Option Expense Accounting

1. Option Expense Accounting • Who are the players in the article? • Cisco • a commission of the SEC led by Chris Cox • What is the Cisco Plan? • Sell securities that are similar to the option grants to employees to institutional investors • Catch? • selected investors, not transferable, restricted market

2. Option Expense Accounting • Why is the issue so important? • New law effective June 2005: Companies need to account for options granted to employees as expenses

3. Option Expense Accounting • Interlude: These (call) options are characterized by • Open-endedness (or very long-term expiration) • Strike price= current share price • Numbers granted heavily weighted toward top management:regular employee: maybe 100 options per yearCEO: 100,000 to 1 Million options per year • Various restrictions on exercising • Forfeiture when leaving(recent example: Daimler-Chrysler)

4. Option Expense Accounting • Do these option grants really cost the company anything? • Yes, if the company did not sell the shares to the employees at the strike price, they could sell the shares on the market for the current price which is higher. It is this difference that is the cost to the company and the share holders. • It is the same difference that the option holder realizes as gain.

5. Option Expense Accounting • So what is the difficulty? • The expense needs to be accounted for at the time of issuing the options • Math models (Black-Scholes) rely on assumptions that are reasonably true only in the short-term, and don’t deal well with the restrictions . • Also they arrive at a high price. Companies don’t like that: high price -> high expense -> low profit -> lower share price

6. The Two SEC Alternatives • Pay other parties to be the writers of the options • Catch: again, very expensive • Create a security that mirrors the profits of employee option holders as a group • Needs a market to develop • Needs disclosure by companies on past option redemptions