Many of the arguments that are used to support the idea of stock option expensing as compensation when options are granted to company executives and other employees depend in part on stock grants being expensed. Stock grants ARE currently expensed, but appealing to the status quo is about as weak a logical basis for an argument as might exist.
If Intel were to give all of its employees 100 shares of stock, should the company record a compensation expense?The answer to this question is that not enough information is given. In particular, are the 100 shares of stock Intel stock, or Microsoft stock?
There is no possibility of getting the right answer by a valid argument unless you understand how and why the two cases MUST be distinguished.
In either case, if the share prices were the same, the immediate benefit to the employee would be the same, neglecting tax treatment differences. This would be true even if the employees didn’t know which company’s stock they received.
However, in one case the shareholders suffer dilution in their proportional ownership of Intel, and in the other case they suffer a reduction in the value of the company itself as it has given up an economic asset. OTOH, a company cannot count its own shares among its economic assets.
This fact IS accepted by the FASB, and is explained by two independent arguments.
First, a company’s own shares have no scarcity value to the company as it can create new ones effectively at will without significant cost.
Secondly, a company cannot own itself, as all internally held shares are actually owned by the external shareholders and whose existence is thus of no economic consequence to anyone.
No matter what argument supporters of stock and option expensing may produce, if it doesn’t account for the differences between company and non-company stock, it carries no weight.
Shareholders can be diluted in their ownership, OR they can experience a loss in the value of what it is that they own, but trying to pile one loss upon the other is simply absurd.
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Don,
Don: “Do we agree that whatever the value a stock or option recipient assigns to what he has received, it implies nothing at all about what expense the company may or may not have incurred in making the grant?”
I agree as well. My point above was that both stock and option represent a probabilistic claim to future non-negative cash flows, and so cannot have a zero subjective value for ANYONE. It is a logical absurdity to believe a rational person would subjectively value either instrument at zero. It is the non-negativity of the recipient’s possible payoffs that implies either instrument will economically be a liability and expense to the giver and an asset and income to the recipient. It’s high time corporate accounting caught up with that indisputable reality.
Regards,
Mike
Mike,
“…I agree as well. My point above was that both stock and option represent a probabilistic claim to future non-negative cash flows, and so cannot have a zero subjective value for ANYONE. It is a logical absurdity to believe a rational person would subjectively value either instrument at zero….”
OK, let’s hold that aside for the moment.
Do we agree that if a company gives or sells me one or more claims, for any price, or no price, for any reason, or for no reason, that this in no way precludes the company from repeating the process for you, or for anyone else, or for any number of anyone elses?
Regards, Don
Don,
Don: “Do we agree that if a company gives or sells me one or more claims, for any price, or no price, for any reason, or for no reason, that this in no way precludes the company from repeating the process for you, or for anyone else, or for any number of anyone elses?”
Except for a fiduciary’s responsibility to sell for a positive, non-zero price, I agree that the process can be repeated ad nauseum.
Regards,
Mike
Mike,
OK, now back to your previous quote –
“…both stock and option represent a probabilistic claim to future non-negative cash flows, and so cannot have a zero subjective value for ANYONE…”
There is an important exception. ANYONE except someone who has the responsibility for fulfilling or redeeming the claim.
Regards, Don
Don,
Don: “There is an important exception. ANYONE except someone who has the responsibility for fulfilling or redeeming the claim.”
You’ll have to elaborate. Are you referring to a non-stockholder manager / decision maker, or to the stockholders, or whom? I cannot readily identify an actor who has “responsibility for fulfilling or redeeming the claim”, so I cannot respond to your assertion.
Regards,
Mike
Mike,
“…You’ll have to elaborate….”
If I write a check, it’s a claim on my checking account. But if I write it to myself, it has no value to me.
In the case of stock or options, it’s the company itself. It may seem trivial, but when we have a Nobel Economist (Merton) saying that stock has an opportunity cost to the company, even though we have agreed above that no grant or sale can preclude another, it needs to be considered.
