quite succinctly:
- If options are not a form of compensation, what are they?
- If compensation is not an expense, what is it?
- And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?
Allow there is a general consensus among those who do not have a self-interest in maintaining the status quo. The real problem is how the stock options should be valued. If they were sold in a market then the market price would be used, but often they are not traded. Some want to use some standard valuation formula such as Black-Scholes but usually those standard formulas are not appropriate. Furthermore, there is a portfolio problem that affects the value to the employee. The stock options may concentrate an employee's wealth more heavily in the company's stock that that employee would if the employee were simply selecting a portfolio of investments. Generally the selected portfolio will be more diversified than what the holdings would be under a stock option plan.
Many business organizations are opposing the new bill being considered by Congress. These include the Business Roundtable (composed of the CEO's of the largest 200 corporations), the U.S. Chamber of Commerce and the National Association of Manufacturers. But a special panel of the Conference Board, a major business organization, recommended an overhaul of stock option accounting. The Commission on Public Trust and Private Enterprise urged changes in accounting rules to:
Critics of the report charge the report is asking for accounting rule changes to curb abuses unrelated to stock options. For example, the Commission seems to feel corporate executives are overpaid. That is a problem that is not easily handled by accounting rule changes.
Bear Stearns reported the effect expensing stock options would have had on reported earnings: