Staff Options Impair the Informative Value of Net Income

In accordance with the US-American Generally Accepted Accounting Principles (US-GAAP), employers are not required to state personnel expenditure in full in the balance sheet when remunerating employees with share options. This signifies that the reported net income for the year is higher than is actually the case.

Dr. Dieter Hess and Erik Lüders conducted a scientific study at the Centre for European Economic Research (ZEW), Mannheim, and analysed whether companies exercise this accounting option systematically, and whether the net income for the year is still informative enough when using this option. The results suggest that the use of this option may lead to considerable misjudgements of the earnings situation. Interestingly enough it is the "New Economy" companies that exercise this accounting option by substituting a large share of salary payments with options. According to estimations made by Hess and Lüders, Broadcom and Yahoo would have to record a loss instead of a profit for the financial year 1999 if they did not use this option.

How can it be that the US-American accounting principles, which are known to be very rigid, allow for such options? After heated discussions, Statement 123 of the Financial Accounting Standard Board (FAS 123) was adopted in October 1995, and recommends that the fair value of staff options, i.e. the value that would be attained for them at the stock exchange, be recorded as personnel cost. This, however, is not mandatory. Rather, it is within the discretion of the companies to continue on the basis of the older Opinion 25 of the Accounting Principal Boards (APB 25) which does not prescribe the statement of the fair value, but only of the internal value of the options. The latter constitutes the difference between the share price at the point of time when the right of option was granted and the exercise price of the option, i.e. the price for the purchase of this share. If a company desires to reduce its personnel costs to zero that have to be reported for awarded staff options, it only needs to select the exercise price in such a way that it corresponds to the share price, i.e. it grants so-called at-the-money options and reports them in accordance with APB 25 in the balance sheet. It is precisely this course of action that can be observed in most American companies. Solely two of the 500 values of the S&P-Index act on the recommendation of FAS 123 and report the options' fair value as personnel costs.

The concealed costs can be recognised when appreciating how much one would have to pay for such options on the market. Usually, companies award call options with a maturity from eight to ten years. These options are not tradable and cannot be exercised in the first four years, nevertheless, it is possible to calculate a fair value on the basis of option pricing models. According to calculations made by Hess and Lüders the fair value is usually 20 to 40 percent of the share price.

Contact

Dr. Dieter Hess, E-mail: dieter.hess@uni-konstanz.de

Erik Lüders, E-mail: lueders@zew.de