Regards, Don
RTR,
RTR: “Yes, earnings and cash assets drop by $100,000 after the direct cash compensation expense. Now what reason is there to create any new shares? The executive can take that $100,000 (disregarding tax consequences) and buy $100,000 of already existing shares on the market himself. OR, the company instead of giving the executive $100,000 in cash can buy $100,000 worth of already existing shares on the open market and then give those shares to the executive. It completely avoids all subsequent confusing accounting messes. There’s zero need to create a newly issued block of stock (independent of twisted tax purposes). So naturally, I’m suspicious.”
I agree with all of your above remarks.
RTR: “Income is not affected, I agree. But assets do not go up by $100,000. If that were true, the company could do this issuing of new blocks ad infinitum and liquidate/pay out the proceeds as special dividends to the shareholders (including the new guy) and the net effect would always be positive cash flow (a pure “perfectly” working inflation print machine). It would be a pyramid scheme.”
Assets would increase by the $100,000 in cash the executive pays in exchange for receiving the newly issued stock. This increase offsets the preceding and equal decrease from the $100,000 compensation payment in my example. The net effect of the two transactions is to leave assets unchanged, which is why I am claiming that the free stock grant is equivalent to a cash compensation payment followed by a purchase of newly issued stock of the same value as the cash compensation. The collapsing of these distinct transactions into one, for twisted tax purposes as you appropriately describe it, is the source of much of the confusion surrounding the proper accounting of executive grants of stock and options. Send me a private email if you wish me to explain why the process you’ve described would not be a pyramid scheme.
RTR: “*The assets stay the same.* $100,000 of newly created marketable securities has been traded for $100,000 of cash. $0 of marketable securities has not been traded for $100,000 of cash, which would be necessary for the assets to increase by $100,000. The assets have only changed form. There’s no change on the asset/balance sheet. *Now there are an extra $100,000 worth of shares out there in the outstanding number of shares float.* I’m regarding “marketable securities” (once they are “minted”/”authorized”) on the asset sheet as having existing value just like a building. A $10M building sold does not increase assets by $10M. Assets (market value of) stay the same; only the form of the assets has changed from a building to cash.”
Your position appears to be that, if the company has printed stock certificates that would be worth $100,000 when sold, the company should set up a $100,000 asset just as soon as the ink is dry on the certificates. I do not agree with that. No assets have changed form as you suggest; instead, a new liability is created in exchange for new assets. The future cash flows whose economic value give potential value to those certificates are generated from current company assets and whatever assets are purchased with the proceeds from the certificate sales. The value of future cash flows from the first source is already reflected in the value of the company’s balance sheet assets, and the value of the future cash flows from the second source will be set up only when the company receives the second source (the $100,000) and it becomes possible to begin generating future cashflows. That is why the potential value of the paper stock certificates should be booked only when they are realized upon sale. Otherwise, you truly would have created a wealth pump that never empties.
RTR: “We need to compare to the alternative case whereby the executive does not buy a newly issued block. He takes his $100,000 of cash and buys already existing shares on the market. The outstanding number of shares is the same. The assets/balance sheet has not changed, as it should not, as the only change is the original employee expense payment of $100,000 cash. That’s why *newly issued* shares are vastly distinct from already existing shares.”
In the case where the executive buys existing shares, the company’s balance sheet assets and stockholders equity are reduced by $100,000. In the case where the executive is “given” $100,000 in newly issued stock, the company’s balance sheet assets and stockholders equity are unchanged, but the existing stockholders are going to jointly share $100,000 in value dilution. In either case, the value per share for the pre-grant stockholders will remain unchanged. The only difference between the two cases is that the company retains its size, as measured by total assets, when it grants newly issued stock to the executive.
