EMPLOYEE STOCK OPTIONS
TEAM MEMBERS:
Ceretha Crowder – History Hung-Yu Tseng – Examples Lorenzo Parker – Controversy Phillip Horton – Other Considerations
November 13, 2006 Accounting for Planning and Control Dr. P. Ratliff
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EMPLOYEE STOCK OPTIONS
The employee stock ownership plan (ESOP) concept was developed in the 1950s by lawyer and investment banker Louis Kelso, who argued that the capitalist system would be stronger if all workers, not just a few stockholders, could share in owning capital-producing assets. However, few companies took up Kelso‟s ideas because an ESOP‟s authority to borrow money to buy stock for participants was based on IRS rulings and had no clear statutory authorization. In 1957, eight young semiconductor whiz-kids left Shockley Semiconductor Laboratories because of poor management and started their own company. However, they were short the funds. They eventually received start-up equity from Fairchild Camera and Instrument, of Syossett, NY, on the condition that the upfront equity would provide a right to buy the new start-up if things went well. Things did go well, and Fairchild bought out the founders, leaving each with $25,000 in Fairchild Semiconductors‟ stock. Inspired by the prospect for equity gains realized by the founders of Fairchild Semiconductors, many employees began leaving various employers to start new companies in Silicon Valley. Employers, in order to retain employees and prevent a mass exodus, were forced to give out comparable employee stock options. According to the October 30, 2006 issue of Business Week, options fever has a new meaning in the Valley. Over 40 Valley companies face government scrutiny. Many companies picked dates when stock prices were low to grant options and ensure the biggest payoff- without reflecting these grants as expenses, as required by the accounting rules.
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A stock option gives an employee the right to purchase a predetermined number of shares in the company at a specified (fixed) price for a set period of time, generally as long as 10 years. The price at which the option is provided is called the “grant” price and is usually the market price at the time the options are granted. Employees who have been granted stock options hope that the share price will go up and that they will be able to “cash in” by exercising (purchasing) the stock at the lower grant price and then selling the stock at the current market price. There are two principal kinds of stock option programs, each with unique rules and tax consequences: non-qualified stock options (NSOs) and incentive stock options (ISOs). NSOs (1) meet IRS requirements for special tax treatment; 2) are not subject to ordinary income taxes when you exercise them, but you must hold for a specified time period; 3) may subject you to the alternative minimum tax when exercised; 4) are subject to capital gains tax when shares are sold after the holding period. NSOs 1) do not qualify for special IRS tax treatment and 2) are subject to ordinary income tax when you exercise the stock options. Here is an example of a typical employee stock option plan: an employee is granted the option to purchase 1,000 shares of the company‟s stock at the current market price of $5 per share – typically the exercise price will be equal to the price when the options are granted. If the price of the stock increases to $20 per share, for example, the employee may exercise his or her option to buy 1,000 shares at $5 and then sell the stock at the current market price of $20. The employee does not own the shares until they actually purchase them. After purchasing them, the employee can either sell the shares at the current market price or hold them and sell them later.
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Both privately and publicly held companies make options available for several reasons: They want to attract and keep good workers. They want their employees to feel like owners or partners in the business. They want to hire skilled workers by offering compensation that goes beyond a salary. This is especially true in start-up companies that want to hold on to as much cash as possible.
