Bob
Jensen's threads on outrageous executive compensation are at http://faculty.trinity.edu/rjensen/FraudConclusion.htm#OutrageousCompensation
Frontline
(from PBS) videos on accounting and finance regulation and scandals in the U.S.
--- http://www.pbs.org/wgbh/pages/frontline/shows/regulation/view/
Note that one of the Frontline videos in about the options backdating scandals
--- http://www.pbs.org/wgbh/pages/frontline/shows/regulation/view/
Also see the definition at http://www.biz.uiowa.edu/faculty/elie/backdating.htm
Comparisons
of IFRS with Domestic Standards of Many Nations
http://www.iasplus.com/country/compare.htm
More Detailed
Differences
(Comparisons) between FASB and IASB Accounting Standards
2011 Update
"IFRS and US GAAP: Similarities and Differences" according to PwC
(2011 Edition)
http://www.pwc.com/us/en/issues/ifrs-reporting/publications/ifrs-and-us-gaap-similarities-and-differences.jhtml
Note the Download button!
Note that warnings are given throughout the document that the similarities and
differences mentioned in the booklet are not comprehensive of all similarities
and differences. The document is, however, a valuable addition to students of
FASB versus IASB standard differences and similarities.
It's not easy keeping track of what's changing and
how, but this publication can help. Changes for 2011 include:
- Revised introduction reflecting the current
status, likely next steps, and what companies should be doing now
(see page 2);
- Updated convergence timeline, including
current proposed timing of exposure drafts, deliberations, comment
periods, and final standards
(see page 7);
- More current analysis of the differences
between IFRS and US GAAP -- including an assessment of the impact
embodied within the differences
(starting on page 17); and
- Details incorporating authoritative standards
and interpretive guidance issued through July 31, 2011
(throughout).
This continues to be one of PwC's most-read
publications, and we are confident the 2011 edition will further your
understanding of these issues and potential next steps.
For further exploration of the similarities and
differences between IFRS and US GAAP, please also visit our
IFRS Video Learning Center.
To request a hard copy of this publication, please contact your PwC
engagement team or
contact us.
Jensen Comment
My favorite comparison topics (Derivatives and Hedging) begin on Page 158
The booklet does a good job listing differences but, in my opinion, overly
downplays the importance of these differences. It may well be that IFRS is more
restrictive in some areas and less restrictive in other areas to a fault. This
is one topical area where IFRS becomes much too subjective such that comparisons
of derivatives and hedging activities under IFRS can defeat the main purpose of
"standards." The main purpose of an "accounting standard" is to lead to greater
comparability of inter-company financial statements. Boo on IFRS in this topical
area, especially when it comes to testing hedge effectiveness!
One key quotation is on Page 165
IFRS does not specifically discuss the methodology
of applying a critical-terms match in the level of detail included within
U.S. GAAP.
Then it goes yatta, yatta, yatta.
Jensen Comment
This is so typical of when IFRS fails to present the "same level of detail" and
more importantly fails to provide "implementation guidance" comparable with the
FASB's DIG implementation topics and illustrations.
I have a
huge beef with the lack of illustrations in IFRS versus the many illustrations
in U.S. GAAP.
I have a
huge beef with the lack of illustrations in IFRS versus the many illustrations
in U.S. GAAP.
I have a huge beef with the lack of illustrations in
IFRS versus the many illustrations in U.S. GAAP.
Bob Jensen's threads on accounting standards setting controversies ---
http://faculty.trinity.edu/rjensen/Theory01.htm#MethodsForSetting
Comparisons
of IFRS with Domestic Standards of Many Nations
http://www.iasplus.com/country/compare.htm
"A Much Needed Accounting
Lesson for Two Senators," by Tom Selling, The Accounting Onion, August 8,
2011 ---
Click Here
http://accountingonion.typepad.com/theaccountingonion/2011/08/a-free-accounting-lesson-for-two-us-senators.html?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+typepad%2Ftheaccountingonion+%28The+Accounting+Onion%29
August 8, 2011 reply from Bob
Jensen
Hi Tom,
I was not aware of this
pending legislation appreciate your calling our attention to more ignorance
of our senators in Washington DC.
What would help your
article is to introduce a better distinction between intrinsic value versus
time value in the valuation of options and opportunity value/risk over time
---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#IntrinsicValue
In your illustration, the
option is granted "at-the-money" such that there is zero intrinsic value to
the company or the employee receives the contractual right (which may be in
advance of both the vesting and exercise dates). The entire $2 total value
is all time value on the grant date. Something of value (i.e., all time
value and no intrinsic value) has been granted to the employee in lieu of
higher wages even if the option's resale is restricted. This is the entire
basis for the FAS 123R requirement that the option be booked as an expense
on the date of granting the contractual right. Something of value was
transferred from the corporation to the employee on the grant date. Of
course there's an enormous problem of estimating time value on the grant
date since the Black-Scholes model is known to be lousy when applied to
employee stock options (since employees tend to be more risk averse
regarding the tanking of time value).
William Brighernti has
a practical solution for valuation of stock options using the Black-Scholes
model ---
http://www.cpa-connecticut.com/sfas123r.html
http://www.cpa-connecticut.com/IPIC.html
I'm not at all clear why
you, Tom, are arguing that FAS 123R makes an error (sausage) for not
requiring a deduction for intrinsic value present value at the grant date.
Firstly, the future intrinsic value is a great unknown and is generally, in
my viewpoint, too uncertain to book at the date options are granted.
Secondly, it's the employee who is bearing the financial risk of that
intrinsic value which starts at zero when the option is granted.
The corporation (actually
shareholders) will lose opportunity value if the granted option eventually
gains in intrinsic value. But at the same time, the corporation (and its
shareholders not receiving stock options) gain opportunity value if the gain
in intrinsic value arises from the added efficiency, creativity, and
motivation of employee to create this intrinsic value for his or her
options. In other words, shareholders did not really lose the entire entire
intrinsic value of the option on the exercise date. They in fact gained
because shareholders can sell their own shares for higher values if they
owned the shares on the date the employee options were first granted in lieu
of wages.
My point is that the
intrinsic value of an employee option that arises between the option's grant
and exercise dates is not entirely an opportunity loss to shareholders equal
to the intrinsic value on the exercise date. Shareholders who held shares
between the grant and exercise dates gained to the extent that the intrinsic
value arising from the marginal efforts of employees to increase the
intrinsic value of their options.
What's not clear to me is
why the corporation gets any tax break for dealing in its own stock or stock
options. Employees, on the other hand, should have to pay a compensation
tax, and it seems to me that they owe this tax on the date that they are
entitled to sell the option (which may in fact be the exercise date but may
also be in advance of the exercise date). Some might argue that an employee
using a cash basis for tax accounting purposes does not owe the tax until
cash is received, but the tax code requires that employees owe taxes on the
date value is received irrespective of cash timing such as if employees are
given inventory in lieu of wages.
There are of course fine
points that must be worked out in the tax code. If each Apple employee
receives a free iPad for personal use but is not allowed to resell that iPad
for ten years when it is worth virtually zero, the employee should probably
be taxed on the date the iPad is received rather than ten years from the
grant date. That's because the employee is receiving the benefits of use
before the iPad can be sold for cash. There is no benefit of use in a stock
option, however, before the option can be turned into cash (ignoring its
possible and questionable use as loan collateral).
Hence, I think an
employee stock option is fundamentally different from inventory grants in
terms of tax obligations. Employers should get tax deductions for inventory
grants, and employees should be taxed for value received on the grant dates.
Corporations should not get tax losses/gains for and dealings in their own
shares or share options, but employees should be taxed for value received on
the date they have the right to convert their stock option contracts into
cash. If they do not sell on that date, the contracts become investments
taxable on the basis of the difference between ultimate sales value and the
value on the date for which they paid an initial compensation tax.
Bob Jensen
Wow:
A Must Read for Sure
"Cooking the Books Why do firms issue
financial misstatements? Based on the Research of Jap Efendi, Anup Srivastava
And Edward P. Swanson," Kellog Insight, February 2011 ---
http://insight.kellogg.northwestern.edu/index.php/Kellogg/article/cooking_the_books/#When:18:17:07Z
When the dot-com bubble of
the late 1990s sent stock prices soaring, something else soared, too: CEOs’
perceptions of their net wealth. That theory alone may explain a large part
of the psychology and behavior of why some corporate managers allowed their
accounting books to get cooked.
On March 10, 2000, the
dot-com bubble burst abruptly and as a result many firms had to issue
accounting restatements well into the next decade. Let’s face it, a lot of
people lost a lot of money, and not just the CEOs who watched large portions
of their own stock holdings in their own companies vaporize. Let’s also not
forget the chasm of broken trust that opened between the business community
and the public.
So what happened? Did the
CEOs transmogrify into greed-poisoned crooks? That answer may satisfy our
human desire for a villain, but that is not exactly how things played out,
says Anup Srivastava, an assistant professor of accounting information and
management at the Kellogg School of Management.
While most firms were not
guilty of accounting irregularities or criminal activity, a few were.
Srivastava and Jap Efendi, an assistant professor at University of Texas at
Arlington, and Edward P. Swanson, a professor at Texas A&M, dug into the
problem of overvaluation of firms’ equity, and they developed several
reasons why CEOs may have overseen the release of false or misleading
financial statements. At the heart of the matter was a confluence of CEO
compensation structuring with a little idea (holding large implications)
about how very large incentives can cause normally law-abiding citizens to
step outside the law’s bounds.
Taking Risks Srivastava
explains that in 2005, Harvard professor emeritus and noted financial
economist Michael C. Jensen wrote a paper titled “Agency costs of overvalued
equity,” which was published in the journal Financial Management. “In this
paper, Jensen argues that managers are normal human beings but when the
stakes are very high, normal human beings begin making extremely risky
decisions,” Srivastava says. “Our paper examining the overvaluation of a
firm’s equity during the dot-com years is the only paper that has tested his
theory.”
When Srivastava says a firm
is overvalued, he is referring to extreme situations where the stock may be
worth 100 to 1,000 percent of its fundamental value. When this happens, the
firm’s fundamentals cannot justify the stock price and so managers begin to
“do things.”
“They start taking extreme
risks. They make acquisitions and play with their accounting numbers,”
Srivastava explains. “This is very destructive to society. Decisions based
on overvalued equity are not good for society because they lead to a loss of
wealth.”
Srivastava says that an
important trend in CEO compensation over the past two decades has been an
increasing emphasis placed on company stock options. When this collides with
market overvaluation, CEOs may find that their in-the-money stock options
balloon into the stratosphere to nearly one hundred times the value of their
salary.
“Let’s say their
in-the-money stock options are worth a billion dollars now,” Srivastava
says. “They may start to think, ‘I’m a billionaire.’” By confusing their
overinflated stock options with their net wealth, these CEOs begin to make
riskier and riskier decisions, perhaps to preserve their perceived wealth.
It is a fragile zone to live within; a 10 percent decline in their company’s
stock price could spell out a 50 percent decline in their net wealth.
“In this scenario, they will
do anything and everything to keep the stock values high,” Srivastava says.
But this motivation may also extend beyond their own personal gain; they may
want to maintain the status quo by not liquidating their holdings as to
avoid attention from the Securities and Exchange Commission or their
investors regarding the overvaluation problem.
“What we highlight in our
paper is the fact that when equity is overvalued, and overvaluation in
equity results in large in-the-money options for managers, then managers
have incentives to take very risky accounting decisions,” Srivastava says.
Show Me the Money The
researchers used ninety-five sample firms—pinpointed from a Government
Accountability Office (GAO) database of companies that restated a previously
issued financial statement—and compared these to ninety-five control firms
that had not issued restatements but were matched in terms of size,
industry, and asset values. They then examined the firms that announced a
restatement between January 1, 2001, and June 30, 2002, for accounting
errors in prior years, extending back to April 1995. (Firms often announce a
restatement one to two years after the year being restated, e.g., a
restatement announced in January 2001 could be for the accounting year 1999
or 2000.) The team used press releases and annual reports to discover the
exact year of the misstatement, a detail the GAO database lacks.
For example, say an Internet
company called WidgetTechs tanked in the 2000 bust and announced a
restatement of its accounts later. Srivastava and his team basically poked
through records to find WidgetTechs’ historic stock prices and its
compensation package. Then they dissected this data to look for trends that
associated aspects of compensation to time points right before, during, and
after accounting irregularities, or criminal activity, was said to have
occurred.
By doing this, Srivastava
and his colleagues found that the best predictors of accounting
misstatements turned out to be in-the-money values of stock options held by
CEOs. To illuminate the magnitude of in-the-money option holdings, they
found the average holdings for CEOs at restating firms was approximately $50
million, which greatly exceeded the average of $9 million at matched firms
that did not announce a restatement. Stated another way, the CEOs of
restating firms held options with in-the-money value that was forty-six
times their salary, compared with options six times the salary of CEOs in
control firms.
The team then parsed the
restating firms into two main categories based on accounting issue
classifications assigned by the GAO—non-malfeasance and malfeasance—that
describe the degree of seriousness of the firm’s accounting error. (A
malfeasance category correlates to fraudulent behavior or an SEC-induced
restatement, while a non-malfeasance category correlates to a non-criminal,
less serious issue or irregularity.)
The researchers found that
the in-the-money value of options for CEOs at restating firms with evidence
of accounting malfeasance was even higher, averaging approximately $130
million (compared to an average of $50 million for all restating firms).
One of the study’s key
insights centered on the degree to which options were in-the-money. The
analysis detected no difference between the value or number of options
issued by restatement and control firms to their CEOs. In other words, the
larger in-the-money values of restatement firms were not due to the number
of options held but the degree to which the firm’s stock options were
in-the-money. Within both the restating firms and the control firms, the
research team analyzed CEO compensation to look for predictors that a firm
would issue a restatement. They tested the base salary, bonus, options
grant, in-the-money stock options, restricted stock grants, and restricted
stock holdings. The only statistically significant variable turned out to be
in-the-money options.
Continued in article
Bob Jensen's recipes for cooking the books
---
http://faculty.trinity.edu/rjensen/Theory02.htm#Manipulation
Teaching Case from The Wall Street Journal Accounting Weekly Review on
April 22, 2011
Strings Attached to Options Grant for GE's Immelt
by: Andrew Dowell and
Joann S. Lublin
Apr 20, 2011
Click here to view the full article on WSJ.com
TOPICS: Corporate
Governance, Executive Compensation, Stock Options
SUMMARY: GE granted two
million stock options valued at $7.4 million to CEO Jeffrey Immelt one year
ago in March 2010. The company now has stipulated that the options will only
"...vest if the company successfully boosts its industrial businesses and
delivers shareholder returns...that are as good or better than those of the
Standard & Poor's 500-stock index...The move underscores [in part]
shareholders' increasing clout regarding matters of executive compensation.
GE's decision comes ahead of the company's annual meeting next week, when
shareholders will cast a nonbinding vote on GE's pay practices."
CLASSROOM APPLICATION: The
article is excellent for discussing corporate governance, the annual meeting
of shareholders, the proxy process, the incentive value of stock option
plans, and the accounting and valuation components of these plans.
QUESTIONS:
1. (Introductory) What are executive stock options? What is the
business purpose of awarding options?
2. (Introductory) What is a proxy statement? Access the filing of
the proxy statement on the SEC web site at
http://www.sec.gov/Archives/edgar/data/40545/000119312511065578/ddef14a.htm#tx122802_10
What matters will be decided at the annual GE shareholders' meeting? What
information is contained in the proxy statement in relation to these
matters?
3. (Advanced) The article states that "GE says" the options granted
to Mr. Immelt were valued at $7.4 million in March 2010. How is this value
determined? Where does "GE state" the value of these options?
4. (Advanced) Access the filing referred to in the article at
http://www.sec.gov/Archives/edgar/data/40545/000119312511101003/ddefa14a.htm
On what form was this filing made? On what date? Summarize the contents of
the filing.
5. (Introductory) What is the Institutional Shareholder Services (ISS)?
What was their initial recommendation to shareholders about the grant of
options to Mr. Immelt?
6. (Advanced) Access the filing by GE on the SEC web site at
http://www.sec.gov/Archives/edgar/data/40545/000119312511091124/ddefa14a.htm
after the company's communication to shareholders that it disagreed with the
ISS recommendation. Read the points made by GE, and particularly scroll down
to the fourth item regard the option valuation model used by GE versus the
one used by ISS. What are the concerns? How does the option pricing formula
help to assess the compensation given to Jeffrey Immelt?
Reviewed By: Judy Beckman, University of Rhode Island
"Strings Attached to Options Grant for GE's
Immelt," by: Andrew Dowell and Joann S. Lublin, The Wall Street Journal,
April 20, 2011 ---
http://online.wsj.com/article/SB10001424052748703789104576272701168635450.html?mod=djem_jiewr_AC_domainid
Responding to shareholder
criticism, General Electric Co. agreed to put new conditions on two million
stock options granted to Chief Executive Jeff Immelt a year ago.
The options, which GE says
were valued at $7.4 million when granted in March 2010, will now only vest
if the company successfully boosts its industrial businesses and delivers
shareholder returns, including stock appreciation and dividends, that are as
good or better than those of the Standard & Poor's 500-stock index.
"Some shareholders have
expressed the view that additional performance conditions should be applied
to Mr. Immelt's 2010 stock option award," GE said in a filing with the
Securities and Exchange Commission.
The move underscores the
pressure on Mr. Immelt to get the company growing again, as well as
shareholders' increasing clout regarding matters of executive compensation.
GE's decision comes ahead of the company's annual meeting next week, when
shareholders will cast a nonbinding vote on GE's pay practices.
The options grant was
unusual for GE, which last granted Mr. Immelt options in 2002 and afterward
shifted to equity awards based on measurable performance targets. The
company said the 2010 award was intended to "increase the equity-based
portion of his compensation" and to express confidence in the CEO.
Institutional Shareholder
Services, which advises mutual funds and other shareholders about how to
vote on corporate matters, criticized the grant for not being sufficiently
pegged to GE's performance.
In light of the new
conditions, ISS dropped its objections and recommended that shareholders
vote to support GE's pay practices.
Under the new terms, 50% of
the options will vest only if the company pulls in cumulative industrial
cash flow from operating activities of at least $55 billion between the
start of 2011 and the end of 2014. The other half will vest only if GE's
total shareholder return is equal to or better than that of the S&P 500 over
the same period.
Mr. Immelt is one of just 10
CEOs who got more than one million options last year—including two who
received bigger grants than his, according to an analysis of the latest
proxy statements by Hay Group for The Wall Street Journal. The consultancy
looked at 320 CEOs of major U.S. corporations, of whom 232 received option
awards in 2010.
Continued in article
Bob Jensen's threads on FAS 123R are at
http://faculty.trinity.edu/rjensen/theory/sfas123/jensen01.htm
The New York Times has
proposed to turn us all into Seinfeld's
Elaine Benes
The article below has a really weird
introduction to say the least, especially for a venerable journal like the
Harvard Business Review.
The article is really about the new New York
Times way of charging readers, which is a very, very complicated scheme to
say the least.
"Is Paul Krugman "Click-Worthy"?" by Joshua Gans,
Harvard Business Review Blog, March 18. 2011 ---
Click Here
http://blogs.hbr.org/cs/2011/03/is_paul_krugman_click-worth.html?referral=00563&cm_mmc=email-_-newsletter-_-daily_alert-_-alert_date&utm_source=newsletter_daily_alert&utm_medium=email&utm_campaign=alert_date
Last year, one of the
most famous economists in the world,
Avinash Dixit,
released a paper, "An Option Value Model from Seinfeld,"
based on this episode (you can download it
here). ---
http://www.princeton.edu/~dixitak/home/Elaine-Final-Web.pdf
Bob
Jensen's Threads on Real Options, Option Pricing Theory, and Arbitrage Pricing
Theory ---
http://faculty.trinity.edu/rjensen/realopt.htm
Bob Jensen's threads on option pricing theory
are at
http://faculty.trinity.edu/rjensen/149wp/149wp.htm
"Do
stock options improve employee performance?" PhysOrg, August 12, 2010
---
http://www.physorg.com/news200843868.html
It has become an
article of faith in Silicon Valley that stock options create incentives for
employees to work harder and smarter. But does that assumption stand up? It
depends on who is receiving the options, according to a new study
co-authored by Nicole Bastian Johnson, assistant professor of accounting ---
Nicole Bastian Johnson, assistant professor of accounting , UC Berkeley ---
http://www2.haas.berkeley.edu/Faculty/johnson_nicole.aspx
Stock options have rewarded
many thousands of employees, particularly those working in the information
technology industry, with income that far outstrips their normal salaries.
It's become an article of faith in Silicon Valley that those rewards create
incentives for employees to work harder and smarter, in turn rewarding the
companies that lavish options on the workforce with better performance and
greater shareholder value.
"Our findings provide
evidence that options provide incentive effects at the executive level that
are sufficiently large to be reflected in firm performance, but no evidence
for similar incentive effects for non-executive employees," wrote Johnson
and co-authors David Aboody of UCLA's Anderson School of Management and Ron
Kasznik of Stanford's Graduate School of Business.
Their paper, "Employee Stock
Options and Future Firm Performance: Evidence from Option Repricings," will
be published in the Journal of Accounting and Economics later this year.
Learning that granting options to a broad selection of employees may not be
an effective tool is the paper's most important contribution to the
literature, Johnson says.
Options and their effect on
corporate performance have been frequently studied. However, nearly all of
the research has focused on options for executive-level employees. Few
researchers have looked at companies that granted options to rank-and-file
employees, largely because obtaining data is so difficult, says Johnson.
Public companies generally
disclose option grants on regularly scheduled proxy statements, but usually
for only top-level managers. Digging through hundreds of corporate filings
with the Securities and Exchange Commission to find who else may have
received options is extremely time-consuming. But that's exactly what
Johnson and her colleagues did.
The researchers identified
1,364 companies with employee stock options whose stock price declined by 30
percent or more annually in any of the years between 1990 and 1996. Of those
companies, 300 repriced and formed a basis of comparison to a control group
of the 1,064 that didn't.
The researchers theorized
that when a company's stock price falls below the exercise price of an
option, much of any incentive effect the options may have had disappears.
Repricing those options should restore those incentives, the researchers
assumed. A situation in which options have been repriced should be similar
to that of a newly instituted option-grant program.
So the researchers first
asked whether companies that repriced outperformed the companies that
didn't, as measured by cash flow and operating income over one, three, and
five years. Companies that repriced options did significantly outperform the
control group, and the performance gap grew over time.
Johnson and her colleagues
also found that companies that had repriced options for only executive-level
employees significantly outperformed the companies that had not repriced at
all. But firms that repriced options for only non-executive employees did
not outperform the control group.
While Johnson is confident
that the study's results are meaningful, there are, she says, a number of
caveats.
The researchers chose to
study performance before significant accounting changes were made to the
treatment of options, particularly the rule instituted in 2005 requiring
companies to expense the cost of options. However, while that rule may have
prompted some firms to cut back on granting stock options, the researchers
do not have any reason to assume it would have changed the effect that
option grants have on employee behavior—the focus of their study.
Hi Ruth,
Denny Beresford and Jim
Leisenring once faced a more seriously “pissed off audience” and were lucky to
escape:
I often use this quotation as an example of where the FASB does not always cave
in to big business
(Intel, Cisco, Microsoft, Apple, etc. are big, big businesses):
A Quote from FAS 123 History (1993)
Dennis R. Beresford and James J. Leisenring came
to the Red Lion Inn on a hot August morning with a simple goal: to explain a
change in an accounting rule. Before it was over they were lucky to have escaped
the first lynching in San Jose in a half-century. Measuring out the rope were
300 seriously pissed off Silicon Valley CEOs and other senior execs who could
see the ruin of their lives' work because some glorified bean counters in
Washington had decided to count sacrifice flies as home runs.
Michael S. Malone, Upside Today, November 1, 1993 ---
http://www.upside.com/texis/mvm/story?id=34712c0a45
A Bit of Accounting History: The Evolution
of FAS 123R
"Lieberman’s Legacy on Accounting," by Floyd Norris, The New York
Times, January 20, 2011 ---
http://norris.blogs.nytimes.com/2011/01/20/liebermans-legacy-on-accounting/
Gail Collins, who has
known
Joe Lieberman since he was a local politician
in Connecticut, ends her
column about his decision not to seek
re-election with a threat to write a book entitled, “Everything Bad
Is Joe Lieberman’s Fault.”
I assume she is kidding,
but if she goes through with it she should definitely include a chapter
on stock option accounting. It was he who, in 1994, got the Senate to
vote 88 to 9 in favor of a resolution opposing a rule requiring
companies to treat the value of stock options they hand out as an
expense.
He then threatened
to push through legislation to basically abolish the
Financial Accounting Standards Board, and the
board caved. It would be another decade before reasonable accounting
came to the world of options, with the American board moving only after
the International Accounting Standards Board had done so.
The senator crowed when
the board caved, calling it “a great victory for American business and
workers.” To hear him tell it, forcing disclosure of reality would
“diminish the ability of small companies to raise capital and attract
employees.”
Had he not been there,
some of the worst excesses of the technology stock bubble might have
been avoided. Certainly shareholders would have had a better
understanding of how the bosses were getting rich. Somehow Silicon
Valley survived after the accounting was changed.
"Floyd Norris on Joe Lieberman’s Views on
Accounting," by David Albrecht, The Summa, January 21, 2011 ---
http://profalbrecht.wordpress.com/2011/01/21/floyd-norris-on-joe-liebermans-views-on-accounting/
January 21, 2011 by David Albrecht
Senator Joe Lieberman
has announced his plans not to seek re-election. This means that January 3,
2013 will be his last day to serve as the 112th Congress is replaced by the
113th. Gail Collins, Op-Ed columnist for the New York Times is
thrilled, announcing tongue-in-cheek plans for a new book, “Everything
Bad Is Joe Lieberman’s Fault.”
Piling on, respected New
York Times business columnist Floyd Norris suggests that Collins include a
chapter on Joe Lieberman’s opposition to an accounting rule on executive
stock options. Norris says that not having a rule to expense executive stock
options caused the stock market bubble of the late 1990s. Floyd, I love you,
but you should check with me before you write your next piece on accounting.
Surely Lieberman was
promoting his personal interests in fighting the rule, and had no altruistic
purpose in mind such as improving the world of accounting. However, he was
correct on this one issue.
Adding the value of
executive stock options as an expense on the income statement was a bad idea
in the 1990s when Lieberman fought it, it was still a bad idea in 2005 when
the FASB adopted it, and it will continue to be a bad idea for as long as
the rule is on the books.
Here’s why Norris and the
FASB are wrong about expensing stock options. Traditionally, the income
statement has been reserved for (1) the value received from selling products
and services, and (2) the money spent (costs) to generate these revenues. An
executive stock option causes no money to be spent by the company. It is
merely a vehicle to increase (potentially) the wealth of the receiving
executive by a grant of ownership from the company’s owners. The current
owners take a hit, but that hit has nothing to do with the profit from
company operations. No money is being spent by the company on the
executives, and no money will ever be spent by the company on the
executives.
The expensing rule is but
one example of the the use of accounting rules to accomplish societal
objectives. When executives are granted stock options, the current group of
stockholders have been robbed by the company’s board of directors, with the
receiving executives as willing co-conspirators. Crying foul, investors have
looked for a way to curb this practice. Their solution is to add a charge to
current earnings, thereby making it more difficult for executives to qualify
for their annual bonus. Unfortunately, the only result accomplished is to
diminish the importance of the income statement.
It would be so much more
powerful to simply vote out the directors who voted in the executive stock
option. If a few boards were voted out because of granting these options,
the practice would dry up in a hurry, I assure you.
Mr. Norris, thanks for
writing about accounting. This time, though, you got it wrong.
Debit and credit – - David
Albrecht
January 22, 2011 reply from Bob Jensen
Hi David,
We been round and round about this before, and I
just do not agree with your reasoning. Let me tell you a Fairy Tale I used to
read to my children.
Years and years ago a
penniless gnome named
Rumpelstiltskin limped along a cobblestone road
carrying his portable spinning machine on his humped back. He encountered a
sign reading: "You're Entering the Land of Albrecht."
Inside the Land of
Albrecht Rumpelstiltskin encountered a golfer named
Walter Schuetze, and the two chatted under a
Rosewood Tree. Rumpelstiltskin bragged that if he had bale of straw he
could spin it into a gold nugget. Walter Schuetze asked
Rumpelstiltskin to rest under the tree for a moment, raced to a nearby farm,
and returned with a bale of straw.
Walter Schuetze then
explained that he'd formed a new corporation in the Land of Albrecht with
the following general journal entries:
Cash
$1
Common stock $1
-To record the formation of Schuetze Inc.
Straw inventory $1
Cash
$1
-To record the purchase of a
bale of straw
Walter Schuetze truthfully
further explained that he had no more money. But he would give
Rumpelstiltskin an employee stock option in this new corporation if
Rumpelstiltskin would be an employee of the company and spin the straw
inventory into a nugget of gold. Now this is a transaction for services
rendered but in the Land of Albrecht such employee stock option transactions
are not booked.
No journal entry in the journal for the stock
option granted to Rumpelstiltskin
Rumpelstiltskin labored on
his spinning machine and did indeed transform the straw inventory into a
nugget of gold. Walter Schuetze then took physical inventory under the
accounting rules in the land of Albrecht and made the following entries:
Retained earnings $1
Straw inventory $1
-To record the disappearance of the
bale of straw
Walter Schuetze then
recorded the final journal entry as follows:
Common stock $1
Retained earnings $1
-To record the liquidation of
Schuetze Inc. in the Land of Albrecht
Walter Schuetze then bid
Rumpelstiltskin good day and proceeded whistling with joy down the
cobblestone road looking for a golf course.
Rumpelstiltskin followed
making screeching noises and waving his stock option. Walter Schuetze looked
back at the pitiful gnome and explained that in the Land of Albrecht a stock
option in a defunct corporation is worthless. It was never even booked
into the accounting journal.
In a rage Rumpelstiltskin
picked up a cobblestone, hit Walter Schuetze in the head, dragged this
former SEC Chief Accountant into a ditch, retrieved the nugget of gold from
the golfer's golf bag, and proceeded on in the Land of Albrecht toward his
ultimate destination where the accounting rules were much more fair --- the
Land of the FASB.
Walter Schuetze awakened
with a headache and no gold nugget. When he finally did find a golf course
in the Land of the FASB his only option was to raise some lunch money by
caddying for Denny Beresford.
Almost all lived happily
ever after with the FASB's ruling on accounting for stock options under FAS
123R except for former FASB Board Member Walter Schuetze who fumed over FAS
123R for the rest of his lonely life in the Land of the FASB.
Long before I reached this thrilling ending to
this Fairy Tale my children were always fast asleep.
Moral of the story:
Option value is the sum of intrinsic value plus time value.
Employees trade their services for the time value of options that should be
recorded as the value at the time of vesting for services rendered.
Otherwise inventories will be seriously undervalued as they are in the Land
of Albrecht.
If the corporation is disbanded the nugget of gold remaining cannot be
confiscated without considering the value of the employee stock options that
have not yet expired in the more equitable Land of the FASB.
