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The Complicated Calculus of Stock Options

By David Leonhardt

The New York Times, March 30, 2003

Sir David Tweedie, the chairman of the International Accounting Standards Board, wants to require companies to count stock options as an expense.

Lurking in the small type of corporate financial statements is a new problem that threatens the ability of investors to divine the true health of a company's earnings.

Companies are taking widely varying approaches to estimating the cost of the stock options they award to their executives and employees, and the differences are sometimes large enough to make comparisons between companies difficult.

Much of the debate over stock options during the last year has focused on whether companies should be required to subtract the cost of options from earnings. Companies now must only estimate that cost in a footnote on their financial statements.

But with investors paying more attention to those footnotes and more than 200 companies voluntarily including the options expense in their earnings, the discussion is beginning to shift to the confusion over the ways that companies calculate the cost.

"Option expenses are easily the most misunderstood item in financial statements," said Craig Columbus, a market strategist at Thomson Financial, an investment research company. "They're riddled with inconsistencies and very subjective."

If General Motors had used Ford Motor's method, for example, G.M.'s earnings per share would have been 18 cents, or 6 percent lower than they were last year, after adjusting for stock options, according to Thomson. If Cisco Systems had made financial assumptions like the ones used by similar companies, it would have lost money last year after accounting for options, rather than appearing to earn 5 cents a share.

Those inconsistencies are starting to matter much more than they once did. Had companies counted options as a cost, the earnings per share of the companies in the Standard & Poor's 500-stock index would have been 20 percent lower in 2001 than they actually were, according to Bear, Stearns, which based its analysis on the estimates companies made in footnotes. Two years earlier, the gap had been only 6 percent.

More than 20 percent of large companies, meanwhile, including Ford and G.M., have said during the last year that they will begin deducting the estimated cost of options from their earnings, largely to persuade investors that their accounting is accurate. Regulators in the United States and Europe are also considering whether to require companies to count options as expenses, and, after a decade of bitter, on-and-off political debate, most analysts say a requirement is now likely.

The Financial Accounting Standards Board, the arbiter of corporate America's bookkeeping practices, announced this month that it would devise new rules for options accounting over the next year. Part of that effort will include studying how to estimate the cost of options.

The International Accounting Standards Board, based in London, is also analyzing the issue, and the two bodies hope to establish consistent rules that can be used around the world, said G. Michael Crooch, a member of the Financial Accounting Standards Board. Sir David Tweedie, the international board's chairman, has been a vocal proponent of counting options against earnings. "All around the world, people are moving in the same direction," Sir David has said.

Investors, for their part, have begun paying more attention to the options costs, even when they appear only in footnotes. Last year, S.& P. started publishing a statistic called core earnings, which subtracts large companies' own estimates of their options costs from their profits. Starting with the first-quarter earnings reports to be issued in the next few weeks, the Financial Accounting Standards Board has required companies themselves to list the cost every three months, rather than once a year.

Accounting experts emphasize that individual companies are not necessarily at fault when their estimates are out of line with a peer's. The company with the less popular method may end up being more accurate.

Companies themselves make a similar point. Executives at General Motors, for instance, say they understand that the company's estimates are different from Ford's but consider them to be accurate, said Jerry Dubrowski, a G.M. spokesman.

BUT the different estimates across corporate America are too big for all companies to be correct. This is the main reason that experts, who overwhelmingly favor required expensing of options, say a new rule by itself would only begin to solve the problem.

Regulators "should put together some series of guidelines" for how to estimate options costs, said David M. Blitzer, the chairman of the index committee at S.& P. "If they produce at least some guidelines, if not some rules, it will make life simpler for everyone. And it will cut down on some of the game playing."

The inconsistencies range from the complex to the mundane. To calculate the cost of a stock option — which gives its holder the right to buy a share at a fixed price — companies must estimate the future volatility of their stock. An option is more valuable when the underlying share gyrates, giving its holder many chances to cash it in.

For example, a 10-year option with an exercise price of $20 on a stock that remains stuck at $20 for that decade is worthless. But if the stock first rises to $40, then falls to $10, then shoots up to $50, before ending the decade back at $20, the holder could have made money by redeeming the option any time the shares were trading above $20.

