The Executive Compensation Controversy - Fondazione Rodolfo ...

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THE EXECUTIVE COMPENSATION CONTROVERSY: 24 MAY 2010A TRANSATLANTIC ANALYSISthe CEO through cash compensation or non-qualified stock options, and €1.57 to convey €1in qualified stock options. Thus, for executives and companies in the highest tax brackets,qualified stock options became tax disadvantageous compared to non-qualified stock options,and (as illustrated in Figure 2.7) have remained so throughout the early 2000s. Restricted orqualified stock options – which had been the dominant form of long-term incentives for twodecades – virtually disappeared from existence.Congress resurrected a new form of qualified options (now called “Incentive StockOptions” or ISOs) as a last-minute addition to the Economic Recovery Tax Act of 1981. 40ISOs carried many of the restrictions common for qualified stock options (holding periodsafter exercise, minimum exercise prices, etc.), and in addition were limited to $100,000 perexecutive per year (calculated as the stock price multiplied by the number of options on thedate of grant). While ISOs have continued to be popular in the 2000s for middle-levelmanagers (where the $100,000 limitation is not binding) and for companies without taxableprofits (where loss of deductibility for ISOs is not costly), virtually all options granted toCEOs and other top executives since 1972 have been non-qualified stock options.2.4.2. Thereʼs No Accounting for Options (1972-2005)The restricted and qualified stock options created by the 1950 and 1964 Revenue Actswere not formally considered “compensation” and therefore companies did not record anexpense for such options for either tax or accounting purposes. The switch to non-qualifiedoptions in the 1970s – which were considered compensation for tax purposes – raised a newquestion: how should options be accounted for in company income statements? Onepossibility was to follow the tax code and recognizing an accounting expense at the time anoption is exercised. But, in spite of its simplicity, this method is inconsistent with the basictenet of accounting that expenses should be matched to the time period when the servicesassociated with those expenses were rendered. Rather, the tenet suggested that options shouldbe expensed over their term based on the grant-date value of the option. At the time, however(and for a long time to come) there was no accepted way of placing a value on an employeestock option.In October 1972, the Accounting Principles Board (APB) – the predecessor to thecurrent Financial Accounting Standards Board (FASB) – issued APB Opinion No. 25,“Accounting for Stock Issued to Employees.” Under APB Opinion No. 25, the compensation40 Bettner, “Incentive Stock Options Get Mixed Reviews, Despite the Tax Break They Offer Executives,”Wall Street Journal (August 24, 1981), p. 32.-31-
THE EXECUTIVE COMPENSATION CONTROVERSY: 24 MAY 2010A TRANSATLANTIC ANALYSISexpense associated with stock option was defined as the (positive) difference between thestock price and the exercise price as of the first date when both the number of options grantedand the exercise price become known or fixed. The expense for this spread between the priceand exercise price – called the “intrinsic value” – was amortized over the period in which theemployee is prohibited from exercising the option. 41 Under this rule, there was no charge foroptions granted with an exercise price equal to (or exceeding) the grant-date market price,because the spread is zero on the grant date.The accounting treatment of options promulgated the mistaken belief often espoused inboardrooms that options could be granted without any cost to the company. The treatmentalso cemented the dominance of the “traditional stock option” (an option granted with a fiveor ten-year term with an exercise price equal to the grant-date market price) and preventedcompanies from offering more novel option plans. For example, APB Opinion 25 imposes ahigher accounting charge for options with an exercise price indexed to the stock-priceperformance of the market or industry, because the exercise price is not immediately fixed.Similarly, it imposes a higher accounting charge for options that only become exercisable ifcertain performance triggers are achieved, because the number of options is not immediatelyfixed.The 1972 opinion pre-dated the Black and Scholes (1973) equation, which offered thefirst formula for computing the value of a traded call option. Academic research in optionvaluation exploded over the next decade, and financial economists and accountants becameincreasing intrigued with using these new methodologies to value, and account for, optionsissued to corporate executives and employees.In 1984, FASB floated the idea that companies account for employee stock optionsusing the so-called “minimum value approach.” 42 By June 1986, the FASB “idea” hadevolved into a proposal with the important change that the accounting charge would be basedon the fair market value (e.g., the Black-Scholes value) and not a minimum value. Theproposal was vehemently opposed by all of the “Big Eight” accounting firms, the AmericanElectronics Association (including more than 2,800 corporate members), the Financial41 This period is often called the “vesting period” but this terminology is misleading.42 Under the “minimum value approach,” the value of an option on a non-dividend-paying stock is calculatedas the current stock price minus the grant-date present value of the exercise price. For example, the value of aten-year option granted with an exercise price of €30 when the grant-date market price was €25 would be V =€25 - €30/(1+r) 10 , where r is the risk-free rate.-32-
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