Stock Options and Coke, Part Two

[rowyn]

If it’s not an expense, what is it?

A footnote.

Let me elaborate.

A typical accountant-prepared financial statement contains a balance sheet and a income statement. The balance sheet shows all the company’s assets (real estate owned, inventories, accounts receivables,* etc.) and liabilities (loans, accounts payable,** etc.) The income statement shows how much money the company has paid out and how much money they were paid.

The balance sheet and the income statement provide varying levels of detail depending on how the accountant chooses to present numbers, but they usually summarize the company’s entire standing, and they usually occupy one or two pages each, whether it’s for a mega-corporation like Coca Cola, or a mom-and-pop grocery store. (Assuming Mom & Pop bother to prepare one at all).

In addition to the balance sheet and income statement, the financial statement may contain assorted other disclosures, the company’s statement of purpose, expectations for coming years, rah-rah-cheerleading, and footnotes. How much space this stuff takes up varies from company to company. Coca Cola’s year-end 2000 statement was 64 pages, and that’s not an unusual length. (You can see it for yourself here but don’t blame me if it causes your brains to leak out of your ears.)

When investors look at a company’s financial statement, they flip through until they get to the balance sheet and income statement, maybe look over the cash-flow numbers if those are separate, maybe do a little number-crunching of their own to examine various ratios. Few people—even among analysts, professional stock brokers, and financial journalists—even glance at the rest of it. Some do. One of the men from The Motley Fool emphasized, among his reasons for not investing in Yahoo!, an intense distrust for their free-wheeling handling of stock options. (Sorry for the lack of a specific link; I got the article some weeks ago via email and don’t know where it is in the site archives.)

My point is this: companies, especially high-tech companies, offer their employees in some cases the majority of their compensation in the form of stock options. CEOs get millions of dollars in stock options. And this is a footnote on the financial statement? Microsoft to investors: “Oh, and, by the way, we gave out two billion dollars in stock options, too. But that’s nothing you need to worry your pretty little head about.”

Further, this accounting practice distorts the use of stock options. Think about it. CEO looks over his books, thinks to himself: “Hmm, if I give all my employees 5% raises, that’ll lower my net income by 20%. But if I give them all 100 stock options, that doesn’t effect my bottom line at ALL. Hey, I can give out 200 stock options each, or 2,000! What difference does it make? Stock options are FREE! Stock options for everyone!”

Wince.

The issue of stock option abuse is both real and serious, and much too close to my facetious example above. The Congressional accounting reform bill pushed through the Senate on Monday declined to address it (though it may yet come up when the House and Senate reconcile their versions, I don’t know.) There are honest reasons for not wanting to treat stock options as an expense. Mostly, it’s just that they’re hard to value. If you’re going to expense them, you need to do so when they vest—when the employee first becomes able to use them-- not when they’re exercised. (Otherwise they could hugely distort your company’s financial picture. “Our stock rose 70% this year! Then all our employees cashed all their accumulated stock options, causing us to have paper losses of 2.5 billion. Now our stock has plummeted 85%.”)

At the point at which options vest, the company has no idea how much they’re going to end up worth to the employee. It may become worth thousands, or they may be completely worthless, depending on what the market does. Further, there’s no direct exchange of money at this point, either. It’s not like the company has cut a check to the employee. There’s no “accounts payable” holding funds to cover the “cost” of the options. Those against expensing stock options contend that it will make the financial statement more “opaque”--harder for the average person to understand.

However, the market is expert at valuing all kinds of risks, bets, hedges, derivatives, and whathaveyou. Companies already use formulas to tell their employees how much those options they haven’t used are going to be worth. They can evaluate what they’re worth. And they can tell their stockholders how much it’s cost them.

And, in my not-so-humble-opinion, they should.

Monday, Coca-Cola joined a handful of other companies in announcing that they would to do so. Coca-Cola’s decision is particularly noteworthy because the other companies (like Boeing) aren’t nearly as big or influential as Coke, who has the potential to start a trend, forcing other companies to join them or risk being snubbed by investors.

Moreover, as a libertarian, I am particularly pleased to see a large company recognize the value in doing the right thing. Being honest with your investors is good for business. Congress shouldn’t have to tell you that. And in Coca-Cola’s case, they didn’t.

So, here’s to you, Coca-Cola.

I’ll have a Coke and a smile.


* Accounts receivable is a fancy way of saying “Money others owe me and haven’t paid yet.”
** Accounts payable is “money I owe others but haven’t paid yet.”

Comments

[chipuni.livejournal.com]

Just letting you know:

These articles are superb. Have you tried posting them to, say, Kuro5hin?

[rowyn]

Thank you. :) No, I haven't tried posting them elsewhere. To be honest, I hadn't thought of trying to reach a wider audience than my friends, since what I put in here is readily available around the 'net. I just know that a lot of people are either too intimidated or too disinterested in financial news to look into this sort of thing--or even to click on a link, if I provide one. But I figure most of the people on my friends list will read what I compose myself, if only out of curiousity to see what caught my interest enough to rant about. I know that I'm that way with, say, Prester Scott. I don't necessarily read his sources (maybe half the time?) but I invariably read his own essays.

So this was more my way of trying to reach my immediate friends and share something I feel is important. And maybe help people see that you needn't be an expert in the field to understand it. :)

I hadn't been to Kuro5hin before. I'll have to give it a look. Perhaps it'd be worth it to offer it to a broader audience.

[prester-scott.livejournal.com]

Outstanding! Thank you for my financial education of the day (and likely the month or year).

Rowyn, I owe you a coke.

[koogrr.livejournal.com]

Yay! It made sense.

I didn't read the 64 pages, because I don't want leaky brain ears.

