Stock options are expenses, no doubt about it
5 August 2002

The Sunday Times ran an article on stock options yesterday. It was an educational article, and concluded, rightly in my opinion, that stock options should be treated as expenses in the accounts. However, the article mentioned some objections to such a treatment. In my opinion, these objections are not justified, but the article did not adequately rebut them. Allow me to redress the omission.

The article mentioned that stock options dilute the holdings of other investors in a company and should be treated more like a rights issue, which is not listed as an expense. However, what the article failed to point out is that a rights issue normally does not dilute existing shareholders' stake in the company, whereas stock options do.

The article next mentioned that treating options as an expense would cut into their bottom-line profits and cause share prices to fall. However, since options effectively reduce existing shareholders' stake in the company, a fall in share prices is actually the correct reaction to the issue of options.

The article then mentioned that treating options as expenses would discourage their issue, thus resulting in the loss of a "valuable tool" to recruit employees and motivate executives. Actually, the profit-linked bonus is probably a better tool to recruit and motivate workers. Options cause workers to become unduly concerned with the stock market rather than with company performance.

Finally, the article suggested that determining the value of options, and thus the expense associated with their issue, is difficult, whereas the current accounting treatment, to declare diluted earnings per share based on the additional shares that are issued once the options are exercised, already allows the dilutive effect of options to be taken into account. This is probably the most reasonable objection to treating options as expenses. However, declaring diluted earnings per share still leaves the basic earnings and earnings per share untouched, allowing the company to declare unduly optimistic earnings growth and returns on equity, and thus misleading investors, or at least making it more likely for investors to be misled, either intentionally or unintentionally.

So there should be no question that stock options should be treated as expenses. Rather, if there is any question to be asked of stock options, it should perhaps be whether they should be done away with altogether as a form of employee remuneration.

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