GuyFord&RichardPetty Executive Options Schemes ­ How much are they Costing and What do They Look Like? ByGuyW.Ford&RichardM.Petty Abstract In this paper we provide an overview of empirical data relating to the use, scale and cost of executive options schemes in Australia. Our data is based on a sample of 100 large listed Australian corporations. Our data suggests that approximately 80% of large listed corporations in Australia presently employ executive options schemes, but that the size and cost of these schemes reduced significantly after 2000. We argue that this reflects the impact of increased public scrutiny over options schemes and the impending move in Australia towards a financial reporting regime in which treating the cost of options as an expense for the purposes of calculating annual profit and loss is mandatory. 1. Introduction Bytheearlyyearsofthenewmillenniumdebateaboutthe role,legitimacyandimpactofexecutiveoptionswasendemic. Althoughacademicliteraturehadbeguntoproducetroubling resultsinrelationtolinksbetweentheexistenceandmagnitude ofexecutiveoptionsschemesandopportunisticbehaviouron thepartofrecipientexecutives(e.gAboody&Kasnik000, Ali&Stapledon000,Chen,00),theissuewhichdominated public debate related to desirability of revising financial reportingrulestorequirethatthecostofexecutiveoptionsbe countedinthedeterminationoftheannualreportedprofitability ofcorporationsgrantingoptionstotheirexecutives. Thesedebatesreachedandengulfedtheactorsentrenched at the commanding heights of the regulatory, political and financial institutions of the United States. Faced by a recalcitrantcorporatesectorlargelyunwillingtoembracethe principleofrecognisingthecostofoptionsintheprocessof calculating profits (despite the capacity to do so under the precepts of SFAS 1), apparently for fear of the negative impact this would have on reported profits, a number of high profile U.S figures made their views very plain indeed. In a speechdeliveredatNewYorkUniversity,U.SFederalReserve ChairmanAlanGreenspanisreported1tohavesaid: "If investors are dissuaded by lower reported earnings as a result of expensing, it means that they were less informed than they should have been. Capital employed on the basis of misinformation is likely to be capital misused." WarrenBuffetwasevenmoredirect,asking: "Ifoptionsaren'taformofcompensation,whatarethey?If compensation isn't an expense, what is it? And if expenses shouldn't go into calculations of earnings, where in the world should they go?" 8 IntheUnitedStatesSenate,SenatorsLevinandMcCain introduced a bill which, if enacted would have forced corporationseithertoexpenseoptionsortopaytaxonthem. Inevitably,therepercussionsofthesedebateswerefeltinother advancedmarketeconomiessuchasAustralia,wherethekey issueswererenderedevenmoretangiblebythelackofeven basicmandatoryaccountingrulesonthesubjectofexecutive options(Carlin&Ford,00). There, the announcement that an accounting standard requiringthatthecostofoptionsberecognisedasanexpensein the calculation of corporate profit would be operative by 20054 appearstohavebeentakenasasignalforareturnofcollective calm and disinterest5 in what before the announcement of an impending standard had been a contentious issue. Remarkably, in our view, the debate in Australia receded withoutanysystematicairingofkeyempiricalissuesrelating tothemagnitudeandimpactofoptionsusageorthepossible policy consequences flowing there from. Thus, in this paper, wecontributetotheliteraturebyprovidinganoverviewof anumberofkeyparametersrelatingtotheuseofexecutive optionsinAustralia.Thepaperproceedsasfollows. Insectiontwo,wedescribeoursampleandthetimeperiod overwhichweconductedourresearch,andsetoutevidenceon thefrequencywithwhichlargelistedAustraliancorporations usedoptionsschemesinthecontextoftheremunerationof theiremployeesduringthatperiod.Insectionthree,wereview thescaleoftheseschemesbyexaminingthenumberofoptions issued,thenumberofoptionsoutstandingandthenumberof options exercised by our sample of corporations during the periodwestudied. Insectionfourwepresentsomeestimatesoftheimpact the options schemes we observed would have had on the operating profit before taxation reported by our sample of corporations had they been under an obligation to factor JournalofLawandFinancialMangement-Volume4,No. costsassociatedwiththeiroptionsschemesintotheirannual earnings calculations. Finally, in section five we set out some conclusionsandprognosticationsforfutureresearch. 