The Stock Options Mirage

WE all agree today that preferential allotments of shares to promoters area form of highway robbery that benefits promoters at the expense of small shareholders. But are stock options all that different? They too are preferential allotments, not to promoters but to selected employees and managers.

Whereas preferential allotments to promoters are reviled as robbery, stock options are praised as incentives that keep morale high and share wealth equitably with key employees. Infosys is widely admired for creating dozens of crorepati employees, Microsoft for creating a thousand millionaire employees.

And yet, according to the Financial Accounting Standards Board of the USA, stock options divert profits from shareholders to beneficiaries. Worse, they grossly exaggerate the profits of companies by not recording stock options as an expense.

So shareholders are duped twice over, first by getting exaggerated data on profits and second by suffering equity dilution through the constant issue of new shares to employees as stock options.

According to The Economist, between 1991 and 2000 Microsoft issued 1.6 million shares as stock options and bought back 677 million shares to partly offset the equity dilution.

The buy-back cost was a whopping $16.2 billion, and so the company claimed $12 billion as tax relief. But while for tax purposes it showed stock options as an enormous expense, it made no such revelation in the accounts presented to shareholders.

According to a study by Smithers and Co., which has researched this matter, if Microsoft had accounted properly for its stock options, then in 1998 it would have made a mammoth loss of $17.8 billion, as against its actual claim of a profit of $4.5 billion.

The sums involved are mind-boggling. It is one thing to share some wealth with employees, quite another to have a situation where employee compensation converts apparently large profits into even larger losses. Warren Buffet, the legendary investor, has summed up the issue in his usual blunt fashion.

“If stock options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And if expenses shouldn’t go into the calculation of earnings, where in the world do they go?”

Another set of accounting problems arise in mergers and acquisitions. When one company takes over another, the purchase price typically exceeds the book value of assets, the difference being goodwill. One accounting practice is to write off the goodwill over a period of years.

The second practice is called pooling — the acquirer records the cost of acquisition as simply the assets of the acquired company. Just imagine: you can pay $100 million for a company with $5 million of assets, and $95 million of this cost will not appear on your balance sheet.

The result: the cost of acquisitions is greatly understated, and that explains in part why so many mergers produce poor outcomes.

Understatement means that returns to capital after merger are artificially inflated. This suits those keen on pushing for mergers, including top managers who have little else to show as achievements, but is grossly misleading and unfair to investors.

The accounts of Ciso, a superstar of the new economy, have been analysed in the magazine Barron’s by Abraham Briloff, a professor of accounting. In the financial year ending June 2000, Cisco bought 12 other companies for a total cost of $16 billion, paid for with its shares.

Five of these purchases, worth $1.2 billion, were not regarded as significant enough to even be taken into account in restating the company’s profits. The other seven companies, for which Cisco paid $14.8 billion, were shown as costing just $133 million. Thus, thanks to pooling, $16 billion of acquisitions were shown as costing only $134 million.

The FASB is now cracking down on pooling. This will probably mean a dramatic decline in mergers and acquisitions. Which is probably excellent news for shareholders.

What are the implications for India? Nobody seems to know for sure. It seems that nobody has specialised in doing a really searching analysis of how stock options and mergers and acquisitions are affecting the value of companies.

The question is of prime importance in new economy sectors, mostly computer software but also entertainment and some other specialised services. New economy companies have been liberal, sometimes very liberal, in issuing stock options.

And, more recently, many software companies have started acquiring smaller firms at home and abroad. Clearly this can have major implications for shareholders, and the outcome needs to be spelled out in the interests of transparency and fairness.

Stock options have strong defenders, of course. If stock options were not handed out, wages would have to be higher, and fewer employees would stay on. Remember that not all stock options are exercised. Departing employees lose their options.

And in some cases the market price may fall below the issue price, making options worthless. All this makes it relatively difficult to make a fair estimate of the current cost of stock options, whose future value involves guesswork. Is it the cost of buying back an equivalent number of shares from the market? Maybe, but there could be different views on this.

The balance sheet of Infosys has several interesting entries relating to stock options. One entry says that Indian GAAP does not require amortisation of deferred stock compensation but American GAAP does.

Accordingly, the company has provided $3.8 million dollars for amortising stock options in the nine months ending December 2000. The net profit for this period under Indian GAAP is $97.8 million, under American GAAP $93.6 million. This is not a dramatic difference.

However, it would be premature to conclude that the impact is modest for all companies, or that stock options and acquisitions have been accurately costed by all companies. We need a really hard-noseds look at the accounts of all companies that have been prominent in stock options and mergers. That could reveal quite a few cans of worms.

What do you think?