Book ---
Click Here
http://www.amazon.com/gp/product/0071703071?ie=UTF8&tag=worbet-20&linkCode=as2&camp=1789&creative=390957&creativeASIN=0071703071
Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial
Reports, Third Edition [Hardcover]
Howard Schilit (Author), Jeremy Perler (Author)
Also available as an eBook
Bob Jensen's threads on creative accounting ---
http://faculty.trinity.edu/rjensen/Theory02.htm#Manipulation
Bob Jensen's threads on employee stock option
accounting are at
http://faculty.trinity.edu/rjensen/theory/sfas123/jensen01.htm
A New Teaching Case on Executive Options
Backdating
Options Backdating ---
http://en.wikipedia.org/wiki/Options_backdating
From The Wall Street Journal Accounting
Weekly Review on March 12, 2010
Options Trial to Take New Tack
by: Mark
Maremont
Mar 09, 2010
Click here to view the full article on WSJ.com
TOPICS: Advanced
Financial Accounting, Executive Compensation, Stock Options
SUMMARY: "The
criminal options-backdating trial of the former chief executive of home
builder KB Home, Bruce Karatz, is scheduled to start Tuesday [3/9/2010], in
the latest test of the federal government's checkered attempt to crack down
on a practice that enriched scores of executives around the U.S....The
government alleges that Mr. Karantz reaped millions of dollars in
'undisclosed compensation' to which he wasn't entitled."
CLASSROOM APPLICATION: The
article can be used in coverage of equity-based compensation methods in
financial accounting classes.
QUESTIONS:
1. (Introductory)
As described in the article, what is the practice of backdating stock
options?
2. (Introductory)
Specifically refer to the chart showing the dates of options grant to KB
Home's former CEO, Bruce Karatz, and describe how it evidences the issues in
options backdating.
3. (Advanced)
Describe the accounting for employee compensation through stock options. How
can the government argue that Mr. Karatz received "undisclosed compensation"
if the options actually were issued at a later date than indicated in the
accounting records and the value of the company's stock had increased in the
intervening time?
4. (Introductory)
Refer to the first related article. Many firms opt to issue restricted stock
as compensation to employees. What is restricted stock?
5. (Introductory)
How do you think that the executive-compensation research firm Equilar,
Inc., determined the values of restricted stock issued to executives and
employees?
6. (Advanced)
One reason companies issue restricted stock is "to replace employees'
underwater stock options." What is an "underwater stock option"? How did the
behaviors of backdating stock options help to avoid options going
"underwater" and becoming worthless?
7. (Advanced)
Refer to the second related article. How did research firm Equilar determine
the value of options granted to Silicon Valley tech firms? Why did the
company need to decide on one method to use in its analysis?
Reviewed By: Judy Beckman, University of Rhode Island
RELATED ARTICLES:
Despite Downturn, Top Tech Firms Awarded Big Restricted-Stock Grants
by Pui-Wang Tam
Feb 25, 2010
Online Exclusive
Stock Options Still Popular with Tech Firms
by Pui-Wing Tam
Mar 04, 2010
Online Exclusive
"Options Trial to Take New Tack:
Prosecutors Focus on How Backdating Benefited Former KB Home Chief Executive,"
by Mark Maremont, The Wall Street Journal, March 9, 2010 ---
http://online.wsj.com/article/SB10001424052748703954904575109901879413726.html?mod=djem_jiewr_AC_domainid
The criminal
options-backdating trial of the former chief executive of home builder KB
Home is scheduled to start Tuesday, in the latest test of the federal
government's checkered attempt to crack down on a practice that enriched
scores of executives around the U.S.
Bruce Karatz, who resigned
as CEO of Los Angeles-based KB Home in 2006, will be tried on 20 criminal
counts in U.S. District Court in Los Angeles related to allegations that
between 1999 and 2006 he backdated his own stock options and those of other
executives. He had been one of the home-building industry's highest-paid
executives. The government alleges he reaped millions of dollars in
"undisclosed compensation" to which he wasn't entitled.
Mr. Karatz has pleaded not
guilty and his lawyers have said in legal briefs he never thought he was
committing a crime, calling the government's evidence "gossamer thin." In a
statement, his lawyer John Keker said the accounting rules governing
options-granting "made little sense," but "company after company applied
those rules in good faith, in a way the government now says was wrong."
More than two dozen former
executives of various companies have been criminally charged since 2006 in a
federal crackdown on options backdating. But after a spate of early
convictions and guilty pleas, officials have had setbacks in recent months.
A U.S. judge in Santa Ana,
Calif., recently dismissed criminal charges against former and current
officials of Broadcom Corp., finding prosecutorial misconduct and a lack of
criminal intent. A U.S. judge in St. Louis last month halted a civil trial
against a former official of Engineered Support Systems Inc., finding the
government's case was weak.
Backdating involves
retroactively setting the price of a stock option to a low point in the
stock's value, allowing employees to reap higher profits if the stock is
later sold.
The case against Mr. Karatz
differs in key ways from the Broadcom case. Broadcom's co-founders never
received any backdated options, but Mr. Karatz was the biggest recipient of
KB Home's improperly priced grants. He received roughly half of the total
annual options awarded to all KB corporate officers, according to
prosecutors.
Filings show that at least
four grants to Mr. Karatz were dated at yearly, quarterly or monthly low
points in KB Home's stock.
Prosecutors also allege that
Mr. Karatz tried to cover up the backdating, in part by lying to the
company's top lawyer during a 2006 internal investigation. The allegation,
if proven, could help show criminal intent, by suggesting that Mr. Karatz
knew his conduct was wrong.
A key witness for
prosecutors will be Gary A. Ray, KB Home's ex-head of human resources, who
agreed to cooperate after pleading guilty to a conspiracy charge in 2008.
According to documents filed with the court, Mr. Ray said he initially went
along with the false story about the options granting process, but later
informed Mr. Karatz he couldn't tell KB Home's outside lawyers "the same
lies" he had given to the top internal lawyer.
Jensen Comment
The American Accounting Association in 2007 gave its Notable Contributions to
Accounting Literature Award (and $5,000) to Iowa's finance professor Eric Lie
---
http://aaahq.org/awards/awrd3win.htm
Erik Lie
"On the Timing of CEO Stock Option Awards"
Management Science (May, 2005)
|
|
Teaching Case on Executive Compensation and
Stock Options
From The Wall Street Journal Accounting
Weekly Review on March 4, 2011
J&J CEO's 2010 Bonus Cut by 45%
by: Peter Loftus
Feb 28, 2011
Click here to view the full article on WSJ.com
TOPICS: Compensation,
Executive Compensation, Stock Options
SUMMARY: Johnson
& Johnson's chief executive's pay has been reduced following a year of
product recalls due to manufacturing problems. The company does not
acknowledge that the pay reduction is related to this specific problem, but
notes that the compensation review encompasses many company performance
factors.
CLASSROOM
APPLICATION: The article is useful to introduce
compensation package issues and accounting for these plans.
QUESTIONS:
1. (Introductory) From where did the reporter get the information
in this article about bonus pay and other compensation awarded to the
Johnson & Johnson (J&J) chief executive William Weldon?
2. (Introductory) Who evaluated William Weldon's performance in
2010? On what basis did they do so? Why was Mr. Weldon's overall
compensation reduced in 2010 relative to 2009?
3. (Introductory) What items comprise Mr. Weldon's compensation
package?
4. (Advanced) Access the Johnson & Johnson financial statements
filed on Form 10-K with the SEC on and available at
http://www.sec.gov/cgi-bin/viewer?action=view&cik=200406&accession_number=0000950123-11-018128&xbrl_type=v#
Proceed to the Notes to Financial Statements, No. 17. Common Stock, Stock
Option Plans, and Stock Compensation Plans. Summarize the information found
in this footnote.
5. (Advanced) From where does the company obtain the shares of its
common stock needed to be issued to executives and employees who exercise
their stock options?
6. (Advanced) Over what range of stock prices may J&J option
holders exercise their options? How does that compare to the company's
current stock price? Over how long a time period may employees exercise
these options?
7. (Advanced) What is restricted stock? How does J&J satisfy
obligations to issue shares of stock to its executives and employees under
these plans?
Reviewed By: Judy Beckman, University of Rhode Island
"J&J CEO's 2010 Bonus Cut by 45%," by: Peter
Loftus, The Wall Street Journal, February 28, 2011 ---
http://online.wsj.com/article/SB10001424052748704150604576166313696650734.html?mod=djem_jiewr_AC_domainid
Johnson & Johnson slashed
Chief Executive William Weldon's performance bonus by 45% for 2010, a year
in which the health-care giant issued a series of product recalls due to
manufacturing-quality lapses.
The recalls are continuing,
with the company saying this past week that certain packages of the
decongestant Sudafed were being recalled because of a misprint on product
directions.
In an annual report filed
with the Securities and Exchange Commission Friday, J&J said Mr. Weldon's
performance bonus for 2010 was $1.98 million, down from $3.6 million for
2009. The bonus, which was approved by the compensation committee of J&J's
board in January, is paid out in the form of 85% cash and 15% in J&J shares.
In addition, the New
Brunswick, N.J., company granted fewer stock options, restricted share units
and nonequity incentive compensation units to Mr. Weldon this year than last
year. He was granted 560,691 stock options in January, with an exercise
price of $62.20, versus 586,873 options last year with an exercise price of
$62.62.
J&J did, however, boost Mr.
Weldon's base salary for 2011 by 3% to $1.9 million, according to the SEC
filing. The year-earlier figures were contained in last year's annual
report.
J&J spokeswoman Carol
Goodrich said the board's compensation committee evaluated Mr. Weldon and
other senior executives against a set of financial and strategic objectives
that will be disclosed in a proxy statement expected to be filed with the
SEC in March. She said the objectives are based on a pay-for-performance
philosophy, but declined to be more specific.
Ms. Goodrich declined to say
whether the reduction in Mr. Weldon's performance bonus was related to the
product recalls.
Mr. Weldon's total
compensation was valued at $30.8 million for 2009, the last full year for
which total compensation was reported. The figure included salary, bonus,
changes in pension value and other items.
Continued in article
Bob Jensen's threads on outrageous executive
compensation are at
http://faculty.trinity.edu/rjensen/FraudConclusion.htm#OutrageousCompensation
Update on IFRS and SPEs
October 12, 2009 message from Bob Jensen to the AECM
I previously provided a long quotation from the FT article by Yale’s Robert
Shiller on the need for creative finance.
"In defence of financial innovation," by Yale's Robert Shiller,
Financial Times, September 27, 2009
http://www.ft.com/cms/s/0/c4a74ba2-ab83-11de-9be4-00144feabdc0.html?nclick_check=1
The FASB has done a part-way job in dealing with some of the
creative financing paths to date, but the FASB has miles to go before it
rests or gives up. The IASB is still asking “what’s creative finance.”
At the moment the big international accounting firms are chomping
at the bit to replace U.S. GAAP with IFRS and accounting educators in the
U.S. are gearing up to teach IFRS as if U.S. GAAP already has one foot in
the grave.
The SEC might’ve jumped on the 2014 timetable promoted by former
SEC Director Chris Cox, but the SEC is concealing its hand regarding when
and if U.S. GAAP will be lowered into the grave. My understanding is that
the major hang up is the absence of IFRS standards to deal with even the
most basic and long-standing creative finance ploys such as SPEs (that date
back to before the Enron scandal). To date international standards remain
silent on SPEs even though the FASB has the controversial FIN 141R on SPEs,
SPVs, VIEs, and synthetic leasing ---
http://faculty.trinity.edu/rjensen/theory/00overview/speOverview.htm
IFRS needs huge updates on the
following types of contracting and financial engineering:
Hence my bell weather of how badly the IASB wants to bury U.S.
GAAP is how the IASB deals with SPEs and related creative financing
vehicles. For this I requested my former student, great friend, and IASB
insider Paul Pacter to keep me posted on SPEs in the IASB. It’s not like the
IASB has been ignoring the problem, especially since the SEC is foot
dragging on the failings to date of the IASB to deal with creative financing
contracting in the U.S.
Paul is a former project leader for both the FASB and IASB and
still is very, very active in the development of international standards (he
lead the recent SME project). He does this in spite of being located in Hong
Kong with Deloitte. By the way, Paul has also been a major resource for
setting accounting standards in China. Paul is also the founder and
Webmaster if the absolutely fantastic IAS Plus ---
http://www.iasplus.com/index.htm
I would never leave home without it.
Over his
years and years of world travel, my great friend Paul Pacter must’ve taken
100,000 high quality photographs. Paul’s photo gallery is at
http://www.whencanyou.com/index.htm
After all this preamble let me get to the purpose of this
message. The purpose is to forward a message from Paul Pacter regarding
accounting for SPEs.
The links to the two articles attached to Pauls message are can be found at
the following URLs:
Robert E. (Bob) Jensen
Trinity University Accounting Professor (Emeritus)
190 Sunset Hill Road
Sugar Hill, NH 03586
Tel. 603-823-8482
www.trinity.edu/rjensen
Reply From:
Pacter, Paul (CN - Hong Kong) [mailto:paupacter@deloitte.com.hk]
Sent: Sunday, October 11, 2009 8:22 PM
To: Jensen, Robert
Subject: SPEs
Bob,
From Paul Pacter on October 12, 2009
Bob
You asked me to think of you re SPEs. Attached is an excellent report on
SPEs (plus related press release). The three bullet points I highlighted
below – alone – could be a good teaching tool.
Paul
12 October
2009: Regulators' report on special purpose entities
|
|
The Joint Forum has released its Report on Special Purpose Entities.
This paper serves two broad objectives. First, it provides
background on the variety of special purpose entities (SPEs) found
across the financial sectors, the motivations of market participants
to make use of these structures, and risk management issues that
arise from their use. Second, it suggests policy implications and
issues for consideration by market participants and the supervisory
community. Regarding accounting, here are three comments made in the
report:
|
The ability to achieve off-balance sheet accounting
treatment is affected by the accounting regime to which the
originating or sponsoring entity is subject. Generally
speaking, off-balance sheet treatment is easier to achieve
under US GAAP than under IFRS. However, the US FASB new
accounting rules related to SPEs that are effective in 2010
will significantly reduce the ability of institutions to use
SPEs to achieve off-balance sheet treatment. As a result, US
accounting changes will significantly alter the motivations
for originators in using SPEs. These accounting changes will
also affect leverage and risk-based capital ratios, and
could have an important effect on the management of
regulatory capital adequacy requirements by firms.
European financial firms generally have less ability to
remove assets from their balance sheets by using SPEs.
However, this is offset by the fact that risk-based capital
requirements are not as closely tied to accounting in
Europe. In contrast, while US firms currently can more
easily remove assets from their balance sheets, the US
implementation of Basel I required more capital for certain
exposures than in Europe.
Some examples (but not an exclusive list) of the ways SPEs
can potentially confuse or obfuscate the financial position
of a company are:
-
Return on equity and return on assets can be exaggerated
if revenue flows are received from SPEs but the assets
in those vehicles are not recognised on the balance
sheet;
-
Sector exposure may be obscured, either deliberately or
not, by recognising some SPEs on balance sheet and not
others;
-
Leverage ratios may be obscured.
|
An appendix to the report examines, in detail, the current
accounting treatment of SPEs under IFRSs and under US GAAP. Click to
download:
The Joint Forum is a consortium of the Basel Committee on Banking
Supervision, the International Organization of Securities
Commissions, and the International Association of Insurance
Supervisors that addresses issues common to the banking, securities,
and insurance sectors, including the supervision of financial
conglomerates. |
Jensen Comment: Paul gave me permission to forward the above
message.
This message (including any attachments) contains confidential
information intended for a specific individual and purpose, and is protected
by law. If you are not the intended recipient, you should delete this
message. Any disclosure, copying, or distribution of this message, or the
taking of any action based on it, is strictly prohibited.
©2009 Deloitte Touche Tohmatsu in Hong Kong SAR, Deloitte Touche
Tohmatsu in Macau SAR, and Deloitte Touche Tohmatsu Certified Public
Accountants Ltd. in the Chinese Mainland. All rights reserved.
Deloitte refers to one or more of Deloitte Touche Tohmatsu, a
Swiss Verein, and its network of member firms, each of which is a legally
separate and independent entity. Please see
www.deloitte.com/cn/en/about for a detailed description of the
legal structure of Deloitte Touche Tohmatsu and its member firms.
Bob Jensen's threads on accounting theory ---
http://faculty.trinity.edu/rjensen/theory01.htm
What's Right and What's
troublesome about synthetics,
(SPEs), SPVs, and VIEs in accounting standards?
http://faculty.trinity.edu/rjensen//theory/00overview/speOverview.htm
I'm sorry," Reyes said. "There is much that I regret. If I
could turn back the clock, I would."
As pointed out in the Opinion Journal, January 18, 2008 Reyes' choice of
words is truly ironic since he was convicted of options "backdating."
When he committed the fraud he truly did turn the clock back. Now he would like
to turn it back again since he got caught.
From The Wall Street Journal
Accounting Weekly Review, January 18, 2008
|
Brocade Ex-CEO Gets 21 Months in Prison
by Justin Scheck and Steve Stecklow
The Wall Street Journal
Jan 17, 2008
Page: A3
Click
here to view the full article on WSJ.com ---
http://online.wsj.com/article/SB120050817585095031.html?mod=djem_jiewr_ac
TOPICS: Accounting, Financial
Accounting, Financial Reporting, Stock Options
SUMMARY: Gregory Reyes, the former
chief executive of Brocade Communications Systems Inc. was the first to go on
trial and be convicted over the improper dating of stock-option awards. The
backdating scandal came to light from academic accounting research that was
brought to the attention of the WSJ. Executives committing this fraudulent
activity were awarded stock options that were backdated to a point at which
the companies' stock prices were lower, often the lowest of the year or
quarter. The related article describes the practice as "illegal if not
accounted for properly." Mr. Reyes had faced a potential 20 year
sentence, but that "...was reduced late last year when Judge Breyer
ruled there was no quantifiable loss of money to the company."
CLASSROOM
APPLICATION: Accounting for stock options and related disclosures
QUESTIONS:
1.) Summarize the accounting and disclosure requirements for stock options.
Refer to authoritative accounting literature and include a description of
dates associated with stock option grants sufficient to discuss the issues in
the article.
2.) What does it mean to "back date" a stock option award?
3.) The related article describes the practice of backdating stock options as
"illegal if not accounted for properly." What accounting would have
been appropriate? You may refer to your answer to question 1 as necessary.
4.) The potential sentence and fine to Mr. Reyes was reduced by the judge in
the case because he "ruled there was no quantifiable loss of money to
the company." What are the costs of stock option to the issuing company?
To its shareholders? Support your answer.
Reviewed By:
Judy Beckman, University
of Rhode Island
RELATED
ARTICLES:
Brocade
Ex-CEO Seeks To Overturn Conviction
by Justin Scheck
Dec 13, 2007
Page: A15
|
Also see the definition at http://www.biz.uiowa.edu/faculty/elie/backdating.htm
The SEC's Module on Stock
Options Compensation and Options Backdating Scandals --- http://www.sec.gov/spotlight/optionsbackdating.htm
"S.E.C. Fines Marvell
$10 Million," The New
York Times, May 9, 2008 --- Click Here
The Marvell Technology
Group, a maker of semiconductors, agreed on Thursday to pay a $10 million civil
fine to settle regulators’ accusations of improper backdating of stock options.
The Securities and
Exchange Commission announced the settlement with the Silicon
Valley company, which it said failed to publicly disclose the
employee stock option awards as expenses and backdated the options to dates
with lower stock prices. Marvell neither admitted nor denied wrongdoing but did
agree to refrain from future violations of the securities laws.
The backdating
scheme allowed the company to overstate its profit by $362 million from fiscal
years 2000 through 2006, the S.E.C. said in its civil lawsuit.
Continued in article
Bob Jensen's Fraud Updates
--- http://faculty.trinity.edu/rjensen/FraudUpdates.htm
From The Wall Street Journal Accounting Weekly Review on September 7,
2012
Facebook Plays Defense
by:
Geoffrey A. Fowler
Sep 05, 2012
Click here to view the full article on WSJ.com
TOPICS: Executive Compensation, Individual Taxation, Stock Price
Effects, Stockholders' Equity
SUMMARY: "In a regulatory [Form 8-K] filing Tuesday, Facebook said
Chief Executive Mark Zuckerberg won't sell any stock in the company for a
year, and that two of its directors...have no plans to sell their personal
holdings beyond the amount needed to cover their tax liabilities." The
discussion in the article emphasizes the company's plans to maintain a
relatively constant level of outstanding shares and also mentions tax
treatment of individuals receiving the restricted stock.
CLASSROOM APPLICATION: The article may be used in a tax class to
cover the topic of restricted stock and in a financial accounting class
covering authorized, issued, and outstanding shares. NOTE: INSTRUCTORS WILL
WANT TO REMOVE THE FOLLOWING STATEMENTS AS THEY CONTAIN ANSWERS TO THE
QUESTIONS ASKED IN THE REVIEW. Restricted stock is taxed similarly to
non-qualified stock options except that employees are taxed on the full fair
value of the stock at the vesting date, unless the employee makes an
election under section 83(b) to accelerate the date to the grant date. As
described in the article from review of an SEC Form 8-K filing, Facebook
intends to maintain a similar level of outstanding shares after the vesting
of the restricted stock as before the vesting date by repurchasing treasury
shares.
QUESTIONS:
1. (Introductory) What is restricted stock? What will happen in
October in relation to Facebook's employees' restricted stock units?
2. (Advanced) How are issuances of restricted stock units treated
for tax purposes? In your answer, explain why the two directors mentioned in
the article might sell shares because they face tax liabilities if they
otherwise do not plan to sell these shares of stock.
3. (Advanced) Define the terms authorized, issued, and outstanding
shares of stock. How will the issuance of the restricted stock affect each
of these categories of stock?
4. (Introductory) According to the article, what will Facebook do
to offset the impact of releases of restricted stock previously granted to
executives and employees? Again, explain the impact of this action on the
three types of stock identified above.
5. (Advanced) Why is Facebook's action important to shareholders
who bought the stock upon its initial public offering?
Reviewed By: Judy Beckman, University of Rhode Island
"Facebook Plays Defense," by Geoffrey A. Fowler,
The Wall Street Journal, September 5, 2012 ---
http://professional.wsj.com/article/SB10000872396390443759504577631854230025164.html?mod=djem_jiewr_AC_domainid&mg=reno-wsj
Facebook Inc. FB +2.00% took
steps Tuesday to reassure investors and employees worried about its
plummeting stock price, as the social network's shares hit new lows.
In a regulatory filing
Tuesday, Facebook said Chief Executive Mark Zuckerberg won't sell any stock
in the company for a year, and that two of its directors—Marc Andreessen and
Donald Graham—have no plans to sell their personal holdings beyond the
amount needed to cover their tax liabilities.
Facebook also detailed how
it will essentially buy back 101 million shares when it issues previously
restricted stock units to its staff in October. At recent prices, it would
spend roughly $1.9 billion to keep those shares off the market.
Together, the steps function
like a kind of defensive wall around the Facebook share price. They
effectively reduce the amount of Facebook stock in the public market and
spread out the amount of shares that could flood the market in November
after a lockup period on the stock expires.
Facebook spokesman Larry Yu
said the details in the filing were approved by the company's compensation
committee on Aug. 30. "We wanted to get the filing out as soon as we could
after that meeting as a measure of clarity and transparency," he said.
Mr. Yu declined to comment
on the impact that the moves might have on investors.
Facebook's stock has been in
a tailspin since the Menlo Park, Calif., company's initial public offering
in May. After making their market debut at $38 a share amid much hype that
month, they have plunged more than 50% over concerns about how much the
company is really worth.
On Tuesday, Facebook's
shares dropped to a fresh low of $17.73 in 4 p.m. trading after analysts at
the two biggest underwriters for the company's IPO—Morgan Stanley MS +3.51%
and J.P. Morgan Chase JPM +4.08% & Co.—cut their price targets on the stock.
In after-hours trading
following the regulatory filing, Facebook's shares ticked up 1.7% to $18.03.
Facebook's stock has
continued to suffer as share lockups began expiring last month, releasing
271 million shares—or nearly 13% of those outstanding—on the market. More
lockup expirations in October, November and December will allow insiders and
others to sell more than 1.4 billion shares.
Enlarge Image image image
Julie Jacobson/Associated Press
Facebook said Mr. Zuckerberg
won't sell any shares in the social network for a year. Mr. Zuckerberg,
above, in May.
Last month, director and
early investor Peter Thiel sold the majority of his Facebook holdings—some
20.1 million shares—after restrictions on insider selling lifted.
Facebook has publicly said
little about its stock slide but internally is reassuring employees about
their shares. In a companywide meeting last month, Mr. Zuckerberg told them
it may be "painful" to watch the stock plunge, but that investments Facebook
has made will soon bear fruit.
In its filing, Facebook said
Mr. Zuckerberg "has no intention to conduct any sale transactions in our
securities for at least 12 months." Mr. Zuckerberg sold Facebook stock in
the IPO to cover his tax liabilities, and now holds about 444 million shares
of Class B common stock and an option exercisable for an additional 60
million Class B shares.
A Facebook spokesman
declined to make Mr. Zuckerberg available to comment.
A spokeswoman declined to
make Mr. Andreessen available for comment. Mr. Graham declined to comment.
Facebook also said it plans
to withhold 45% of employees' restricted stock units to cover their tax
liabilities, paying the obligations, worth about $1.9 billion, in cash and
from existing credit facilities. In doing so, it would remove 101 million
shares from the market for accounting purposes, about 4% of the shares
outstanding. Facebook also said the lockup date for some employees' stock
would be Oct. 29, after previously suggesting it might fall on Nov. 14.
Continued in article
Bob Jensen's threads on employee stock option
accounting ---
http://faculty.trinity.edu/rjensen/theory/sfas123/jensen01.htm
Bob Jensen's threads on accounting theory ---
http://faculty.trinity.edu/rjensen/Theory01.htm
In 2004 the FASB issued a
revision called FAS 123R to the employee stock option standard that caused a
huge stir because for the first time employee stock options had to be expensed
when they vested rather than when employees exercised the options.
FAS 123R ---
Click Here
Any future revisions will be in the FASB Codification database.
This is one of the few standards
where industry mounted a serious lobbying effort to have Congress and/or the SEC
override the requirement to expense employee stock options when vested. In
particular, huge technology firms like Cisco and Intel mounted an expensive
lobbying effort. I can only speculate, but I think the lobbying effort might've
succeeded had it not been for the timing of media coverage of outrageous and
egregious executive compensation scandals ---
http://faculty.trinity.edu/rjensen/FraudConclusion.htm#OutrageousCompensation
It became politically correct in Congress to resist any effort to make executive
compensation in corporations less transparent.
Even though the original industry
effort failed to override the FAS 123R requirement to book employee stock
options as expenses, pressures continued long after FAS 123R went into effect in
2004. Janet Tavakoli summarizes an effort launched by bit names in academia,
government, and industry.
Warren
Buffett's wisdom is often at odds with "famous names" and the nonsense
taught by economists in graduate business schools. In August 2006, veture
capitalist Kip Hagopian published a commentary in California Management
Review, the scholarly journal of the University of
California-Berkley Haas School of Business.He stated that expensing employee
stock options was improper accou8nting and argued stock prices reflect
employee stock options liabilities, implying that shareholders know how to
efficiently value those stock options. He got 29 "famous names" to undersign
his article. These included Milton Friedman (who would pass away in
November) and Harry Markowitz, both former University of Chicago professors
and winners of the Nobel Prize in Economics; George P. Schultz and Paul
O'Neill, both former U.S. Treasury Secretaries; and Arther Laffer, Holman W.
Jenkins Jr., a member of the Wall Street Journal editorial board, and
supported this notion in a separate commentary.
Even iff
it were true that shareholders are well equipped to independently value
stock options --- and it is not --- the proper place to account for costs is
in the accounting statement. Shareholders shouldn't have to make a separate
correction for material information that has been omitted from financial
statements. The "famous names" should have lobbied for more transparency, or
better yet, the abolishment of stock options as a compensation scheme.
Instead, these Princes of Darkness advocated opacity.
Janet Tavakoli,
Dear Mr. Buffet (Wiley, 2009, Page 36).
Jensen Comment
With all due respects to Janet FAS 123, before FAS 123R did require
companies to disclose the values of employee stock options and gave an
option to expense that value on the date of vesting (only one out of the
Fortune 500 companies expensed this value). This made it easier for
financial statement users to adjust earnings for options expense, but it did
make it more difficult for users and analysts. FAS 123R requires that such
values be expensed.
September 11, 2009 reply from Patricia Walters
[patricia@DISCLOSUREANALYTICS.COM]
Bob:
The IASB issued IFRS 2 Share-based Payments almost a year earlier than 123R.
So there might have been additional pressure for the FASB not to be seen as
more lenient on this issue. If I remember correctly, the Canadian standard
was also issued before the US standard.
Companies used the traditional arguments against expensing stock comp
including: competitive disadvantage, too costly and it's already in the
notes.
In one of the more interesting presentations by a preparer representative
that I attended, the presenter argued the following:
(1) Information was in footnotes.
(2) Analysts and other users were relying on this information and already
making adjustments to the reported numbers.
(3) BUT: Information was not reliable!
(4) Therefore, companies should be required to move information from notes
to financial statements.
Even after questioning him to be sure he really meant the information
provided in the notes wasn't reliable, he still maintained that was the
case, despite admitting people used that information.
My favorite preparer argument, though, has always been what I refer to as
the "end of civilization as we know it" argument. For stock options, this
took the form of the end of entrepreneurship in the US if companies had to
expense this compensation (because, of course, they wouldn't want to use
options for compensation if they had to be expensed).
I believe the prediction of the death of stock options was premature.
Regards
Pat
There is considerable theoretical and practical
objection to valuing employee stock options on the date of vesting. Most
accounting literature suggests using the Black-Scholes model for valuing
options. William Brighernti has a practical solution for valuation of stock
options using the Black-Scholes model ---
http://www.cpa-connecticut.com/sfas123r.html
http://www.cpa-connecticut.com/IPIC.html
The problem in theory and practice is that the Black-Scholes model that is
popular in financial markets for purchased options is not especially well suited
for employee stock options where employees tend to have greater fears that
option values will tank before expiration dates. It's a little like having to
put your salary in suspension and then losing it before you get it back. As a
result the lattice model described below may be more approprate.
"How
to “Excel” at Options Valuation," by Charles P. Baril, Luis
Betancourt, and John W. Briggs, Journal of Accountancy, December 2005
---
http://www.aicpa.org/pubs/jofa/dec2005/baril.htm
This is one of the best articles for accounting
educators on issues of option valuation!