Traditionally, stock option plans have been used as a way for companies to reward top management and “key” employees and link their interests with those of the company and other shareholders. More and more companies, however, now consider all of their employees as “key.” As a result, there has been an increase in the popularity of broad-based stock option plans, particularly since the late 1980s. The executives at Toys “R” Us were the first executives to realize that options were a great motivational tool not just for executives, but for employees as well. Broad-based stock options are now the
norm in high-technology companies and are becoming popular in many companies in other business industries as part of an overall equity compensation strategy. Companies such as Pepsico, Starbucks, Southwest Airlines, and Cisco now give stock options to most or all of their employees. As of 2001, the NCEO estimates that up to 10 million employees receive stock options. Joseph Blasi at Rutgers University found that 97 of the top 100 e-commerce companies offer options to most or all employees. A 2003 WorldatWork study showed that options are popular in all kinds of public companies, with 15% of public companies offering options to most or all employees. Employee Stock Options Current Examples According to USA Today published on 10/17/2006, Class Lewis reported that 142 companies were investigated for backdating stock options. These companies strategically
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selected dates to purchase stock grants in order to buy low and sell high. By orchestrating the purchases of these stocks at substantially lower prices, the holders could expect to earn much more money when the stock was sold. Consequently, this is not illegal as long as the companies maintain adequate tax return records. However, the SEC (Securities and Exchange Commission) and Justice Department have found that a substantially high number of companies failed to follow the outlined rules regulating stock purchasing activities. As a result, federal authorities have filed fraud charges against several executives and ongoing investigations are taking place to prosecute others expected of violating this law. Currently, 142 companies have been identified as taking part in the illegal practice of backdating stock options. Following is a breakdown of companies in each category of involvement and the industries most affected by the scandal. (Source: Class Lewis)
Companies Conducting internal probes Target of SEC probes Target of justice Dept. probes Ousted executives or directors Being sued by shareholders Criminal charges Industries Software & programming Semiconductors Communications equipment/services Computer equipment & services Retail Biotech & drugs, medical equipment supplies Electronic instruments & controls, scientific instruments Health care facilities Insurance Aerospace & defense Oil well services & equipment Restaurants
142 91 55 23 65 2
29 25 18 17 14 11 7 3 3 2 2 2
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Schools Other
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Apple is a very well known company that currently faces questionable accounting practices. As a result of these challenges, it is likely that the company will be removed from the NASDAQ listing. Due to years of inadequate financial reports, the company has to restate several returns. According to an internal investigation, there were 15 instances of backdated stock options between 1997 and 2002. During this period of time, the company issued option stock was more favorable than its market price. Undoubtedly, this is not illegal; although, the company has to record and properly disclose the information in their accounting department. As a result of this big debacle, the former chief financial officer, Fred Anderson, resigned from the company‟s board. McAfee, another well known company slid nearly 13 percent in July of 2006 after the company announced an ongoing review of its stock option polices. In October 11, 2006, George Samenuk, McAfee CEO and chairman of the board announced his early retirement and apologized for his part in stock options problems. Kevin Weiss, president of McAfee, was terminated and following the board‟s review, it was concluded that the company needed to restate up to 150 million dollars, no-cash for stock option expenses spanning 10 years. United Health Group is the second largest health insurer in the nation. Similar to Apple and McAfee, this company has also been found to have widespread stock option problems. William McGuire, Chairman and CEO, will leave the company and board members because he has been under pressure since the Wall Street Journal reported in March that he received stock options for the yearly low price in the company‟s share price in the years of 1997, 1999, and 2000. The company acknowledged stock option
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handling problem on May 11, 2006. It is projected that the company may have to restate around $286 million in earnings for 2003, 2004, and 2005. The IRS (Internal Revenue Service) has asked United Health Group for documents dating back to 2003 concerning stock options and other compensation packages for some executives. Also, an independent committee of its board members has been investigating the company‟s stock option programs from 1994 until present. Recently, Broadcom Corp.‟s audit committee discovered back dating accounting problems with stock option grants to employees awarded from 2000 to 2002. The company forecast additional non-cash stock based compensation costs of more than $750 million. The majority of this money would be recorded by restating its financial reports for the years of 2000-2005. Broadcom Corporation reported that the expenses would not affect its cash balance, financial operations, or its shareholders. Once a company runs into stock option problem, there are a series of predictable bad events that may occur: Analysts calls, inability to comment, stock drop Failure to certify financials, auditor‟s hesitance, failure to timely file NASDAQ or NYSE de-listing. Suspension of S-8 registration statements, ESPPs. Reserves or restatements. SEC investigations, shareholder lawsuits. Officers‟ departures or leaves of absence Board member resignations Tax liability
