By Lisa Marquis Jackson. A long-standing issue of debate in the general business community, expensing stock options has now worked its way into the accounting practices of home builders. And like most issues that can threaten to change the way companies do business, it is not without advocates and opponents.
In March 2003, Pulte Homes announced that it would begin expensing stock options effective Jan. 1, 2003. "We have disclosed the impact of stock options in our financial statements, but the decision to expense options is part of our commitment to transparency in financial disclosures and reporting," said Roger A. Cregg, senior vice president and CFO.
In today's business environment, many Fortune 500 companies agree that expensing options in the year they are granted is a more forthright way to disclose total compensation to shareholders. After all, options dilute the profitability of companies, to varying degrees. "For home building, the percentage of earnings per share is a low, single-digit impact," says Merrill Lynch vice president, Joseph Sroka. "In some other industries, their earnings are virtually wiped out."
In a report issued last year, Merrill Lynch projected that expensing options would affect home builder stocks, on average, by about 3 percent. This seems fairly insignificant when compared to the overall Consumer Discretionary sector average projections of 9 percent. However, "if something else affected their earnings to that degree, they would consider it a big deal," says John Burns, president of John Burns Real Estate Consulting.
"We forecast 2003 to be about the same," says Sroka. "None of the companies have really altered their compensation structures."
Centex, which began expensing options starting April 1 (FY 2004), cites several benefits. "It's the prudent thing to do and the regulatory environment is heading that direction," says Centex executive vice president and CFO, Leldon Echols. "It will provide us with the ability to give a more accurate, true compensation cost in our financial statement. Plus, if we are looking at all forms of equity-based compensation on equal footing, our various business units can really give closer consideration to what forms of compensation they value."
Determining Fair Value
Much of the debate centers on the methods used to determine fair value of stock-based compensation. There is already evidence that different option-pricing models produce different results. By using different measurements of volatility or expected service of employees, different measures of fair value for similar compensation packages could result. The Federal Accounting Standards Board (FASB) Statement 123 is a common method used by many U.S. companies, including Pulte. It defines a fair value based method of accounting for employee stock options.
But it's the widely-used Black-Scholes option pricing model that garners the most controversy. Because it was originally created for other uses, many disagree over its application for valuing the nuances of compensation.
Joel Rassman, Toll Brothers CFO, stated: "I don't agree that the SEC's answer to how you value the stock option is correct. Black-Scholes was devised to value freely tradable options. The methodology for valuing stock options [using Black-Scholes] comes up with an artificially high value. It's a hind sighted view calculation."
Echols, on the other hand, sees less problem: "We think the Black-Scholes approach is reasonable. The ability to apply it is fairly straightforward."
Builders, in general, are reluctant to incorporate the expensing practice. "We think it's premature to implement something before people decide what the right answer is," says Larry Seay, CFO of Scottsdale, Ariz.-based Meritage Corp. "We think that the current diluted earnings per share calculation takes into account options. If we start including an expense for the options, you're essentially double-accounting. You're overstating the effect of the options."
In March, the FASB announced that a new project had been added to its agenda -- one that will seek to improve the accounting and disclosures relating to stock-based compensation and address whether to require the cost to be treated as an expense. According to an FASB news release: "The board plans to start deliberating key issues on this subject at future public hearings with a view to issuing an Exposure Draft later this year that could become effective in 2004."
Another priority is to develop a consistent approach to valuing the options. "There are a significant number of Fortune 500 companies that have evolved into using an expensing method. There is a movement clearly afoot. What we want to try to do is see if we can develop some consistency in the marketplace," says Cheryl Thompson, FASB spokesperson. The one fact most companies do still agree on: Stock options remain an affective compensation tool. "If there wasn't a value to stock options, why have you been giving them away?" says Thompson. Valuation consistency may evolve as a convergence between U.S. and international standards, commonly known as the International Accounting Standards Board (IASB) fair value method.
"Some people have been critical about valuations," says Thompson. "But there are many who believe the Black-Scholes is a pretty good model. Maybe there are ways of fine-tuning that. That is one of the things that will be addressed in the [FASB] project."