Research shows that employees value options at a small fraction of their
Black-Scholes value, because of the possibility that they will expire underwater. ---
http://www.cfo.com/article.cfm/3014835
"Toting
Up Stock Options," by Frederick Rose, Stanford Business, November
2004, pp. 21 ---
http://www.gsb.stanford.edu/news/bmag/sbsm0411/feature_stockoptions.shtml
How to value stock
options in divorce proceedings ---
http://www.optionanimation.com/MarlowHowToValueStockOptionsInDivorce.htm
How the courts value
stock options ---
http://www.divorcesource.com/research/edj/employee/96oct109.shtml
Search for the term options
at
http://www.financeprofessor.com/summaries/shortsummaries/FinanceProfessor_Corporate_Summaries.html
"Guidance
on fair value measurements under FAS 123(R)," IAS Plus, May 8, 2006
---
http://www.iasplus.com/index.htm
Deloitte & Touche (USA) has
updated its book of guidance on FASB Statement No. 123(R) Share-Based Payment:
A
Roadmap to Applying the Fair Value Guidance to Share-Based Payment Awards
(PDF 2220k). This second edition reflects all
authoritative guidance on FAS 123(R) issued as of 28 April 2006. It includes
over 60 new questions and answers, particularly in the areas of earnings per
share, income tax accounting, and liability classification. Our interpretations
incorporate the views in SEC Staff Accounting Bulletin Topic 14
"Share-Based Payment" (SAB 107), as well as subsequent clarifications
of EITF Topic No. D-98 "Classification and Measurement of Redeemable
Securities" (dealing with mezzanine equity treatment). The publication
contains other resource materials, including a GAAP accounting and disclosure
checklist. Note that while FAS 123 is similar to
IFRS 2
Share-based Payment, there are some measurement
differences that are
Described
Here.
Bob Jensen's threads on employee stock
options are at
http://faculty.trinity.edu/rjensen/theory/sfas123/jensen01.htm
Bob Jensen's threads on fair value
accounting are at
http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue
Bob
Jensen's threads on valuation are at
http://faculty.trinity.edu/rjensen/roi.htm
April
5, 2005 message from Dennis Beresford
[dberesfo@TERRY.UGA.EDU]
The SEC recently released an interesting memo from its Office of
Economic Analysis to the Chief Accountant on economic valuation of stock
options. It is available at:
http://www.sec.gov/interps/account/secoeamemo032905.pdf
The memo concludes that valuing employee stock options under new
FASB Statement 123R is "not unusual" and is quite similar to
valuations done in other areas of accounting and finance. This seems to deflate
the arguments of some within the business community who continue to assert that
employee stock options are too hard to value. The memo footnotes several
academic studies from both accounting and finance scholars in supporting its
findings.
Denny Beresford
Bob Jensen's threads on employee stock options are at
http://faculty.trinity.edu/rjensen/theory/sfas123/jensen01.htm
Bob Jensen's threads on valuation are at
http://faculty.trinity.edu/rjensen/roi.htm
Concept
of Real Options ---
http://faculty.trinity.edu/rjensen/realopt.htm
Fodder for Accounting and
Finance Agency Theorists to Digest
Principle-Agent Theory --- http://en.wikipedia.org/wiki/Agency_Theory
In political science and economics, the principal-agent problem
or agency dilemma treats the difficulties that arise under conditions of
incomplete and asymmetric information when a principal hires an agent. Various
mechanisms may be used to try to align the interests of the agent with those of
the principal, such as piece rates/commissions, profit sharing, efficiency
wages, performance measurement (including financial statements), the agent
posting a bond, or fear of firing. The principal-agent problem is found in most
employer/employee relationships, for example, when stockholders hire top
executives of corporations. Numerous studies in political science have noted
the problems inherent in the delegation of legislative authority to
bureaucratic agencies. Especially since bureaucrats often have expertise that
legislators and executives lack, laws and executive directives are open to
bureaucratic interpretation, creating opportunities and incentives for the
bureaucrat-as-agent to deviate from the preferences of the constitutional
branches of government. Variance in the intensity of legislative oversight also
serves to increase principal-agent problems in implementing legislative preferences.
Four principles of contract design
·
3.1 Informativeness
Principle
·
3.2
Incentive-Intensity Principle
·
3.3 Monitoring
Intensity Principle
·
3.4 Equal
Compensation Principle
·
3.5 A linear model
·
3.6 Nonlinearities
"Compensation Under
Competition," by Richard Posner, The Becker-Posner Blog, April 7,
2008 --- http://www.becker-posner-blog.com/
There is a long-standing concern that corporate executives are
more risk averse than a corporation's shareholders, because the latter can
eliminate firm-specific risk by holding a diversified portfolio, while the
former cannot, because they have firm-specific human capital that they will
lose if the firm tanks. The solution to this problem was thought to consist in
making stock options a large part of the executive's compensation, so that his
incentives would be closely aligned with those of the shareholders. True,
because he would bear more risk, he would have to be paid more in total
compensation than if he did not receive a large part of his compensation in the
form of stock options. But the cost to the corporation of the additional pay
would presumably be offset by the gain to the shareholders from the executives'
enhanced incentives to maximize shareholder wealth.
But we are beginning to realize that the grant of stock options
may make corporate executives take more risks than the shareholders desire [Jensen insert: To say nothing of
cheating on earnings reports]. Suppose that instead
of being compensated for bearing risk just by being paid a higher salary or
given even more stock options, the executive is guaranteed generous retirement
and severance benefits that are unaffected by the price of the corporation’s
stock. Now he has a hedge against risk, and can take more risks in operating
the corporation because his personal downside risk has been truncated. Perhaps
this was a factor in the recent stock market bubbles--the one that burst in
2000 with the crash of the high-tech stocks and the one that burst this year as
a result of the collapse of the subprime mortgage market and the resulting
credit crunch. A bubble is both a repellent and a lure. It is a lure because
during the bubble values are rising steeply, so an investor who exits before
the bubble has peaked may be leaving a good deal of money on the table. He will
be especially loath to do that if he is hedged against the consequences of the
bubble's eventual bursting.
Boards of directors could devise compensation schemes that
limited the attractiveness of risky undertakings, but they have little
incentive to do so. The boards tend to be dominated by CEOs and other high
corporate executives of other firms, who have an interest in keeping executive
compensation high and who are abetted by compensation consultants who naturally
recommend generous compensation packages to directors who are recipients of
generous compensation and therefore believe that the CEOs of the companies on
whose boards they sit should be paid top dollar.
It is not clear what the free-market antidote to this tendency to
ratchet up executive compensation is. The compensation of the CEO and other
high officials of a large corporation is usually only a small part of the
corporation's costs, so shaving such compensation is unlikely to be a powerful
competitive weapon. But more important, what rival corporation would have the
governance structure that would enable such shaving to be accomplished by
overcoming the obstacles that I have discussed? The private-equity firm is a
partial answer, because it has only a few shareholders and so need not delegate
compensation to a board of directors that has other interests besides the
welfare of the shareholders at heart. The reason it is only a partial answer is
that there are too few owners of capital who want or have the ability or
experience to participate as actively in management as the private-equity
entrepreneurs and there are too many efficiently large corporations for all of
them to have the good fortune of being owned by a handful of entrepreneurial
investors. There is a vast pool of passive equity capital that can be put to
work only in companies that are organized in the traditional board-governed
corporate form.
Here is another though related example of a stubborn
efficiency-in-compensation problem, also in a highly competitive sector of the
economy: law-firm billing practices. Major law firms, with few exceptions, base
their bills to their clients on the number of hours that the firm's lawyers
work on the client's case or other project. In other words, they bill on the
basis of inputs rather than outputs. This is rational when output is difficult
to evaluate, as is often the case with a law firm's output because of the
uncertainty of litigation (in nonlitigation practice, because of legal and
factual uncertainties). The fact that a firm loses a case doesn't mean that it
did a bad job; both the winner's firm and the loser's firm may have done
equally good jobs--the lawyers don't control the outcome. A law firm can give
the client a pretty good idea of the quality of the lawyers it assigns to the
client's case, because there are observable proxies for a lawyer's unobservable
quality, proxies such as his educational and employment history. What the
client cannot readily judge is whether the law firm put in excessive hours on
the case, and the result, according to persistent and cumulatively persuasive
anecdotage, is a tendency for law firms to invest hours in a case beyond the
point at which the marginal value of the additional hour is just equal to the
marginal cost to the client. Young lawyers often feel that they are being
assigned work to do that has little value to the client but that will increase
the firm's income because the firm bills its lawyers' time at a considerably
higher rate than the cost of that time to the firm. The very high turnover at
many law firms is attributed in part to dissatisfaction of young lawyers with
the amount of busywork that they are assigned, work that bores them and does
not contribute to the development of their professional skills, yet may be very
time-consuming.
The problem is compounded by the distorted incentives of
corporate general counsels. A general counsel wants to show his boss, the corporate
CEO, that he monitors expenses carefully, and, since he knows that he is likely
to lose at least some of his cases, he also wants to be able to avoid if
possible being blamed by his boss for the loss. Hourly billing serves both of
these ends. The law firm and the general counsel play a little game, in which
the law firm prices its hours on the assumption that it will not be able to
collect its billing rates on all of them, and the general counsel reduces the
number of hours that he is willing to pay for. He can then show his CEO that he
squeezed the water out of the law firm's bills. At the same time, by paying a
prominent law firm by the hour, he can assure his CEO, in the event a case is
lost, that he had told the firm to do as much work as was needed to maximize
the likelihood of a favorable outcome, rather than paying a fixed rate agreed
to at the outset that might have induced the law firm to skimp on the amount of
work it put into the case.
One can imagine a law firm's adopting a different method of
pricing, in which it would charge at the outset a fixed fee, subject to
adjustments up or down at the end of the case based on outcome, amount of work,
or some other performance measure or combination of such measures. The
conventional law firm billing system is a form of cost-plus pricing, which is
considered wasteful. But litigation is risky, and cost-plus pricing diminishes
risk by eliminating a contractor's incentive to cut corners. If the disutility
of risk to a general counsel is great, he will prefer to "overpay"
law firms rather than trying to explain to the CEO that the novel compensation
deal that he worked out with the law firm that lost the case was not a factor
in the loss; that he had not been penny wise and pound foolish.
Although the compensation practices that I have described seem
inefficient, it does not follow that corrective measures would be appropriate.
They would be costly and the net benefits might well be negative. It is
efficient to live with a good deal of inefficiency. Stated otherwise, the fact
that competitive markets contain large pockets of inefficiency is not in itself
inefficient. For example, while cartel pricing is inefficient, if the cost of
preventing cartelization exceeded the benefits one wouldn't want to prevent it.
Yet cartel pricing would still be inefficient in the sense of misallocating
resources, relative to the allocation under competition. We must live with a
good deal of inefficiency, but it is still inefficiency.
Continued
in article
"Compensation Under
Competition," by Nobel Laureate Gary Becker, The Becker-Posner Blog,
April 7, 2008 --- http://www.becker-posner-blog.com/
Executive compensation has been criticized both for being too
generous, and for encouraging excessive risk-taking relative to the desires of
stockholders. Yet while there are links between the level of pay and the amount
of risk chosen, these are mainly distinct issues. Executives may be paid
little, but the pay can be structured to have a much better payoff when profits
are high than when profits are low. In this case, the average level of pay over
both good and bad times would not be particularly generous, but its structure
would tend to encourage risk-taking behavior. On the other hand, a CEO's pay
might be excessively high on average, but not appreciable better when his
company does well than when it does badly. He would be overpaid, but he would
not have a financial incentive to take much risks.
Does the pay structure in American corporations, with the growing
emphasis during the past several decades on stock options, bonuses, and
severance and retirement pay, encourage excessive risk-taking, where
"excessive" is defined relative to the desires of stockholders? It
may look that way now with the sizable number of major financial companies that
have taken huge write downs in their mortgage-backed and other assets, while
top executives of some of these companies have only had modest declines in
their pay (although others, such as the head of Bears Sterns, have taken huge
hits). However, these financial difficulties do not necessarily imply that
heads of most financial companies knowingly engaged in more speculative
activities than desired by stockholders because of the incentives CEOs had. A
more compelling explanation is that heads of companies have undervalued the
risks involved in holding derivatives and other exotic securities, particularly
securities that were rather new and not well understood. Let me stress, however,
that I am not trying to excuse the many CEOs in the financial sector and in
other sectors who got off much too easily for terrible investment decisions.
Bubbles are prolonged periods of excessive optimism where the
true longer-term risk to holding particular assets is generally underestimated.
The housing boom of the past few years now appears to have been a serious
bubble where pervasive optimism about housing price movements raised the rate
of increase in housing prices far beyond sustainable levels. Sophisticated
lenders as well as low-income borrowers underestimated the risks involved in
the residential housing market, as they appeared to have assumed that housing
prices would continue to rise for a number of years in excess of ten percent
per year.
Evidence suggesting that the risk taken by companies during the
recent boom was not mainly due to a principal-agent problem between executives
and stockholders is that the major private equity firms also experienced
serious loses on their investments, especially on their housing investments.
Private equity companies have much less of a principal-agent problem than do
Citicorp, Bears Sterns and other publicly traded companies because private
equity companies have a concentrated ownership. Also borrowers in the
residential housing market have basically no principal-agent problems since
they buy for themselves; yet many of them too took on excessive risk because of
undo optimism about the housing market.
The private equity example provides a more general way to test
whether CEOs take greater risks than their stockholders desire. One can analyze
the relation between the degree of concentration of stock ownership in
different companies and various measures of risk, such as their year-to-year
variance earnings, adjusted for industry and other relevant determinants of
this variance. The excessive risk argument would suggest that the more
concentrated the ownership, the smaller would be the actual exposure to
earnings and asset risk.
Another test of the excessive risk argument is whether the trend
toward greater compensation in the form of stock options and other performance
contingent compensation increased the risk taking of companies. Some have
attributed much of the dot-com bubble to increased performance based compensation.
However, most dot-com companies that went under were quite small and rather
closely held by venture capitalists and similar investors. Hence these
companies did not have a sharp conflict between stockholders and managers.
Moreover, during the dot-com bubble, assets of minor Internet companies were
raised in market value to more than 100 times earnings, even when they had no
sales, let alone earnings. Such huge earnings-profits ratios suggest excessive
risk taking by stockholders more than by managers.
Economic theory does imply that the increasing trend toward
performance-based compensation would increase the degree of risk-taking by top
executives. It is much less clear whether this effect is large- doubts are
expressed by Canice Prendergast in his study "The Tenuous Trade-Off
Between Risk And Incentives", Journal of Political Economy, 2002, (Oct),
1071-1102. It is also unclear if CEOs have been induced to take more risks than
the level of risk desired by stockholders. Furthermore, and most important,
there is no persuasive evidence that the structure of CEO compensation played
an important roll in either the dot-com or housing bubbles.
Bob Jensen's threads on
outrageous executive compensation and schemes that reward failure are at http://faculty.trinity.edu/rjensen/FraudConclusion.htm#OutrageousCompensation
SEC reaches settlement with Monster's McKelvey for stock options
backdating
McKelvey caused Monster to misrepresent in
its periodic filings and proxy statements filed with the Commission that all
stock options were granted at the fair market value of the stock on the date of
the award, when that was not the case. McKelvey also caused Monster to file
materially misstated financial statements with the Commission in its Forms 10-K
and 10-Q that did not recognize compensation expense for the company's stock
option grants, as required by generally accepted accounting principles. As a
result, Monster overstated its aggregate pretax operating income by
approximately $339.5 million, for fiscal years 1997 through 2005. Although
McKelvey did not receive backdated options, he benefited from the scheme by
granting backdated options to four individuals that he personally employed,
including three pilots and a mechanic. Under the settlement, McKelvey will be
permanently enjoined from violating Section 17(a) of the Securities Act of
1933, and Sections 10(b), 13(b)(5) and 14(a) of the Securities Exchange Act of
1934, and Rules 10b-5, 13a-14, 13b2-1, 13b2-2 and 14a-9, and from aiding and
abetting violations of Sections 13(a) and 13(b)(2)(A) of the Exchange Act and
Rules 12b-20, 13a-1, 13a-11, and 13a-13. Additionally, McKelvey will pay
$275,989.72 in disgorgement and prejudgment interest, and will be barred from
serving as an officer or director of a public company. The settlement does not
include a civil penalty due to overriding personal circumstances related to
McKelvey. McKelvey agreed to the settlement without admitting or denying the
allegations in the complaint.
AccountingWeb, January 29, 2008 --- http://www.accountingweb.com/cgi-bin/item.cgi?id=104543
More than 180 stock options
backdating scandals have been investigated.
Back dated options awards are equivalent to betting on yesterday's football
games.
"$117.5 Million Settlement
Reported in Options Case," The New York Times, October 15, 2007 ---
http://www.nytimes.com/reuters/technology/reuters-options.html?_r=1&oref=slogin
The software maker Mercury Interactive has agreed to pay $117.5
million to settle an investor lawsuit over the company’s stock options award
practices, a lawyer for the plaintiffs said today.
The settlement with Mercury, now owned by Hewlett-Packard, is
believed to be the biggest in any stock options backdating case to date, said
Joel Bernstein, an attorney at the firm of Labaton Sucharow LLP, who represents
investors in the lawsuit.
Many investor lawsuits have resulted from the options scandal in
corporate America,
in which more than 180 companies have been investigated by authorities or have
conducted internal inquiries into whether they manipulated grants to make them
more valuable for top executives.
In one legal settlement last month, Rambus agreed to pay $18
million to resolve an investor lawsuit related to its accounting for option grants.
The Mercury settlement, which was reached in principle among the
parties but is still subject to court approval, would resolve a lawsuit filed
in August 2005.
H.P. said in a statement that it had agreed to a settlement but
did not provide details.
Continued
in article.
A
Short History of Employee Stock Options
"Bosses' Pay: How Stock Options Became Part of the Problem Once Seen
as a Reform, They Grew Into Font of Riches And System to Be Gamed Reload,” by
Mark Maremont and Charles Forelle, The
Wall Street Journal, December 27, 2006; Page A1 --- http://online.wsj.com/public/article/SB116718927302760228-N9OV_AeDh_nT31VqRKS1wZeGN3w_20070223.html?mod=blogs
Eugene Isenberg is the little-known
chief executive of a modest-sized oil-services company in Houston. But he stands out in one way: He is among
the highest-paid corporate executives in history. In the past 19 years, he has
pocketed more than $450 million.
The key to this
wealth: stock options, in abundance. His employer, Nabors Industries Ltd., has
lavished more than 25 million options on him over the years.
They became
lucrative partly because of Nabors's generally rising stock price, but also
because of some controversial moves that gave the options more punch. When
Nabors's stock fell below the price at which the options could be exercised,
temporarily making them worthless, Nabors let him trade in some of his options
for new ones with lower exercise prices. And when Mr. Isenberg cashed some
options in, Nabors "reloaded" him, replacing those he'd exercised
with the same number of new ones.
Stock options
were hailed two decades ago as a remedy for runaway executive pay. Academics,
politicians and investors, tired of seeing CEOs pocket big money for a so-so
job, pushed to have stock options become a primary method of compensating
executives. Options -- granting the right to buy stock tomorrow at today's
price -- would pay off only if the company's stock went up. To advocates they
were the ideal carrot, an incentive for good work that aligned executives'
interests with those of shareholders.
That happened --
sometimes. But at many companies, options morphed into the biggest executive
bonanza yet, pouring out cash like a stuck ATM, and sorely disappointing those
who thought options would moderate executive pay.
Instead of
replacing big bonuses, options became an additional form of pay slathered on
top of already-generous packages. Employers doled out options in ever-growing
numbers, in part because, until recently, accounting rules meant companies
didn't have to treat this largess to executives as an expense. And like Nabors,
some used repricing, reloading and other tactics that made it even easier for
executives to score huge hauls.
• The Biggest
Paydays: See a chart of executives who have profited most from stock options,
from 1992 to 2005.
• Plus, complete
coverageThis year, options practices exploded in one of the biggest
corporate-fraud scandals in decades. Some companies and executives stole from
shareholders, by pretending that options had been issued earlier than they
really were, at more favorable prices. At least 130 U.S. corporations are under
investigation for possible backdating of option grants. Some have admitted to
it. More than 60 executives and directors of public companies have lost their
jobs so far, 17 of them chief executive officers. After probable backdating was
exposed at giant insurer UnitedHealth Group Inc., the CEO had to resign and
give up about $200 million of stock-options value. The company said it will
have to restate past earnings by as much as $1.7 billion.
Nabors's Mr.
Isenberg offers an example of the huge wealth CEOs have gained through stock
options. Now, some of his option grants appear to raise questions about how
they were dated. A number came on days when the stock hit its lowest close for
the month or the quarter. At other companies, a series of low-price grants has
been a pattern that has suggested possible dating problems. At the least, the
favorable grant dates added to Mr. Isenberg's mammoth options gains.
A spokesman for
Nabors said its legal department did an internal review and found "no
irregularities in its grant practices." Nabors showed internal documents
to The Wall Street Journal that the company said provide evidence the grants
were properly dated. Some of the documents bolster that assertion. The spokesman,
citing Mr. Isenberg's record in lifting Nabors from a company in bankruptcy
court to one with a market value of more than $9 billion today, also said that
"Nabors strongly believes that Mr. Isenberg is appropriately
compensated."
The backdating scandal
at scores of companies shows one way stock options, once seen as an
executive-pay reform, have often been distorted by corporate officials and
their consultants. Nell Minow, a longtime corporate-governance advocate, calls
backdating "just another in an endless and unstoppable series of
mechanisms to subvert the purpose of stock options." A vocal proponent of
options in the early 1990s, Ms. Minow now regrets that stance. "Options
became completely disconnected from shareholder interests," she says.
"I grossly underestimated the capacity of corporate boards and corporate
managers to circumvent the principles we established."
From 1992 to
2001, the average value of option grants to CEOs of S&P 500 companies
soared nearly tenfold, according to data compiled by Kevin J. Murphy of the University of Southern California. The result was that
options, which in 1992 made up less than a quarter of the average CEO's pay, by
2001 provided more than half of pay packages -- packages that were much larger.
Companies have started doling out fewer options in the past few years, but
grants remain far more generous than a decade ago.
In 1985, Miami financier Victor
Posner pulled down $12.7 million, putting him atop lists of best-paid CEOs that
year. Last year, 393 executives earned more than that, thanks largely to gains
from exercising options, according to Standard & Poor's ExecuComp, which
tracks executive pay at about 1,800 public companies. The top 2005 earner was
Barry Diller of IAC/InterActiveCorp., with $295 million, nearly all from
options.
Defenders of
options, who remain numerous, say options shouldn't be judged by a few giant
packages. Many companies have given out options judiciously, say defenders,
some of whom attribute rising executive pay to tight competition for top
managers. Others say stock options have helped to foster innovation, by giving
young but cash-poor companies a currency with which to attract talent.
Some supporters
of options even give them partial credit for the long bull market that began in
1982, figuring that options help focus top executives on the key issue for
shareholders: the stock price. Frederic W. Cook, a New York compensation consultant, calls the
stock option "the most perfect equity derivative that's ever been
invented: It's simple, elegant, easily understood, and it gives you a little
piece of the action."
Popular Demand
Stock options
usually give recipients a 10-year window to buy the company's stock at the
price when the options are granted. If someone gets options when the stock
trades at $50 and it goes to $75, the holder can cash out at the $50
"exercise price" -- also called a "strike price" -- and
nail a $25 profit on each option. Options usually don't "vest," or
become exercisable, for at least a year after they're granted.
Stock options
appeared at least as early as the 1920s, says Carola Frydman, an assistant
professor of finance at Massachusetts Institute of Technology who has studied
the history of executive pay. The modern era began in 1950, when Congress,
reversing a court ruling, gave options substantial tax advantages over ordinary
income. By the middle of that decade, they accounted for nearly a third of CEO
compensation at large industrial companies.
"In the
1950s, they called it the period of stock-option opulence," says Ms.
Frydman. "They didn't know what was coming."
After losing
popularity during the weak stock market of the 1970s, options surged back into
favor in the late 1980s. One reason was public fury over mammoth executive
paydays for bosses with just average performance. In an influential 1990
Harvard Business Review article, Mr. Murphy and Michael C. Jensen said the
problem was executives were paid like "bureaucrats" instead of
entrepreneurs. They called for giving "big rewards for superior
performance and big penalties for poor performance."
"We were
suggesting people shift from salaries to stock options to put more pay at
risk," Mr. Murphy says today. But "that's not what companies ended up
doing. They layered on massive amounts of options on top of the rest."
The bandwagon
got two big boosts from an unlikely source: Congress.
First, it passed
a law, pushed by President Clinton, seeking to rein in executive pay by
limiting the tax break for it. The 1993 law said companies couldn't deduct
yearly compensation of more than $1 million for any one of their top five
officers.
But it exempted
certain kinds of pay linked to performance, which included stock options.
Companies rushed to restructure pay plans to grant more options. In 1994, the
first year the law was in effect, the value of option grants to CEOs at S&P
500 firms leapt by 45% on average, according to Mr. Murphy, and nearly doubled
again over the next two years.
The 1993 law
"deserves pride of place in the Museum
of Unintended Consequences,"
said Christopher Cox, chairman of the Securities and Exchange Commission, this
fall.
Then in 1994,
Congress helped beat back a proposed rule requiring companies to treat a
stock-option grant as an expense and deduct it from profits. The plan, backed
by the SEC and accounting rule makers, sparked intense corporate opposition.
Congress stepped in to fight it, and after a long battle, the accounting rule
makers caved. They issued a watered-down rule saying all that companies had to
do was disclose in a footnote what options would have done to their profits,
had the proposal passed.
Meanwhile,
Congress left alone an older law that gave companies a tax deduction whenever
stock options were exercised. Under that rule, which applied to the most common
type of option given to executives, the employer can deduct a dollar from its
income for tax purposes for every dollar of option gains pocketed by employees.
With rules like
these, "what wasn't there to like about a stock option?" says Paula Todd,
a compensation expert at consulting firm Towers Perrin. "You could grant
them in unlimited amounts, with no expense, and claim a tax deduction.
[Companies] would pay their dry cleaners if they could with stock
options."
Better Than
Average
Soon, other
forces spurred companies to give executives ever more stock options. One was
the "Lake Wobegon
effect," named for the mythical Minnesota
town in radio host Garrison Keillor's world where all the children are above
average. Many boards believed their chiefs should be paid at least as much as
the average in their industry, and often more. That attitude had the effect of
pushing this average up, year after year.
Another force
largely escaped notice because it seemed benign. This was a tendency by
companies to grant top executives the same number of options each year, or
more, even if the stock price had risen. During a bull market, doing so kept
raising the value of pay packages.
Consider an
executive who is granted a million options when the stock is at $20. If it's
50% higher a year later, the executive can reap a $10 profit per option, or $10
million.
But now the
stock is at $30. If the executive again gets a million options, and the stock
again rises 50%, the executive's profit is $15 million, not $10 million. In
order to give this executive an option grant of merely the same value in year
two as in year one, the year-two grant would have to contain far fewer options.
Directors had a
hard time telling a CEO they were cutting the number of options because the
stock had risen. Ms. Todd says the CEO's reaction would be, "I worked to
get the stock price up, and my next grant is smaller and has a higher strike
price?'"
Exxon awarded
CEO Lee Raymond a similar number of options yearly from 1993 through 1999 --
800,000 to 900,000, adjusted for later stock splits. Over that period, the
stock rose sharply. The rise meant the value of the 1999 grant was $8.5
million, or six times that of the 1993 grant, by ExecuComp's tally. The
calculation used a standard formula for valuing options known as
"Black-Scholes," which sets a value for a grant at the time it's
given by estimating how much gain it will someday bring the recipient.
An Exxon Mobil
Corp. spokesman said the grants were made by a panel of outside directors and
based partly on the size of grants to top executives elsewhere. After 2001,
Exxon replaced options grants with restricted stock, a different form of
compensation that the board said was "more effective in aligning
executives' interests with those of shareholders." Mr. Raymond retired a
year ago.
At times, the
value of options companies doled out has been equal to a large share of their
profits. Retailer Abercrombie & Fitch Co. gave CEO Michael Jeffries 4.66
million options in 1999, a grant ExecuComp valued at $120 million. The firm's
1999 net income was $150 million.
Abercrombie
didn't actually have to shell out $120 million when it gave the options to Mr.
Jeffries, of course. But it incurred an obligation to issue 4.66 million shares
someday at the 1999 price. And this obligation didn't have to be reflected as
an expense on the company's income statement.
A spokesman for
Abercrombie said the grant had a "delayed vesting" feature
"intended to incentivize Mike Jeffries to remain with the company...and to
continue to generate exceptional financial results." Under him, the stock
has risen more than 750% since it began trading in 1996. Mr. Jeffries is
eligible to exercise the big 1999 grant now, and if he did so would reap about
a $120 million profit.
The options-issuing
frenzy reached a peak in 1999 and 2000. Dot-com companies, some with little
other way to pay employees, handed out options like confetti. Thousands of
people made fortunes on stratospheric rises in the stocks of tech firms, some
of which didn't exist a couple of years later. Meanwhile, some "old
economy" companies, trying not to lose top people to Silicon
Valley, cranked up their own options generators.
In mid-2002,
Alan Greenspan testified to Congress about what was then a tech and telecom
bust, and about a wave of corporate scandals at firms like Enron, WorldCom and
Tyco International. The Federal Reserve's then-chairman spoke of an
"infectious greed" that seemed to grip some in business, for which he
partly blamed "poorly structured" stock options. Giant grants
"perversely created incentives to artificially inflate reported earnings
in order to keep stock prices high and rising," he said. "The
incentives they created overcame the good judgment of too many corporate
managers."
Moving the Goal
Post
When stock
prices failed to rise, some companies changed the rules. If the share price
fell well below stock options' exercise price, they simply lowered that price.
Companies defended the move by saying options far "under water" or
"out of the money" no longer served as incentives to executives to
perform well.
Critics of
repricing say it subverts the fundamental options purpose of aligning managers'
and shareholders' interests. Since shareholders can't get a refund on a stock
they bought that has fallen, the critics say, why should executives be able to
do something similar?
Repricings
"basically ensure that the manager gets paid no matter what. It takes a
lot of risk out of the whole thing," says David Yermack, a New York University professor who studies executive
pay.
About 11% of
companies repriced options at least once between 1992 and 1997, according to
research by Chandra Subramaniam, an associate professor of accounting at the University of Texas
at Arlington.
Borland Software Corp. did it eight times in the decade ended in 1998. System
Software Associates Inc. repriced the same options five times in 1996 and 1997
as its stock kept plunging, Mr. Subramaniam says. In a paper published in 2004,
he and his co-authors calculated that repricings padded executives' pay by an
average of nearly $500,000 each.
In 1998, a
change in accounting rules crimped repricing somewhat. Companies now had to
take a hefty charge against earnings if they put new exercise prices on
existing options. But there was a loophole. If they canceled the old options,
waited six months and issued new ones at a lower price, there was no penalty.
Continued in article
A
Double Standard: Companies are still playing games with executive stock
option expense reporting
Sen. Carl Levin, D.-Mich., introduced legislation
Friday to bar companies from reporting tax deductions for stock option expenses
to the Internal Revenue Service that far exceed what they disclose to
shareholders as expenses. A Senate investigation this summer found that U.S. public
companies between December 2004 and June 2005 legally avoided billions of
dollars in taxes by claiming $43 billion more in tax deductions for options
awards than the compensation for options recorded on their books. His bill
would require the corporate tax deduction for stock option compensation equal
stock option expenses reported to the Securities and Exchange Commission.