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Stock Options and the Controversy Businesses have always been in competition with each other to provide ever increasing quality, timeliness, and innovativeness of their products and services. To do this, businesses first need to attract talented employees. One of the popular strategies for luring and keeping this talent especially in upper level management is to offer Stock Options to potential employees. According to the National Center for Employee Ownership as many as 10 million employees participate in some 4,000 plans. A decade ago only 1 million U.S. employees had them. Stock options have been around since the 1950‟s, but they have become under scrutiny in the last 20 years. With the more recent dot-com bubble, WorldCom, and Enron Scandal several controversial issue have surface dealing with employee stock options. The first issue is with regards to accounting practice and it deals with how these incentives should be depicted on annual and quarterly financial reports. The reason being is that stock options are potential places where compensation can be hidden from analysts and shareholders. The IRS‟s position is that corporation should list these stock options as expenses on their financial reports. Of course this would reduce overall profits but there are those, including the celebrated and successful CEO of Berkshire Hathaway, Warren Buffet, who argue that this reduced profit figure is a more accurate reflection of a corporation‟s performance. He states “ When a company gives something of value to its employees in return for their services, its clearly a compensation expense. And if expenses don‟t belong in earning statement, where in the world do they belong?” The latest legislation that was designed to address the fraudulent accounting practice undertaken by the accountants for Enron and WorldCom only indirectly addresses the
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problems of executive compensation plans in financial statements. It makes no judgment as to the treatment of options by corporate auditors. This leaves it to the newly created Oversight Board to determine what standards are acceptable in the treatment of options. There is no requirement that corporations accurately reflect executive compensation as an expense on their financial reports. Thus it is still possible earning statements by corporations remain higher than actual corporate earnings, as in the case of Enron, even with the enactment of the Sarbanes-Oxley. One of the main reasons for issuing shares is to raise money in order to buy assets, pay liabilities, or fund ongoing operations. The ultimate goals of shareholders is to get a return on their investment that is greater than they could get on the open market, in turn adding wealth, and creating value. When looked at that way, the company is not really using its stock as it was intended (when shares are used as compensation)…not that that is necessarily wrong. The point is that stock options should be accounted for properly so that external users and investors can make a better-informed judgment. By not expensing options, these companies are in essence giving away shares and not reaping the benefits of issuing shares, which is to raise capital not loose it and additionally misleading investors technically and fundamentally speaking. The second controversial issue is in regards to the value of these options. A compensatory stock option plan is designed to provide compensation in addition to their salaries in exchange for services they provide. A company will grant certain employees the right (the option) to purchase company stock at a set price in the future (exercise price). These rights are not available immediately, the employee needs to fulfill their side of the barging, or provide services over a specified period of time called a service period.
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Should the company‟s stock improve over that period, the employee could make a bundle, as seen from Google‟s first day of trading made 1,400 of its employees “paper” millionaires. But how does a business attribute value to these shares? They could be worth a lot, but then again if the stock price falls those same shares could be worthless. Nevertheless, if the value goes up employees with stock options make a fortune but in the case if the value goes down investors lose out and employees with these options are no worse off than before because unlike the investors employees with stock options don‟t actually use taxed income to purchase the stock but trade their services for the stock. Which raises another controversy about employee stock options are they value at market price or should they be valued based off the services a company receives by having someone work for them in terms of that employee‟s salary. All businesses are required to report options value on the income statement using the Fair Value Method, which estimates the present value of the future stock price at exercise date. The difference between that and the current price would be the value of the options attached to the stock. This approach has faced opposition from corporations with large amounts of outstanding options simply because, those companies have equity tied to options that will significantly impact their bottom lines. It was argued for many years that stock options had no cost because there was no cash flow, and because the value of the company is not decrease. But, barter transactions that involve no cash (employment for shares) still have an implicit value. The opportunity cost of foregoing receipt of full market value for the issue of new shares is a „true‟ cost. Yes, the equity of the business does go up (when management compensation is not measured) because „some‟ money was received, but not the full market value.