RTR: “As a new aside, existing shareholders prefer the percentage ownership of the company the shares represent, to its market cash equivalent. If they did not they would act to sell (that percentage of) their shares. Issuing new shares is an involuntary method (seen from the perspective of the existing shareholders) to get employees shares. If employees want part ownership of the company they should voluntarily purchase it on their own from the existing share holders.”
As I believe I’ve just explained, existing stockholder values are not necessarily impaired by stock or option grants, and the company can certainly maintain a larger capital base by using them, SO LONG AS they are granted in lieu of compensation that would otherwise be paid in cash. I don’t believe this has historically been the case since accounting rules have enabled management to hide the economic effects of extraordinary grants to themselves. If the accounting and tax perversities are fixed, I am confident that the problem of excessive, or excessively favorable, grants will be as well.
RTR: “That’s the problem. And at any rate this is certainly not a streamlining process. You can’t “give away” the newly issued stock for “nothing”. That reduces the company’s assets by $100,000. They can certainly reduce his compensation by $100,000 and buy him $100,000 of already existing shares. That is the *only* way they’ll end with the same total number of shares outstanding (and everyone’s percentage of the total constantly changing “value” of the company stays the same proportion in which they preferably acted to buy).”
I agree with the logic of your analysis, but believe that it may often be more desirable to maintain asset levels than share counts, so long as it is done in such a way that shares do not incur value dilution relative to what they would have incurred with cash compensation.
RTR: “We seem to believe, instead of each individual share (no matter how many of those shares may be owned by specific individuals) eating their piece of a $100,000 compensation expense, that we can simply take “by (even if privately contracted) force” the percentage piece of $100,000 of each share, add them up, and give them to the executive as newly created shares. This sullies the accounting statements (especially compensation and earnings) and was cause of the confusion between dilution of shareholder value and dilution of outstanding number of shares.”
I don’t think much damage would result if both grants and options are expensed, grants are added to share counts, AND a liability is established and continually marked to market for all outstanding option grants (along with some of the greek deltas on those options as indicators of balance sheet instability). Were this done, stockholders would have all the information they need to appraise the company and its management.
Regards,
Mike
Don,
Don: “If I write a check, it’s a claim on my checking account. But if I write it to myself, it has no value to me.”
True enough, but it you write it to me it does have a negative value to you. Similarly, if a company’s managers simply print up N times as many shares as are currently outstanding, and distribute them to existing stockholders in proportion to their current holdings, that has no value effect; it is simply a stock split that does not affect income through expenses. But, if the company’s managers print them up and grant them to themselves, then there is as meaningful a negative value to the existing stockholders as there is to you in writing me that check. A rational accounting system must convey the fact of that loss in value to the existing stockholders or management can and will rob them blind. Expensing stock options, and establishing and continuously updating a liability for them, is the proper way to do that.
Don: “In the case of stock or options, it’s the company itself. It may seem trivial, but when we have a Nobel Economist (Merton) saying that stock has an opportunity cost to the company, even though we have agreed above that no grant or sale can preclude another, it needs to be considered.”
Do me a favor and type in enough of Merton’s quote so I can discern the proper context and I’ll be glad to address his statement.
Regards,
Mike
Mike,
Merton, as requested, from Harvard Business Review, March 2003 –
“…Even if no cash changes hands, issuing stock options to employees incurs a sacrifice of cash, an opportunity cost that needs to be accounted for. If a company were to grant stock, rather than options, to employees, everyone would agree that the company’s cost for this transaction would be the cash it otherwise would have received if it had sold the shares at the current market price to investors….”
This fails to be an opportunity cost in two ways.
First, every possible use of shares that the company may wish to pursue is still possible no matter how many grants or sales have previously been executed as shares are interchangeable.
Secondly, the sale of stock on the market is, to the first level of analysis, a wash for the shareholders as the additional company cash is precisely offset by the dilution in their ownership percentage. An true opportunity cost must preclude a NET benefit, not a GROSS one.
Selling stock on the market only makes sense if management has a investment use for the cash which has an investment return that exceeds the expected return on the stock itself.