"Senator Aims to Cut Option Deductions," SmartPros, October 1,
2007 --- http://accounting.smartpros.com/x59266.xml
Reprice,
Backdate," by Mark Maremont and Charles Forelle, The Wall Street
Journal, December 27, 2006; Page A1 --- http://online.wsj.com/article/SB116718927302760228.html
"Toll
of the stock options scandal heavy in 2006: More prosecutions are
expected to be brought next year," by Marcy Gordon, SeattlePi,
December 27, 2006 --- http://seattlepi.nwsource.com/business/297346_stockoptions27.html
Eighteen chief executives swept
out. More than 100 public companies under federal investigation and more than $5
billion in profits erased by restatements. Indictments so far: five former top
executives at two companies, Brocade Communications Systems Inc. and Comverse
Technology Inc. The toll of the stock options timing affair -- corporate America's
scandal of the year -- has been heavy. Federal officials say more prosecutions
will be brought in 2007 over manipulation of the timing of stock option grants
to enrich top company executives.
The toll of the stock options
timing affair -- corporate America's
scandal of the year -- has been heavy. Federal officials say more prosecutions
will be brought in 2007 over manipulation of the timing of stock option grants
to enrich top company executives.
Nearly every business day, more
companies report federal or internal investigations. New lawsuits by
shareholders are filed. More businesses disclose that because past option
grants may have distorted their financial results, they may have to restate
earnings.
Next year could well bring more
restatements, and companies' stock could be stripped from public trading
because reviews of options grants made them late in filing their quarterly
financial reports.
The Justice Department will
"continue to be engaged for perhaps years to come, as we work these cases
out," U.S. Attorney Kevin Ryan, who heads a task force in Northern California pursuing options timing cases, said
recently at a gathering of attorneys. "The final chapter hasn't been
written yet."
Many of the companies ensnared in
the scandal are in Silicon Valley's high-tech
industry, where stock options for employees created legions of millionaires in
the dot-com era.
The prized perks allow executives
and employees to buy shares of their company's stock in the future at a set
price. If the stock rises before the options are exercised, the employee can
buy the stock at the predetermined, lower price, then sell it at the higher,
current price -- and pocket the difference.
Among the wide swath of companies
caught up in internal or government investigations: Apple Computer Inc., Barnes
& Noble Inc., Caremark Rx Inc., Issaquah-based Costco Wholesale Corp.,
Seattle-based F5 Networks, Gap Inc., The Home Depot Inc., McAfee Inc., Monster
Worldwide Inc., Restoration Hardware Inc., Staples Inc. and UnitedHealth Group
Inc.
Some prominent executives at
blue-chip companies have lost their jobs in the affair, including former
UnitedHealth CEO William McGuire, who engineered the company's ascent from a
regional health insurer into the nation's second-largest.
Continued in article
While
it won't sue Apple for Nancy Heinen's alleged backdating of options, the SEC
does want to talk to CEO Steve Jobs, most likely about the timing of events
Though Apple (AAPL) was given a clean bill of
health by regulators over its involvement in the backdating of stock options,
the investigation of a former executive continues to dog Chief Executive Steve
Jobs. Securities & Exchange Commission lawyers suing former Apple General
Counsel Nancy Heinen over her alleged role in the matter have issued subpoenas
to Jobs. The SEC has said it won't sue Apple over the backdating of grants,
praising the company for its cooperation with the investigation. Attorneys say
the company and current executives are unlikely to face criminal charges from
the Justice Dept. or civil charges from the SEC.
Arik Hesseldahl, "SEC Subpoenas Jobs On Backdating," Business Week,
September 20, 2007 --- http://www.businessweek.com/technology/content/sep2007/tc20070920_913875.htm?link_position=link2
Question
What is a "Black Swan" in portfolio theory?
Hint: Our strategies for managing risk, for instance--including Modern
Portfolio Theory and the Black-Scholes formula for pricing options--are likely
to fail at the worst possible time.
"Shattering
the Bell Curve: The power law rules," by David A. Shaywitz, The
Wall Street Journal, April 24, 2007 --- http://www.opinionjournal.com/la/?id=110009979
Excerpt
The attractiveness of the bell curve resides in its democratic distribution and
its mathematical accessibility. Collect enough data and the pattern reveals
itself, allowing both robust predictions of future data points (such as the
height of the next five people to enter the room) and accurate estimations of
the size and frequency of extreme values (anticipating the occasional giant or
dwarf.
The power-law distribution, by
contrast, would seem to have little to recommend it. Not only does it
disproportionately reward the few, but it also turns out to be notoriously
difficult to derive with precision. The most important events may occur so
rarely that existing data points can never truly assure us that the future
won't look very different from the present. We can be fairly certain that we
will never meet anyone 14-feet tall, but it is entirely possible that, over
time, we will hear of a man twice as rich as Bill Gates or witness a market
crash twice as devastating as that of October 1987.
The problem, insists Mr. Taleb, is
that most of the time we are in the land of the power law and don't know it. Our strategies for managing risk, for instance--including
Modern Portfolio Theory and the Black-Scholes formula for pricing options--are
likely to fail at the worst possible time,
Mr. Taleb argues, because they are generally (and mistakenly) based on
bell-curve assumptions. He gleefully cites the example of Long Term Capital
Management (LTCM), an early hedge fund that blew up after its Nobel laureate
founders "allowed themselves to take a monstrous amount of risk"
because "their models ruled out the possibility of large deviations."
Mr. Taleb is fascinated by the
rare but pivotal events that characterize life in the power-law world. He calls
them Black Swans, after the philosopher Karl Popper's observation that only a
single black swan is required to falsify the theory that "all swans are
white" even when there are thousands of white swans in evidence. Provocatively,
Mr. Taleb defines Black Swans as events (such as the rise of the Internet or
the fall of LTCM) that are not only rare and consequential but also predictable
only in retrospect. We never see them coming, but we have no trouble concocting
post hoc explanations for why they should have been obvious. Surely, Mr. Taleb
taunts, we won't get fooled again. But of course we will. Writing in a style
that owes as much to Stephen Colbert as it does to Michel de Montaigne, Mr.
Taleb divides the world into those who "get it" and everyone else, a
world partitioned into heroes (Popper, Hayek, Yogi Berra), those on notice
(Harold Bloom, necktie wearers, personal-finance advisers) and entities that
are dead to him (the bell curve, newspapers, the Nobel Prize in Economics).
A humanist at heart, Mr. Taleb
ponders not only the effect of Black Swans but also the reason we have so much
trouble acknowledging their existence. And this is where he hits his stride. We
eagerly romp with him through the follies of confirmation bias (our tendency to
reaffirm our beliefs rather than contradict them), narrative fallacy (our
weakness for compelling stories), silent evidence (our failure to account for
what we don't see), ludic fallacy (our willingness to oversimplify and take
games or models too seriously), and epistemic arrogance (our habit of
overestimating our knowledge and underestimating our ignorance).
For anyone who has been compelled
to give a long-term vision or read a marketing forecast for the next decade,
Mr. Taleb's chapter excoriating "The Scandal of Prediction" will ring
painfully true. "What is surprising is not the magnitude of our forecast
errors," observes Mr. Taleb, "but our absence of awareness of
it." We tend to fail--miserably--at predicting the future, but such
failure is little noted nor long remembered. It seems to be of remarkably
little professional consequence.
I suspect that part of the
explanation for this inconsistency may be found in a study of stock analysts
that Mr. Taleb cites. Their predictions, while badly inaccurate, were not
random but rather highly correlated with each other. The lesson, evidently, is
that it's better to be wrong than alone.
If we accept Mr. Taleb's premise about
power-law ascendancy, we are left with a troubling question: How do you
function in a world where accurate prediction is rarely possible, where history
isn't a reliable guide to the future and where the most important events cannot
be anticipated?
Mr. Taleb presents a range of
answers--be prepared for various outcomes, he says, and don't rush for
buses--but it's clear that he remains slightly vexed by the world he describes
so vividly. Then again, beatific serenity may not be the goal here. As Mr. Taleb
warns, certitude is likely to be found only in a fool's (bell-curve) paradise,
where we choose the comfort of the "precisely wrong" over the
challenge of the "broadly correct." Beneath Mr. Taleb's blustery
rhetoric lives a surprisingly humble soul who has chosen to follow a demanding
and somewhat lonely path.
I wonder how many of us will have
the courage to join him. Very few, I predict--unless, of course, something
unexpected happens.
Dr. Shaywitz is a physician-scientist in New Jersey. You can buy "The Black
Swan" from most online bookstores, including the OpinionJournal bookstore.
Yet Again the SEC Amends Executive Compensation
Disclosure (particularly regarding stock options)
The US Securities and Exchange Commission has
amended its executive and director compensation disclosure rules to more
closely conform the reporting of stock and option awards to FASB Statement No.
123 (revised 2004) Share-Based Payment. FAS 123R is similar to IFRS 2
Share-based Payment. The amendment modifies rules that were adopted in July
2006.
SEC Press Release 2006 219 --- http://www.iasplus.com/usa/0612seccomp.pdf
Bob Jensen's threads on outrageous executive compensation are at http://faculty.trinity.edu/rjensen/FraudConclusion.htm#OutrageousCompensation
Home
Depot may see fallout over options backdating
Home Depot Inc.'s admission this week that
some stock option grants were backdated could spur lawsuits, result in fines
and have tax implications, analysts and other experts said. The disclosure of
19 years of backdating tops off a difficult year for the world's No. 1 home
improvement retailer as it continues to be dogged by criticism about executive
pay, a disappointing stock performance and the fallout from the slower U.S.
housing market.
"Home Depot may see fallout over options backdating," Reuters,
December 8, 2006 --- Click Here
Jensen Comment
Those that blame back dating on changes in tax laws and/or newer options
expense requirements under FAS 123(R) should note the 19 years of backdating by
Home Depot.
"How
Backdating Helped Executives Cut Their Taxes: Evidence Suggests
Recipients Of Some Stock-Option Grants Manipulated Exercise Dates," by
Mark Maremont and Charles Forelle, The Wall Street Journal, December 12,
2006; Page A1 --- http://online.wsj.com/article/SB116589240479347248.html?mod=todays_us_page_one
New evidence suggests that
corporate executives may have found another way to manipulate their stock
options, this time to cheat on their income taxes.
In a paper that began circulating
in recent days, a Securities and Exchange Commission economist concludes there
is strong statistical evidence that executives manipulated the exercise dates
of their options as part of a tax dodge. And a review of corporate filings
turns up some companies with startling options-exercise patterns.
The new information could open
another front in the options-backdating scandal. Backdating already has sparked
the broadest corporate-fraud probe in decades, with more than 130 companies
under investigation by federal authorities. So far, attention has focused on
the practice of retroactively selecting favorable dates to grant options. The
new wrinkle involves rigging the dates on which options are exercised,
sometimes years after they're granted.
The tax dodge related to options,
however, almost certainly involves fewer executives than are caught up in the
furor over the backdating of grants. (See related article.)
The reason it can be tempting to
backdate the exercise of options lies in the way the Internal Revenue Service
treats different types of income for tax purposes. Options, a common part of
executive pay packages, give the recipient the right to buy a company's stock
at a fixed price in the future. That price, known as the strike price, is
usually the stock's market price on the day the options were granted.
About three-quarters of the time,
executives immediately sell the shares they buy when they exercise options.
Under IRS rules that typically apply, those executives must pay ordinary income
tax, as well as payroll taxes, on the difference between the stock's value on
the date the option was exercised and the option's strike price. The highest
federal marginal income tax rate is 35%.
But for a variety of reasons,
including corporate rules that require top managers to own a certain amount of
stock, some executives don't sell immediately. Those who hold the shares for at
least a year pay a much lower capital-gains tax -- currently 15% -- on any
profit between the time they exercise and when they eventually dispose of the
shares. That lower rate gives the executive an incentive to exercise the
options at a relative low point for the stock: The move reduces the amount of
money that would be owed at the ordinary income tax rate, and shifts the
difference so it is potentially taxed at the much-lower capital gains rate.
Consider an executive who holds
options on 100,000 shares with a strike price of $10. If he exercises and sells
when the price is $20, he realizes $1 million in income and must pay $350,000
in income taxes.
If he instead can claim an
exercise price of $16, he lowers his income tax to $210,000. If he then sells a
year later and the stock is at the same price of $20, he pays $60,000 in
capital-gains levies, for a total tax bite of $270,000. In other words, he has
the same $1 million gain but saves $80,000 in taxes. The problem arises if the
executive misrepresents when the exercise occurred to claim a lower exercise
price.
Determining which executives or
companies might be involved is difficult, and it's impossible to know what
information they may have included in their tax returns. But some executives
have exhibited unusual timing in their options exercises.
At Maxim Integrated Products Inc.,
a Sunnyvale, Calif., chip maker, chief executive John F.
Gifford exercised options and held shares seven times between 1997 and 2002,
according to regulatory filings and insider-trading data from Thomson
Financial. In all but one case, Mr. Gifford's reported exercise date was the
very day the stock reached its lowest closing price of the month. After the
Sarbanes-Oxley corporate-reform law took effect in 2002, drastically reducing
the opportunity to backdate by tightening reporting requirements, his fortunate
timing vanished.
Maxim is facing investigations by
the SEC and federal prosecutors in California
over its option-granting practices. A special committee of directors is also
probing the matter.
Chuck Rigg, a Maxim vice
president, said the company is "looking into" questions about Mr. Gifford's
options exercises, but said initial data don't indicate any problems. Mr. Rigg
added that the company used an outside broker to handle options exercises.
"There's not a way you can backdate that," he said. Mr. Gifford
didn't respond to requests for comment.
Continued in article
"Options
backdating might never have happened if reasonable options accounting had been
required years ago," by Floyd Norris, The New York Times,
October 13, 2006 --- http://norris.blogs.nytimes.com/?ref=business
The
FASB has published FASB Statement No. 123 (revised 2004), Share-Based Payment. Statement 123(R)
will provide investors and other users of financial statements with more
complete and neutral financial information by requiring that the compensation
cost relating to share-based payment transactions be recognized in financial
statements. That cost will be measured based on the fair value of the equity or
liability instruments issued.
This
and other FASB standards can be downloaded free from http://www.fasb.org/st/index.shtml
Question
How is “spring-loading” is “bound up in the notion of insider trading” by
executives?
You can't beat corporate executives bent on inventing ways to cheat
investors in executive compensation tricks invented by corporate accountants
and investors.
"Accounting
Rules Allow “Spring-loading,” “Bullet-dodging” Option Grants," AccountingWeb,
October 6, 2006 --- http://www.accountingweb.com/cgi-bin/item.cgi?id=102652
The
government will not have any accounting basis for enforcement actions against
companies for “spring-loading” or “bullet-dodging” stock option grants,
according to Scott Taub, deputy chief accountant for the U.S. Securities and
Exchange Commission (SEC ). Taub spoke at a Financial Accounting Standards
Board (FASB) advisory council meeting in New
York on Tuesday, Reuters reports.
Christopher Cox, SEC Commissioner,
said last month that the practice of “spring-loading” is “bound up in the
notion of insider trading,” according to CFO.com, suggesting that companies
might still face legal action, but said that the SEC focused on insider trading
in cases where it has occurred and can be proved.
“Spring-loading” occurs when a
company purposely schedules an option grant ahead of the announcement of good
news that will boost the stock price. “Bullet–dodging” involves setting the
grant date just after a negative announcement that will be followed by a
rebound in the stock price.
Taub told Reuters that the SEC was
not trying to endorse the practice, and added “the accounting for those kinds
of options is clear. We felt our hands were tied.”
“There are people in our building
who have varying feelings about whether spring-loading is good or bad.
Accounting-wise we felt stuck.”
“This is accounting literature
written in the 70’s that clearly did not hold up well. We don’t get to enforce
the accounting standards we wish existed, we have to enforce the accounting
standards that do exist,” Taub went on to say, according to Reuters.
Cox made his comments on
“spring-loading” and “bullet dodging” at a Senate Finance Committee hearing in
September. Cox had said in July that “backdating is more easily determined than
spring-loading, because of the nature of the evidence,” the LA Times reports.
SEC Commissioner Paul Atkins has
argued that there is nothing wrong with spring-loading. Boards award options
based on business judgments, Atkins said, according to the Wall Street Journal.
“An insider-trading theory falls flat in this context, where there is no
counterparty who could be harmed by an options grant. The counterparty here is
the corporation and thus the shareholders.”
In the case of Analog Devices
Inc., a Norwood, Mass., technology company, the SEC
questioned the propriety of stock option grants made by the company because it
did not adequately disclose that it priced stock options before the release of
good financial results, the Journal says. Analog Devices is also being
investigated for backdating stock options.
In another case, the SEC is
looking at grants made to executives of Cybertronics Inc., a Houston medical-device maker that made grants
to several executives on the day a Food and Drug Administrations advisory panel
recommended approval of a Cybertronics device. Trading in the stock was halted
that day and the grants used the exercise price of the previous day.
It is not clear what the tax
implications are for spring-loading, says S. James DiBrnardo, a partner at
Morgan Lewis & Bockius LLP, the Journal says. DiBernardo says the Internal
Revenue Service (IRS) might argue that spring-loaded options are also discount
options like backdated options. But he says that the IRS would have a much more
difficult time proving their case, because they would have to prove the “true”
market value on the date the spring-loaded options were granted.
Barf
Alert: Expensing Employee Stock Options
is Improper Accounting
Hey
Denny!
Options accounting expense deferral will just no go away because CEOs caught
with their hands in the till (backdating of options) are harder to fight than
City Hall. The good news is that we've heard all the arguments for decades and
will not have to devote journal space and FASB research time since there are
hundreds of leftover studies.
"Accounting, Economic Experts Call Expensing Stock Options Improper
Accounting," AccountingWeb, August 18, 2006 --- http://www.accountingweb.com/cgi-bin/item.cgi?id=102475
A University of California (UC),
Berkley management journal became the focus in reopening the debate on stock
option expensing when it published a position paper calling on the Securities
and Exchange Commission (SEC) to repeal the Financial Accounting Standards
Board’s (FASB) new standard requiring the expensing of employee stock options.
“Mandating the expensing of
employee stock options is one of the most radical changes in accounting rules
history, and we believe the FASB and the SEC have made a mistake,” said Kip
Hagopian, a veteran venture capitalist and principal author of the position
paper. “We are concerned that the SEC did not hold its own hearings on this
rule, and we are asking the Commission to reopen this issue for review and
debate.”
Thirty of the nation’s leading
experts in accounting, economics, business and finance signed the paper,
entitled Expensing Employee Stock Options is Improper Accounting, to
express their concern that financial statements are being impaired, not
improved, by this rule. The thirty signatories include three Nobel Prize
winners in economics, two former chief executive officers (CEOs) of “big four”
accounting firms, two former secretaries of the treasury, and dozens of leading
academics. Among the signatories is Dean Tom Campbell, dean of the UC Berkley’s
Haas School of Business, who noted that the paper represents his personal
views, not those of the university or the business school.
“The SEC rule poses an obstacle to
proper accounting,” Campbell
agrees. “Allowing for a more serious open debate of the accounting merits of
this rule is what California Management Review has offered to do, and it is exactly
what author Kip Hagopian and we signatories are asking the SEC to do.”
Key findings from Expensing
Employee Stock Options is Improper Accounting include:
* An Employee Stock Option (ESO)
is a “gain-sharing instrument” in which shareholders agree to share their gains
(stock appreciation), if any, with employees;
* A gain-sharing instrument, by
its nature, has no accounting cost unless there is a gain to be shared;
* The cost of a gain-sharing instrument
must be located on the books of the party that reaps the gain;
* In the case of an ESO, the gain
is reaped by shareholders and not by the enterprise; so the cost of the ESO is
borne by the shareholders;
* This cost to shareholders
(which, coincidentally, exactly equals the employee’s post-tax profit) is
already properly accounted for under the treasury stock method of accounting
(described in FAS 128, entitled “Earnings per Share”) as a transfer of value
from shareholders to employee option holders; and
* Neither the grant nor the
vesting of an ESO meets the standard accounting definition of an expense.
Moreover, ESOs can be granted only to employees, are not transferable, and are
cancelable at the will of the company (by terminating the employee).
Consequently they cannot be sold on the open market. And to sell them to
employees defeats their purpose. Thus, companies do not forgo any cash when
they grant ESOs, so their issuance cannot be an opportunity cost.
“With the appointment of three new
commissioners, including the new SEC chairman Chris Cox and the new Chief
Accountant Con Hewitt, we feel the timing is propitious to reopen the debate on
expensing options,” said Clarence Schmitz, one of the signatories and a retired
national managing partner at KPMG. “Thirty of the leading minds in accounting,
economics and business weighed in on this issue. We’re confident that our case
against expensing is solid and are hopeful that it will be well received by the
SEC.”
When
Top Scholars Write Outside Their Realm of Expertise to Favor Executives at the
Expense of Investors
To close, the appeal to authority is
enticing because it gives the aura that those with brilliant minds adopt a
particular point of view. While powerful rhetorically, this approach constitutes
a logical error because authorities sometimes make mistakes, such appeals to
authority do not address the subject under debate, and the opposing side can
solicit its own bevy of experts. Worse, this strategy backfires when the list
of experts do not really possess the requisite knowledge base in the field of
battle. With such ignorant experts, the glamour of Hagopian's paper disappears.
I could stop my critique at this point, but opponents of the expensing of
employee stock options would continue their nonsense. Therefore, I shall resume
the critique in the next column by reviewing the arguments by FASB and by
Bodie, Kaplan, and Merton.
J. Edward Ketz,
"Accounting for Stock Options: Reasoning by Authority: Part
1," SmartPros, November 2006
--- http://accounting.smartpros.com/x55203.xml
Jensen Comment
Bravo Ed!
Why are CEOs making such a fuss over the accounting for
stock options? It has nothing to do with their concern about accounting theory,
argues J. Edward Ketz. "If they cared about accounting theory, CEOs would
be more supportive of the FASB, the SEC, and the IASB in developing and
improving accounting practice. They don't want improvements in accounting, else
somebody might actually know what they are up to.
J. Edward Ketz, "The Accounting Cycle Accounting for Stock Options
(Part Three): Why CEOs Fight Stock Option Accounting," SmartPros,
November 2006 --- http://accounting.smartpros.com/x55207.xml
Kip Hagopian wrote a recent
article in California Management Review in which he claimed that
"Expensing Employee Stock Options is Improper Accounting." I
explained in my first column that his appeal to authority was misplaced, an
error in logic. My second column clarified why expensing employee stock options
is indeed proper and that Hagopian's assertions are invalid. In this essay, I
shall endeavor to discuss why CEOs are making such a fuss over the accounting
for stock options.
Let's state the obvious fact: that
CEOs are creating this hubbub over how to account for stock options has nothing
to do with their concern about accounting theory. They don't care a wooden
nickel about such matters. If they cared about accounting theory, CEOs would be
more supportive of the Financial Accounting Standards Board (FASB), the
Securities and Exchange Commission (SEC), and the International Accounting
Standards Board (IASB) in developing and improving accounting practice. They
don't want improvements in accounting, else somebody might actually know what
they are up to.
If CEOs cared about investors,
they would quit employing aggressive accounting techniques and they would quit
biasing their estimates (whether of interest rates, asset lives, or fair
values) to obtain their desired results. As they continue to utilize
aggressive, almost fraudulent accounting, we can infer that they are looking
out after themselves rather than anybody in the investment community.
If CEOs were worried about the
state of accounting in the U.S.,
then we would expect them to learn the vocabulary, the concepts, and the
principles of accounting to engage in meaningful debate. Mr. Hagopian and the
set of signatories have not bothered themselves with the trifles of accounting,
as seen in their invention of "gain-sharing instruments," their lack
of appreciation for accrual accounting, and the misapplication of the entity
concept.
If CEOs were really apprehensive
about today's accounting, then we would expect them to get involved in the many
less-than-stellar accounting rules and argue for a tightening and an
improvement in them. Pension accounting and lease accounting and the accounting
for business combinations, to name a few, are deficient FASB standards and in
need of great work. Instead, CEOs get involved primarily to prevent FASB from
doing too much damage to them.
So why does Kip Hagopian and so
many CEOs still carp about the accounting for stock options? I posit it is
because, first, they do not want the general public to understand the ever
increasing gap between the wages of the average American worker and the average
corporate CEO and, second, they do not want investors and creditors to realize
the nexus between treasury stock repurchases and their personal bank accounts.
The average CEO in 2004 earned
$11.8 million, while the average worker made only $27,460. The ratio of
CEO-to-worker pay was 42 in 1980, 107 in 1990, and hit an all-time high of 525
in 2001. Even now the ratio is 431. The explosive growth in CEO compensation
comes about primarily with stock and stock options.
Maybe as CNN's Lou Dobbs continues
his criticism of exporting American jobs overseas to cheaper venues, he could
advocate that we start outsourcing CEOs for cheaper ones. Or maybe he should
just insist on receiving some value for the compensation. Broadcom's managers
have received $5 billion from stock options while the business entity has lost
$6 billion in operating profits. What have these executives done to deserve $5
billion in stock options?
I shall leave it to others to
debate the issue of when CEO pay becomes excessive. At this time, I merely
think people ought to have the facts so the debate will be meaningful. And
saying that stock options are costless is, well, witless.
The second point is that we need
to understand better the nexus between stock repurchases and CEO's personal
bank accounts. Stock options line their bank accounts of managers with tons of
money, but needing some emphasis is the fact that stock options are quite
similar to the government's printing more money. When the government prints
more money, the effect is inflation; for instance, it takes more money to buy
the same goods. In like manner, when corporations print more stock
certificates, the effect is also dilutive; for instance, an investor's shares
in the company provides over time a claim to fewer and fewer of the net assets
of the entity.
Corporate managers comprehend this
inflationary aspect of stock options quite well, so they nearly always couple
an aggressive stock option plan with a strategy to buy back shares with some
hogwash like they want to put some cash in the hands of stockholders. If CEOs
really wanted to do that, they could declare a dividend instead of playing this
song-and-dance.
Cisco Systems has enriched its
executives with $24 billion of stock options; it has counterbalanced the
dilutive effect by repurchasing $19 billion of its own stock. Broadcom, Dell,
and many other hi-tech companies have acted likewise.
Indeed, it is the nexus of the
stock options and the stock repurchases that explains why stock options ought
to be expensed. Managers find it critical to repurchase enough shares of stock
to offset the inflationary ripples that stock options create. Simultaneously,
the cash that the business enterprise disburses to replenish the lost shares
represents the assets conveyed to compensate the management team.
While Kip Hagopian is entitled to
his opinion, the standard setters at FASB, SEC, and IASB should not give it
much weight. It is tainted with the greed of Lay and Kozlowski. It is mere
rhetoric to justify incredibly exorbitant salaries.
J. EDWARD
KETZ is accounting
professor at The Pennsylvania
State University.
Dr. Ketz's teaching and research interests focus on financial accounting,
accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of
recent accounting scandals. He also has edited Accounting Ethics, a four-volume set that explores
ethical thought in accounting since the Great Depression and across several
countries.
From
The Wall Street Journal Accounting Weekly Review on November 10, 2006
TITLE:
UnitedHealth Expects Probe to Result in 'Greater' Charges
REPORTER: Steve Stecklow and Vanessa Fuhrmans
DATE: Nov 09, 2006
PAGE: B1
LINK: http://online.wsj.com/article/SB116299996219517252.html?mod=djem_jiewr_ac
TOPICS: Accounting, Accounting Changes and Error Corrections, Sarbanes-Oxley
Act, Securities and Exchange Commission, Stock Options
SUMMARY:
"UnitedHealth Group Inc. said it would have to take charges related to its
backdated stock options that will be 'significantly greater' than its previous
estimates and expects the charges to impact more than 10 years of previously
reported earnings."
QUESTIONS:
1.) Describe the options backdating scandal that has developed since March,
2006. If you are unfamiliar with the issue, you may click on the link for
"Perfect Payday: Complete coverage" on the left hand side of the
on-line article.
2.)
For how long has options backdating been going on at UnitedHealth? Have the
accounting requirements remained the same throughout that period of time?
Summarize the required accounting and other financial reporting practices for
executive and employee stock options over the last 10 years.
3.)
Suppose that, once UnitedHealth finishes its review, the restatement of
earnings nearly doubles to $500 million and that the restatement applies
equally to each of the preceding 10 years. What accounting entry must be made
to correct this $500 million error? What will be the ultimate impact on each
year's earnings and on stockholders' equity at the end of each year? How will
this correction be disclosed? In your answer, cite the accounting standards
which require the treatment you present.
4.)
Click on "Read the full text" of UnitedHealth's Nov. 8 filing with
the SEC on the right-hand side of the on-line article. What Form number did
UnitedHealth file? Summarize the implications of the depth of the options
backdating problem found at this company.
5.)
Refer to the related article. What role does the Public Accounting Oversight
Board fill in assisting accountants to audit companies' accounting for stock
options?
Reviewed
By: Judy Beckman, University
of Rhode Island
---
RELATED ARTICLES ---
TITLE: Guidelines Set for How to Audit Stock Options
REPORTER: Siobhan Hughes
PAGE: A10 ISSUE: Oct 18, 2006
LINK: http://online.wsj.com/article/SB116114078518696161.html?mod=djem_jiewr_ac
Bob
Jensen's fraud updates are at http://faculty.trinity.edu/rjensen/FraudUpdates.htm
"FASB
Appears In a New Light On Stock Options: Some Companies That Opposed
Expensing Rule Are Caught Up In U.S. Probe on 'Backdating'," by David
Reilly, The Wall Street Journal, August 14, 2006; Page C1 --- http://online.wsj.com/article/SB115552025107534780.html?mod=todays_us_money_and_investing
When the nation's accounting-rule
makers proposed in 2004 that companies treat employee stock options as an
expense that cuts into profit, corporate executives all but stormed the
Financial Accounting Standards Board's headquarters in Norwalk, Conn.
In letters and public statements,
business leaders declared that such an accounting rule would damage their
bottom lines, compromise their ability to attract talented employees and make
them less competitive against foreign rivals that didn't face similar
requirements. Their protests failed to sway FASB; the new rule went into effect
this year.
Now, some of the same companies
that opposed it are among those caught up in a widening probe by federal
authorities of companies that allegedly "backdated" employee stock
options, a practice in which executives retroactively pick an options-grant
date at which the company's share price was at a low, meaning they potentially
can lock in a greater profit. This could violate securities laws and lead to
misstated financial results and tax problems. This turn of events casts the
companies' arguments against expensing stock options in a different light and
offers what some accounting-industry observers say is a vindication for FASB.
It isn't clear that a rule
requiring the expensing of options would have prevented the abuses now believed
to have taken place from the early 1990s until recent years. But expensing
"would have served as a deterrent," because the related cost would
have affected profit rather than being shown in a footnote, says Rebecca Todd
McEnally, director of the capital-markets policy group at the CFA Institute, a
financial-markets organization. "Auditors would have had to pay
considerably more attention to [options grants] than they apparently did."