These volatility estimates are not easy to make, but evidence suggests that companies could do a better job simply by paying more attention to history. Since 1995, only about one-quarter of companies have more accurately predicted their volatility than they would have simply by using their past volatility as a forecast, according to Camelback Equity Consulting in Scottsdale, Ariz.

"There is no standard method for arriving at these estimates," Patricia McConnell and Janet Pegg, accounting analysts at Bear, Stearns, wrote in a recent report. "Even the volatility assumption itself appears to be volatile."

SBC Communications estimates its future volatility as 23 percent, based on a complex measurement. Verizon Communications, another Baby Bell, predicts its volatility as almost 29 percent, even though Verizon's volatility over the past three years has been noticeably lower than SBC's, according to Thomson.

Verizon and SBC also offer different estimates of another important part of the options formula: the length of time that people will hold on to their options. Verizon says its employees will keep their options for an average of six years, while SBC predicts an average life of 4.4 years, further increasing the gap between the two companies' estimates.

The assumptions make Verizon's option charge look much bigger than it would if the two companies had used the same method. If Verizon had used SBC's method in 2001, Verizon's loss of 4 cents a share would have swung to a 2-cent-a-share profit.

Russell Johnson, an SBC spokesman, said that its assumptions were consistent with accounting standards. It forecasts a short average life for its options because its executives and employees have exercised their options quickly in the past, he said. Another inconsistency, however, is harder to explain. In their calculations, companies must estimate the return that investors could receive, without risk, over the same period that they are likely to hold the option. The higher this risk-free rate, the more valuable the option — and the higher its estimated cost.

Arriving at an estimate of this risk-free rate should be the easiest part of the options calculation, accounting experts say. It should simply be equal to the annual return on a government bond issued at the same time as the option.

"We recognize all the difficulties in this process," said Takis Makridis, an analyst at Camelback, "but this is the walk in the park."

Yet companies still arrive at different answers. Mr. Makridis points to Dillard's, the retailer based in Little Rock, Ark., and Foot Locker, based in Manhattan. In early 2001, both distributed options that they estimated would be redeemed after an average of two years.

At the time, two-year government bonds were yielding about 4.2 percent — roughly the risk-free rate that Foot Locker assumed. Dillard's, on the other hand, assumed a risk-free rate of 2.27 percent, lowering the size of its estimated option expense.

Julie J. Bull, a Dillard's spokeswoman, did not comment.

Mr. Makridis said: "There really is no grounding for Dillard's estimate."

CAMELBACK and Thomson Financial have decided that they can make money from the confusion, and on Tuesday the companies will begin selling to investors and companies two methods, either of which they say will make it easier to compare companies. One will average the assumptions made by similar companies and then use that average to calculate each company's charge. Another will use objective data about a company, like its historical volatility, to estimate the charge.

Corporate executives have cited the difficulties in estimating charges for options as a reason why accounting regulators should not require the charges. "There is not a reliable or accurate formula for expensing stock options," said Terry Anderson, a Cisco spokeswoman.

Executives and their lobbyists have also said that a new rule would make option awards less common and, by extension, damage the American economy by giving many people less incentive to work hard.

In the 1990's, options became many executives' favorite form of compensation, allowing many to become wealthy as the market rose. The unique accounting treatment of options, as the only form of compensation that appears to have no cost, added to their popularity.

But accounting experts argue that options do have a cost and — like salaries, bonuses, direct stock grants and health care benefits — should affect the bottom line. Instead of giving options to executives, companies could instead issue new shares of stock to raise capital and expand their businesses.

"Boards of directors and management think options are free to grant," said Kevin J. Murphy, a finance professor at the University of Southern California. "As a result, options are granted too freely to too many people."

Despite the current inconsistencies, accountants say a uniform system for calculating options costs is possible, noting that earnings statements already contain many economic estimates, like the rate at which machines and buildings lose their value, known as depreciation. A clear options standard might also eliminate some of the simple errors in option accounting.

"There has been some anecdotal evidence that companies have not been as careful with this number as they would have been if they had to put it in their income statement," said Mr. Crooch of the Financial Accounting Standards Board. "I am a great believer that there is greater care when a number goes into the income statement."