Regards, Don
Don,
Don: “Merton, as requested, from Harvard Business Review, March 2003 –
‘…Even if no cash changes hands, issuing stock options to employees incurs a sacrifice of cash, an opportunity cost that needs to be accounted for. If a company were to grant stock, rather than options, to employees, everyone would agree that the company’s cost for this transaction would be the cash it otherwise would have received if it had sold the shares at the current market price to investors….’ ”
Thanks for digging Merton’s quote up for me, Don. The only surprising aspect of that quote is his introductory phrase ‘EVEN if no cash changes hands’. It would make more sense to me if he had written ‘ESPECIALLY if no cash changes hands’. But who am I to quibble with a Nobelist?
Don: “This fails to be an opportunity cost in two ways.”
I couldn’t disagree more.
Don: “First, every possible use of shares that the company may wish to pursue is still possible no matter how many grants or sales have previously been executed as shares are interchangeable.”
A grant is not an opportunity cost because it precludes issuing further shares or limits the use of current or future shares, it is an opportunity cost to current stockholders because they could either have (1) sold the stock or option grants for cash to someone else, or (2) retained for themselves the future cash payments and value increases that will now accrue to the owners of the granted stock or options. In either case, the original stockholders have foregone cash; hence, Merton is entirely correct to assert that it is an opportunity cost. Even LTCM Nobelists get things right once in a while!
Don: “Secondly, the sale of stock on the market is, to the first level of analysis, a wash for the shareholders as the additional company cash is precisely offset by the dilution in their ownership percentage. An true opportunity cost must preclude a NET benefit, not a GROSS one.”
What you say is true, and echoes what RTR and I have asserted above, but is unrelated to the argument in the Merton quote. Merton is clearly addressing OPTION GRANTS; using stock grants only as an analogy, and is not at all dealing with stock sold for cash which is the subject of your last statement. Your statement is irrelevant to Merton’s assertion.
Don: “Selling stock on the market only makes sense if management has a investment use for the cash which has an investment return that exceeds the expected return on the stock itself.”
This statement is a truism, but it too has no relevance to the issue of whether or not grants entail an opportunity cost from the perspective of current stockholders.
Neither of your two supposed opportunity cost failures withstands scrutiny, so I have to conclude that the assertion that grants impose an opportunity cost to existing stockholders stands unscathed.
Don, at this point your original post has probably set a new Mises.org high-water mark for comments; congratulations on that. But we two seem to be at a conceptual impasse. I almost feel as though I’m playing a game of tennis where my opponent always gets to serve up the ball, and when I hit it back over the net he doesn’t even bother to try to return it … he just serves up a different ball. I have reached the point of fatigue in dealing with new analogies and hypothetical goods facing bizarre demand schedules, while my arguments — which are framed in terms of the actual goods at issue — fall to the ground, ignored and uncontested.
I’m still game to defend my own assertions. Just so no one has to rescan all of the above posts, here’s a short recap of my position:
(1) Grants of stocks or options ALWAYS have a positive subjective value to ANY valuer. This is an a priori truth that logically follows from the non-negativity of possible future cash flows and the possibility of at least one positive future cash flow (the caveat is necessary to deal with the case of a stock option with a strike price set so high that it is inconceivable that it will ever be in the money).
(2) Grants of stocks or options ALWAYS have an opportunity cost associated with them: the cash that could otherwise be raised by selling rather than granting them.
(3) A rational and responsible accounting system would convey this very real cost to the parties who incur them: the existing stockholders.
(4) A stock or option grant is economically equivalent to two distinct and simultaneous transactions with the same individual: a compensation payment and a sale of a capital instrument: the stock or call option.
(5) Accounting for a stock or option grant as two distinct transactions would communicate the true economic state of a company to its stockholders. Such an accounting would show income reduced in the period of the grant, and subsequent periods would be affected by changes in the ongoing economic (not original) value of all outstanding grants. The latter aspect of this proposed treatment is NOT what FASB is proposing, but FASB hardly ever gets things right!
