What’s Wrong with Expensing Employee Stock Options? by Charles W. Calomiris

August 2005

AEI scholar and Columbia Business School professor Charles Calomiris (bio) proposes that instead of treating employee stock options as an expense in computing their earnings—as required beginning next year by the Financial Accounting Standards Board—companies would better serve their investors by offering a constantly updated calculation of earnings per share. Such a calculation should take into account an estimate of the number of share options granted to employees that are expected to be converted into shares in the future.

Partly in reaction to recent corporate scandals, public officials and others have urged the Financial Accounting Standards Board (FASB) to require that companies place a value on the stock options they grant to employees and treat that value as an expense in computing their earnings. The FASB has responded with a commitment to impose this requirement for financial statements beginning next year.

However, according to AEI scholar Calomiris, the FASB proposal for expensing is misguided. It is based on a fundamental conceptual misunderstanding of the costs and benefits of employee stock options. Furthermore, because there is no accepted method for establishing the value of employee stock options, which are long-term contracts with many variables and contingencies, the FASB proposal underestimates the difficulties of measurement that the proposed expensing entails. Calomiris’s study, “What’s Wrong with Expensing Employee Stock Options?” explains the errors in the FASB approach, clarifies the circumstances in which employee stock options create or do not create costs and benefits for firms and issuers, and proposes an alternative accounting reform that would better accomplish FASB’s disclosure objectives.

Employee stock options are not an expense of the issuing firm, although their issuance creates gross costs and gross benefits to the preexisting shareholders of issuing firms. From the standpoint of managerial accounting, management should weigh the costs and benefits to its shareholders when deciding whether to grant stock options to employees. Calomiris points out that on average, the net benefits of employee stock options should, and apparently do, outweigh their costs, especially after one takes account of incentive and tax considerations often ignored by advocates of expensing. Because benefits typically exceed costs, these stock options do not typically entail “opportunity costs” for firms.

If the intent of proposed expensing under the Generally Accepted Accounting Principles (GAAP) is to incorporate appropriate managerial accounting into financial accounts, then it would be improper, and misleading to investors, to include in earnings reports only the expected gross costs of employee stock options but not their expected gross benefits. Furthermore, Calomiris demonstrates that expensing these stock options creates the undesirable consequence of double-counting their costs.

Aside from these fundamental conceptual problems, there are multiple and substantial measurement problems associated with gauging even the gross costs of employee stock options. Calomiris demonstrates that while marketable options have an observable value, illiquid and heavily constrained employee stock options have a highly uncertain value, and no comprehensive model to date has emerged that provides an adequate and empirically verified guide to employee stock option values.

FASB has attempted to sidestep the valuation problem by granting firms discretion to choose their own valuation model. However, allowing firms to exercise discretion in creating economic models to determine the costs of employee stock options will undermine the credibility, consistency, and comparability of firms’ accounts. Furthermore, modeling discretion is of dubious value; under existing knowledge, there simply is no agreed-upon answer or approach to finding an answer to many of these daunting measurement problems.

In light of the conceptual and measurement problems associated with the expensing of employee stock options, expensing is not a desirable policy. The legitimate goal that motivates advocates of expensing—to ensure that unsophisticated investors understand the possible impact that employee stock options could have on share values—would be better achieved by an alternative approach.

It would be better to require that firms estimate on an ongoing basis the cost of the number of options granted to employees that are expected to be converted into actual shares in the future and include those estimates in a constantly updated calculation of earnings per share. That statistic could be given a prominent place in the public reports of the firm and would be available as an important source of information for investors.

The computation of expected dilution (the estimate of the number of shares that are expected to be issued for options exercised in the future) would, of course, be subject to the same measurement problems noted above. But the consequences of those errors would not be the same.

First, there would not be double-counting of these employee stock option costs.
Second, there would not be any potential for confusion on the part of investors about the actual expenses of the firm.
Third, avoiding expensing would eliminate the incorporation of unreliable and misleading measures of “cost” in the companies’ earnings.
Fourth, the costs of expected converted employee stock options could be updated on an ongoing basis, so that changes in stock prices and volatility could be reflected in later analyses.

This forward-looking approach would allow stockholders to take account of dilution before it occurs (an improvement on the current system of measuring earnings per share) and would provide a more accurate measure of future dilution than expensing provides.

Charles W. Calomiris is the Arthur F. Burns Scholar in Economics at AEI. He is also the Henry Kaufman Professor of Financial Institutions and the academic director of the Jerome A. Chazen Institute of International Business at Columbia Business School.

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