Stock options: Lieberman Lobbyists in London and the tax arena

“LONDON–European opponents of stock option expensing said June 7 they are stepping up pressure on United Kingdom officials to win last-minute exemptions from the coming use of an international standard to account for employee share and share option plans in Europe.” BNA’s Daily Tax Report today

John McCain is right – his buddy Joe Lieberman should step out of FASB’s way and let FASB require that the cost of employee stock options be moved from the footnote to the income statement. IASB is fighting the battle worldwide and it seems there are European versions of the Lieberman lobbyists.

As far as the accounting issue, Warren Buffet et al. are right, options are an expense. At times, the Lieberman lobbyists claim that the expense is recognized, which is true for anyone who knows how to read the footnotes. At other times, the Lieberman lobbyists claim that adopting SFAS 123 on the income statement would lower stock prices. But if agents are as rational as we economists claim they are, these two statements contradict each other.

But my pet peeve goes to the tax/transfer pricing issue. Consider a U.S. multinational with an R&D force that is generating enhancements in the technology used jointly by the parent company and an offshore subsidiary ala Cost Sharing Arrangement. Should not the cost of the ESOs for the R&D personal be part of the cost sharing pool of costs? While the IRS should admit they may be issues involving the anticipated benefits part of their transfer pricing regulations (section 1.482-7, which can be found here), any claim that ESOs are not a cost is something that will hopefully generate another one of those wonderful Buffet opeds.

But aren’t there serious questions as to valuing ESOs? Certainly the restriction that employees cannot sell their options to brokers would cause one to modify the textbook version of the Black-Scholes model. But tax practitioners often rely on some silly arguments, two of which can be found in the writings of Tim Reason of CFO Magazine. His “The Holes in Black-Scholes” writes:

Sibson tested a broad sample of 1,445 companies during six periods between 1972 and 2002. For each period, the average actual gains as a percent of Black-Scholes value ranged from 95 percent to 910 percent. Only 3 to 5 percent of stocks were within 90 to 110 percent of the price estimated by Black-Scholes.

While Reason suggests that such differences show the Black-Scholes model does not properly value ESOs, he is clearly confusing ex post values with some alleged misstatement of the ex ante value. But the fact the options are an inherently risky asset can potentially explain these divergences without any appeal to measurement errors from the Black-Scholes model.

In his “Windows into Valuation”, Reason notes Microsoft ESOs that J. P. Morgan purchased in late 2003 for $2, but were initially valued per SFAS 123 at $10.24 when they were issued in 2002. Reason writes:

Microsoft plans to allow employees to sell existing underwater options to JP Morgan, but so far the investment bank has offered just a fraction of the price Black-Scholes puts on them. Opponents of expensing say the bank’s low bids prove that existing pricing models overvalue options.

He then notes a statement from Kim Boylan, counsel to the International Employee Stock Options Coalition, also suggesting this evidence indicates problems with the SFAS 123 estimated value. But does this difference in the estimated value in 2002 versus the market price in late 2003 represent a concern that the SFAS 123 footnote seriously overstated the true value of the ESO or is this simply a reflection of the change in the value of Microsoft’s ESOs over this period? Using reasonable assumptions, a Black-Scholes model would predict a decline in value for these options near 80%.

I’m not sure whether Mr. Reason and Ms. Boylan do not understand the financial economics of ESOs or they are acting as Lieberman lobbyists. Alas, in the tax/transfer pricing arena, the IRS is often said to be outgunned and outmanned. But given how incredibly weak some of the arguments from the Lieberman lobbyists and their counterparts in the tax/transfer pricing arena are, one would hope that a few reinforcements for the IRS as well as FASB and IASB would represent a high bang for the buck.