Friday, August 8, 2008

Accounting for Stock Options

One of the most elusive accounting concepts for me has been stock options. How does one account for stock options? Should it be expensed from the income statement as a cost? Or should we only increase the number of shares and thus dilute the earnings for the shareholders. Mr. Marty Whitman, Chairman of Third Avenue Funds suggests that from a creditor’s and company’s standpoint stock options should not be expensed as it is not a cash charge and has no effect on credit-worthiness of a company. He certainly believes that stock options are compensation from a stockholders point of view but given that stock options result in dilution, their effect is best reported in the dilutive effect of the earnings per share rather than as an expense for the company. According to him, Mr. Buffett’s view about stock options is an over generalization and that stock options are not a cost to the company.
He believes that it is a fallacy to consider cost of options to the company as equal to the value of the options to the recipient. To drive home his point he even cites an example where a sales clerk buys a $100 sweater for a 40% discount from her department store for $60 and the store incurs $100 as cost because that is what the sweater is worth to the sales clerk even though the actual cost for the sweater might be $35.
But I don’t agree with Mr. Whitman. The above situation is not analogous to stock options.
Options are given with intention of retaining talent and are the cost of retaining talent. So they must be definitely expensed as a cost in the income statement. Its similar to the cost of labour and cost of capital, the cost the company must bear to recruit labour and capital. Even when the store sells sweaters at 40% discount its is incurring a cost of $40 to retain its sales clerk and if it becomes a industry wide practice it would become compulsory for the store to give discounts to its employess and would eventually become a necessary $100 cost to retain employees beacause that is the value of the sweater to the company also. Mr. Whitman has explained his views from two perspectives, one of the creditor and other of the stockholder but from neither standpoint he believes stock options to be expensed as a cost from the income statement. But I believe atleast from a shareholders standpoint its a cost which must be expensed from the income statement.
By the way I read this matter about stock options from Martin Whitman’s letter, 2002

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