2. How Prevalent Are Executive Options Plans in Australia? In order to develop insights into the scope of use of executive options plans inAustralia, we selected a sample consisting of the top 100Australian listed corporations (as measured by market capitalisation) as at the conclusion of 1996.Wethengathereddatarelatingtotheuseofexecutive options plans by these organisations from 1997 through to 004,inclusive6. We classified corporations within our sample as falling intooneofthreeclassesineachoftheyearswereviewed. The first group are labelled "no plan". Corporations fell into thiscategoryinaparticularyeariftheirannualreportforthat period contained no reference to options plans.The second grouparelabelled"hasplan".Thesecorporationsdidinclude referencestotheexistenceofoptionsplanswithintheirannual financial reports. The final group are labelled "exit". These firms either merged or were delisted during the period under review, makingitimpossibletogatherdatainrelationtotheiroptions schemesfortheentireperiodunderreview.However,forthe sakeofcompleteness,thesecompaniesarealsotrackedinour dataset,allowingthecalculationoftheproportionofsurviving firmswithinthesamplewhichmaintainedanexecutiveoptions planineachyearwestudied. Slightly more than half of the sample of large firms we examined had options plans in 1997. This grew rapidly to approximately 80% of our surviving firms by 2000, and stabilisedthereafter.However,thedatadisplaysnoconvincing evidence that the turn of the millennium controversies surroundingtheuseandimpactofoptionsreferredtoabove hasresultedinanymeasurabledampeningintheenthusiasm ofAustraliancorporationsfortheuseofoptionsschemesas anelementofexecutivecompensation.Thisdataissetoutin Table1,below. ExecutiveOptionsSchemes Whilethisdataclearlyshowsapatternofgrowthinthe application of executive options schemes in first half of the periodreviewed,followedbyaperiodofstabilisation,itdoes not permit direct insight into the size and level of activity (bothintermsoffreshgrantsandexercisesofoptions)ofthese schemes.Thisisdiscussedinsectionthreebelow. 3. Size and Activity of the Observed Options Schemes Inordertogaugethescaleofoptionsschemesandthe degree of activity of those schemes, we measured three variables.Thesewere;thevolumeofnewoptiongrantseach year,thevolumeofoptionexerciseseachyearandthevolume ofoutstandingoptionsattheendofeachyear. Totakeaccountofvariationsinthesizeoftheorganisations westudiedandthechangesinthetotalnumberoforganisations whichhadactiveoptionsplansineachoftheyearswestudied, weexpressthedatarelatingtoeachvariableasapercentage ofoutstandingordinaryequityattheconclusionofeachyear studied. The first two variables, "Grants" and "Exercises" measurethelevelofactivityintheoptionsplansweexamined7 whilethethirdvariable,"Vol.Outstanding"providesascale measure. Our findings are presented in Table 2, below. Twofeaturesofthedatainparticularareworthnoting. First, between 1997 and 000, there was much higher growthinthescaleoftheoptionsplansweobservedthanin thepropensityofcorporationswithinoursampletoemploy options plans. Recall that 5% of our sample had options plansin1997,versus78%by000.Thisrepresentsgrowthof approximately50%acrossthatperiod.However,overthesame timeframe,thevolumeofoptionsonissueasaproportionof outstandingordinaryequitycapitalrosefrom1.56%to6.7%, afourfoldincreaseinscale.Thus,onaverage,notonlydid morecorporationschoosetouseoptionsschemes,butthescale of those schemes grew significantly. Second,itwouldappearthatcorporationsusingoptions schemes significantly changed their behaviour from 2001 onwards.Observe,forexample,howthevolumeofoptions grantsrecordedin001felltoapproximatelyaquarterofthe levelobservedin000.Thiswasnotatransientevent.The Table 1 ­ Proportion of Sample Organisations With Executive Options Plans Table 2 November005 9 GuyFord&RichardPetty level of grant activity for the remainder of the time period reviewedalsoremainedwithinatightrangeofthe001grant volumelevel. Balancedagainstthis,therewasnomaterialfallinthe proportionofoursamplewhichcontinuedtooperateexecutive optionsplans,andinconsequence,takingaccountofthelagged effectassociatedwithexercises,theaveragescaleofoptions plans(asmeasuredbyoptionsoutstandingasaproportionof outstanding ordinary equity capital) declined during the final yearswestudied,settlinginarangeclosertowhatithadbeen in the first two years for which we collected data. We cannot draw firm conclusions as to the cause of this material change in grant volume and scheme size. Market factors may account for part of these occurrences: the five year periodleadingupto000hadbeenoneofsteadygrowthin theAustralianAll-OrdinariesSharePriceIndex,butthetwo