Some of the companies opposing an
expensing rule argued in 2004 that options didn't actually "cost"
companies anything and that investors had all the information they needed
regarding this type of compensation. One executive at that time even insisted
to FASB there was no way for her company to issue options in a way that would
provide potentially greater gains for executives; the company, KLA-Tencor
Corp., has since acknowledged that probably did happen.
Other companies complained to FASB
that its proposal would give investors a distorted view of a company's
finances. Patrick Erlandson, chief financial officer at UnitedHealth Group
Inc., wrote in a June 2004 letter that "expensing stock options does not
provide financial statement readers with the most appropriate reflection of the
economic impact of stock-options grants on an entity's financial
statements."
UnitedHealth this spring disclosed
that its options-grant practices are the subject of an "informal" SEC
inquiry and that the Internal Revenue Service has requested documents regarding
the options. Federal prosecutors also are probing the Minnetonka, Minn.,
company, which has warned it may have to restate prior year's results. A
company spokesman declined to comment on the letter.
Those favoring expensing of stock
options "seem to do so for the wrong reasons," the then-top-three
executives at Macrovision Corp., including Chairman John Ryan, wrote FASB in
2004. "They tend to focus on corporate greed," the letter said,
referring to scandals such as the implosion of Enron. "Stock options in
themselves do not make people corrupt," the letter added.
In June, Macrovision, based in Santa Clara, Calif.,
disclosed that the Securities and Exchange Commission had requested information
about the company's options practices since 1997; later that month the company
said it was subpoenaed by federal prosecutors.
"It's irrelevant what the
thought process was three years ago," says James Budge, Macrovision's
current chief financial officer, who wasn't in that position in 2004 and didn't
sign the company's letter to FASB. "There is a rule there today and we
live by it." But he adds that he doesn't think the expensing rule solves
any of the problems related to backdating.
Stock options give employees the
right to buy stock at a preset, or exercise, price at a future date --
typically the same as the company's closing price on the date the option is
granted. Backdating the grant date to coincide with a recent low point in a
company's share price essentially builds in an instant paper gain on the
options.
FASB tried to put options
expensing in place in the mid-1990s but got pushed back by companies and
Congress. Then came Enron, and FASB tried again, and succeeded. Since the
beginning of this year, all public companies have had to record a cost for
issuing options on their income statements.
Some executives argued in 2004
that expensing could lead to abuses. The difficulty in assessing values needed
to expense options would result in an "opportunity for creativity for
those who might push the envelope," Nathan Sarkisian, chief financial
officer at Altera Corp., wrote in a June 25, 2004, letter.
In May, Altera said the SEC and
federal prosecutors were looking into its options-granting practices. The San Jose, Calif.,
company has since said there were problems with options granted between 1996
and 2000 and that it expects to restate nine years of financial results. A
spokeswoman declined to comment.
In another letter to FASB, the KLA
executive questioned the motives of those pushing an options-expensing rule.
Maureen Lamb, then a vice president, finance, wrote that while there were flaws
in the accounting rules for stock-based compensation, "the politically
charged belief that the blame lies with executives unwilling to give up their
ill-begotten compensation is backward and unproductive."
Ms. Lamb, who is no longer with
the company, added that "KLA-Tencor does not currently have the ability to
issue any equity-based compensation other than at-the-money stock
options." At the time, only options with exercise prices below the current
trading price -- "in-the-money" options -- had to be expensed. So-called
at-the-money options have an exercise price equal to the grant day's trading
price; they didn't have to be expensed back then, but under the new rule they
do.
This June, a committee of KLA's
board reached a preliminary conclusion that the price dates for certain grants
likely differed from recorded grant dates. In other words, the options likely
weren't "at-the-money" and should have been expensed. Federal
regulators and prosecutors have requested information from the company.
KLA officials didn't return calls
seeking comment. Ms. Lamb, now chief financial officer of Photon Dynamics Inc.,
a San Jose
technology company, also didn't return calls seeking comment.
It appears that thousands of
CEOs were allowed by their boards to bet on yesterday's horse race
In theory, directors are supposed to help keep
wayward practices like options backdating in check at most companies, but at
Mercury it was the directors themselves — who received a final seal of approval
from the company’s compensation committee — who kept the backdating ball
rolling. Now, as federal investigations of possible regulatory and accounting
violations related to options backdating have expanded to include more than 80
companies. Mercury’s pay practices — and the actions of the three outside
directors on its compensation and audit committees — have come under scrutiny.
In late June, the Securities and Exchange Commission advised the three men that
it was considering filing a civil complaint against them in connection with
dozens of manipulated options grants.
Eric Dash, "Who Signed Off on Those Options?" The New York Times,
August 27, 2006 --- http://www.nytimes.com/2006/08/27/business/yourmoney/27mercury.html
Timely
Filing of 10-K Reports is not "Optional"
Corinthian Colleges, Inc. announced Thursday that the
staff of the Nasdaq stock exchange has threatened the company with de-listing
for its failure to submit its 2006 annual financial statements to the
Securities and Exchange Commission on time. Corinthian said it has appealed the
staff’s recommendation and sought a hearing to challenge the ruling, noting
that the company had previously told the SEC that it would be filing its Form
10-K late while it conducts an outside review of its awarding of historic stock
option grants. The company is one of several for-profit higher education
companies facing scrutiny from federal regulators for their procedures and
practices in awarding stock options.
Inside Higher Ed, October 5, 2006
Teaching Case on Employee Compensation
From The Wall Street Journal Accounting Weekly Review on April 16,
2010
For Entrepreneurs, Sharing Isn't Always Fun
by: Sarah
E. Needleman
Apr 13, 2010
Click here to view the full article on WSJ.com
TOPICS: Compensation,
Dilution, Equity, Stock Options, Stock Valuation
SUMMARY: The
article discusses small businesses' use of equity "as a substitute for a
portion of salary when trying to attract top talent" either in the form of a
portion of the company's overall financial value or in stock options that
become valuable if the company goes public. In essence, when employees
accept equity in lieu of salary, small business owners are diluting
potential reward, notes Michael Keeling, president of ESOP Association, "a
Washington trade group representing businesses with employee stock ownership
plans." Another issue arising in relation to small businesses in particular
is that "companies sometimes outgrow the competence of the individuals they
hire," in the words of Chris Carey, a small-business adviser in Brooklyn,
NY, and so owners considering using equity-based compensation "
CLASSROOM APPLICATION: The
article can be used to discuss the use of stock option plans by small
businesses in addition to the typical view of larger firms' use of these
plans and the recent focus on the backdating scandal in executive stock
option plans. Though the article doesn't address accounting issues per se,
points about compensation value stemming from equity-based compensation and
the definition of dilutive effects on owners' shares in firm value are
useful for understanding the economic substance behind accounting for
equity-based compensation.
QUESTIONS:
1. (Introductory)
Define the term equity-based compensation.
2. (Introductory)
What two forms of equity-based compensation used by small businesses,
particularly at the start-up phase of business, are described in this
article?
3. (Introductory)
What is dilution? How does offering a share of stockholders' equity or a
stock option plan to an employee dilute an owner's interest in a business
currently? In the future?
4. (Advanced)
Consider the accounting for stock option plans offered by ForceLogix to its
employees in 2008 and 2009 as described in the article. How do you think the
granting of these stock options was accounted for?
5. (Advanced)
Access the ForceLogix (formerly Courtland Capital Corp.) Financial
Statements for the year ended August 31, 2009, available online at
http://www.sedar.com/DisplayCompanyDocuments.do?lang=EN&issuerNo=00026340
or by searching for them through the company's web site link to investor
information. Read Note 2, Summary of Significant Accounting Policies
(particularly the paragraph on stock-based compensation) and Note 6, Share
Capital. Does this description confirm your answer to the question above?
Explain, including a comment on the method used to value the options.
6. (Advanced)
Have the stock options described in the article been exercised? Cite your
source for this information.
7. (Introductory)
Have the stock options described in the article been exercised? Cite your
source for this information.
8. (Advanced)
Refer again to the ForceLogix financial statements Note 2, this time the
paragraph on Loss per share. What can you infer about the current market
value of the company's stock from the fact that no diluted earnings (loss)
per share is shown in these financial statements and the statement in this
note that the impact of potentially dilutive securities would be
anti-dilutive.
Reviewed By: Judy Beckman, University of Rhode Island
"For Entrepreneurs, Sharing Isn't Always Fun,"
by: Sarah E. Needleman, The Wall Street Journal, April 13, 2010 ---
http://online.wsj.com/article/SB10001424052702303828304575180073125261114.html?mod=djem_jiewr_AC_domainid
Business owners with limited
payroll budgets may be tempted to use equity as a substitute for a portion
of salary when trying to attract top talent—but this means possibly parting
with a piece of their business's future success.
Mary and Matt Paul say
they're grateful that their employees turned down an offer of equity in lieu
of more pay when they launched their transportation-services firm, Crown
Cars & Limousines Inc., more than 15 years ago.
"They didn't trust that the
company was going to be successful," says Ms. Paul of the recruits. "I'm
happy it worked out that way because now I couldn't imagine sharing my
profits." She says the company earned roughly $4 million in 2009.
Businesses have long used
part-ownership in place of—or in addition to—bigger salaries. Some offer a
piece of their firm's overall financial value as equity. Others dispense it
in the form of stock options that only become valuable if their company goes
public.
The latter may be a tougher
sell these days since few companies have gone public in recent years: There
were just 63 U.S. initial-public offerings last year and 43 in 2008,
compared with 272 in 2007 and 221 in 2006, according to Renaissance Capital
LLC, an independent research firm in Greenwich, Conn.
For a small business, where
profits often aren't too big to begin with, this can mean dividing the pot
even further. "In essence you are diluting your potential reward," says
Michael Keeling, president of ESOP Association, a Washington trade group
representing businesses with employee-stock-ownership plans.
Chris Carey, a
small-business adviser in Brooklyn, N.Y., says owners thinking about
offering new recruits equity-based pay should consider what would happen if
they later decide that those workers aren't worth retaining.
"Companies sometimes outgrow
the competence of the individuals they hire," says Mr. Carey. Other
recruiting incentives, such as performance-based bonuses, may be more
palatable for owners fearful of landing in that kind of situation, he says.
On the flip side, sharing a
smaller percentage of something successful can be "better than 100% of your
business closing down," says ESOP's Mr. Keeling.
View Full Image
Studio West Photography
Employees at ForceLogix
Offering equity can be an especially useful tool in a downturn. Business
owners should be able to more easily offset a below-market salary with
equity-based pay when unemployment is high, theorizes Andrew Zacharakis,
professor of entrepreneurship at Babson College in Wellesley, Mass. "A lot
of people are trying to get something on their résumé, even though it may
not pay as much as what they earn in a good economic climate," he says.
Equity can also sweeten a
job offer for candidates who are always in high demand because they possess
unique skills or knowledge. Bret Farrar proposed giving a financial stake in
his small consulting firm to two prospective recruits last year in lieu of
bigger salaries.
He says both candidates
accepted the positions over other, higher-paying opportunities. "We wanted
to attract better people and keep them for the long haul," says Mr. Farrar,
founder of Sendero Business Services LP in Dallas.
Even in prosperous times,
equity can be an effective recruiting tool for small firms, says David Wise,
a senior consultant for Hay Group Inc., a management-consulting firm based
in Philadelphia.
"There's a limited pool of
equity available, and larger companies with more employees have to be that
much more selective in allocating it," says Mr. Wise. "For a smaller
company, providing an equity stake is one way to compete for talent with the
big boys."
When Patrick Stakenas
co-founded ForceLogix Technologies Inc. in Chicago in 2005, he says he and
his business partner, Steve Potts, couldn't afford to pay recruits salaries
on par with market rates. So they offered equity in their sales-technology
firm to compensate for the difference.
"We looked for people who
understood they'd have the opportunity to make a lot of money down the
road," says Mr. Stakenas.
Over the next few years,
ForceLogix employees also received pay raises mostly in the form of equity.
"A couple of times in 2008 and 2009 cash was very tight, so tight that we
weren't going to potentially make payroll," says Mr. Stakenas. "We promised
employees that if they stay, there will be more equity for them, and all of
them stayed."
This past December,
ForceLogix went public on the Toronto stock exchange at 10 cents a share,
making its 10 employees' stock options finally worth something. The price
has been fluctuating between eight and 11 cents ever since.
"They can sit on it or
sell it," says Mr. Stakenas, who declines to offer specifics on how much
equity his staff has in his firm. "All of them are holding onto it because
they want to see the company go further."
Bob Jensen's threads on employee stock
options and equity sharing are at
http://faculty.trinity.edu/rjensen/theory/sfas123/jensen01.htm
Executive
Compensation Fraud at Apple Corporation:
Apple's mea culpa on backdating last week was eloquently incomplete
Apple's mea culpa on backdating last
week was eloquently incomplete, and all the more intriguing because the gaps
seemed almost Socratically mapped to invite the media to fill the holes by
asking obvious questions. The big joke here is that the logic of the witch hunt
will stop the media from asking the obvious questions, not least because CEO
Steve Jobs is a hero to much of the press and there's little appetite for
bringing him down. Don't misunderstand. We believe it would be a gross
injustice if he were defenestrated over backdating, just as we have serious
doubts about the prosecutions launched against other backdating CEOS. And
Apple's likely purpose in issuing its statement, naturally, was not lexical
comprehensiveness but saving Mr. Jobs's job.
Holman W. Jenkins, Jr., "A Typical Backdating Miscreant, The Wall
Street Journal, October 11, 2006; Page A15 --- http://online.wsj.com/article/SB116052823194588801.html?mod=opinion&ojcontent=otep
"Apple
C.E.O. Apologizes for Stock Practices," The New York Times, October 5, 2006 --- Click Here
Now that an internal investigation
over Apple Computer Inc.'s stock-option practices has helped abate investor
worries over Steve Jobs' role as CEO, a key lingering concern will be the impact
of pending earnings restatements.
Apple said Wednesday its
three-month investigation did not uncover any misconduct of any current
employees but did raise ''serious concerns'' over the accounting actions of two
unnamed former officers.
The iPod and Macintosh maker also
said its former chief financial officer, Fred Anderson, had resigned from the
company's board of directors.
Jobs -- his position intact --
apologized.
The probe found that Jobs knew
that some option grants had been given favorable dates in ''a few instances,''
but he did not benefit from them and was not aware of the accounting
implications, the company said.
''I apologize to Apple's
shareholders and employees for these problems, which happened on my watch,''
Jobs said in a statement. ''We will now work to resolve the remaining issues as
quickly as possible and to put the proper remedial measures in place to ensure
that this never happens again.''
Apple said it will likely have to
restate some earnings due to revised tax and stock option-related charges.
Auditors are still reviewing the situation, and Apple said it has not yet
determined the extent of the financial impact.
The looming restatements could
dramatically reduce some of the windfall generated during the company's recent run
of record profit, analysts said.
Shares of Apple shed 10 cents to
$75.28 in midday trading Thursday on the Nasdaq Stock Market. The stock has
traded between $47.87 and $86.40 over the past year.
Apple has reported profit totaling
$3.1 billion during the past four years. If the restatements are severe, it
could dent Apple's stock, said IDC analyst Richard Shim.
''The restatements have the
potential to bite them again depending on how large they end up being,'' Shim
said. ''That said, the company is certainly firing on all cylinders so
investors may be willing to forgive them, but it's something that will linger
in the backs of their minds.''
Piper Jaffray analyst Gene Munster
said he and other investors are breathing a sigh of relief that Jobs kept his
job throughout the scandal.
''The risk was that if something
bizarre happened and Steve Jobs got fired over it,'' Munster
said from his office in Minneapolis.
''That could have significantly impacted the company in a negative way. Steve
Jobs is Apple. Ultimately, the scope of the backdating was bigger than we
thought, but the impact turned out to be less severe.''
Apple is one of the most prominent
among more than 100 companies caught in the nationwide stock options
mishandling scandal. Cupertino-based Apple initiated its own stock-options
investigation in June after problems at other companies began to unravel.
In many instances, the problem has
centered on the ''backdating'' of stock options -- a practice in which insiders
could make the rewards more lucrative by retroactively pinning the option's
exercise price to a low point in the stock's value.
Apple said its probe found
irregularities in the recording of stock option grants made on 15 dates between
1997 and 2002, with the last one involving a January 2002 grant, the company
said. The grants had dates that preceded the approval of those grants.
Apple spokesman Steve Dowling said
the 15 grants represented 6 percent of the total issued during that period. He said
he did not have further details regarding the specific grants or whether they
were awarded to officers or employees.
The company did not identify the
two former officers whose accounting, recording and reporting of option grants raised
''serious concerns'' during the probe.
Apple said Anderson, who served as
the company's chief financial officer from 1996 until 2004, resigned from the
board, citing he did so in ''Apple's best interest.''
Dowling said the company will
provide more details about the probe to the Securities and Exchange Commission.
The company's special committee
conducting the investigation examined more than 650,000 e-mails and documents,
and interviewed more than 40 current and former employees, directors and advisers.
"Apple
Says Jobs Knew of Options," by Laurie J. Flynn, The New York Times,
October 5, 2006 --- Click Here
The
external auditor for Apple Corporation is KPMG --- http://faculty.trinity.edu/rjensen/Fraud001.htm#KPMG
The Enron stuff is very sexy, but that type of fraud was not pervasive.
Backdatings of executive stock option frauds are another matter.
From Jim Mahar's blog on September
22, 2006 --- http://financeprofessorblog.blogspot.com/
The sleuth who exposed (stock option)
backdating scandal
I
allways like to see finance professors in the news!
Philadelphia Inquirer | 09/21/2006 | Sleuth who exposed
backdating scandal:
A few "look-ins":
"From
his second-floor office at Iowa's
Tippie College of Business, [Erik] Lie spent months analyzing data to
demonstrate how companies were illegally and retroactively timing, or
backdating, stock option grants to fatten bonuses paid to top executives.
"He's uncovered a
scandal that has just mushroomed," said Adam C. Pritchard, a former
attorney at the Securities and Exchange Commission and now a law professor at
the University of
Michigan.
and
later in the article:
"'The
Enron stuff is very sexy, but that type of fraud was not pervasive,' said
Andrew Metrick, a professor of finance and corporate governance at the Wharton School
in Philadelphia.
'This is widespread, pervasive. I think when this is all said and done, the
total amount of dollars that we'll find have been stolen from the corporate
till is larger here than any other case we've seen.'"
Suspected Fraud:
Attorneys, Auditors, Others Getting Attention In Options Timing Affair
"It's hard to believe ... that the
executives did this all by themselves," Sen. Charles Grassley, R-Iowa,
said at a hearing Wednesday. "And to be honest, the idea that all
executives at different companies came up with this idea at the same time
stretches the imagination." Grassley said he planned to write to
"several major corporations" that have engaged in backdating of stock
options, asking them to provide the minutes of board meetings in which
directors discussed the matter as well as documents from attorneys, accountants
and consultants who assisted. In backdating, options are issued retroactively to
coincide with low points in a company's share price, a practice that can fatten
profits for options recipients when they sell their shares at higher market
prices. Backdating options can be legal as long as the practice is disclosed to
investors and properly approved by the company's board. In some cases, however,
the practice can run afoul of federal accounting and tax laws. "We need to
understand and bring enforcement action against all the actors who were
involved with this abusive scandal," Grassley declared.
"Attorneys, Auditors, Others Getting Attention In Options Timing
Affair," SmartPros, September 11, 2006 --- http://accounting.smartpros.com/x54672.xml
From
The Wall Street Journal Accounting Weekly Review on September 22, 2006
TITLE:
SEC Accountant Issues Guidelines on Stock Options
REPORTER: David Reilly
DATE: Sep 20, 2006
PAGE: C3
LINK: http://online.wsj.com/article/SB115871130408368314.html?mod=djem_jiewr_ac
TOPICS: Accounting, Fair Value Accounting, Securities and Exchange Commission,
Standard Setting, Stock Options
SUMMARY:
"The Securities and Exchange Commission's chief accountant issued guidance
on how companies should account for employee stock options in light of
regulators' probes into "backdating" of this type of
compensation." Specific guidance issued in a letter by Chief Accountant
Conrad Hewitt is developed from the SEC's observations from reviews of cases
investigated during the options backdating scandal.
QUESTIONS:
1.) Through what mechanism is the Securities and Exchange Commission (SEC)
issuing this new guidance on accounting for stock options? How does this
guidance differ from that provided in statements of financial accounting
standards issued by the Financial Accounting Standards Board (FASB)?
2.)
Summarize the requirements currently in place to account for employee stock options.
What accounting standard establishes these requirements?
3.)
Refer to the related article. What were the political pressures that were put
to bear on the FASB when it implemented changes in accounting for stock
options?
4.)
Define the terms "in the money", "at the money", and
"out of the money" stock options.
5.)
How do current accounting requirements differ from those that were in effect
prior to issuance of this most recent standard? Relate this description to your
definitions provided in answer to question 4
6.)
Describe the issue of options backdating. Again, relate this answer to the
definitions provided in answer to question 4.
7.)
Based on comments in the main article, how has elevating the accounting for
stock options to the face of the financial statements, rather than merely
requiring disclosures of the fair values of stock options granted to employees,
likely impacted the audit process over these activities?
Reviewed
By: Judy Beckman, University
of Rhode Island
---
RELATED ARTICLES ---
TITLE: FASB Appears in a New Light on Stock Options
REPORTER: David Reilly
PAGE:
C1 ISSUE: Aug 14, 2006
LINK: http://online.wsj.com/article/SB115552025107534780.html?mod=djem_jiewr_ac
"SEC
Accountant Issues Guidelines On Stock Options," by David Reilly, The
Wall Street Journal, September 20, 2006; Page C3 --- Click Here
The Securities and Exchange
Commission's chief accountant issued guidance on how companies should account
for employee stock options in light of regulators' probes into
"backdating" of this type of compensation.
But chief accountant Conrad Hewitt
made clear that in considering problems related to options accounting the
commission would distinguish between honest mistakes, such as paperwork errors,
and those that showed a company was trying to game accounting rules. Mr.
Hewitt's tone echoed previous comments made by SEC Chairman Christopher Cox
that indicated the commission would look closely at a company's intent when
investigating possible backdating practices.
Stock options give employees the
right to purchase stock at a preset price, known as the strike or exercise
price, at a future date. Under accounting rules in place until the start of
this year, companies didn't have to recognize any expense related to options
grants if the exercise price was equal to the company's share price on the date
the options were granted.
However, many companies
retroactively picked a grant date to correspond with a low-point for their
stock, in effect setting a lower bar for executives.
Under accounting rules in place at
the time, such grants could have required companies to book an expense because
the exercise price picked wasn't actually the same as the company's share price
on the real grant date. Starting this year, companies have had to take an
expense for all options grants.
Mr. Hewitt's letter laid out
examples where questions have arisen over whether a company should have taken
an expense for options under the old accounting rules. In cases where companies
picked an exercise price over a 30-day period, for example, they generally
should have recorded an expense for the options, the letter said. However,
so-called springloading of options, where companies grant options ahead of good
news, doesn't result in an accounting issue, the letter said.
The SEC guidance to companies
follows an alert to auditors on backdating issues in July from the Public
Company Accounting Oversight Board. More than 100 companies are under
investigation in relation to backdating, according to recent congressional
testimony from Mr. Cox. The agency has brought civil charges against executives
from two companies in tandem with criminal charges by prosecutors.
Mr. Hewitt stressed that the
guidance related only to accounting issues, not legal matters arising from
backdating issues.
Bob Jensen's threads on
executive options compensation scandals are at http://faculty.trinity.edu/rjensen/theory/sfas123/jensen01.htm
Bob Jensen's threads on
outrageous executive compensation are at http://faculty.trinity.edu/rjensen/FraudConclusion.htm#OutrageousCompensation
Executives Are Betting On
Yesterday's Horse Races
As an aside, once
again this shows that finance and accounting go hand in hand as Collins, Gong,
and Li are accounting professors!
From Jim Mahar's blog on May 23,
2006 --- http://financeprofessorblog.blogspot.com/
Do managers backdate
options?
Do
managers backdate options? It sure seems that way.
From Reuters:
A U.S. government
probe into stock option grants for executives widened on Tuesday with more
technology companies being called on to explain the way these grants are
awarded.
The investigation focuses on whether companies are giving
executives backdated options after a run-up in the stock. Backdated securities
are priced at a value before a rally, which boosts their returns.
From NPR:
The
Securities and Exchange Commission (SEC) is reportedly examining the timing of
stock option awards by corporations." (BTW this is included to you can
listen to it--has several professors speaking on it.)
From the LA Times:
""The stock-option game is supposed to confer the
potential for profit, but also some risk," said John Freeman, a professor
of business ethics at the University of South Carolina Law School who was a
special counsel to the SEC during the 1970s. "When in essence the
executives are betting on yesterday's horse races, knowing the outcome, there's
no risk whatever.""
What does past academic research have to say on this? Most of the
evidence suggests that backdating probably does occur.
For years there have been papers showing that managers tend to
announce bad news prior to option grants and even time the grants prior to
price run ups (see Yermack 1997) it has only been more recently that
researchers have noticed that the price appreciation was not merely due to firm
specific factors (which managers may be able to control and time) but also
market wide factors (i.e. the stock market goes up after option grants).
Last year a paper by
Narayanan and Seyhun suggested
that this may be the result of backdating the option grants. More recently two
papers by Collins, Gong, and Li (a)
and (b) find further evidence that
backdating is (or at least was) happening and that unscheduled grant dates
(where this can occur) tend to be found more commonly at firms whose management
has relatively more control over their board of directors.
Stay tuned!!
* A quick comment to any manager who may have done this: Why bother? Why risk
it all cheating for a few extra dollars? (Indeed it reminds me of the Adelphia
case where the firm outsourced snow plowing to a Rigas owned firm. It just
doesn't seem worth it.)
*As an aside, once again this shows that finance and accounting go hand in hand
as Collins, Gong, and Li are accounting professors!
"PCAOB Issues Alert to Auditors on Backdating," SmartPros,
July 31, 2006 --- http://accounting.smartpros.com/x54136.xml
The oversight board's first-ever
"audit practice alert," released on Friday, warns auditors to
"be alert to the risk that the issuer may not have properly accounted for
stock options, and as a result, may have materially misstated its financial
statements."
The nine-page practice alert, Matters Relating to Timing and Accounting for Options Grants
(PDF), was prompted by recent reports and
disclosures about issuer practices related to the granting of stock options,
including the "backdating" of such grants.
In a statement Friday, the board
said these reports and disclosures indicate that some issuers' actual practices
in granting options might not have been consistent with the manner in which
these transactions were initially recorded and disclosed. Some issuers have
announced restatements of previously issued financial statements as a result of
these practices. In addition, some of these practices could result in legal and
other contingencies that may require recognition of additional expense or
disclosure in financial statements.
The alert advises auditors that
these practices may have implications for audits of financial statements or of
internal control over financial reporting and discusses factors that may be
relevant in assessing the risks related to these matters. The alert reminds
auditors to "be mindful" of applicable financial accounting
standards, including SFAS No.
123 (Accounting
for Stock-Based Compensation).
PCAOB audit practice alerts are
issued by the board's staff to "highlight new, emerging, or otherwise
noteworthy circumstances that may affect how auditors conduct audits under the
existing requirements of PCAOB standards and relevant laws." They will be
posted on the board's Web site, www.pcaobus.org, as well as transmitted to registered public accounting
firms via email when possible.
From
the Wharton School of Business at the University of Pennsylvania
"How New Accounting Rules Are Changing the Way CEOs Get Paid (Audio
Available)," Knowledge@Wharton, May 3, 2006 --- http://knowledge.wharton.upenn.edu/index.cfm?fa=viewArticle&id=1465
When a well-known compensation
consulting firm predicted in early April that new accounting rules wouldn't
have any impact on the use of options as compensation for corporate executives,
Wharton accounting professor Mary Ellen Carter was ready to disagree.
"That's just not true," she says. "Options will be cut and
directors will be switching to restricted stock for executive compensation."
Carter's response is the result of
her research into the role of accounting in the design of CEO equity
compensation, specifically as it relates to the use of options and restricted
stock. Her study coincides with a ruling, implemented this year by the
Financial Accounting Standards Board (FASB), requiring all firms to expense the
value of employee stock options. Specifically, Carter looks at the accounting
practices of 1,500 firms from 1995 to 2001, before many large companies began
expensing stock options but during the years when the FASB began pushing the
reform. Carter corroborates the findings of her study by examining changes in
CEO compensation within firms that voluntarily began to expense options in 2002
and 2003.
In a new paper on this topic
entitled, "The Role of Accounting in the Design of CEO Equity
Compensation," Carter concludes that CEO compensation will change now that
companies are required to subtract the expense of stock options from their
earnings, just as they are required to account for salaries and other costs.
And Carter predicts that as a result, firms will switch from options to
restricted stock as a preferred compensation option.
"By eliminating the financial
reporting benefits of stock options, firms expensing stock options no longer
have an ability to avoid recording expenses with any form of equity
compensation," writes Carter, who authored the study with Luann J. Lynch,
a professor at the Darden Graduate School of Business Administration, and
Wharton accounting professor Irem Tuna.
"We found that companies
prior to the rule changes granted more options because of favorable financial
reporting. Results suggest that favorable accounting treatment for stock options
led to a higher use of options and lower use of restricted stock than would
have been the case absent accounting considerations. Our findings confirm the
role of accounting in equity compensation design."
Leveling the Playing Field
The timing of Carter's report
could hardly be better.
This past year, a revised FASB
rule took effect that requires companies to expense the value of stock options
given to employees. Most public companies are required to expense options for
fiscal years beginning after June 15, 2005. Since most companies operate on a
calendar basis, this means expensing options by March 31, 2006. Known as SFAS
123(R), the new accounting standard was developed by the FASB to create a more
level playing field when it came to management incentive compensation and its
impact on a company's bottom line. Before SFAS 123(R), companies that gave out
stock options did not have to report the "fair value of the option"
-- i.e., did not have to claim the options as an expense, which in turn would
result in a reduction in net income at the end of the fiscal year. However,
companies that relied on cash bonuses or restricted stock for equity
compensation have always had to report or "expense" the value amount,
an accounting requirement that reduced corporate net income at year's end.
The FASB first proposed changing
the accounting standard in 1991. At the time, the move was strenuously opposed,
particularly by many hi-tech firms and start-up businesses that relied heavily
on stock options as an incentive to recruit and motivate employees to work for
companies that reported little or no income. As nearly everyone knows, stock
options are perks given to employees that allow them to buy company stock in
the future at a set price. If the stock rises before the options are exercised,
the employee can buy the stock at the lower predetermined price, and then sell
it at the higher price and quickly realize the difference.
During the dot-com boom, the use
of stock options skyrocketed. According to the National Center
for Employee Ownership, up to 10 million employees held stock options by 2002.
"Stock options were always seen as an incentive, a way of tying employee
or executive action and company performance to compensation," says Carter.
