Impact of Employee Stock Options on Cash Flow

1
Impact of Employee Stock Options on Cash Flow

• Conrad S. Ciccotello
• C. Terry Grant
• Gerry H. Grant
• Financial Analysts Journal, Vol. 60, No. 2,
  March/April
• 2004, pp. 39-46.

2
Background Expense Recognition of Employee Stock
Options

• Do Stock Options Constitute Compensation Expense?
• Raging National Debate since FASB issued Stock
  Compensation Fair Value Exposure Draft in June
  1993

3
Historical PerspectiveAPB No. 25 Background

• APB No. 25 Uses an Intrinsic Value Framework
• Excess of Market Price of the Stock over the
  Exercise Price on the Measurement Date

4
APB No. 25 Background

• Measure Compensation Expense as Excess of Market
  Price Over Exercise Price on Measurement Date
  (usually same as grant date)
• Compensation expense estimated and recorded at
  grant date using then current market price
• No Compensation expense adjustment in future
  periods

5
APB No. 25 Background

• Under APB No. 25, Most Employee Stock Options Are
  Fixed and At the Money or Out of the Money on
  the Grant (Measurement) Date
• Therefore, Usually No Compensation Expense
  Recognized Under APB No. 25

6
SFAS No. 123 Exposure Draft(Issued June 1993)

• Compensation Expense Should be Based on Value
  Received by Employees
• SFAS No. 123 Based on Fair Value Framework

7
SFAS No. 123 Exposure Draft

• Employee Stock Options Valued using Fair Value
  Method
• Complex Option Pricing Model Used
• Black-Scholes Option Pricing Model
• (Or, Binomial Option Pricing Model)
• Expense Recognized Over Vesting Period

8
SFAS No. 123 Exposure Draft

• Example Company grants 10,000 options with
  market price and exercise price of 10 per share,
  vesting occurs after 5 years
• If Fair Value of Options 3/share, the company
  would recognize 30,000 of compensation expense
  as 6,000 per year over the 5 year vesting period

9
SFAS 123 Chronology of Events

• June 1993, Exposure Draft issued
• Blizzard of opposition from businesses
• Late 1993, Senator Lieberman issued bill that
  mandates the SEC block reporting of compensation
  expense for ESOPs
• 1994 Arthur Levitt encourages FASB to abandon
  proposal SEC wont enforce
• 1995 Compromised SFAS 123 issued

10
SFAS No. 123 Background

• FASB Issued SFAS No. 123, October 1995
• Compromise Companies are Encouraged to Use Fair
  Value Method (Black-Scholes Option Pricing Model)
  but Can Opt for Intrinsic Value Method (APB No.
  25)
• If APB No. 25 used, company must disclose in
  notes pro-forma Net Income and EPS as-if Fair
  Value Method had been used

11
Growing Support For Expensing of Stock Options

• As of February 2003
• Approximately 150 Companies have Announced
  Plans to Expense Stock Options
• See Dow Jones Newswire

12
Little Attention Given to Cash Flow Impacts of
ESOPs

• Analysts Often Focus on Cash Flows
• Real Money to Pay Bills
• More Objective than Earnings Numbers
• Less subject to Earnings Management Games

13
Three Types of Cash Flows

• Operating Cash Flows
• Generated from Selling Goods Services
• Generally thought to be Repeatable
• Investing Cash Flows
• Sale of property, plant, and equipment
• Sale of stocks bonds of other entities
• Collections of Principal on loans made
• Financing Cash Flows
• Sale of Equity instruments
• Sale of Bonds
• Notes or other Borrowings

14
ESOP Surprising Result

• Taxation of ESOPs
• At Exercise, Employee Recognizes as Ordinary
  Income the Difference Between Market Price of
  Stock Exercise Price
• Employer Deducts in Exercise Year the Same Amount
  as Employee Recognizes as Income
• Exercise of ESOPs Increase Cash Flows Due to Tax
  Benefit of Exercise

15
SFAS No. 95 Statement of Cash Flows Surprise

• Issued long before current ESOP controversies
  (1987)
• Generally requires classification of all income
  tax expenses and income tax benefits as Operating
  Cash Flows
• Allocation to Investing Financing categories
  would be complex arbitrary

16
SFAS No. 95 Tax Benefit Treatment

• If Compensation Expense is Recognized Direct
  Method CF Statement Used
• Report Tax Benefit as an Operating Cash Flow

17
Financial Reporting Rule Gaps for Tax Benefit of
Options

• Typically no Compensation Expense Recognized
  under APB No. 25
• And/Or Indirect Method CF Statement Used

18
Diverse Financial Reporting for ESOP Tax Benefit

• Increase Stockholders Equity (Credit to APIC)
• Reported on Statement of Stockholders Equity
• Operating Cash Flow (Tax Savings)
• Financing Cash Flow (Tax Savings)
• Footnote Disclosure
• Not Reported at All

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FASB EITF 00-15Income Tax Benefit for ESOPs

• EITF 00-15 Intended to Decrease Diversity
• Material Tax Benefits of ESOPs Must be Disclosed
• Encourages Reporting as Operating Cash Flow
• However, Three Options Remain
• Operating Cash Flow
• Credit to APIC (Statement of Stockholders
  Equity)
• Footnote Disclosure

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Quality of Financial Reporting

• Highest Quality
• Report as Operating Cash Flow
• Lowest Quality
• Credit to APIC
• Not generally understood
• Easily overlooked
• Questionable Quality
• Footnote Disclosure

21
Origin of Study Wall Street Journal Article on
Microsofts Tax Benefit

• FY 1999, Microsoft Realized almost half of
  Operating Cash Flows from Tax Benefits of ESOPs
• 5.5 Billion (48.4) of Operating Cash Flows
• These Cash Flows are Quite Different from
  Traditional Operating Cash Flows
• Can Easily Dry Up in Depressed Stock Market

22
SampleNASDAQ 100 SP 100

• Analyze Financial Reporting Differences
• (SP 100 Vs. Nasdaq 100)
• Identify Size of Impact
• Classify Tax Benefit Reporting Method
• Examine Dilution Effect of Exercised Options

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Top Ten NASDAQ100 Ranked on Tax Benefit as of
Operating Cash Flow 1999-2001
24
Top Ten SP100 Ranked on Tax Benefit as of
Operating Cash Flow 1999-2001
25
Tax Benefit from Exercise of Employee Stock
Options
26
Disclosure Location of Tax Benefit
27
Net Cash Needed as Percentage of Revenues to Fund
Option Exercises Without Dilution
28
Ratio of Cash Spent to Cash Necessary to Fund
Option Exercises Without Dilution
29
Growth in Shares Outstanding Due to Option
Exercises
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Exercisable Options Vs. Common Shares Outstanding
at FY End 2001
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Conclusions

• Cash Flow Impacts are Significant
• Nasdaq 100 Median 13 of Operating Cash Flows
• SP 100 Median 1 of Operating Cash Flows
• Nasdaq 100 Firms Needed to Spend 39 Cents of
  every Revenue Dollar on Share Repurchases
• Median Nasdaq 100 Firm Repurchased No Shares
  Resulting in 5.2 Growth in Shares
• Nasdaq 100 Firms Face Increased Dilution Risk
  with Greater of Options Outstanding