It's a brand new world out there, one requiring companies to estimate and report an expense for share based pay. For most companies, this means using a complicated model to estimate the cost of a stock option.
In most cases where a cost must be estimated and reported, companies usually turn to their accounting firm. Some companies still can. But companies with an outside auditor cannot expect their auditor to provide these calculations; auditors will audit the estimate provided by the company but the company has to provide an estimate to start the process.
We believe determining the "right" cost of an option is as much art as science. You not only have to understand the math but you also have to understand how a change in one variable will impact the calculation.
This website is not intended to give you a complete and thorough understanding of all the intricacies of Black-Scholes-Merton or other approaches. We do, however, want to give you an appreciation of the process.
First, let's have some fun. Click here for an illustration of how the formula variables can impact the calculation. Move the values around and watch the graph.
Next, how do we use this information? Long story short, we often conduct a sensitivity analysis for our clients which we call Scenario Testing. Click here for an illustration.
Now for information you can use. For a checklist you can print out and use, click here.
Lastly, here are some FAQs that we think you will find helpful:
David Harper is an editor of Investopedia and the following is a good summary of our views.
(Click on each question to see its answer, or expand all answers)
The essence of the rule can be summarized in four words: grant date fair value. Companies must recognize an expense estimate ("fair value") when equity incentives are granted ("grant date"). On the grant date, a plain-vanilla option has no intrinsic value (since the strike equals the stock price) but it does have time value. In a nutshell, option cost = intrinsic value + time value.
Most public companies must recognize the expense on "the first quarter of the first fiscal year beginning after the effective date" of June 15, 2005. In other words, a public company with a fiscal year ending on December 31st needs to begin expensing in the first quarter of 2006. The effective date for smaller public companies (i.e., revenues and market capitalization less than $25 million) and private companies was delayed to December 15, 2005. For those with a fiscal year end in December, they too need to begin recognition in the first quarter of 2006.
The rule applies when the company pays employees with stock or somehow settles with stock. The big distinction is between equity instruments (e.g., options, restricted stock, ESPP plans) and liability instruments such as deferred cash. Note that liability-based awards still must be recognized at fair value, but unlike equity-based awards that are measured only once at grant, liabilities are re-measured (marked-to-market) each period.
Yes. We like to say this rule is "merely accounting." It directly impacts neither the cash flows nor the tax burden of the company. True, the reported income tax expense is changed, but that is an income statement line item. Remember that financial statements are different from the tax books. (The rule does re-classify the cash flow benefit of exercises from operating cash flow to financing cash flow – this is a very good thing: it was in the wrong place to begin with! This change appropriately reduces operating cash flow but does not change net cash flow).
FASB decided to give companies a choice. Their intent was noble: they want companies to be accurate and the better model depends on your information base. But I like to say "they shifted the burden of discretion onto the company's shoulders." You have a choice and, given the exact same information about your company, two experts can produce materially different results.
Probably not! Stock options are deferred compensation funded by shareholders. As David Zion of CS First Boston has written, "the final cost of an employee stock option plan is the amount the options are in the money when they are exercised." Therefore, the expense is an estimate about a future, unknowable cost. Investors should attempt to discern the economic implications of option grants; but this is not an especially unique problem: investors are meant to deconstruct GAAP statements.
In our opinion, the best way to treat them from an investor standpoint is to assess their potential dilution; i.e., their potential impact on the future share base. Institutional Investor Services (ISS) has for years employed a very sound method (they call it shareholder value transfer). They apply a very advanced analytic, but you can take a similar tack with little effort and get 80% of the benefit.
We recommend that you not place the accounting cart before the business horse. If you prefer consultant-speak, accounting should be a program implication rather than a design criteria. I recommend you view the new rule as an opportunity to revisit the incentive plan and deploy incentives in light of their economic costs. Equity is a valuable and scare resource. The rule may not perfectly "level the playing field" in regard to the cost of equity-based incentives, but it does a pretty good job of eliminating major accounting distortions.
Too many consultants try to help their clients to game the accounting impact; worse, some Boards play games by accelerating outstanding options, or even worse, back dating stock options. Don't game the pricing model too much; you'll need to be consistent in your methodology and today's clever approach could betray you down the line. Don't assume your investors are fooled by accounting shenanigans. They may be shortsighted but they aren't stupid. And, please, don't engage a consultant who reflexively suggests that you explore cash-based SARs because they might exploit a loophole.
The investor base is always learning. We think you will do much better to concern yourself with the metrics and hurdles (i.e., pay to performance equation) attached to performance-based restricted stock than the incremental accounting hit. Providing incentives to talent is a critical business design. Don't let mere accounting drive it.
In an advisory newsletter David Harper edits, they explicitly tag the acceleration of outstanding options (i.e., for purposes of minimizing the recognized expense) as a governance red flag. Such actions betray a Board that cares more about window dressing than disclosure. We like companies that preserve their ESPP (rather than dismantle it in order to save a few pennies in EPS) because, as First Data wrote, "the ESPP is a valuable employee benefit that assists the Company in its efforts to attract, retain and motivate valuable employees... these benefits are well worth the additional expense recognized for accounting purposes."
"Mark has worked with Rentrak for several years, conducting multiple assignments at the Board and Executive level. LCI has been a significant help to our Board and to me by providing not only data but also a clear understanding of our objectives and strategic advice. He and his team have been extraordinarily responsive and a pleasure to work with."
"I have worked with Mark for more than ten years. LCI provides excellent customer service and demonstrates the utmost professionalism. Mark takes into account our special needs and incorporates the nuances of our Company into his recommendations. Their responsiveness to unique circumstances that have arisen is nothing less than heroic."
Over the years we've seen certain problems crop up on a regular basis. Though common, the following short list of pitfalls often have innovative and even bold solutions that turn blunders into opportunities. In some cases they can be avoided entirely.