"In other words, 'You will get something if you get the stock price to go
up.' It was a way of aligning employees' and executives' interests with those
of the shareholders."
But from the beginning, companies
balked at putting a numerical value on options and expensing them, arguing that
doing so would result in a negative impact on their stock price. After intense
lobbying, the FASB backed off the proposal in the early 1990s, but issued a
compromise, known then as SFAS 123: Companies had to disclose the use of stock
options and their fair value in the footnotes of their financial reports or
proxy statements.
Nearly 10 years later -- in the
wake of the volatile post-Enron era, when improper and unethical accounting
practices were widely exposed in one corporate scandal after another -- the
FASB returned to the concept of expensing stock options. At the time, corporate
institutions like Global Crossing and WorldCom, in addition to Enron, had
became synonymous with corporate greed, and anyone who followed their downfalls
quickly understood how company executives who held substantial stock options
were motivated to artificially inflate stock prices for their own financial
gain.
In an effort to distance
themselves from companies that routinely "cooked the books," many
corporations wanted to showcase their ethical financial practices. So they
began to voluntarily expense options in their proxy statements, a step above
and beyond the footnote citation already required by the FASB. In 2002, General
Electric, Bank One Corp., Coca-Cola, The Washington Post Co.,
Procter & Gamble and General Motors announced that they would expense
options, along with Amazon.com and Computer Associates. Some companies -- like
Papa John's International, USA Interactive and Microsoft -- announced that they
were doing away with options altogether.
Continued in article
July
5, 2006 message from Dennis Beresford [dberesfo@TERRY.UGA.EDU]
Today's Wall Street Journal
reports that Mercury Interactive is the first company to actually restate its
financial statements and describe in detail how it had improperly accounting
for stock options. A revised 10-K for 2004 is now available at the company's
web site
http://www.mercury.com/us/website/pdf-viewer/?url=/us/pdf/company/10ka-final-2004.pdf
make for fascinating reading.
Denny Beresford
Note
the University of
Phoenix issue over
possible backdating of options
"CNET
to Restate Results Over Stock-Option Grants," by John Hechinger,
The Wall Street Journal, July 11, 2006; Page A3 --- http://online.wsj.com/article/SB115253695093802258.html?mod=todays_us_page_one
CNET Networks Inc. said it expects
restatements that will lower its reported earnings for at least three years,
bringing to nearly a dozen the number of companies that have acknowledged
errant stock-options accounting.
The San Francisco Web site
operator and more than 50 other companies are under scrutiny by federal
authorities because they granted stock options to executives at unusually low
prices, often before sharp jumps in the companies' share prices.
. . .
Also, Apollo Group Inc., the big
for-profit education company that operates the University of Phoenix,
disclosed it will be unable to file its 10-Q quarterly SEC filing on time
because of its directors' review of stock-option practices. At the same time,
Apollo revealed that the SEC notified the Phoenix-based company that it was
conducting an informal investigation of its stock-option granting practices.
Apollo, which said it was cooperating with the SEC, already disclosed that it
had received a subpoena from the U.S. attorney for the Southern
District of New York related to the matter. Apollo shares rose 20 cents, or
0.4%, to $50.12 on Nasdaq.
Terri Bishop, an Apollo
spokeswoman, said the company believes "there has been no backdating and
that we have complied with all applicable laws."
In addition, Take-Two Interactive
Software Inc., the New York
maker of gaming software, said it has received a notice from the SEC of an
"informal non-public investigation" into stock-option grants
"from January 1997 to the present." The company already had said a
special committee of independent directors was investigating such matters.
Take-Two said it is cooperating with the SEC and declined further comment. The
company's shares fell 76 cents, or 7.5%, to $9.34, also on Nasdaq.
From
The Wall Street Journal Accounting Weekly Review on June 30, 2006
TITLE:
Timely Question: How to Undo Unfair Options?
REPORTER: Kara Scannell
DATE: Jun 27, 2006
PAGE: C1 LINK: http://online.wsj.com/article/SB115137241897491448.html
TOPICS: Accounting, Auditing, Financial Accounting, Internal Controls, Stock
Options
SUMMARY:
"Boards of directors at companies with executives who may have benefited from
backdated stock-option grants face thorny questions about whether they should
void the options or try to get back money from options already cashed in.
QUESTIONS:
1.) Summarize the issue with backdating stock options granted to executives.
2.)
Why are some executives not being terminated upon discovery of of the stock
option backdating practices? Are some executives being terminated?
3.)
What internal control procedures should be in place regarding issuance of stock
options to executives?
4.)
How does the problem with backdating indicate that internal control breakdowns
occurred at companies in which stock option backdating has been discovered?
5.)
Do you think that there are companies with problems of options backdating in
which there was no breakdown of internal control? Support your answer.
6.)
How was the problem of backdating stock options uncovered? Did this discovery
occur through an annual audit of financial statements, through an internal
audit procedure, or through some other means? Explain.
7.)
Explain how it is possible that an annual financial statement audit did not
detect these problems with stock options backdating in at least some cases now
being uncovered.
Reviewed
By: Judy Beckman, University
of Rhode Island
---
RELATED ARTICLES ---
TITLE: Why '90s Audits Failed to Flag Suspect Options
REPORTER: George Anders
PAGE: B1
ISSUE: Jun 22, 2006
LINK: http://online.wsj.com/article/SB115093901436887061.html
Is
any CEO really entitled to over $6 billion in gains on employee stock
options?
"Calpers
Puts Pressure on Board of UnitedHealth: Holder Demands a Meeting Over
Option-Grant Timing; A Threat to Withhold Votes," by Vanessa Fuhrmans, The
Wall Street Journal, April 26, 2006; Page A3 --- http://online.wsj.com/article/SB114599506269535599.html?mod=todays_us_page_one
The California Public Employees' Retirement System is
demanding a conference call with the compensation committee of the board of
UnitedHealth Group Inc. over its disclosure practices, and is threatening to
withhold votes for board directors seeking re-election.
In a letter sent to James A. Johnson, chairman of the
UnitedHealth board's compensation committee, Calpers board President Rob
Feckner demanded a conference call ahead of Tuesday's UnitedHealth shareholders
meeting to discuss what he called "serious threats to the credibility,
governance and performance of UnitedHealth." Specifically, the letter
criticized the company's failure to explain how it determined stock option
grant dates for Chief Executive William McGuire and a handful of other
executives in past years, and its "inconsistent" disclosure of its
option-granting program.
The move by Calpers increases the scrutiny of the process
by which Dr. McGuire received some of the $1.6 billion in unrealized gains he
holds in company stock options. Calpers holds 6.55 million shares, or 0.5%, of
UnitedHealth's outstanding stock. The pension fund, known for its strong
stances on corporate governance, could spur other investors to join in its
criticism. The move also increases pressure on UnitedHealth's board to more
fully explain its past option-award practices soon, even though its board only
launched a probe into them earlier this month.
Continued
in article
"The thing I think that is more problematic is there
have been some allegations that auditors knew about this and counseled their
clients to do it," said Joseph Carcello, director of research for the
corporate-governance center at the University
of Tennessee. "If
that turns out to be true, they will have problems."
The
SEC is not yet done with Apple: Where were the auditors?
"Apple's
Former CFO Settles Options Case: Finance Official Ties CEO Jobs To
Stock Backdating Plan," by Carrie Johnson, The Washington Post, April 25, 2007; Page
D01 --- Click Here
A former chief financial officer
of Apple reached a settlement with the Securities and Exchange Commission
yesterday over the backdating of stock options and said company founder Steve
Jobs had reassured him that the questionable options had been approved by the
company board.
Fred D. Anderson, who left Apple
last year after a board investigation implicated him in improper backdating,
agreed yesterday to pay $3.5 million to settle civil charges.
Chief executive Steve Jobs has not
been charged in the probe. (Alastair Grant - AP)
Complaint: S.E.C. v. Heinen,
Anderson
Separately, SEC enforcers charged Nancy
R. Heinen, former general counsel for Apple, with violating anti-fraud laws and
misleading auditors at KPMG by signing phony minutes for a board meeting that
government lawyers say never occurred.
Heinen, through her lawyer, Miles
F. Ehrlich, vowed to fight the charges. Ehrlich said Heinen's actions were
authorized by the board, "consistent with the interests of the
shareholders and consistent with the rules as she understood them."
Anderson issued an unusual statement defending his reputation and
tying Jobs to the scandal in the strongest terms to date. He said he warned
Jobs in late January 2001 that tinkering with the dates on which six top
officials were awarded 4.8 million stock options could have accounting and
legal disclosure implications. Jobs, Anderson
said, told him not to worry because the board of directors had approved the
maneuver. Regulators said the action allowed Apple to avoid $19 million in
expenses. Late last year, Apple said that Jobs helped pick some favorable dates
but that he "did not appreciate the accounting implications."
Explaining Anderson's motive for issuing the statement,
his lawyer Jerome Roth said: "We thought it was important that the world
understand what we believe occurred here."
Roth said his client, a prominent
Silicon Valley figure and a managing director at the venture capital firm
Elevation Partners, will not be barred from serving as a public-company officer
or board member under the settlement, in which Anderson did not admit wrongdoing. Roth
declined to characterize the current relationship between Anderson and Jobs.
The SEC charges are the first in
the months-long Apple investigation. Jobs was interviewed by the SEC and
federal prosecutors in San Francisco,
but no charges have been filed against him.
Steve Dowling, a spokesman for
Apple, declined to comment on Jobs's conversations with Anderson. Dowling emphasized that the SEC did
not "file any action against Apple or any of its current employees."
Government authorities praised
Apple for coming forward with the backdating problems last year and for sharing
information with investigators. Apple has not publicly released its
investigation report.
Continued in article
"SEC
charges former Apple executive in options case: The SEC accuses
Apple's former general counsel of fraudulently backdating stock options,"
by Ben Ames, The Washington Post, April 24, 2007 --- Click Here
The SEC said it did not plan to pursue any further action
against Apple itself, which cooperated with the government's probe, but it
stopped short of saying its investigation was closed. Commission officials
declined to comment on whether possible charges could still be filed against
Jobs or other current officers.
"Options troubles at Apple remain despite SEC case against 2 former
officers," Associated Press, MIT's Technology Review, April 25, 2007
--- http://www.technologyreview.com/Wire/18587/
Bob
Jensen's fraud updates are at http://faculty.trinity.edu/rjensen/FraudUpdates.htm
Bob
Jensen's threads on employee stock option accounting under FAS 123 are at
http://faculty.trinity.edu/rjensen/theory/sfas123/jensen01.htm
Bob
Jensen's threads on KPMG's woes are at http://faculty.trinity.edu/rjensen/Fraud001.htm#KPMG
"Backdating
Woes Beg the Question Of Auditors' Role," by David Reilly, The Wall
Street Journal, June 23, 2006; Page C1 --- http://online.wsj.com/article/SB115102871998288378.html?mod=todays_us_money_and_investing
Where were the auditors?
That question, frequently heard
during financial scandals earlier this decade, is being asked again as an
increasing number of companies are being probed about the practice of
backdating employee stock options, which in some cases allowed executives to
profit by retroactively locking in low purchase prices for stock.
For the accounting industry, the
question raises the possibility that the big audit firms didn't live up to
their watchdog role, and presents the Public Company Accounting Oversight
Board, the regulator created in response to the past scandals, its first big
test.
"Whenever the audit firms get
caught in a situation like this, their response is, 'It wasn't in the scope of
our work to find out that these things are going on,' " said Damon
Silvers, associate general counsel at the AFL-CIO and a member of PCAOB's
advisory group. "But that logic leads an investor to say, 'What are we
hiring them for?' "
Others, including accounting
professionals, aren't so certain bookkeepers are part of the problem.
"We're still trying to figure out what the auditors needed to be doing
about this," said Ann Yerger, executive director of the Council of
Institutional Investors, a trade group. "We're hearing lots of things
about breakdowns all through the professional-advisor chains. But we can't
expect audit firms to look at everything."
One pressing issue: Should an
auditor have had reason to doubt the veracity of legal documents showing the
grant date of an option? If not, it is tough for many observers to see how
auditors could be held responsible for not spotting false grant dates.
"I don't blame the auditors
for this," said Nell Minow, editor of The Corporate Library, a governance
research company. "My question is, 'Where were the compensation
committees?' "
To sort out the issue, the PCAOB
advisory group -- comprising investor advocates, accounting experts and members
of firms -- last week suggested the agency provide guidance to accounting firms
on backdating of stock options. A spokeswoman for the board said, "We are
looking to see what action they may be able to take."
To date, more than 40 companies
have been put under the microscope by authorities over the timing of options
issued to top executives. Federal authorities are investigating whether
companies that retroactively applied the grant date of options violated
securities laws, failed to properly disclose compensation and in some cases
improperly stated financial results. A number of companies have said they will
restate financial statements because compensation costs related to backdated
options in questions weren't properly booked.
All of the Big Four accounting
firms -- PricewaterhouseCoopers LLP, Deloitte & Touche LLP, KPMG LLP and
Ernst & Young LLP -- have had clients implicated. None of these top
accounting firms apparently spotted anything wrong at the companies involved.
One firm, Deloitte & Touche, has been directly accused of wrongdoing in
relation to options backdating. A former client, Micrel Inc., has sued the firm
in state court in California
for its alleged blessing of a variation of backdating. Deloitte is fighting
that suit.
The big accounting firms haven't
said whether they believe there was a problem on their end. Speaking at the
PCAOB advisory group's recent meeting, Vincent P. Colman, U.S. national office professional
practice leader at PricewaterhouseCoopers, said his firm was taking the issue
"seriously," but more time is needed "to work this through"
both "forensically" and to insure this is "not going to happen
going forward."
Robert J. Kueppers, deputy chief
executive at Deloitte, said in an interview: "It is one of the most
challenging things, to sort out the difference in these [backdating] practices.
At the end of the day, auditors are principally concerned that investors are
getting financial statements that are not materially misstated, but we also
have responsibilities in the event that there are potential illegal acts."
While the Securities and Exchange
Commission has contacted the Big Four accounting firms about backdating at some
companies, the inquiries have been of a fact-finding nature and are related to
specific clients rather than firmwide auditing practices, according to people
familiar with the matter. Class-action lawsuits filed against companies and
directors involved in the scandal haven't yet targeted auditors.
Backdating of options appears to
have largely stopped after the passage of the Sarbanes-Oxley corporate-reform
law in 2002, which requires companies to disclose stock-option grants within
two days of their occurrence.
Backdating practices from earlier
years took a variety of forms and raised different potential issues for
auditors. At UnitedHealth Group Inc., for example, executives repeatedly received
grants at low points ahead of sharp run-ups in the company's stock. The insurer
has said it may need to restate three years of financial results. Other
companies, such as Microsoft Corp., used a monthly low share price as an
exercise price for options and as a result may have failed to properly book an
expense for them.
At the PCAOB advisory group
meeting, Scott Taub, acting chief accountant at the Securities and Exchange
Commission, said there is a "danger that we end up lumping together
various issues that relate to a grant date of stock options." Backdating
options so an executive can get a bigger paycheck is "an intentional
lie," he said. In other instances where there might be, for example, a
difference of a day or two in the date when a board approved a grant, there
might not have been an intent to backdate, he added.
"The thing I think that is
more problematic is there have been some allegations that auditors knew about
this and counseled their clients to do it," said Joseph Carcello, director
of research for the corporate-governance center at the University of Tennessee.
"If that turns out to be true, they will have problems."
Question
What auditing firms are associated with worst options accounting abuses?
"Study
Finds Backdating of Options Widespread," by Stephanie Saul, The New
York Times, July 17, 2006 --- http://www.nytimes.com/2006/07/17/business/17options.html
More than 2,000 companies appear
to have used backdated stock options to sweeten their top executives’ pay
packages, according to a new study that suggests the practice is far more
widespread than previously disclosed.
The new statistical analysis,
which comes amid a broadening federal inquiry of the practice of timing options
to the stock market, estimates that 29.2 percent of companies have used
backdated options and 13.6 percent of options granted to top executives from
1996 to 2005 were backdated or otherwise manipulated.
So far, more than 60 companies
have disclosed that they are the targets of government investigations, are the
subject of investor lawsuits or have conducted internal audits involving the
practice, in which options are backdated to days when the company’s shares
trade at low prices. They include Apple Computer, CNet and Juniper Networks.
Last week, the United States attorney in San
Francisco announced a task force to investigate the backdating of
options, which appears to have been particularly popular in Silicon
Valley during the 1990’s dot-com boom. The study found that the
abuse was more prevalent in high-technology firms, where an estimated 32
percent of unscheduled grants were backdated; at other firms, an estimated 20
percent were backdated.
An author of the study said the
analysis suggested that the disclosures so far about backdated stock options
may be just the tip of the iceberg.
“It is pretty scary, and it’s
quite surprising to see,” said Erik Lie, an associate professor of finance at
the Tippie College of Business at the University of Iowa.
Professor Lie said the findings
were so surprising that he asked several colleagues to check his numbers.
Together, they concluded that the numbers probably erred on the low side.
The study by Professor Lie and
Randall A. Heron, of the Kelley School of Business at Indiana
University, was posted Saturday to a University of Iowa Web site. Using information from
the Thomson Financial Insider Filing database of insider transactions reported
to the Securities and Exchange Commission, the two men examined 39,888 stock
option grants to top executives at 7,774 companies dated from Jan. 1, 1996 to
Dec. 1, 2005.
The findings were based on an
analysis of whether share values increased or declined after option grant
dates. “Half should be negative and half should be positive,” said Professor
Lie. “That’s the underlying logic.”
But the analysis revealed that the
distribution was shifted upward.
“This is not random chance. It’s
something that’s manipulated, clearly,” said Professor Lie.
Of the companies examined, 29.2
percent, or 2,270, had at some point during the period manipulated stock option
grants, the study estimated.
“Over all, our results suggest
that backdated or otherwise manipulated grants are spread across a remarkable
number of firms, although these firms did not manipulate all their grants,” the
authors said.
The study concluded that before
Aug. 29, 2002, 23 percent of unscheduled grants — as distinguished from grants
that companies routinely schedule annually — were backdated. Unscheduled grants
are easier to backdate.
On that day, the S.E.C. tightened
reporting requirements to require that executives report stock option grants
they receive within two business days. After that, the backdating figure
declined to 10 percent of unscheduled grants, the paper said.
Professor Lie said that a number
of companies simply ignored the new reporting rule. “You still see problems.
The rule is not enforced,” he said.
Professor Lie, who first alerted
S.E.C. investigators to problems with backdating after an analysis that he
conducted in 2004, said there was some positive news in his new research.
“It has been suggested that some
accounting firms have been pushing this practice more than others,” he said.
“There’s actually very little evidence of that, which to me is very
comforting.”
The study found that smaller
auditors rather than larger ones were associated with a larger proportion of
late filings and unscheduled grants, which most likely lead to more backdating
and manipulative practices.
It also singled out two firms —
PricewaterhouseCoopers and KPMG — as being associated with a lower percentage
of manipulation.
Bob
Jensen's threads on why "Incompetent and Corrupt Audits are Routine"
are at http://faculty.trinity.edu/rjensen/FraudConclusion.htm#IncompetentAudits
Which
brings us to Congress, the villain of this tale that the rest of the press
corps wants to ignore. Executive greed is an easier story to sell, we suppose.
But the same Members of Congress who most deplore big CEO paydays are the same
ones who created the incentive for companies to overuse options as
compensation.
"Backdate
Backlash," The Wall Street Journal, May 27, 2006; Page A6 --- Click Here
These columns have never joined the media pack deploring
executive pay, since wages are best determined by directors and shareholders.
But that doesn't mean every pay practice is kosher, especially if it's done on
the sly. That's where the recent news over the "backdating" of stock
options is cause for some concern -- and for more aggressive director
supervision.
CEO pay has been going up, in part because the market is
putting a premium on the skills necessary to navigate today's legal and
competitive minefields. Some of the increases also flow from the greater use of
stock options, which came into their own in the 1990s thanks in part to
Congress (more on that below). Options are supposed to align the interests of
management with those of shareholders, but they can also be abused.
This appears to be the case with "backdating,"
which is the practice of moving the strike date for option grants to ensure
lower exercise prices and thus a bigger payday. Companies grant options
according to shareholder-approved plans, most of which require a grant to carry
the stock price on the day it was awarded. If it turns out the grant carries a
different day's price, those who do the "backdating" could be guilty
of false disclosure and securities fraud.
The number of companies doing this isn't clear, though the
SEC is investigating at least 20 and prosecutors have launched criminal probes
into a half-dozen. In the least savory instances, executives may have been
trying to pull a fast one by altering option dates without the approval of
directors. Vitesse Semiconductor Corp. recently fired three top managers,
including its CEO, because of what it called "issues related to the
integrity of documents relating to Vitesse's stock option grant process."
Never a good sign.
But some boards may also have been asleep at the option
switch. Affiliated Computer Services recently announced it will take a charge
against earnings of as much as $40 million due to accounting problems related
to option grants. Why? Well, ACS explained that its board compensation committee
has typically approved grants over the phone -- making them effective that day
-- with official written consent coming later. ACS says it believes this
practice was "permitted" under law, but shareholders might ask why
they are now getting stuck with the $40 million surprise tab.
Then there's UnitedHealth Group CEO William McGuire, who
is being pilloried for his $1.8 billion in unrealized option gains. The health
insurer has said it may have to restate three years of results due to a "significant
deficiency" in how it administered option grants, which would suggest
backdating.
But what especially caught investor eyes was the news that
the company's board had allowed Mr. McGuire to choose his own grant dates.
Directors may well have meant this as an added perk for a CEO whose tenure has
seen a 50-fold rise in UnitedHealth's share price. Yet the practice still looks
like an abdication by the board, which represents shareholders and is supposed
to guard against needless equity dilution.
Some companies have insisted that their boards consciously
pegged option grants to coincide with relatively low stock prices. But this
would seem to contradict the alleged purpose of options, which is to give
management an incentive to raise the stock price and thus the return to
shareholders. Granting options at a very low price amounts to additional
guaranteed compensation, and ought to be labeled as such.
Especially since shareholders will end up paying for this
executive privilege. UnitedHealth has lost more than $17 billion of its market
value since the backdating story broke. Several companies are restating
results, facing enormous back taxes and are already grappling with the usual
opportunistic lawsuits. * * *
Which brings us to Congress, the villain of this tale that
the rest of the press corps wants to ignore. Executive greed is an easier story
to sell, we suppose. But the same Members of Congress who most deplore big CEO
paydays are the same ones who created the incentive for companies to overuse options
as compensation.
In 1993, amid another wave of envy over CEO pay, Congress
capped the tax deductibility of salaries at $1 million. To no one's surprise
except apparently the Members who passed this law, most CEO salaries have since
had a way of staying just below $1 million year after year. But because
companies still need to compete for and retain top talent, they have found
other forms of compensation -- notably stock options.
And one of the problems with options is that they give
executives every incentive to capitalize all company profits back into the
stock price -- thus contributing to their own pay -- rather than paying out
dividends to shareholders. As SEC Chairman Chris Cox has noted, the 1993 law
deserves "pride of place in the museum of unintended consequences."
In a better world -- one in which Congress kept its nose
out of wage decisions -- corporate directors could pay the salaries they wanted
and wouldn't rely so much on options to motivate executives. This, in turn,
would reduce the incentive for companies to stoop to such dubious pay practices
as option backdating. But as long-time observers of Washington, we can say with certainty that
backdating will cease as a corporate practice long before Congress admits its
mistake.
Question
What are the accounting and tax implications of backdating employee stock
options?
The stock-options backdating scandal continued to
intensify, with the announcement by a Silicon Valley
chip maker that its chairman and its chief financial officer had abruptly
resigned. That brought to eight the number of officials at various companies to
leave their posts amid scrutiny of how companies grant stock options.
"Backdating Probe Widens as 2 Quit Silicon Valley Firm: Power
Integrations Officials Leave Amid Options Scandal; 10 Companies Involved So
Far," by Charles Forelle and James Bandler, The Wall Street Journal,
May 6, 2006; Page A1 --- http://online.wsj.com/article/SB114684512600744974.html?mod=todays_us_nonsub_page_one
More
on Accounting Fraud Via Backdating Options
"ACS
Says Some Options Carried Dates That Preceded Approvals," by Charles
Forelle and James Bandler, The Wall Street Journal, May 11, 2006; Page
A2 ---
http://online.wsj.com/article/SB114731443041049838.html?mod=todays_us_page_one
Affiliated Computer Services Inc. acknowledged that it
issued executive stock options that carried "effective dates"
preceding the written approval of the grants, saying it plans a charge of as
much as $40 million to rectify its accounting related to the grants.
The announcement followed a preliminary internal probe at
ACS, a Dallas
technology outsourcer that is also under scrutiny by the Securities and
Exchange Commission for its options practices. Between 1995 and 2002, the
company granted stock options to Jeffrey Rich, its chief executive for part of
that time, that were routinely dated just before sharp run-ups in the company's
share price, and often at the nadir of big dips.
Mr. Rich left the company last year. A rising share price
helped him reap more than $60 million from options during his tenure at the
company. The timing of his grants helped, too. If his six grants had come at
the stock's average closing price during the year they were dated, he'd have
made about 15% less.
Continued
in article
Is
any CEO really entitled to over $ 6 billion in gains on employee stock
options?
"Calpers Puts Pressure on Board of UnitedHealth: Holder Demands a
Meeting Over Option-Grant Timing; A Threat to Withhold Votes," by Vanessa
Fuhrmans, The Wall Street Journal, April 26, 2006; Page A3 --- http://online.wsj.com/article/SB114599506269535599.html?mod=todays_us_page_one
The California Public Employees' Retirement System is
demanding a conference call with the compensation committee of the board of
UnitedHealth Group Inc. over its disclosure practices, and is threatening to
withhold votes for board directors seeking re-election.
In a letter sent to James A. Johnson, chairman of the
UnitedHealth board's compensation committee, Calpers board President Rob
Feckner demanded a conference call ahead of Tuesday's UnitedHealth shareholders
meeting to discuss what he called "serious threats to the credibility,
governance and performance of UnitedHealth." Specifically, the letter
criticized the company's failure to explain how it determined stock option
grant dates for Chief Executive William McGuire and a handful of other
executives in past years, and its "inconsistent" disclosure of its
option-granting program.
The move by Calpers increases the scrutiny of the process
by which Dr. McGuire received some of the $1.6 billion in unrealized gains he
holds in company stock options. Calpers holds 6.55 million shares, or 0.5%, of
UnitedHealth's outstanding stock. The pension fund, known for its strong
stances on corporate governance, could spur other investors to join in its
criticism. The move also increases pressure on UnitedHealth's board to more
fully explain its past option-award practices soon, even though its board only
launched a probe into them earlier this month.
Continued
in article
After
the Horse is Out of the Barn: UnitedHealth Halts Executive Options
The UnitedHealth Group, under fire for the timing
of lucrative options grants to executives, said Monday that it had discontinued
equity-based awards to its two most senior managers and that it would cease
other perks like paying for personal use of corporate aircraft. UnitedHealth’s
board said it had discontinued equity-based awards for the chief executive,
William W. McGuire, who has some $1.6 billion in unrealized gains from earlier
options grants, and for the president and chief operating officer, Stephen J.
Helmsley.
"UnitedHealth Halts Executive Options," The New York Times,
May 2, 2006 --- http://www.nytimes.com/2006/05/02/business/02unitedhealth.web.html
From
The Wall Street Journal Accounting Weekly Review on May 19, 2006
TITLE:
UnitedHealth Cites 'Deficiency' in Options Grants
REPORTER: James Bandler and Charles Forelle
DATE: May 12, 2006
PAGE: A1
LINK: http://online.wsj.com/article/SB114734563729450037.html
TOPICS: Financial Accounting, Income Taxes, Materiality, Securities and
Exchange Commission, Stock Options, Taxation, Accounting Changes and Error
Corrections, Audit Quality, Auditing
SUMMARY:
UnitedHealth Group Inc. disclosed on May 11 that "...a 'significant
deficiency' in how it administered [stock option] grants could force it to
restate results ...[and cut] net income by as much as $286 million over that
period." The company also disclosed that the SEC is "conducting an
informal inquiry into its options-granting
practices"...UnitedHealth...said its internal review had indicated it had
uncovered 'significant deficiency' in the way it administered, accounted for
and disclosed past option grants and that it may be required to take certain
accounting adjustments for 'stock-based compensation expense.' It said that
could reduce operating earnings by up to $393 million in the past three years,
adding that the company's management believes that any adjustments would not be
'material'."
QUESTIONS:
1.) Summarize the issue regarding accounting for stock options that was
uncovered in a March 18, 2006, Wall Street Journal article and that has
subsequently been the subject of SEC scrutiny.
2.)
The summary description for this review quotes a paragraph in the article
describing the financial statement effects of potential adjustments the
deficiencies in UnitedHealth's option granting practices. The paragraph begins
"In its filing, UnitedHealth, which reported $3.3 billion in net income last
year..." Identify all of the terms in that paragraph with specific meaning
for accounting and/or auditing purposes. Define each of those terms, explain
why it has specific meaning in its use in accounting or auditing, and, if it is
a relevant point, explain why understanding that meaning helps to analyze the
impact of these options issues on UnitedHealth.
3.)
Refer again to the paragraph described in question 1. The concluding sentence
states that the company management believes that adjustments resulting from
their review of options granting practices will not be material. Contrast this
point to the comments by Professor James Cox of Duke University
that "this isn't just a little material...for this kind of issue."
Construct arguments to support one of these positions, being sure to refute
arguments potentially in favor of your opposing side. In your answers to this
and the preceding question, be sure to address the two components of
materiality in an audit engagement.
4.)
Refer to the list of companies in the table entitled "Key Companies in
Options Probes." In what industry do most of these companies operate? Why
is there industry concentration amongst this sample of firms?
5.)
What are the potential issues facing UnitedHealth's auditors, Deloitte and Touche,
regarding these matters? What basic audit steps do you think should be carried
out in relation to any company's accounting for stock options?
6.)
Do you think the situation with UnitedHealth necessarily indicates an audit
failure on the part of Deloitte and Touche? In your answer, define the terms
"audit risk", "business risk" in relation to audits, and
"audit quality."
7.)
Summarize the tax implications described in the article regarding these
matters. How might adjustments to the tax accounting for these stock options
exacerbate or reduce the impact of the adjustments to the accounting for stock
based compensation expense?
Reviewed
By: Judy Beckman, University
of Rhode Island
---
RELATED ARTICLES ---
TITLE: The Perfect Payday
REPORTER: Charles Forelle and James Bandler
PAGE: A1
ISSUE: Mar 18, 2006
LINK: http://online.wsj.com/article/SB114265075068802118.html
TITLE:
How the Journal Analyzed Stock-Option Grants
REPORTER: Charles Forelle
PAGE: A5
ISSUE: Mar 18, 2006
LINK: http://online.wsj.com/article/SB114265125895502125.html
From
The Wall Street Journal Accounting Weekly Review on May 5, 2006
TITLE:
As Options Cloud Looms, Companies May Get Tax Bill
REPORTER: Charles Forelle and James Bandler
DATE: Apr 28, 2006
PAGE: C1
LINK: http://online.wsj.com/article/SB114619341731038487.html
TOPICS: Accounting, Financial Accounting, Securities and Exchange Commission,
Stock Options, Taxation
SUMMARY:
Tax implications of the developing issues in stock options, covered also in a
recent Weekly Review, are discussed.