(6) Failure to do this creates an open invitation to management theft of stockholder values.
(7) The source of this problem was a combination of (i) government intervention in the area of executive compensation targeted at problems caused by its previous interventions which reduced the effectiveness of the market for corporate control, (ii) perverse tax treatment of grants, (iii) failure by FASB and others to recognize the true, dual transaction, nature of grants, and (iv) the willingness of some corporate managers to abuse their stockholders.
This has been a fun exercise. Regards,
Mike
I’m going to summarize where I think we are on the balance sheet.
M: “Your position appears to be that, if the company has printed stock certificates that would be worth $100,000 when sold, the company should set up a $100,000 asset just as soon as the ink is dry on the certificates.”
That was my position. The asset, if it is one, is real time marked to market.
M: “I do not agree with that. No assets have changed form as you suggest; instead, a new liability is created in exchange for new assets.”
If a loan were received I certainly would agree that liabilities are nominally increased $100,000. There’s two different sources a firm obtains financing from: creditors and owners. But you are certainly not wrong, traditionally the balance sheet balances because: Assets = Liabilities + Shareholders’ Equity
I’m just going to summarize the balance sheet for now and leave the income statement and the statement of cash flows for later.
Employee stock grants are not the only case which clouds the distinction between liabilities and shareholders’ equity. There are convertible bonds, bonds with equity characteristics. There are redeemable preferred stock, preferred stock with debt characteristics.
Viewing shareholders’ equity as a residual interest or claim is indeed accurate. I agreed completely with the analysis you provided Michael. Everyone is right that after the stock grant minus the compensation payment: Assets still equal liabilities plus shareholders equity after the event. It has to.
There are different ways to get to (view) that result.
1.) Liability before = liability after. One liability has been exchanged for another liability. Cash compensation is forgone for a newly created liability of claimed residual payments.
2.) Assets before = assets after. Marketable securities are exchanged for cash.
3.) Shareholders’ Equity before = Shareholders’ Equity after. The company wrote a check to itself. The business is still the business.
4.) Assets decrease by the amount that shareholders’ equity increases. Marketable securities are exchanged for future residual claims.
5.) Assets increase by the amount that liabilities increase. Cash is increased by the amount that new residual claim liability is increased.
I’ll stop listing the possible interpretations.
The fundamental question is I think: Are securities of the firm a different class of object than securities of other firms?
We’re all trying to give the most logical answer from an independent third party view of what just happened.
I think we’re all agreed in the assumptions that:
1.) The firm is/should be maximizing shareholder value.
2.) Employees receiving stock grants (plus any cash compensation) are being paid market rate wages, necessary corollary of 1.).
I think we would all agree that assets have not increased after the stock grant event. The firm is not better off in the view that a real asset like a building just doubled in value. I think we would all agree that the primary function of the stock grant event is to exchange cash compensation liability for shareholders’ equity. There’s nothing at all wrong with that and for a company low on cash (such as tech start ups) that could certainly be maximizing shareholder value for that case. So these types of firms do not have the cash to pay the employee (without sacrificing more urgent needs/wants of the business) nor do they have the cash to buy $100,000 of already existing shares to give to the employee. So here’s a case where tax purposes are beside the point. The firm is simply looking to survive and hopefully prosper in the future.
So how does the event originate? An employee is due market rate compensation. This is most certainly a liability. What choices does the firm have? The firm can default into bankruptcy as it cannot meet its obligations. It can get a loan from the bank (but that has additional interest cost). It can give out grants/options (though that may have cost associations with it as well, such as driving the share price down further than the interest cost of a loan rises). That’s what the boardroom members consider.
So are we all agreed that on the balance sheet:
Assets do not change. Liability decreases by the amount that Shareholders’ Equity increases?