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The approach I recommend since these options are in lieu of salary, why not base the value of the options on the value of the employees. It makes sense, since the employee receives a salary, which is basically the market rate for the services they will provide. This is more reliable for two reasons. First, say the value of an IT tech person is $75,000 per year. Next consider a worst-case scenario for that IT person, is that the market place gets saturated with competition from recent graduate IT tech persons, or that his or her skills are obsolete. Will the market salary for a tech person fall 50% in the coarse of a year? Not likely at all-if anything, it would take years for an individual‟s skills to become obsolete. Yet investors know all too well that market and industry conditions, technology, even a creative and successful advertising program of a competitor can send a corporation‟s stock value well below current price. Which lowers option values that employees own by that amount. Second, the employee‟s service period is known to the same degree of certainty as with using any other method. To be sure, there is a level of uncertainty that the employee can be terminated before full vesting, but that risk is the same in any case. One argument over using salary is that options are additional compensation to salary. But nevertheless, we are trying to determine the value of the employee‟s services over a specific time period to base option values on. And that answer is salary. The third and last controversial issue is the timing of recognition of the cost of stock options. Basically when are these options accounted for on the books? This is the fuels for one of the most controversial and debatable issues of stock options and is the basis for several questions. Do you wait for them to be exercised to recognize true value? Do you recognize them when awarded or when vested, and make a stab at the value? Do
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you subsequently adjust that value as stock prices change? Do you record their cost in the income Statement, or bypass it directly to Equity. While there is no clear-cut answer to any of these questions the timing of recognition of the cost of the options is the most controversial issue regardless of the value because Sarbanes-Oxley doesn‟t directly address this issue either. Under international Accounting Standards, an estimate of the cost of stock options granted to employees is charged against profit as an expense in the account. Still, the standards never address when this has to happen. An Investopedia article refers to stock options as camouflage compensation because stock options are typically granted to high ranking officials and are not mandated to be fully disclosed on stock holders reports. And in the case when it is disclosed, it‟s in such a way that it is very difficult for the average investor to determine what the „true‟ value of compensation is determined to be. Nevertheless stock options to employees requires no cash from the company, especially for businesses not yet profitable who are burning cash, and giving shares would result in immediate dilution of earnings and voting control. As far as the employee is concerned they have no taxable income until the option is exercised plus the tax due then is calculated at the lower capital gains rate. Stock options also align the holder‟s interest with shareholder and a rising share price gives employees incentive to work harder and longer. Nevertheless, no matter all the benefits to the company and the employees, stock option are not with out there controversies. There are many more than discussed such as taxes, repurchasing shares, paying dividends, and creditors view on options. However, how these options should be reported on financial statements, at what value should they be reported and when they should be reported are the most controversial issues dealing with stock options and the
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Oversight Board better prepare themselves to deal with hundreds of issues along those three lines. Employee Stock Options – Other Considerations There are many things to consider when employers allow their employees to have stock options. There are also a lot of considerations from the viewpoint of the employees who have stock options. The purpose of this paper is to discuss a few of the issues at hand when dealing with employee stock options. Many companies use employee stock plans as part of their incentive and benefits packages for their loyal employees. Employee stock options are rarely used by new up and coming companies, and they are typically not used in place of competitive salary. There are two types of employee stock plans that dominate today‟s corporate structure: statutory plans or incentive stock options (ISOs) and nonstatutory stock options (NSOs). Taxation is one of the key differences in the two types of option plans. ISOs do not force the employee to pay tax at the time of the grant or when they exercise their options; they pay the tax at the time the stock is sold. The employees owe a capital gains tax on the spread or the difference between the grant price and the exercise price, but neither the employer nor the employees pay Medicare Social Security taxes on the spread. On the other hand, NSOs can be granted to those within the company and those from the outside, but they do not receive the favorable tax breaks that ISOs receive. The optionee can face enormous federal tax obligations if the fair value of the shares is greater than the exercise price. Also, when an NSO is exercised, both employer and optionee owe Medicare and Social Security taxes. There are many pros and cons of both ISOs and NSOs, and individuals should choose the one that fits them best.