QUESTIONS:
1.) What is the recently-developing concern with dating of executive stock
options? In your answer, comment on the Securities and Exchange Commission
investigation into the issue. You may refer to the related article for your
answer.
2.)
Define the terms "compensatory stock options"; "incentive stock
options";"option grant date"; and "option exercise
price".
3.)
Summarize the tax implications to both executives receiving stock options and to
companies issuing stock options if option grant dates are changed to a point
when the stock price is higher than on the originally reported date, but the
exercise price is not changed.
4.)
The author quotes Mr. Brian Foley as saying that one company under SEC and IRS
scrutiny for this issue, UnitedHealth, would have a "serious and incurable
problem" if options were "backdated" and they have been
exercised. What could be the difference between options that were exercised and
options that have not been?
5.)
What are the financial reporting implications of the problems highlighted in
this article? How do the tax issues exacerbate the financial reporting
problems?
Reviewed
By: Judy Beckman, University
of Rhode Island
---
RELATED ARTICLES ---
TITLE: The Perfect Payday
REPORTER: Charles Forelle and James Bandler
PAGE: A1 ISSUE: Mar 18, 2006
LINK: http://online.wsj.com/article/SB114265075068802118.html
"As
Options Cloud Looms, Companies May Get Tax Bill," by Charles Forelle and
James Bandler, April 28, 2006; Page C1 --- http://online.wsj.com/article/SB114619341731038487.html
Companies that backdated stock-option grants to top
executives could face a costly reckoning with the Internal Revenue Service,
with some potentially owing large sums in back taxes, legal experts say.
The tax problems, which could affect the personal tax
filings of hundreds of individual employees, are the latest wrinkle in widening
inquiries into stock-option awards.
A half-dozen companies, including insurance titan
UnitedHealth Group Inc., have said their boards, or the Securities and Exchange
Commission, are examining their past option grants amid concerns that some may
have been backdated to take advantage of lower exercise prices. Backdating
could have resulted in millions of dollars in extra compensation for insiders,
at the expense of shareholders. Most of the probes are preliminary, and so far
the SEC hasn't charged anyone.
If the investigations turn up backdated grants, the
companies face a host of issues, including the prospect of earnings
restatements and delistings. Such options offer the right to buy a stock at a
fixed, or exercise, price, allowing the holder to profit by later selling the
underlying shares at a higher price than the exercise price.
One company that has acknowledged "misdating"
options, Mercury Interactive Corp., a Mountain View, Calif., software company,
has had its stock delisted by the Nasdaq Stock Market and has said it will have
to restate financial results. Vitesse Semiconductor Corp. last week suspended
its chief executive and two other top officials, saying the move was related to
the "integrity of documents" in its stock-option program. Late
Wednesday, Vitesse said its board had discovered additional accounting issues
and had hired a turnaround firm.
Granting an option at a price below the current market
value, while not illegal in itself, could result in problems of wrongful
disclosure under securities laws. Companies' shareholder-approved option plans
and SEC filings often say options will carry the stock price of the day the
company awards them or the day before.
Favorable tax treatment was one reason that options gained
popularity in the 1990s as a way to compensate employees, particularly
executives. When an option is exercised, the company typically can take any
gain pocketed by the employee as a deduction on its tax return, because the IRS
views the option profit as akin to extra compensation paid to the employee. The
employee reports the gain on his or her personal tax return.
Tax experts say that options backdated to a day with a
lower market price don't qualify for a deduction -- although the
disqualification only affects options exercised by the chief executive or any
of the next four most highly compensated executives. And $1 million of each of
the executives' total compensation always can be deducted. As a result, they
say, companies with backdated options could face the prospect of shelling out
cash to revise prior years' tax returns -- and could be ineligible for the
deductions they planned to take in the future on executive option gains.
A Wall Street Journal analysis, published in March,
described a pattern of unusual stock-option grants to a handful of chief
executives, including William McGuire, UnitedHealth's chief executive. Twelve
grants to Mr. McGuire between 1994 and 2002 were each dated in advance of a
substantial run-up in the company's share price, and three of them fell on
yearly lows. Last week, Mr. McGuire told investors on a conference call that,
"to my knowledge, every member of management in this company believes that
at the time we collectively followed appropriate practices."
The potential tax issues could be big, particularly for
companies whose stocks have greatly increased since the grants. UnitedHealth, Minnetonka, Minn.,
reported $346 million in realized option gains among its five best-paid
executives from 2003 to 2005. At the end of last year, it said its five
best-paid executives had another $2.4 billion in unrealized, exercisable
options gains. UnitedHealth's stock has soared since the 1990s, when many of
the options were granted. A board committee investigating options granting at
the company hasn't completed its work, and it isn't known whether any option
grants were backdated at all.
"If they had a backdating problem, and that's a big
if, the tax consequences could certainly be ugly," says Brian Foley, a
compensation consultant and tax lawyer in White
Plains, N.Y. With
respect to the already-exercised options, he added, "they would have an
obvious and serious and incurable problem."
UnitedHealth had a corporate-tax rate ranging between
34.9% and 35.7% in the past three years. Although the company's actual payments
likely were lower, that suggests the tax savings to UnitedHealth from exercised
executive options could have been as much as $120 million from 2003 to 2005. As
of end of 2005, the value of the future tax savings was as much as $800
million.
"That's a huge number," says Robert Willens, a
tax and accounting expert at Lehman Brothers Holdings Inc.
UnitedHealth has reported substantial tax benefits from
deducting its employees' stock option gains. Until recently, the company said
in its proxy statements that it believed its executive option grants qualify
for the tax deduction. Starting in a proxy filed in April 2005, it said some
options might not qualify, but that the amounts involved were immaterial. Ruth
Pachman, an outside spokeswoman for UnitedHealth, said in a statement that the
company "continues to believe" that its proxy statements were
accurate and remain accurate. She said the company "declined to speculate
about hypothetical scenarios."
Executives at other companies reporting options
investigations, including Vitesse and Affiliated Computer Services Inc.,
reported substantial options gains to top executives. ACS, which reported about
$44 million in realized options gains by its top five executives in the most
recent three fiscal years, didn't return calls. Vitesse officials didn't return
several messages seeking comment.
S. James DiBernardo, a partner at Morgan, Lewis &
Bockius LLP who specializes in tax issues, says there is no easy way to make
grants comply with the terms of the tax code retroactively. A company could
reprice the options, he says, but it would have to reprice them at the current
share value, effectively erasing all of an executive's past gains. Another
route is for the top executives to wait until after retirement to exercise the
options -- when they are no longer executive officers.
Ethan Yale, an associate professor at Georgetown University
Law Center
who was retained by UnitedHealth to look into this matter, agreed that the
issue could pose tax problems. He said this is largely uncharted territory and
ambiguities in tax rules might allow a company to get back in compliance
retroactively by repricing the options to the actual grant-date prices.
Continued
in article
"Guidance
on fair value measurements under FAS 123(R)," IAS Plus, May 8,
2006 ---
http://www.iasplus.com/index.htm
Deloitte & Touche (USA) has updated its book of
guidance on FASB Statement No. 123(R) Share-Based Payment: A
Roadmap to Applying the Fair Value Guidance to Share-Based Payment Awards
(PDF 2220k). This second edition reflects all
authoritative guidance on FAS 123(R) issued as of 28 April 2006. It includes
over 60 new questions and answers, particularly in the areas of earnings per
share, income tax accounting, and liability classification. Our interpretations
incorporate the views in SEC Staff Accounting Bulletin Topic 14
"Share-Based Payment" (SAB 107), as well as subsequent clarifications
of EITF Topic No. D-98 "Classification and Measurement of Redeemable
Securities" (dealing with mezzanine equity treatment). The publication
contains other resource materials, including a GAAP accounting and disclosure
checklist. Note that while FAS 123 is similar to IFRS 2
Share-based Payment, there are some measurement
differences that are Described
Here.
Bob
Jensen's threads on employee stock options are at http://faculty.trinity.edu/rjensen/theory/sfas123/jensen01.htm
Bob
Jensen's threads on fair value accounting are at http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue
Bob
Jensen's threads on valuation are at http://faculty.trinity.edu/rjensen/roi.htm
From
The Wall Street Journal Accounting Weekly Review on April 21, 2006
TITLE:
Comverse to Restate Results After Options Audit
REPORTER: James Bandler and Charles Forelle
DATE: Apr 18, 2006
PAGE: A3
LINK: http://online.wsj.com/article/SB114527632069427484.html
TOPICS: Accounting, Executive compensation, Financial Accounting, Stock Options
SUMMARY:
"Comverse Technology Inc. said that after a preliminary review of its
stock-option practices, it expects to restate more than five years of financial
results because the grant dates used in its accounting 'differed' from the
actual grant date...Comverse also said it could face delisting from the Nasdaq
Stock Market because it will be unable to file its annual report for the latest
fiscal year on time." The related articles describe the WSJ analysis of
stock option grants to identify unusual patterns in stock option grant dates
that led to the SEC investigation of several companies regarding this issue.
QUESTIONS:
1.) Summarize accounting for employee stock options. In your answer, define the
terms "grant date" and "measurement date" and identify
their importance to the accounting process.
2.)
Summarize the analysis undertaken by the Wall Street Journal to investigate the
timing of stock option grants. What was the objective of the analysis? What
conclusions were drawn?
3.)
Again refer to the analysis undertaken by the Wall Street Journal to
investigate the timing of stock option grants. How did the analysis support the
conclusions drawn? Are there any possible weaknesses in the support for the
conclusions drawn from the analysis?
4.)
What data used for the analysis of stock options were taken from the companies'
financial statements? Where in the financial statements can these data be
found? Be specific.
5.)
How will restatements affect prior earnings reported by companies who uncover
issues with option grant dates? Specifically describe the accounting and
reporting requirements for problems such as those uncovered by Comverse.
6.)
Under what circumstances will Comverse's cash flows be affected by changes
related to the timing of stock option grant dates? Explain how this answer
differs from your answer regarding earnings effects.
Reviewed
By: Judy Beckman, University
of Rhode Island
---
RELATED ARTICLES ---
TITLE: The Perfect Payday
REPORTER: Charles Forelle and James Bandler
PAGE: A1
ISSUE: Mar 18, 2006
LINK: http://online.wsj.com/article/SB114265075068802118.html
TITLE:
How the Journal Analyzed Stock-Option Grants
REPORTER: Charles Forelle
PAGE: A5
ISSUE: Mar 18, 2006
LINK: http://online.wsj.com/article/SB114265125895502125.html
From
The Wall Street Journal Accounting Weekly Review on January 27, 2006
TITLE:
Google Stock-Sharing Plan may Bite Investors
REPORTER: Gregory Zuckerman
DATE: Jan 19, 2006
PAGE: C1
LINK: http://online.wsj.com/article/SB113763917137950549.html
TOPICS: Accounting, Advanced Financial Accounting, Financial Accounting,
Financial Statement Analysis, Stock Options
SUMMARY:
Google has awarded an increasing number of 'performance-based stock units'
(restricted shares and options) as its business grows. The article analyzes the
impact of these issuances on future earnings. Questions focus on understanding
the accounting for stock options, the use of that information for analysis
presented in the article, and the FASB's concept statements on objectives of
financial reporting and qualitative characteristics of financial information
(particularly, predictive value).
QUESTIONS:
1.)
The author describes the issuances of employee stock options and restricted
stock by Google. Based on the information presented in the article, summarize
the accounting entries Google made .
2.)
From where does the author obtain the information to forecast the expected
impact of these stock and option issuances on Google's future earnings? To
answer this question, access Google's most recent 10-Q filing (for the 3
quarters ended 9/30/2005 and filed on 11/14/2005, available on the SEC's web
site at http://www.sec.gov/Archives/edgar/data/1288776/000119312505225524/d10q.htm
Specifically state where information that is presented in the article can be
found.
3.)
Robert Willens, a Lehman Brothers analyst, notes that compensation expenses for
stock options and restricted stock could impact earnings negatively
"unless the employees who are incentivized generate more than enough revenue
to cover the cost." Explain this analyst's statement.
4.)
The use of information from financial statements in the way that is done for
this article exemplifies the concept of the predictive value of financial
information identified in the Financial Accounting Standard's Board's Concept
Statements. Explain how this is so, including a definition of "predictive
value" as the phrase is used in the concept statements.
5.)
Identify an objective of financial reporting in the FASB's Concept Statement
No. 1 that is exemplified by this article; support your choice with an
explanation.
Reviewed
By: Judy Beckman, University of Rhode Island
With
the aid of a researcher from the University
of Iowa, the WSJ
uncovers evidence of backdating of employee stock options
"How
the Journal Analyzed Stock-Option Grants," by Charles Forelle, The Wall
Street Journal, March 18, 2006; Page A5 --- http://online.wsj.com/article/SB114265125895502125.html?mod=todays_us_page_one
The Wall Street Journal asked Erik
Lie, an associate professor of finance at the University of Iowa
who has studied backdating, to generate a list of companies that made
stock-option grants that were followed by large gains in the stock price.
The Journal examined a number of
the companies, looking at all of their option grants to their top executive
from roughly 1995 through mid-2002. Securities-law changes in 2002 curtailed
the potential for backdating a grant. Executives typically receive option
grants annually.
Mr. Lie and other academics say a
pattern of sharp stock appreciation after grant dates is an indication of
backdating; by chance alone, grants ought to be followed by a mixed bag of
stock performance -- some rises, some declines.
To quantify how unusual a
particular pattern of grants is, the Journal calculated how much each company's
stock rose in the 20 trading days following each grant date. The analysis then
ranked that appreciation against the stock performance in the 20 days following
all other trading days of the year. It ranked all 252 or so trading days in a
given year according to how much the stock rose or fell following them.
For instance, Affiliated Computer
Services Inc. reported an option grant to its then-president, Jeffrey Rich,
dated Oct. 8, 1998. In the succeeding 20 trading days -- equal to roughly a
month -- ACS stock rose 60.2%. That huge gain was the best 20-trading-day
performance all year for ACS. So the Journal ranked Oct. 8 No. 1 for ACS for
1998.
It is very unlikely that several
grants spread over a number of years would all fall on high-ranked days.
But all six of Mr. Rich's did.
Another of his option grants also fell on the No. 1-ranked day of a year, March
9, 1995. Two grants fell on the second-ranked day, those in 1996 and 1997. In
20 02, his options grant was on the third-ranked day of the year, and in 2000,
his grant came on the fourth-ranked day.
If a year has 252 trading days,
the probability of a single options grant coming on the top-ranked day of that
year would be one in 252. The chance of it coming on a day ranked No. 8 or
better would be eight in 252.
The analysis then used the
probability of each grant to figure how likely it is that an executive's
overall multiyear grant pattern, or one more extreme than the actual pattern,
occurred merely by chance. The more high-ranked days in the pattern, the longer
the odds and the more likely it is that some factor other than chance
influenced those dates. Two companies said they did use something other than
chance -- they made grants on days when they thought the stock was temporarily
low. This could explain results that differ somewhat from chance, but it wouldn't
account for the extreme patterns of consistent post-grant rises.
John Emerson, an assistant
professor of statistics at Yale, reviewed the methodology and developed a
computer program to calculate the probabilities for all of the executives'
grants except those to UnitedHealth CEO William McGuire. Because the number of
his grants and complexity of his pattern made a computational method
infeasible, the Journal used an estimate for his probability that Mr. Emerson
said is conservative. Mr. Emerson said the figures for all six executives
surpass a standard threshold statisticians use to assess the significance of a
result.
For Mr. Rich's grants, the
Journal's methodology puts the overall odds of a chance occurrence at about one
in 300 billion -- less likely than flipping a coin 38 times and having it come
up "heads" every time.
Exceedingly long odds also turned
up in the Journal's analysis of grant-date patterns at several other companies.
"It's very, very, very unlikely that they could have produced such
patterns just by choosing random dates," said Mr. Lie.
David Yermack, an associate
professor of finance at New York
University, reviewed the
Journal's methodology and said it was a reasonable way to identify suspicious
patterns of grants. But Mr. Yermack also said the odds shouldn't be thought of
as precise figures, largely because they depend on assumptions in the method
used to determine which grant dates are more favorable than others.
Because nobody actually
authorizing the grant on a given day could have known how the stock would do in
the future, the Journal's analysis used post-grant price surges as an
indication of possible backdating. Academics theorize that the most effective
way to consistently capture low-price days for option grants is to wait until
after a stock has risen, then backdate a grant to a day prior to that rise.
The decision to look at 20 trading
days after each grant was arbitrary. But Messrs. Yermack and Lie said it was a
reasonable yardstick to detect possible backdating. Using a longer period, such
as a year, wouldn't be a good way to spot backdating of a few days or weeks
because the longer-term trading would overwhelm any backdating effect.
The 20-day price rises don't
present an immediate opportunity to profit, since options can't usually be
exercised until held a year or more. But when the options do become
exercisable, they'll be more valuable if they were priced when the stock was
low.
Question
Why do standard setters pretend that accounting standards are "neutral?"
Who said that financial analysts "saw through" stock option
compensation whether or not options were booked?
From
The Wall Street Journal Accounting Weekly Review on February 17, 2006
TITLE:
Hold on Tight: Cuts in Profit Estimates Loom
REPORTER: Gregory Zuckerman
DATE: Feb 14, 2006
PAGE: C1
LINK: http://online.wsj.com/article/SB113988486291673150.html
TOPICS: Accounting, Advanced Financial Accounting, Earnings Forecasts, Earnings
per share, Financial Accounting, Stock Options, Stock Price Effects
SUMMARY:
Goldman Sachs analysts are warning investors to stay away from 30 companies
expected to face revisions in EPS estimates of 30% or more over the next 90
days due to the change in accounting requirements to expense employee stock
options. The article also covers the viewpoint that investors should not expect
substantial share price revisions due to this issue because it is a noncash
charge that reflects no change in underlying economic contracting.
QUESTIONS:
1.) Describe the change in accounting requirements that lead to the concerns
expressed by Goldman Sachs analysts. Why is this accounting change described as
a "non-cash charge" against earnings? What standard requires this
accounting treatment?
2.)
When was this change in accounting implemented? Why do the analysts expect to
see the effect of this change in earnings estimates over the next 90 days?
3.)
How is the change in earnings expected to affect stock prices? Specifically
describe the relationship between earnings and stock prices and address any
examples given in the article about that relationship.
4.)
What are the arguments against any significant adjustment to stock prices from
this earnings change? In your answer, specifically address three issues:
disclosure requirements in effect in FAS 123 prior to revision to FAS 123 (R);
the notion of a non-cash charge against earnings as discussed in answer to
question 1; and the concept of "pro-forma earnings" which you should
define.
5.)
What is the importance of the finding by Credit Suisse that "the amount of
money reaped by employees cashing in their options between 1999 and 2004 was
very close to the fair value placed on those options..."? How do you think
Credit Suisse analyzed this issue? Specifically explain whether you would find
the information that Credit Suisse likely used to undertake this analysis.
Reviewed
By: Judy Beckman, University
of Rhode Island
E&Y
REPORT ON SHARE-BASED PAYMENT – FASB STATEMENT NO. 123 --- Accounting
Education News, January 12, 2006 --- http://accountingeducation.com/index.cfm?page=newsdetails&id=142123
On December 16, 2004, the
Financial Accounting Standards Board (FASB) issued FASB Statement No. 123
(revised 2004), Share-Based Payment, which is a revision of FASB Statement No.
123, Accounting for Stock-Based Compensation. Statement 123(R) supersedes APB
Opinion No. 25, Accounting for Stock Issued to Employees and its
interpretations, and amends FASB Statement No. 95, Statement of Cash Flows.
While the Statement builds on many
of the concepts in Statement 123, there are significant differences between the
requirements of Statement 123(R) and Statement 123. Further, because of the
short time between issuance of the Statement and its required implementation
(annual periods beginning after June 15, 2005 for most public companies), it is
critical that issuers of options and other share-based payments to employees
quickly gain a thorough understanding of those requirements and be prepared to
implement them within an effective internal control framework. Because of the
length and complexity of Statement 123(R), efforts to understand and implement
the Statement should have already begun.
Ernst & Young have designed a
publication as a resource to help you become familiar with Statement 123(R) and
assess the impact that Statement 123(R) will have on your company’s financial
statements. Chapter 1 provides a high-level overview of Statement 123(R) and
describes considerations for compensation plan design and implementation of the
new Statement. The implementation discussion includes a description of certain
requirements of Statement 123(R) that are catching many preparers by surprise.
The remainder of this publication describes the requirements of Statement
123(R) in considerable detail. Throughout this publication they have included the
actual text from Statement 123(R) and other standards (presented in shaded
boxes) followed by their interpretations of that guidance (EY comments made
within the guidance are included in bracketed text).
"Options
and the Deferred Tax Bite: Just when you thought it couldn’t get any more
complicated," by Nancy Nichols and Luis Betancourt, Journal of
Accountancy, March 2006 --- http://www.aicpa.org/pubs/jofa/mar2006/nichols.htm
|
EXECUTIVE SUMMARY
|
|
Implementation of FASB Statement no. 123(R) goes beyond selecting a
method to value employee stock options. CPAs also must help companies
make the necessary tax accounting adjustments to properly track the tax benefits
from stock-based compensation.
Statement no. 123(R) requires companies to use deferred tax
accounting for employee stock options. An option’s tax attributes
determine whether a deductible temporary difference arises when the
company recognizes the option-related compensation expense on its
financial statements. Companies will treat nonqualified and incentive
options differently.
Companies that did not follow the fair value approach of
Statement no. 123 must establish an opening pool of excess tax benefits
for all awards granted after December 15, 1994, “as if” the company had
been accounting for stock options under this statement all along. To do
this CPAs must do a grant-by-grant analysis of the tax effects of options
granted, modified, settled, forfeited or exercised after the effective
date of Statement no. 123.
Certain unusual situations may require special handling.
These include cases in which employees forfeit an option before it is
vested, the company cancels an option after vesting or an option expires
unexercised, typically because it is underwater. CPAs also need to be
cautious of possible pitfalls when options are underwater, when the
company operates in other countries with different tax laws or has a net
operating loss.
Calculating the beginning APIC pool and the ongoing tax
computations required by Statement no. 123(R) is a complex process
requiring careful recordkeeping. The newly approved simplified method
adds yet another set of computations companies need to perform. CPAs
should encourage companies to begin making these calculations as soon as
possible as some require tracking down historical information.
|
|
|
An
innovative method of accounting for employee stock options.
The question is whether employees take a hit and how much the hit becomes if
they must eventually exercise options at less than full market value. Of
course the company might issue more options to them to make up the difference
which it seems to me defeats the purpose somewhat.
When the new rules regarding the expensing of
options go into effect over the next year, technology firms, like Cisco Systems
Inc., will be among the hardest hit. Billions of dollars are stake in Silicon Valley with its high concentration of technology
firms. But unlike other firms that are scrambling to meet the new requirements
in the next fiscal year, Cisco is seeking approval from the Securities and
Exchange Commission (SEC) for an innovative method of accounting for employee stock
options. The new method was proposed to the SEC by Cisco in March, 2005, an
anonymous source told MarketWatch. The plan calls for Cisco to sell a small
number of option-backed securities through an investment bank each time the
company issues stock options to employees. The securities, which would be
available only to large institutional investors, would carry the same terms and
restrictions as employee stock options. These securities would be priced using
the same Dutch method used by Google, Inc. for its initial stock sale last
year, however, the restrictions are expected to reduce the value of the
securities. Cisco would account for options issued at the same time at the same
price as the securities, rather than at the price as it would be set under current
rules. It is anticipated that since the price would be lower the dent made in
earnings by expensing the options would also be reduced. “In order to get an
accurate valuations for stock option valuation, Cisco is working on a market
instrument that would match the same attributes of an employee stock option,”
Cisco said in a statement to MarketWatch on Thursday. “We are awaiting guidance
from regulators on this instrument.” In response to a reporter’s question,
William Donaldson, chairman of the SEC said: “I think it’s a very interesting
approach.”
"Cisco Proposes Option for Options," AccountingWeb, May 13,
2005 ---
http://www.accountingweb.com/cgi-bin/item.cgi?id=100901
As
you may recall, Cisco and other companies in the past have taken a tremendous
advantage of a discrepancy between GAAP rules and tax rules prior to the
revised FAS 123 due to be implemented next year.
When the options are exercised there is cash foregone rather than a cash
outlay. The company simply issues stock for cash at the exercise price and
foregoes the intrinsic value (the difference between the market value and the
exercise price). In spite of fact that cash never flows for intrinsic value of employee
stock options, Cisco has enjoyed a tremendous tax break (millions in some years
and over a billion in at least one other year) in tax deductions for the cash
foregone. In other words, a company like Cisco might report over $1
billion in net profit to shareholders and a net loss to the IRS when requesting
a a large tax refund. The revised FAS 123 eliminates the intrinsic method
of GAAP accounting for stock options and forces fair value to be expensed at
the time of vesting. Now Cisco is proposing a method of reducing the
reported “fair value.”
Bob
Jensen’s threads and illustrations of employee stock option accounting are at
http://faculty.trinity.edu/rjensen/theory/sfas123/jensen01.htm
"TRANSFERABLE
STOCK OPTIONS (TSOs) AND THE COMING REVOLUTION IN EQUITY-BASED PAY"
by Brian J. Hall, Harvard Business School
This link was forwarded by Roger Collins --- http://www.sternstewart.com/content/journal/info/161hallfinal.pdf
Trinity University students may access file on the path
J:\courses\acct5341\theory\TransferableOptions.pdf
Bob Jensen's threads on employee stock options are at http://faculty.trinity.edu/rjensen/theory/sfas123/jensen01.htm
Question
Does the bursting of the subprime bubble shatter the theory of Black-Scholes hedging
of market risk?
"Inside
Wall Street's Black Hole," by Michael
Lewis, National Business News, March 2008 Issue ---
http://www.portfolio.com/news-markets/national-news/portfolio/2008/02/19/Black-Scholes-Pricing-Model/?PMID#
The striking thing about the
seemingly endless collapse of the subprime-mortgage market is how egalitarian
it has been. It's nearly impossible to draw a demographic line between the
victims and the perps. Millions of ordinary people ignorant of high finance
have lost billions of dollars, but so have the biggest names on Wall Street,
and both groups made exactly the same bet: that real estate values would never
fall. Stan O'Neal, the former C.E.O. of Merrill Lynch, was fired for the same
reason the lower-middle-class family in the suburban wasteland between Los Angeles and San
Diego may have lost its surprisingly nice home. Both
underestimated the likelihood of an unlikely event: a financial panic. In
retrospect, the small army of Wall Street traders who lost tens of billions of
dollars in subprime-mortgage investments looks as naive and foolish as the man
on the street. But there's another way of viewing this crisis. The man on the
street, for the first time, acted on the same foolish principles that have
guided the behavior of sophisticated Wall Street traders for the past few
decades.
If you had to pick a moment when
those principles first appeared a bit shaky, you could do worse than the 1987
stock market crash. Black Monday was the first of a breed: a panic that
suggested disastrous economic and social consequences but in the end had no
serious effects at all. The bursting of the internet bubble, the Asian currency
crisis, the Russian government bond default that triggered the failure of the
hedge fund Long-Term Capital Management—all of these extreme events seemed, in
the heat of the moment, to have the power to change the world as we know it. None
of them, it turned out, was that big of a deal for the U.S. economy or
for ordinary citizens. But the 1987 crash marked the beginning of something
else too—a collapse brought about not by real or even perceived economic
problems but by the new complexity of financial markets.
A new strategy known as portfolio
insurance, invented by a pair of finance professors at the University of California
at Berkeley,
had been taken up in a big way by supposedly savvy investors. Portfolio
insurance evolved from the most influential idea on Wall Street, an options-pricing model called Black-Scholes. The model is
based on the assumption that a trader can suck all the risk out of the market
by taking a short position and increasing that position as the market falls,
thus protecting against losses, no matter how steep. Nearly every employee
stock-ownership plan uses Black-Scholes as its guiding principle. A
pension-fund manager sitting on billions of U.S. equities and fearful of a
crash needn't call a Wall Street broker and buy a put option—an option to sell
at a set price, limiting potential losses—on the S&P 500. Managers can
create put options for themselves, cheaply, by shorting the S&P as it
falls, and thus, in theory, be free of all market risk.
Good theory. The glitch was
discovered only after the fact: When a market is crashing and no one is willing
to buy, it's impossible to sell short. If too many investors are trying to
unload stocks as a market falls, they create the very disaster they are seeking
to avoid. Their desire to sell drives the market lower, triggering an even
greater desire to sell and, ultimately, sending the market into a bottomless
free fall. That's what happened on October 19, 1987, when the sweet logic of
Black-Scholes was shown to be irrelevant in the real world of crashes and
panics. Even the biggest portfolio insurance firm, Leland O'Brien Rubinstein
Associates (co-founded and run by the same finance professors who invented
portfolio insurance), tried to sell as the market crashed and couldn't.
Oddly, this failure of financial
theory didn't lead Wall Street to question Black-Scholes in general. "If you try to attack it," says one longtime
trader of abstruse financial options, "you're making a case for your own
unintelligence." The math was too advanced, the theorists too smart; the
debate, for anyone without a degree in mathematics, was bound to end badly. But
after the crash of 1987, individual traders at big Wall Street firms who sold
financial-disaster insurance must have smelled a rat. Across markets—in stocks,
currencies, and bonds—the price of insuring yourself against financial disaster
rose. This rise in prices and the break with Black-Scholes reflected two new
beliefs: one, that huge price jumps were more probable and likely to be more extreme
than the Black-Scholes model assumed; and two, that you can't manufacture an
option on the stock market by selling and buying the market itself, because
that market will never allow it. When you most need to sell—or to buy—is
exactly when everyone else is selling or buying, in effect canceling out any
advantage you once might have had.
"No one believes the original
assumptions anymore," says John Seo, who co-manages Fermat Capital, a $2
billion-plus hedge fund that invests in catastrophe bonds—essentially bonds
with put options that are triggered by such natural catastrophes as hurricanes
and earthquakes. "It's hard to believe that anyone—yes, including me—ever
believed it. It's like trying to replicate a fire-insurance policy by
dynamically increasing or decreasing your coverage as fire conditions wax and
wane. One day, bam, your house is on fire, and you call for more
coverage?"