Sorry about the mistake in 4.) above, typing/thinking too fast.
Don is correct that shareholders’ equity can be increased ad infinitum. As long as there are willing buyers the company can always issue more stock. This will always increase shareholders’ equity and assets by the cash amount received for the newly issued stock. However, we are not arguing that.
We are arguing that stock issued to an *employee* for free/nothing/granted is always a wage liability. The amount that stockholders’ equity is increased by the issue is always and directly offset by an exact increase in liability. Assets remain unchanged and balance with the increase in liability and the increase in shareholders equity.
There’s no need to go into the income and cash flow statements as what is recorded on them necessarily follows from above. Stock grants sand options *should and are* EXPENSED. Case closed.
RTR,
We are very close to complete agreement. A few differences remain.
In response to my comment that “I do not agree with that. No assets have changed form as you suggest; instead, a new liability is created in exchange for new assets”, you wrote:
RTR: “If a loan were received I certainly would agree that liabilities are nominally increased $100,000. There’s two different sources a firm obtains financing from: creditors and owners. But you are certainly not wrong, traditionally the balance sheet balances because: Assets = Liabilities + Shareholders’ Equity”
I believe we only have a terminological difference here. Originally, the right hand side of your balance sheet equation was referred to as “Equities”, as in all equitable claims to the firm’s assets. Equities, or claims against assets, were then subdivided between those of outsiders to the firm and the residue belonging the firm’s stockholders. Every equity is a liability, even stockholders’ equity. When I claimed selling certificates creates a new liability, I was referring to the resulting increment in stockholders’ equity, which is a liability increase. In the case of selling a call option, a new liability would be created. Printing stock certificates is just like printing bond certificates; neither should increment assets until they are sold, and both increase liabilities, broadly interpreted, when they are sold.
RTR: “Employee stock grants are not the only case which clouds the distinction between liabilities and shareholders’ equity. There are convertible bonds, bonds with equity characteristics. There are redeemable preferred stock, preferred stock with debt characteristics.”
You are absolutely correct. Valuing these is complex, and is one of the reasons mathematical finance is such a fascinating field.
RTR: “The fundamental question is I think: Are securities of the firm a different class of object than securities of other firms?”
Hmmm. I’m not sure where you’re headed here. Does this have something to do with Don’s original discussion where he brought Intel’s and Microsoft’s stock into the debate?
Don: “No matter what argument supporters of stock and option expensing may produce, if it doesn’t account for the differences between company and non-company stock, it carries no weight.”
If this is why you are trying to address other firms’ securities, RTR, then I don’t think we need to discuss it at all as it is a Red Herring. From the perspective of a firm, the securities of other firms can only be purchased and held as assets, while their own can only be sold and “held” as liabilities. I think we’ve clearly established that we do not have to address other firms’ securities in order to arrive at the 7 assertions I listed above in my summary to Don.
RTR: “I think we’re all agreed in the assumptions that:
1.) The firm is/should be maximizing shareholder value.
2.) Employees receiving stock grants (plus any cash compensation) are being paid market rate wages, necessary corollary of 1.).”
I think assumption 2) is where we would like to arrive. Recent history demonstrates management lavishing equities to themselves that are far in excess of their cash market rates of compensation. Spurious accounting was an enabling factor in that. But I have no problem with assuming 2) holds for purposes of identifying an appropriate accounting treatment.
As for assumption 1), I would quibble that management also has a responsibility to not diminish the values of other liabilities in their quest to increase shareholder values. For example, there have been many instances of companies that operate at a certain risk level, sell bonds under that risk profile, are later acquired, and then the new management team transforms assets into riskier ventures in order to maximize what’s often called the stockholder’s limited liability put option. If the riskier assets pay off, the extraordinary gains go to the shareholders; if they don’t, the entire mess goes to the bondholders who ultimately don’t receive their scheduled payments. That well-known gambit is unethical, in my opinion, even when debenture covenants do not expressly address the issue.
