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June 11, 2005

Stock Options Redux

Michael Mandel

Here's my argument against the expensing of stock options (laid out originally in my book from last year, Rational Exuberance).

Accounting today makes a sharp distinction between workers and shareholders. Workers receive wages, which are deducted from revenues. Shareholders receive dividends and capital gains.

The whole point of stock options is to blur the difference between the two categories. Stock options motivate workers by offering them a "piece of the action"--in other words, to give them a share of the same returns as the shareholders.

The whole point of expensing of stock options is to take the cost off the balance statement and put it on the income statement--in other words, to make sure that everyone knows that the stock options are a labor cost. Expensing serves no other purpose.

Forced expensing of stock options sends a clear signal to workers that no, they are just workers. And it sends a clear signal to shareholders that yes, the workers are just workers.

That may be reassuring to shareholders, but it's anti-motivational to workers. The way you get innovation is by motivating people to take risks, and that's just not going to happen the same way if workers are squished back into their boxes again.

08:07 AM

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Economist Reuven Brenner offered the correct solution to this dilemma in an article published in the Wall Street Journal (co-authored by Donald Luskin). Stock options are not an expense, they are a liability and should go on the balance. There is a balancing asset: the employees' time that the options are intended to secure. Each year both the asset and the liability should be re-evaluated appropriately and the difference posted as a profit or loss. Read the article.

Posted by: Mike Lion at June 11, 2005 02:09 PM

Stock options, restricted stock, cash, etc., when given to employees is compensation for work done. When these same types of assets are given to shareholders they are distributions made to owners. Employees can also be owners, owners can also be employees, but there is a difference.

Employees have a method for becoming owners: they can buy stock or hold stock. But when employees are given assets for the work that they do or to incentivize them to do work, they are being paid for the work that they do, not for being owners.

Payments that a company makes to its employees are compensation for work done. Compensation for work done is an expense of a business. Expenses of a business are subtracted from the revenues to get profits. It's clear that stock options, restricted stock, assets of any kind, when given to someone to reward or incentivize them to do work is an expense. If expenses aren't shown on the income statement, where should they be shown?

Posted by: Ron at June 11, 2005 05:15 PM

The point of expensing is to increase the decision-usefulness content of financial reports. To stake that principle in pursuit of an alluded behavioral effect on workers is one of the more ludicrous suggestions I have come across for not expensing stock options.

Posted by: Dax at June 11, 2005 11:35 PM

Dax,

To the contrary. I believe that expensing decreases the decision-usefulness of financial reports. A modern innovative corporation has multiple outputs--it produces today's products, and it produces the intellectual capital for tomorrow's products.

That intellectual capital doesn't show up anywhere on the income or balance statement. Moreover, it is co-owned by workers, at least until it is turned into real products. The use of stock options acknowledges that there is investment going on by workers.

Posted by: Michael Mandel at June 12, 2005 03:50 PM

This worker is happy as long as he stands a chance to make money from my stock options - I wouldn't care if they were listed in the income statement or balance sheet.

On the other hand, the owners of the business might not be so estatic if they found that contary the claims of their income statement, they are actually losing money as these options siphon their wealth to the workers.

Would you believe me if I told you my company had zero costs? I pay everyone in stock options, from the supplier to the worker for contributing to my company's "intellectual capital". My profit margin is 100%! Amazing company, but would you touch the stock with a barge pole?

Am I deliberately making the argument sound ludicrous by taking an extreme example? Strangely enough,it sounds logical if I take the extreme opposite example and give you a company that puts all costs on the income statement.

Posted by: Terence Lim at June 13, 2005 04:19 AM


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