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Another very important issue in setting up an employee stock option plan is establishing a vesting schedule. A vesting schedule is detailed in the stock option agreement, and it shows the amount of time it takes for employees to become granted an increasing percentage of their corporation‟s stock options. Some companies offer new employees immediate vesting as an additional sign on bonus when hired, but others build their plans so options are vested over a period of years, and this creates an incentive for employees to remain with the company. Another option for companies is to set performance based goals for employees and stock options are vested incrementally when those goals are met. Two main things must be considered when choosing a vesting schedule: how you want to use the stock options – to attract, motivate, reward or retain employees, and whether you have a qualified or nonqualified stock option plan. Most stock option plans are structured as nonqualified options. Nonqualified stock options are not regulated as strictly as qualified stock options and allow more flexible vesting schedules. Businesses with broad-based stock option plans most commonly vest an equal percentage of options over four years (25%) according to a study by the National Center for Employee Ownership. Qualified stock options like those given in employee stock option plans are regulated heavily by the Employee Retirement Income Security Act of 1974. The Employee Retirement Income Security Act of 1974 requires companies to offer one of two minimum vesting schedules to their employees: cliff vesting or graded vesting. Under graded vesting schedules, employees are vested 20 percent after the first three years of employment, and they become 20 percent vested each following year until they are 100 percent vested after seven years. But, certain qualified plans are not subject to the Employee Retirement Income Security Act of 1974, like most ISOs. In both
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qualified and nonqualified stock option plans, employees who resign are entitled to the vested portion of their accounts. Otherwise, vested employees receive the vested portion upon retirement, disability, or death. Another consideration with employee stock options is the accounting framework and how options are valued. There are two basic accounting statements – the balance sheet and the income statement. Both statements provide information on a company‟s financial condition to investors and creditors outside the firm. There have been some proposals to require firms to recognize the fair value of employee stock options as an expense to the company. The main concern involving employee stock options is the stocks intrinsic value versus the stocks fair value. In 1993, the Financial Accounting Standards Board (FASB) recommended a change in the accounting treatment of employee stock options. The FASB proposed that companies recognize the fair value of the options (measured with options are granted) as an expense on the income statement within the period employees work to receive that compensation. This period typically corresponds with the companies vesting period for those options. Managers form most corporations greatly opposed the FASB‟s proposal. Those managers preferred to use the accounting treatment they had been accustomed to, which allowed them to recognized the intrinsic value of the employee stock options rather than the options‟ fair value. Managers prefer this method because at the time that the options are granted, the intrinsic value is almost always less than the fair value. If the intrinsic value is used in an accounting method, a smaller amount is subtracted from the firms‟ earnings. The intrinsic value of stock is the amount which the options strike price is lower than the stocks current market value. For example, an option to buy one share of stock at a strike
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price of $30 a share on a stock whose current market value is $35 has in intrinsic value of $5. The enormous opposition to FASB‟s proposal gained strength like a freight train until Congress nearly had to intervene, but FASB amended their proposal. The new proposal encouraged but did not require firms to recognize the fair market value of employee stock options. FASB did require that companies using the intrinsic value method show the effects of fair value recognition on their income.
REFERENCES: CEO PAY: READY FOR TAKEOFF By John A. Byrne, with Lori Bongiorno Business Week: April 24, 1995 STOCK OPTIONS: THE RIGHT WAY TO GO http://www.businessweek.com/magizine/content/03_03/b3816091.htm Reckoning the Cost of Stock Options By Anne Tergesen April 15, 2002 BUSINESSWEEK INVESTOR The Bottom Line on Options by Mark Gimien Business Week April 3, 2006 p.32 Money 101 Lesson 10: Employee stock options “Top things to know” CNNMoney.com Stock Options and Related Plans The National Center for Employee Ownership Camouflage Compensation “ 7 things Every Investor Should Know” Investopedia.com
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H.R.3763-The Sarbanes-Oxley Act of 2002 Business Week October 30, 2006, Page 82 Employee Stock Options Fact Sheet http://www.nceo.org/library/optionfact.html Employee Stock Options Plans http://www.sec.gov/answers/empopt..htm Employee Stock Option Services http://www.agedwards.com/public/sc/financial_services/investment_products/stocks/ emp… How Do Stock Options Work? http://money.howstuffworks.com/question436.htm PRIMER - Recent History of Employee Stock Options http://www.financialpolicy.org/dscprimerstockoption2a.htm A Short History of the ESOP http://www.nceo.org/library/history.html Stock options scandal spreads http://www.usatoday.com/money/companies/management/2006-10-17-backdatingusat_x.htm Apple chief knew about stock options http://www.ft.com/cms/s/bf6ebe36-53ed-11db-8a2a-0000779e2340.html Stock Questions Push out United Health CEO http://www.cbsnews.com/stories/2006/10/15/business/main2090164.shtml Broadcom to claim $750 charge for options backdating http://www.infoworld.com/article/06/07/14/HNbroadcomcharges_1.html?NETWORK%2 0HARDWARE Managing Through the Options Mess http://www.edn.com/index.asp?layout=article&articleid=CA6369679&partner=enews
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