RTR: “So are we all agreed that on the balance sheet: Assets do not change. Liability decreases by the amount that Shareholders’ Equity increases?”
I agree that assets would not change for either type of grant, even with the expensing of those grants if the accounting is done correctly. If I ran FASB, and thankfully I don’t, I would have a distinct liability established for granted options to employees, or sold to outsiders for that matter. I would also disclose their notional amounts, expiry dates, and strike prices so they could be properly modeled or taken into account when appraising the firm’s value. That distinct liability would directly reduce shareholders’ equity and reflect their very real value dilution from the grant. I would mark that new liability to market as conditions change, until the option expires. In the case of granted stock, stockholders equity would remain unchanged, but the number of shares would increase. The value dilution would be directly reflected in stockholders’ equity per share, not in the balance sheet.
I hope that clarifies what I’m advocating.
Regards,
Mike
RTR,
RTR: ” Stock grants and options *should and are* EXPENSED. Case closed.”
Amen! What are they putting in the water up there in Chicago? I’d like to spread it around down here in VA.
Mike
M: “I believe we only have a terminological difference here.”
That’s all it was. Just simplification and imprecision in points being made at different times.
Assets = Liabilities
Assets = Liabilities + Shareholders’ Equity
Assets = Bonds(Long-Term Debt), Loans (Short-Term Debt), Accounts Payable, etc. & broken down however + Common Stock, Retained Earnings etc.
M: “I would quibble that management also has a responsibility to not diminish the values of other liabilities in their quest to increase shareholder values. For example, there have been many instances of companies that operate at a certain risk level, sell bonds under that risk profile, are later acquired, and then the new management team transforms assets into riskier ventures in order to maximize what’s often called the stockholder’s limited liability put option.”
The free market can and is taking care of that. The bond issuers limit the terms of the covenents such that violations of them (not just payment failures) result in the loan becoming immediately callable in their entirety. It’s totally the responsibility of the debt issuers to price their risk properly and limit it. “Bad firms” don’t get repeat business.
Great discussion,
RTR
All,
We have all been debating what how grants to employees should be treated on income and balance sheets, without reminding ourselves that, without FASB being foisted upon the market by the SEC, we would undoubtedly have competitive accounting standards promulgated by a multitude of auditing firms. By now, some of them would certainly have insisted upon expensing grants, and refused to sign off on their firms’ accounting without it. Others may not have, either because like Don they don’t believe in it, or because of client resistance. If investors prefer to buy stocks from firms that expense and disclose these option positions, then those firms’ stocks would sell at a premium relative those who don’t. This would incent firms to switch auditing firms, and that would induce auditing firms to converge on the practice of expensing options, and we wouldn’t have to have a heated national argument about it.
Regards,
Mike
Mike and RTR,
I appreciate all your comments and the fact that fatigue is setting in.
To show Mike that I am really reading his comments, I offer the following relatively minor anomaly –
“Merton is clearly addressing OPTION GRANTS; using stock grants only as an analogy, ***and is not at all dealing with stock sold for cash*** which is the subject of your last statement. Your statement is irrelevant to Merton’s assertion.”
From Merton –
“…If a company were to grant ***stock***, rather than options, to employees, everyone would agree that ***the company’s cost for this transaction would be the cash it otherwise would have received if it had sold the shares at the current market price to investors***….”
Your statement is clearly invalid, as Merton is not only talking about stock, but is specifying (wrongly) just what the opportunity cost would be.
If I take a left turn and forget to go by my bank, has the opportunity cost of so doing, preventing me from exchanging $10 for 40 quarters, actually been $10?
Be that as it may, although we have in several places agreed on details, we still are apparently far apart on just what an opportunity cost really is.
I may start another, much shorter, thread on that subject to attract other views, but of course reality is neither the result of a voting process, nor of the proclamations of kings.
