Stocks for the Long Run : the Definitive Guide to Financial Market Returns and Long-term Investment Strategies

profits to new shareholders who, through options, purchased the shares

at below market prices.

In 2000 the FASB reversed its position and, following the lead of the

International Accounting Standards Board (IASB), decided that options

should be expensed when granted.

Technology firms, heavy users of options, lobbied Congress to

block the FASB from instituting those rules. But after the technology

bubble broke, there was clear professional sentiment that options should

be expensed, and the FASB set 2006 as the year that firms must expense

options. Many firms began expensing options earlier, and by the middle

of 2004, 176 firms in the S&P 500, representing over 40 percent of the

market capitalization, expensed options.

Employee Stock Options Lower Risks to Stockholders

The issuance of employee stock options increases the risk borne by

shareholders. If the firm experiences poor earnings and the share price

declines, then many employee options will expire worthless and the

firm, since it had expensed them, will realize a gain by reversing the ex-

pense. On the other hand, if there is good news and the share price rises,

then the options will be exercised and per share earnings will decline be-

cause of the dilution.

The risk that employees shoulder when they accept options instead

of cash compensation thereby reduces the risk to the outside sharehold-

ers. This means that a firm that fully expenses the fair value of options

paid to employees should, all other things equal, be valued slightly

more than firms that pay an equivalent amount of cash in lieu of options.

But this also means that much of the upside of technology stocks is

enjoyed first by employees exercising their options, which dilutes the in-

terest of outside shareholders. This is an important consideration not al-

ways appreciated by those buying stocks in this options-saturated sector.

Controversies in Accounting for Pension Costs

Defined Benefit and Defined Contribution Plans

Almost as contentious as the treatment of options is the accounting treat-

ment of pension costs. There are two major types of pension plans: de-

fined benefit (DB) plans and defined contribution (DC) plans.

Defined contribution plans, which gained enormous popularity in the

1990s’ bull market, place both the employees’ and employer’s pension

CHAPTER 7 Stocks: Sources and Measures of Market Value 105