Posted 11:21 AM by Robert

Expensing Options, Again ... and Again!

Yesterday, the Man Without Qualities questioned just how "reasonable" available options valuations techniques are for purposes of preparing balance sheets. The view here is that the assertion that because investment bankers value options (normally using a method derived from the spectacular work of Professor Merton), that such valuation is "reasonable," is as seductive and misleading as the famous assertion of Lord Justice Bowen that "The state of man's mind is as much a fact as the state of his digestion."

There is another aspect of yesterday's Wall Street Journal article of Zvi Bodie, Robert S. Kaplan and Robert C. Merton that I would like to address. That article makes the following rather absolute assertion, which pretty much forms the foundation of their argument:

When a company issues securities whose value can be reasonably determined, accounting principles require that this value be recorded in the company's financial statements.

The authors also note that in at least some important respects, "options are no different from any other class of financial assets such as stocks, bonds, mortgages, and widely-traded derivative securities."

So it seems worth while to ask if options are always treated in the way the authors rather absolutely assert. Now, it is a little strange that although the entire question under consideration is whether to expense options, the authors do not say that when a company issues securities whose value can be reasonably determined, accounting principles require that this value be expensed on the company's balance sheet. So this apparently absolute, foundational statement doesn't really have the axiomatic quality the authors suggest it has. There may be a good reason for that.

Options are not always expensed when issued, even where they are not employee incentive options, and even in a purely financial contect where there are plenty of reference points to determine their value far more precisely than can be done with employee options. For example, if a company issues a warrant to a lender in connection with a loan transaction, the company should record the warrant at its fair market value in the equity section of its balance sheet. The offset to the amount recorded as equity for the issuance of the warrant would be a discount to the liability for the loan. The discount would then be amortized through the P&L as additional interest expense on the loan over the term. For example, if the company obtains a cash loan of 100, and issues a warrant to the lender valued at 20, the company would record a liability of 100 and the receipt of cash of 100, and would also record a loan discount of 20 as an offset to the 100 liability (resulting in a net liability on the balance sheet of 80) and additional paid-in capital of 20. Then, the 20 discount would be amortized as additional interest expense over the term of the loan. The income tax treatment would be similar.

The accounting treatment of a convertible loan would be the same. The conversion privilege would be valued and recorded in the equity section, with the offset being a discount to the liability for the loan. The discount would then be amortized as additional interest expense through the P&L. However, for income tax purposes, the conversion privilege would not be valued separately from the liability (unlike a detachable warrant, which would be valued separately for tax as well as book purposes, as described above). Consequently, there would be no discount and no additional interest expense for tax purposes.

None of that sounds like up-front "expensing" of the kind urged by the authors of the Journal article. Of course, the above discussion pertains only to options issued in connection with loans and to convertible securities - which are derivatives the authors have suggested bear some important similarities to employee options (although not in this respect).

But it appears to the Man Without Qualities that options (and their brothers, convertibility features) are not always treated in the way the authors' academic algebra exercise asserts, even where the options are pure financial instruments issued into a free trading market.

I am not suggesting that the loan/converts treatment should or should not be a model for how employee options are treated. And even in that context, the option is eventually expensed. What I want to point out is that accounting principles as applied to options have been far more flexible than the Journal authors suggest.

More Than Zero offers some other comments on this article, comments which seem rather telling to the Man Without Qualities.