[minor-architect.livejournal.com]

I agree with Chip - these articles are excellent. Including the one on credit card companies, whatever anyone else may think. ;-) Ever thought about joining the ranks with Sam Gordon (and my own father, for that matter) and becoming an econ prof? You could sign up with a university that offers classes over the Internet and teach 'em that way!

Okay, so that wasn't an entirely serious suggestion. Just how much of that was serious and how much was in jest, I'll leave to you to figure out. ;-)

[rowyn]

Heehee. Thanks, Sophrani. I couldn't be an economics teacher, though. I mean, any potential employer probably want me to take an economics course or something first. At least an accounting class. :)

Liberty

[awolf.livejournal.com]

For a self-proclaimed libertarian, you're ironically advocating for more control within corporations. Drift down here to the seamy side of socialism sometime, dear. ;)

Trickster

Re: Liberty

[caffeinewabbit.livejournal.com]

Actually, she's advocating more self-control within corporations - which is responsible capitalism - as opposed to government controls. Those are very Libertarian ideas.

Re: Liberty

[awolf.livejournal.com]

Mm, you're right, she is.

(No need to espouse my own views here.) :)

Trickster

Re: Liberty

[rowyn]

Yup. :) As a libertarian, I'd like to think that corporations have a more direct and vested interest in getting accounting standards right than the gov't does. (And let's not forget how Congress manages *its* books, hmm?)

Though, realistically, I have to wonder if the market *does* need improved standards forced upon it, since lately corporations have been behaving just as stupidly and short-sightedly as any federal agency. It pains me to say it, but maybe the government could help. }:) (And, actually, I do believe that a free market requires some amount of government intervention, if only so you have someone around to lock up the con men of the corporate world.)

Re: Liberty

[rowyn]

A libertarian is in no way opposed to controls on individual or corporate behavior -- as long as those controls are not imposed by the government. This is why I'm particularly pleased by Coca-Cola's action--because it was entirely voluntary, and done in the absence of any government mandate to do so. :)

The difference between a socialist and a libertarian might be said to be one of optimism. A socialist thinks that government can, and should, force people to do good. A libertarian thinks people will do good if you just leave them alone, and they'll do it more efficiently to boot. We all agree on the ends, we just differ on the methods. }:)

Re: Liberty

[awolf.livejournal.com]

I think people will do good if you leave them alone, but corporations aren't the same as individuals. Corporations are profit machines, and just as the system of peer review is less biased than individual reviewers, corporations are more greedy than individual employees. The system is rigged for spectacular failures when there are no outsider-imposed checks and balances.

But we could argue this all night--you have excellent points, and I too commend Almighty Coke. ;)

Trickster

Re: Liberty

[koogrr.livejournal.com]

It's my opinion that the Libertarian model breaks down once a corporation gets big enough that it is effectively a government. A responsible business and informed consumer model only works when an individual has a noticeable impact, and not when the corporation can assure it is the only game in town. While not a phenomenon one experiences in the US, I can attest that in Canada there was significant 'shoving around' of the government by Multinationals, who demanded concessions, tax breaks, and standards exemptions or they'd take their profit generator someplace else. One gets even more fun in a Company-Town. I think the Libertarian model only works with small business, mom and pop type stores that can't afford to operate at a loss, or price fix in various geographical locations.

I agree that optomism is a part of it, and largely feel that liberals like a powerful government simply so it is capable of pushing back on the un-elected, irresponsible corporations that go too far. To the extent that the government follows the will of the people, it is manifesting the need to control and manage something that a person on their own is unable to. So which to trust more? The answer keeps changing.

Large Corporations Don't Have the Clout You Give Them Credit for

[(Anonymous)]

I think that you are overrating the clout of large corporations. It is true that they have considerable influence when dealing with governments eager to attract their business (e.g. US States or most countries). Where they lack that influence is in dealing with financial markets.

Since Sunday, WorldCom shares have been completely worthless (because of the bankruptcy filing). This didn't happen because of congressional investigation, but because other corporations protected themselves. WorldCom's banks had a provision written into their contracts which required WorldCom's financial statements to comply with generally accepted accounting principles, so when the accounting fraud was revealed, WorldCom was immediatly in default and the credit line could be revoked at will. In addition, WorldCom's vendors started demanding payment faster because they suspected that bankruptcy was coming. It was these two factors rather than anything the government did which forced the company into bankruptcy. For good measure, the markets' opinion of WorldCom's value made it impossible for the company to raise any money by selling stock.

WorldCom was not a small company (over 100 Billion in assets at book prices, although they may sell for far less because of the current glut of telecom equipment), but it was powerless against the forces the financial markets set against it once its situation was known, and you can bet that it will only get tougher to be a CEO in the future. If I were running a bank which was being asked to give, say, Sprint a $5 Billion dollar credit line for next year, not only would the terms force them to comply with generally accepted accounting principles, but I'd get to select and supervise the auditor.

These days, many corporations are dashing to disclose additional details, but I think that the real driver isn't the SEC's new requirement that CEOs swear to the accuracy of their financial statements. These companies have every reason to fear their stock price being pummeled by the market if something embarasing appears to have been concealed and gets out later.

In the long run, the best way to protect against corporate misbehavior is for stockholders to vote with their feet when problems are revealed. That would make many types of corporate misbehavior no longer worth the risk (of course it works best for fighting abuses which could directly hurt lenders or shareholders where this threat is most credible).

Telnar

[caffeinewabbit.livejournal.com]

Last spting I had to write a report over Boeing's financial report, and man, did it suck my will to live. 70 pages of rhetoric and buzzwords - I was lucky to even find the income statement.

It used to be that stock options were created through the use of reserve stock, which was recorded as owner's equity at the time of creation (if I remember correctly). Just shows you how irresponsible the internet boom made everybody :P