I expect to either close or have this thread closed to comments in the next couple of days. Not because I’m not interested in more views, but because the length is a problem. Either of you or anyone else can reach me by email if desired.
Regards, Don
Don,
DL: “From Merton –
‘…If a company were to grant ***stock***, rather than options, to employees, everyone would agree that ***the company’s cost for this transaction would be the cash it otherwise would have received if it had sold the shares at the current market price to investors***….’
Your statement is clearly invalid, as Merton is not only talking about stock, but is specifying (wrongly) just what the opportunity cost would be.
If I take a left turn and forget to go by my bank, has the opportunity cost of so doing, preventing me from exchanging $10 for 40 quarters, actually been $10?
Be that as it may, although we have in several places agreed on details, we still are apparently far apart on just what an opportunity cost really is.”
Don, let’s look at a slightly more complete version of the quoted paragraph from the Bodie, Kaplan, and Merton article:
BKM wrote: “Even if no cash changes hands, issuing stock options to employees incurs a sacrifice of cash, an opportunity cost, that needs to be accounted for. If a company were to grant stock, rather than options, to employees, everyone would agree that the company’s cost for this transaction would be the cash it otherwise would have received if it had sold the shares at the current market price to investors. It is exactly the same with stock options. When a company grants options to employees, it foregoes the opportunity to receive cash from underwriters who could take these same options and sell them in a competitive option market to investors.”
This is clearly an argument by analogy as I had surmised. My statement above is not invalid as you claim. In that paragraph, BKM assert that granting options has an opportunity cost. They then, in the mistaken belief that there is universal agreement over the opportunity cost entailed in granting stock, try to find common ground by making an analogy with stock grants and their (assumed to be obvious) opportunity costs. They complete the argument by asserting, correctly in my opinion, that option grants are economically similar to stock grants. As I mentioned previously, a stock grant is just a special case of an option grant: mathematically, as the strike price and the time to expiry approach zero, the option grant BECOMES a stock grant. The stock grant is an end-point of the continuum of possible option grants. BKM are correct on all counts in my book.
You are absolutely correct, Don, that RTR and I must have an entirely different conception than you of what an opportunity cost is. I believe ours is consistent with both neo-classical and Austrian economics: the value of the most highly valued displaced alternative. For stock and option grants, this is clearly the cash that the granted instrument could have generated from sale in a competitive market in the case of a publicly held firm, or the subjectively evaluated monetary equivalent of the anticipated foregone future asset cash flows in the case of sole-proprietor / single stockholder issuing his first grants to others.
Your conception of opportunity cost, in the case of corporate securities, appears to rest upon a lack of scarcity: the ability of a firm to print as many stock certificates and option contracts as it wishes. Even if a company could do this — and they can’t, but that’s another discussion — I simply cannot understand how the failure to capture the easily attainable cash from granted securities is not an opportunity cost to be reflected in a firm’s books.
Like you, I think we have beaten our differences to death, and don’t intend to post any further comments. I am glad that you posted this topic on this site’s blog. I wish young and talented Austrian economists would dive into the world of mathematical finance. It is not only fascinating in its own right, but reconciling its indisputable market acceptance and success with the prevailing Austrian eschewal of mathematics and subjectivist probability is a challenging, but I believe achievable, project.
Regards,
Mike
Mike,
No response required.
Just to be sure, my view is NOT that stock and option grants don’t seem to provide perverse incentives, and I DO believe that most, if not all, grants are abused. My problem is with the ‘solution.’
If an infant is crying, a narrowly effective solution is strangulation, but this is clearly a cure that’s worse than the disease.
In the case of stock and option grants, I believe that it is the invisibility of the damage that shareholders suffer when stock is repurchased, not for investment purposes, but rather with the intent to mask the degree to which shareholders’ rights to the company’s free cash flow are violated and the cash is effectively looted by the management. It is the apparent failure of accounting to distinguish between the possible motives for repurchase that is, in my mind, the real problem.
Regards, Don
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