THE PROBLEM
This is interesting: The very theory underlying all
insurance against financial panic falls apart in the face of an actual panic. A
few smart traders may have abandoned the theory, but the market itself hasn't;
in fact, its influence has mushroomed in the most fantastic ways. At the end of
2006, according to the Bank for International Settlements, there were $415
trillion in derivatives—that is, $415 trillion in securities for which there is
no completely satisfactory pricing model. Added to this are trillions more in
exchange-traded options, employee stock options, mortgage bonds, and God knows
what else—most of which, presumably, are still priced using some version of
Black-Scholes. Investors need to believe that there's a rational price for what
they buy, even if it requires a leap of faith. "The model created
markets," Seo says. "Markets follow models. So these markets spring
up, and the people in them figure out that, at least for some of it,
Black-Scholes doesn't work. For certain kinds of risk—the risk of rare, extreme
events—the model is not just wrong. It's very wrong. But the only reason these
markets sprang up in the first place was the supposition that Black-Scholes
could price these things fairly."
Continued in artricle
Jensen
Comment
Although the Black-Scholes Model may be popular when companies are valuing
stock options, the fact of the matter is employees tend not to like this model
for employee stock options because they place a higher premium on the
possibility that the options will take at worthless value --- http://faculty.trinity.edu/rjensen/theory/sfas123/jensen01.htm
Things to Consider When Valuing Options
FASB Rules That Companies Must Begin Deducting Stock Options
From Profits Next Year --- http://biz.yahoo.com/ap/041216/accounting_rules_7.html
This applies to all employees under the FASB ruling, but the U.S. House
of Representatives under heavy tech industry lobbying approved (312 for, 111
against) legislation to limit expense treatment for stock options to only those
granted to the top five officers of a company.
Does anybody know the status of this pending
legislation?
See http://faculty.trinity.edu/rjensen/theory/sfas123/jensen01.htm
December
16, 2004 Reply from Dennis Beresford
The Senate never acted on this so the House bill dies at the end of the
year. It could be reintroduced in the new Congress but certain key Senators
have expressed strong opposition so most observers think a legislative override
of the new FASB standard is unlikely.
Accounting Standards are Not Neutral (i.e., they change
management decisions)
Question
How do you value a capped option?
Answer
Beats me, but the Black Scholes model component for time value must be
modified. But then the BS model doesn't work too well anyway since
employees tend to value uncapped options much lower than BS model estimates
(mostly out of fear that their options will tank). They will accordingly
reduce their estimates of value even lower if the options have caps. I
leave it up to you to explain to students why options with seven year expiration
dates have lower value than traditional ten year dates, which in turn will
result in higher corporate earnings per share if seven year expirations are
used. Hint: It all has to do with that time value component of
option value.
"Stock-Option Plans Get Revised to Meet New Rule,"
by Linlling Wei, The Wall Street Journal, December 30, 2004, Page C3 --- http://online.wsj.com/article/0,,SB110435344663812226,00.html?mod=todays_us_money_and_investing
Companies are giving their
stock-option plans makeovers.
In preparation for an accounting
mandate that they treat employee stock options as an expense, companies are slashing
option grants, replacing garden-variety options with various forms of stock
compensation or tweaking the features of standard options.
"Most companies are looking
at 'what are the alternatives?' " said Judy Thorp, national partner
in charge of the compensation and benefits practice at KPMG.
One move under consideration, pay
specialists say, is to cap the potential gain an employee or an executive can
get from cashing in options. Tech Data Corp., for instance, already has won shareholder
approval to issue such "maximum-value" stock options. Applera Corp.
recently asked shareholders to vote on a similar proposal. Officials at both
companies weren't available for comment.
A cap can make options less costly
to companies than traditional options. It also "eliminates a concern of
some investors that the open-ended nature of a traditional option could result
in windfall gains for employees or executives," said Carl Weinberg, a
compensation expert in the human-resources practice at PricewaterhouseCoopers.
Stock options give recipients the
right to buy their companies' shares at a fixed price within a certain period.
They pay off only if the stock price rises, unlike stock grants that companies
have long had to count as expenses. Employees, compensation experts say, tend
to exercise their options well before the rights expire, which typically occurs
10 years after the grant date.
Stock options grew in popularity
during the 1990s. About 14 million American workers -- or 13% of the work force
in the private sector -- hold options, according to professors at Rutgers University and Harvard University.
Under the new Financial Accounting
Standards Board rule, companies will have to deduct the value of stock options
from profits, beginning in mid-2005. The options are valued when they are
issued, and companies spread the cost out over the vesting period. Technology
companies -- heavy issuers of options -- could continue to lobby Congress to
derail the rule, but analysts see little chance of congressional intervention.
Some companies, including Exxon Mobil Corp. and insurer Progressive Corp., have stopped granting stock options
altogether. Instead, they make grants of restricted stock, or shares that
recipients can't sell for a set period. Because they provide a more certain
payoff, companies usually can dole out fewer such shares. It is also easier for
companies to value these shares.
Other companies, like SBC Communications Inc., are
turning to stock grants that are paid out only when specific financial or
operational targets are met. Shareholders favor such "performance
shares" as a way to align compensation more closely with investors'
interests. Microsoft Corp.
has decided to give its top 600 managers shares tied to the company's
performance.
Shareholders of Intel Corp., meanwhile, have
approved a new option plan that, among other changes, requires employees to
exercise options in seven years instead of 10. At aluminum company Alcoa Inc., new stock options
will have a six-year lifespan instead of 10 years. Options with shorter lives
have a lower value.
Research by Stanford
University accounting and
economics faculty add empirical evidence on how firms manipulate ("Gaming
of the System") footnote disclosure of employee stock options under FAS
123. The study add strong empirical support to the forthcoming FASB new
standard that will require booking of options on the date of vesting.
"Toting
Up Stock Options," by Frederick Rose, Stanford Business, November
2004, pp. 21 --- http://www.gsb.stanford.edu/news/bmag/sbsm0411/feature_stockoptions.shtml
Accounting for employee stock
options thus has been a riddle. After some 30 years of dispute and
countervailing pressures, options are once again the focus of accounting
debate. Companies currently must follow a Financial Accounting Standards Board
ruling cobbled together in 1995, when the last major battle over options
accounting was fought. Forces that favored compulsory expensing lost that
earlier policy debate. The current rule, known as FAS 123, came into effect for
fiscal years ending after December
15, 1995, and began to lift the veil around options. But, while FAS
123 requires employers to disclose some calculations for employee options
grants in financial notes, there is no stipulation that costs be expensed on
the corporate income statement. The FASB and its supporters were routed at the
last minute and compelled to permit a giant loophole. The loophole frees
employers to avoid income statement recognition of options expenses by opting
for the 1972 Opinion 25 that had allowed avoidance of options expensing in the
first place. FAS 123 added the requirement for footnote disclosures.
Now, the Financial Accounting
Standards Board is again moving toward requiring options expenses. “Let the
mud-slinging begin—again,” CFO Magazine sniped earlier this yearAnd indeed it
did. Global pressure played a hand this time. The International Accounting
Standards Board—Business School professor and associate dean Mary Barth is a
member—has adopted requirements much like those of FAS 123, but stipulating
that the calculations be used to determine income statement expenses. The
international standards will come into force January 1, at which time American
accounting standards could be weaker than elsewhere if solutions aren’t set in
the United States.
But on this round of debate there
has been new insight. In a potential breakthrough, two Stanford professors
created a key to the accounting quandary. An approach proposed by economists
Jeremy Bulow and John Shoven identifies a feature common to virtually all
current employee option programs and uses that to overcome many of the problems
of uncertainty that blocked options expensing in the past. Accounting and
securities regulators expressed considerable interest in Bulow and Shoven’s
proposal, and earlier this year a Financial Times opinion piece endorsed
the approach. Importantly, the Financial Times piece was written by a
triumvirate of options experts that included Robert Merton, who with Myron
Scholes was awarded the 1997 Nobel Memorial Prize in Economic Sciencesfor
groundbreaking options valuation analysis developed with the late Fischer Black
that has emerged as the “Black-Scholes” formula.
Bulow, who is the Richard A. Stepp
Professor of Economics at the Business
School, and Shoven, the
Charles R. Schwab Professor of Economics and director of the Stanford Institute
for Economic Policy Research, opened up this accounting approach by chopping up
the continuous time of an option’s run into discrete units. We’ll consider the
theory in more detail, but it is important to first look at present accounting
problems with options.
Accounting Dissected
Graduate School of Business research has produced disconcerting evidence
that while current accounting footnotes influence investors and add to their
understanding of a company, they appear to have been used at times in distorted
ways that fail to fully reflect the weight of employee stock options. Mary
Barth and Ron Kasznik, together with David Aboody of the Anderson School of
Management at UCLA, in a paper this year found that options—even where they are
absent from the income statement—are viewed by investors as a cost to the firm.
The study sampled more than 750 companies between 1996 and 1998 with elaborate
statistical checks.
Barth, Kasznik, and Aboody used
footnote disclosures required by FAS 123 to consider assumptions used by the
reporting companies. These notes require an estimated value of options grants
using the Black-Scholes formula. The calculation appraises the time value of
options through an assumed risk-free interest rate, projected volatility of the
stock, and forecast dividend yield. There is thus considerable guessing about
future periods as much as a decade ahead. If investors believed that options
stimulated employees to substantially improve performance—rather than just
dipping into the shareholders’ cookie jar—companies with substantial employee
options outstanding should perform better, not worse. Yet the Stanford
researchers found that the market performance of those stocks with higher
estimated options expenses lagged stocks with less. In short, whether the
numbers are right or wrong, investors have their opinions, do react, and often
don’t like what they see.
GSB researchers moreover unearthed
distressing signs that investor faith in FAS 123 footnotes could be misplaced.
A separate work by Barth, Kasznik, and Aboody finds that wide management
discretion over assumptions used in calculations has at times understated
publicly reported options expenses. Analyzing over 3,800 corporate financial
results during the years 1996 to 2001, the researchers concluded that
understatement of these expenses was more likely in cases where companies
granted large quantities of employee options and were active in capital
markets, thus exposing themselves to more scrutiny by banks and investors.
Manipulation of key numbers is
easy. While Barth, Kasznik, and Aboody noted little fudging of interest rate
assumptions, which can be compared with other forecasts, they found that
company estimates of future stock volatility, dividend yield assumptions, and
expected option life were subject to “downward management” by firms anxious to
keep perceived option costs low and implicit earnings high.
Moreover, research by Kasznik and
Aboody several years ago found that company managers tend to stick a thumb on
the scales when it comes time to set stock option exercise prices—either
releasing bad news shortly before options were usually granted or holding off
good news until options were set. In either case, exercise prices would be
depressed—to the prospective advantage of management option recipients.
Timeline Solutions
Such “gaming of the system” could be substantially reduced under the Bulow and
Shoven approach. In their central thesis, the two economists write: “Most
companies’ long-term options are not really very long term at all. While an
option may technically expire after 10 years, the employee only has 90 days to
exercise if he either quits or is fired. Therefore, what an employee with a
vested option really owns at any given time is a 90-day option.” This
understanding of a short, finite period greatly simplifies options accounting.
With this short window, a Black-Scholes calculation can be based on far firmer
estimates, using well-established short-term interest rates, recently observed
stock volatility, and current dividend rates—and for larger firms, direct
market prices of publicly traded options—to yield a firm expense number.
To implement this method, firms
would expense the value of 90-day options at the beginning of each quarter, the
value determined by the exercise price and the current stock price. This
expense would be offset partially by the ending (intrinsic) value of any 90-day
options expensed in the previous quarter and not exercised. Firms would have
some flexibility in choosing when to begin expensing unvested options, but they
would be taking the risk of a large charge if the stock price rose before
expensing began because there is no offset in the first quarter that an option
is expensed.
This approach prompted keen
interest. “The Bulow-Shoven method appears to remove one of the last valid
arguments against expensing options. In the coming months, all sides of this
debate will have to reconsider their views and positions,” wrote Financial
Engineering News in a recent article.
But the Bulow-Shoven proposal
arrived late on the scene and conflicted in some important parts with standards
the FASB had put forth in draft policy earlier this year. It also differed from
the International Accounting Standard that is to come into effect on January 1
after extensive efforts to coordinate with U.S. standards. While the
economists found substantial initial interest among regulators, the FASB in
early August voted to stick with its earlier proposed revisions. Minutes of the
board’s meeting indicate the board—contending in part that elements of the
approach were at odds with current accounting concepts—sidestepped the
economists’ proposals.
Bulow is sympathetic with the
FASB’s position. “It’s very tough for these regulators,” he notes. “Accounting
rules pre-date modern financial theory, and the regulators must develop each
rule with an eye toward how it affects everything else.” He likens the problem
to computer coding complexity. Microsoft’s current Windows software is far
bulkier and more convoluted than modern Linux coding “in part because it must
be made backward compatible to previous systems, which in themselves were
developed to be backward compatible all the way back to DOS.” Even so, once
opened up, the economic interpretation of options accounting may yet give rise
either to restructured employee incentives or eventually to yet another accounting
change, he suggests. “For a variety of reasons, most people not in the business
of charging for option valuation software or suing companies would be better
off if we adopted some version of Bulow-Shoven,” he says.
Continued in article
One of the Dumbest Bills in the History of the U.S. Congress
(only not quite as dumb as a new law passed by the Indiana Legislature).
An obvious example of the junk compromises that lobbying money can buy.
Either stock options are booked as expenses or they are not booked as expenses.
From The Wall Street Journal Accounting Educators' Review on July 22, 2004
TITLE: House Passes Curb on Expense Rules for Stock Options
REPORTER: Michael Schroeder
DATE: Jul 21, 2004
PAGE: C3
LINK: http://online.wsj.com/article/0,,SB109035089345768760,00.html
TOPICS: Financial Accounting, Financial Accounting Standards Board, Stock
Options
SUMMARY: The House approved legislation to limit expense treatment for stock
options to only those granted to the top five officers of a company. This
legislation responds to a standard proposed by the Financial Accounting
Standards Board (FASB) requiring expense treatment for the value of all
employee stock compensation. "The House vote gives the tech lobby, led by
Cisco Systems Inc. and Intel Corp., a significant victory over a weighty list
of policy makers who argued against Congress intruding in
standard-setting...."
QUESTIONS: 1.) Describe the current accounting and reporting requirements
for employee stock options. What standard establishes these requirements?
2.) Describe the changes proposed by the FASB in this area of accounting.
Hint: you may verify your understanding of the proposal by reading the document
on the FASB's web site at http://www.fasb.org/draft/ed_intropg_share-based_payment.shtml
3.) Again reference the FASB's exposure draft via the following link http://www.fasb.org/draft/ed_intropg_share-based_payment.shtml
What were the FASB's reasons for proposing this change? Why hasn't this
required accounting been implemented before now?
4.) What are Congress's reasons for proposing this legislation? Who supports
the legislation?
5.) As a professional accountant, are you concerned about Congress passing
laws regarding the development of accounting standards? Why or why not?
6.) Refer to the related article. How are the companies who support this
legislation in Congress described as 'irresponsible'? How is this issue of
stock compensation tied to stock buy back programs?
The House,
responding to lobbying by technology companies, overwhelmingly approved a bill
that would limit the required "expensing" of stock options.
The bill
overrides a proposal by a national accounting-standards panel that would have
required companies to expense the value of all stock options. In their 312-111
vote, the lawmakers instead approved legislation to limit the expensing rule to
options granted only to the top five officers of a company. The Financial
Accounting Standards Board had proposed earlier this year that companies
subtract the value of all employee stock compensation from company profits.
The House
vote gives the tech lobby, led by Cisco Systems Inc. and Intel Corp., a significant victory over a weighty list of
policy makers who argued against Congress intruding in standard-setting in the wake
of major accounting-fraud scandals beginning with Enron Corp.
Among strong
supporters of stock-option expensing as a means to improve the accuracy of
financial statements are Federal Reserve chairman Alan Greenspan, Treasury
Secretary John Snow, and Securities and Exchange Commission William Donaldson.
Mr. Greenspan warned Congress earlier this year "it would be a bad mistake
for the Congress to impede FASB," because the proposed accounting for
stock options "strikes me as correct."
Still, the
measure faces stiff opposition in the Senate. Even though a comparable bill is
pending in the Senate with 25 co-sponsors, Richard Shelby (R., Ala.), who
chairs the banking committee, has pledged to block any effort by Congress to
meddle in rule-making by FASB, an independent accounting-standards body based
in Norwalk, Conn.
Sen. Peter
G. Fitzgerald (R.,Ill.), joined by Sens. John McCain (R,., Ariz.), Carl Levin
(D., Mich.) and Richard Durbin (D.,Ill), introduced a resolution to protect
FASB's independence and integrity under its assault by the House. But critics
of the bill say they are worried that House leadership may attempt to
short-circuit the process by inserting an amendment in a must-pass
appropriations bill that would derail FASB's stock-options proposal.
In approving
the measure, a bipartisan roster of members argued that the proposal would
cause hits to earnings, particularly for small technology companies, and hurt
start-up companies that depend on stock options as an important compensation
tool to attract talent. The accounting rule would mostly penalize the
rank-and-file employees of small companies who depend on company stock for an
important part of their compensation, bill supporters said.
--- RELATED ARTICLES ---
TITLE: Microsoft Can Count. Intel Can't.
REPORTER: Jesse Eisinger
PAGE: C1
ISSUE: Jul 21, 2004
LINK: http://online.wsj.com/article/0,,SB109035182748468780,00.html
Tech
companies have a choice of two paths, and both were on display yesterday.
Microsoft Corp. -- long viewed by laymen, computer geeks and the
feds as the Darth Vader of the technology world -- decided to do right by
shareholders. After a long period of anticipation, the company finally figured out
what it wants to do with its Olympian mound of green, and it chose wisely.
Microsoft
decided to give back to shareholders even more cash than investors had been
expecting. The company raised its ongoing dividend, giving the company about 1%
dividend yield; said it would buy back $30 billion of stock over four years;
and said it would issue a special $32 billion one-time payout. (See related article.)
And then
there is the path of the irresponsible. It has been chosen by Intel Corp. and Cisco Systems Inc. and denizens of Silicon Valley.
Nonetheless, these companies are celebrated by investors and accorded huge
multiples. These are the companies that refuse to pay significant dividends,
hoard cash and buy back stock merely to mask the massive dilution that comes
from their shareholder-damaging stock-option programs.
As Microsoft
was announcing its shareholder-friendly plan, Silicon
Valley was sitting on the shoulders of members of Congress,
whispering sweet nothings in their ears. As in, stock options cost nothing. And
312 members of the House listened.
That was the
number of congressmen who voted for the Baker Bill, a measure that damages efforts
of the Financial Accounting Standards Board to enact rules mandating the
expensing of stock options. The bill violates FASB's independence and fights
the inevitable. Hundreds of companies have moved to voluntarily expense stock
options because compensation costs companies money -- no matter what Silicon Valley will have Congress believe.
Continued in the article
July 24, 2004
reply from David Albrecht [albrecht@PROFALBRECHT.COM]
I prefer to think that
the House was injecting a little sanity into the process. If the FASB would
stop trying to accomplish social purposes with their rules, I'd be a lot
happier.
To be sure, there is no
actual dollar cost to the company when it issues stock options to employees.
Hence, in my opinion, there should be no expensing (expense=the cost of doing
business).
The option program must
be ratified by elected representatives of the shareholders, so it is OK with
that group. Why, oh why, does the FASB persist in promoting certain social
agendas?
If there was to be any
accounting for the stock options, then it should be through comprehensive
income. However, the FASB has gutted that in its quest to be politically
correct and try to limit an options practice that directly enriches the many
(executives and stockholders) over the interests of the many (employees).
And Bob, I don't think I
have an uneducated view, so don't persist in calling me dumb (a reasonable
inference from the subject of your e-mail). I really don't like being called
dumb. So knock it off!
David Albrecht
July 25, 2004
reply from Bob Jensen
Hi David,
I think you missed the point David. Are you
defending the legislation itself as being smart rather than dumb?
The DUMB part of the law passed by Congress is that
it doesn't resolve anything in accounting. The bill would not be dumb if it
banned all expensing of employee stock options. The bill would not be dumb if
it required expensing of employee stock options. The magic number five is the
DUMB part.
I did not say that expensing stock options is dumb.
I did not say that NOT expensing stock options is dumb. What is dumb is the
legal declaration of a magic bright line number five. The "top five"
employee stock options are legally declared expenses and all other employee
stock options are legally declared not expenses.
For example, if the fifth executive on the ladder
at Cisco is awarded stock options having a value of $3.2 million, this becomes
legally an expense under the new U.S. House legislation. Fifty three other
executives at Cisco receiving options valued at
$3.1415926535897932384626433832795 did not receive anything of worthwhile under
this legislation and there is no expense.
This is a little like declaring Pi to be legally
3.20 for the first five years of school and a non-terminating decimal
3.1415926535897932384626433832795... after grade five (see Glen Gray's message
on the Indiana Legislature's new definition of Pi). Following the new Indiana
Law, a new chapter must now be added to the History of Pi --- http://www-gap.dcs.st-and.ac.uk/~history/HistTopics/Pi_through_the_ages.html
In any case, when was David Albrecht ever
associated (never by me) with a non-expensing stock option accounting theory? I
assume you were being factitious. Just because you declare stock options not to
be an expense in your email message is a religious argument. It won't sell
unless you can back it by an argument that sells. At the moment arguments on
both sides are selling, although I think Silicon Valley
executives are selling for reasons of deceit rather than theory that I can buy
into. And yes I am aware of some sound arguments for not expensing stock
options, especially those of Walter Schuetze --- http://faculty.trinity.edu/rjensen/theory/sfas123/jensen01.htm
Do you think that Silicon
Valley is spending millions on this lobbying effort to defend the
pureness Walter Schuetzes' theoretical arguments or to defend a theory of
deception that earnings are really higher because an employee receiving
$3.1415926535897932384626433832795 million in stock options really did not cost
anybody anything. Either the employee is being deceived or investors are being
deceived by following this new bright line of five legislation.
Cisco argues out of both sides
of its mouth when it comes to cash flow and stock options. It argues that there is no expense for intrinsic
value on the date of vesting since there is value granted but no cash
flow. Cisco argues that there is tax
expense on the date of exercise even though there is never cash flowing out of
the company for options at any time.
When the options are exercised
there is cash foregone rather than a cash outlay. The company simply issues stock for cash at
the exercise price and foregoes the intrinsic value (the difference between the
market value and the exercise price). In
spite of fact that cash never flows for intrinsic value of employee stock
options, Cisco has enjoyed a tremendous tax break (millions in some years and
over a billion in at least one other year) in tax deductions for the cash
foregone.
Given that there is cash
foregone in the case of options, the apparently unresolvable accounting issue
is whether to deduct the expense on the accrual basis (i.e., deduct the value
on the date of vesting) or the cash basis (on the date of exercise).
However, if we follow David
Albrecht's argument that cash must actually flow out of Cisco for there to be
compensation expense, then we might also come to the conclusion that there is
never to be recognized compensation expense since cash never actually flows
even when options are exercised. When
employees exercise their options the company has simply sold them some stock.
Would Cisco ever hate this if the U.S. Tax Code followed the same line of
reasoning.
Of course cash can actually be
made to flow since a company could issue stock at full price and simply give
employees a cash "bonus" equal to intrinsic value. In the end, the accounting issue really
becomes one of accrual versus cash basis accounting. Since we estimate bad debt and warranty
expenses on an accrual basis before cash actually flows, it makes more sense to
me to do the same thing with stock options since GAAP is rooted in the accrual
basis for financial reporting.
The tax code is more complex and
inconsistent than GAAP since it has a greater cash flow orientation (e.g., for
bad debts and warranty expenses) even though there are some accrual items as
well (e.g., inventory buildup).
Thus I would argue that the
question is not one of whether there is cash flow or no cash flow. The question is whether one adopts an accrual
accounting for options or the present cash foregone basis of accounting on the
date of exercise.
Bob Jensen
July 25, 2004
reply from Dennis Beresford [DBeresfo@TERRY.UGA.EDU]
I'd be interested in why
you believe stock option expense should be included in comprehensive income
rather than the income statement. Should the issuance of restricted stock be
treated similarly? What principle or other guideline do you think should be
used to determine what goes into one of these measures vs. the other? The FASB
(along with the IASB) is in the process of reconsidering the notion of
comprehensive income and I'm sure they would be interested in views on this
topic.
I agree with Bob
Jensen's assessment that the recently passed House of Representatives bill is
one of the dumbest things that group has done. The House would have been more
honest if it had simply passed a bill that said something like, "A lot of
companies have told us that expensing options will hurt the economy and we
believe them." Instead, they have characterized the bill as a
"compromise" saying that it will deal with the "real
problem" of certain executives receiving obscene amounts of total
compensation (this may be the "social purpose" that you allude to).
Thus, the bill calls for recording expense for only the five most highly
compensated individuals and assuming no volatility in determining the value of
the options for those individuals. If dumb isn't the right way to describe that
approach, how about idiotic, insane, or similar terms?
It's been ten years
since I had to deal with this issue at the FASB and I'm certainly glad that the
target is on someone else's back this time around and not mine. However, I do
have to say that it pains me to see that we are still not having what I would
call a fully informed debate on this subject. I had fully expected the
opponents to expensing stock options to dream up a number of new arguments this
time around, but they are simply recycling the old ones. The House action can't
be characterized as anything than the purchase of a position through political
contributions. I'm keeping my fingers crossed that the Senate won't be so dumb.
Denny Beresford
University of Georgia
As the FASB and SEC struggle to join the International Accounting Standards
Board (IASB) in requiring the expensing of stock options when vested (which I think
is the best accounting alternative), the large and powerful technology industry
lobby is swinging its weight around the halls of Congress to get its own way.
SUMMARY:
Jack Ciesielski, publisher of Analysts' Accounting Observer, used Google's
disclosures of compensation expense and deferred compensation from its employee
stock option plans to estimate the value corporate officers place on their
soon-to-be-issued stock.
1.)
In general, summarize the two ways in which Mr. Ciesielski estimated the value
placed on Google shares by corporate officers.
2.)
What disclosures did Mr. Ciesielski use to estimate the value placed on Google
shares by corporate executives? In general, what standards and laws require
these disclosures? What specific SEC requirement provided useful information in
the disclosures for the first quarter of this year?
3.)
Focus on the method of estimation using the deferred compensation account and
the SEC requirement reflected in the accounting during the first quarter of
this year. Where is "deferred compensation" under stock option plans
included in the financial statements? What amount is included in that account?
How could Mr. Ciesielski determine that Google added $75.4 million to that account?
4.)
Focus on the estimation using the Black-Scholes formula. What is that formula
designed to estimate? What inputs must be used to make this estimate? How could
Mr. Ciesielski, and Professor Larcker, run this model "backwards"?
5.)
What advantage in the marketplace can an analyst obtain by being able to use
accounting information in such a clever way as Mr. Ciesielski has done?
SUMMARY:
Firms following International Financial Reporting Standards (IFRS) will be
required to expense stock options as of January 1, 2005. European companies "have realized
this is coming and have changed their ways of remunerating employeses,"
said an analyst with UBS in London.
Questions focus on understanding the use of IASs in comparison to USGAAP and on
the implications of accounting standards for economic behavior.
2.)
What are the major differences between current USGAAP and the new IFRS on stock
compensation?
3.)
How much will the standard being adopted by the IASB influence development of a
new accounting standard on stock compensation in the US? What other factors influence
the potential change in US reporting in this area?
In the table below, I present a series of messages between me and a friend
who was trying to make a case for expensing stock options at intrinsic rather
than full value (intrinsic plus time value).
The disagreement between President Bush and Alan Greenspan
regarding accounting for employee stock options (ESOs) is noted in Appendix C
of this letter.
Each company had only one highly skilled employee. The Nobel Cash employee agreed to cash wages,
whereas Nobel the Nobel Option employee received an option to purchase 15,000
shares of stock. At the end of five
years, she was entitled to exercise her option by paying out $10 for a share of
stock having a par value of $1 per share.
Actual value of the option depended upon the performance of her company
and its outlook for the future that is extrapolated, in part, from past
performance.
Both companies earned $2 for every $1 spent and had exactly
the same revenue performance. To
simplify the illustration, it will be assumed that no return was possible on
any idle cash.
Note that the Nobel Cash and Nobel Option accounting
outcomes illustrated above would be generated out of either the current FASB
rules or the exit value model proposed by Walter Schuetze. Both models are identical for a company that
has only cash as an asset and no liabilities.
If both companies had gone public with an IPO, chances are
high that the Nobel Option company would have been much more successful in
terms of the prices received for each share sold to the public. But when the companies liquidated after five
years, the original shareholder, Kent Nobel, actually obtained less ($312,000)
from the Nobel Option company than the $320,000 he received from Nobel
Cash. He also lost voting control of the
Nobel Option company while retaining control of the Nobel Cash company.
If the companies did not liquidate after five years, the
value to employees could be much higher than the $468,000 liquidation
value. One major reason is the fact that
intangibles are not booked, and the revenue growth suggests that there are some
unbooked intangibles allowing the companies to double reported revenue every
year. Value could also be less for a
variety of reasons, including off-balance sheet financing and diminished
optimism for future performance that is not yet reflected in the financial
statements.
My bottom line conclusion is that failing to book (expense)
employee stock options, in traditional or exit value accounting models, creates
highly misleading financial reports that inflate earnings per share, retained
earnings, and even cash and other assets.
It is also possible to use the cash saved in wages to reduce debt,
further improving the attractiveness of the a company that has, in effect,
hidden “debt” in deferred employee compensation locked up on stock option
plans.
Walter Schuetze argues that employee stock options are
shareholder liabilities rather than the liabilities of the firm. I agree that employee option holders are not
creditors, but they are out there silently gobbling up larger and larger shares
of equity in their companies. The FASB
fought long and hard for a tougher standard than FAS 123, but accounting firms
like Arthur Andersen fought vigorously to derail the FASB’s attempts to require
firms to book stock options when they are granted.
Under either current FASB 123 or exit value accounting, investors are
misled by stock option accounting that does not book and expense such options on
the grant date.
My summary for how the Arthur Andersen fought against the
FASB is summarized in the following reference:
SUMMARY:
While "restricted stock generally requires continued employment...[and]
employees don't have ownership rights on the shares until several years after
they are awarded...executives are getting paid dividends on their restricted
stock before it has vested." Disclosures of executive compensation often
exclude these dividend payments.
2.)
What does the author say companies indicate as reasons for paying dividends on
restricted stock?
3.)
How is it possible that executives may receive dividends on stocks they never
end up owning?
4.)
Paul Hodgson, a researcher in executive compensation, estimates that some
companies reinvest the dividends for executives holding restricted stock. How
does this alleviate the concerns raised in this article?
5.)
Prepare summary journal entries, without dollar amounts, made by companies that
award dividends on restricted stock and then require the dividends to be
reinvested.
6.)
Compare the results of the transactions described in question 6 to the results
of a stock dividend, explaining both similarities and differences. Do you think
that these two transactions are perceived differently by stockholders?
7.)
As stated in the article, ""Dividends are additional compensation and
should be disclosed as exactly that.'" Are dividends on restricted stock
paid to executives included in compensation expense in the income statement?
Support your answer.
8.)
What disclosures are required regarding dividend payments? How can analysts and
investors "crunch the numbers" using these disclosures to determine
dividends received by executives on restricted stock if disclosure of that
amount is not made under compensation disclosures?