yearperiod000­001wasonecharacterisedbylittlegrowth andhighvolatility.TheIndexthenshowedsubstantialdecline over the year 2002 and the first quarter of 2003. These patterns couldbelinkedtooptionsschemesbecominglessattractive intheremunerationpackagesofexecutivesovertheseperiods intime. Further,itdoesnotseemtoofarfetchedtosuggestthat thelevelofpoliticalandmediaattentionfocusedonexecutive options during 001 and 008 together with the looming likelihood that in the not too distant future the financial reportingruleswouldevolvetorequireexpensingofoptions sawcompaniesretreatingfromtheexpansiveuseofoptions schemeswhichtheyhadadoptedby1999and000.Inthis regard,TableshowsthenumberofarticlesinmajorAustralian newspapers,onayear-by-yearbasis,between1996and004. Followingvirtuallynomediainterestintheperiodto1996001,asubstantialnumberofarticlesappearin00.From 2003,mediaarticlesdeclinealmostassignificantlyastheyrose intheprecedingperiod.9Thoughnotcomprehensive,thisdoes provideatleastsomeevidencewhichappearsconsistentwith ourthoughtsonthepossibledriversofthemarkedreduction in option grants which transpired in 001 and later periods comparedwithgrantactivityin1999and000.Finally,we turntothequestionofthecostoftheexecutiveoptionschemes westudied.Thisissetoutinsectionfour,below. 4. Estimated Cost of Executive Options Schemes Atnotimeduringtheperiodwestudiedwastheirany requirement that Australian corporations with executive optionsschemesreflectthecostoftheseschemesintheirannual profit calculations, and none of the companies we studied did so voluntarily. However, from the late 1990s onwards, the organisationswestudiedtypicallymadereasonablydetailed disclosuresrelatingtotheiroptionsplansinthenotestotheir accounts. Coupledwithdisclosures(notformingpartoftheirannual financial reports) about their options plans these companies wererequiredtomaketotheAustralianStockExchange,we were able to gather sufficient data to support the estimation of theexpenseassociatedwiththeoptionsschemesemployedby oursampleofcompanies,butnotrecognisedinthecalculation of their reported profits. Thequestionofhowbesttoestimateexpensesassociated with options schemes and reflect these expenses within corporate financial statements remains controversial and contested(Coulton&Taylor,00).Inparticular,thoughmost approachesaccepttheuseoftechniquessuchastheBlackScholesmodeltoestimatethefairvalueofoptionsatthedate ofgrant10,thequestionofhowsuchvaluesmightberecognised in financial statements and subsequently modified in light of changingcircumstances(forexamplechangingmarketprices fortheunderlyingequitysecurities,optionsfailingtovest)is highlycontroversial. Itisnotourobjectivetoengagewiththefinancialreporting debateinthispaper.However,becausewereportdatainTable belowwhichrepresentsourestimateofthedegreetowhichthe reportedoperatingprofitbeforetaxofoursampleofcompanies wouldhavebeenreducedhadthecostofoptionsbeenfactored into the calculation of that number, it is necessary to briefly explainthevaluationandreportingmethodologyweemployed inconstructingourexpenseestimates. WebeganbyusingaBlack-Scholesmodeltoestimatethe fairvalueofoptionsgrantedinanygivenyear.Wethentreated thatentireamountasanexpenseoftheperiodduringwhichthe grantoccurred.Ateachsubsequentbalancedate,wemarked outstandingoptionstomarket,againusingtheBlack-Scholes modelasourbasisforestimatingfairvalue. Anyresultingvaluationincrements(ordecrements)were taken to each period's profit and loss calculation as expenses (orexpensereversals).Anylapsesofoptionswereaccounted forasexpensereversalsintheperiodduringwhichthelapse occurred.Theneteffectofthismarktomarketbasedapproach toaccountingforexecutiveoptions,isthatoverthelifeofthe option, the expense which is distributed through the profit and lossstatementofthegrantingentitywillequaltheintrinsic valueoftheoptionatthepointintimewhenitisexercised. Table 3 ­ Newspaper Articles on Executive Options 40 JournalofLawandFinancialMangement-Volume4,No. Thus,innetterms,expenseswillonlyberecognisedover time when a transfer of intrinsic economic value between employerandemployeeactuallydoestranspire.Consequently, the expense to shareholders is exactly the same as the opportunity cost of the foregone cashflows which they could haveenjoyedasaresultoftheissueofequityatmarketprices, butdidnotbecauseequitywasissuedtoemployeesatbelow marketprices. The chief objection to this approach to the financial reportingoftheimpactofexecutiveoptionsschemesisthat its reliance on the mark to market process may result in substantial increases in the volatility of reported earnings (Bergeretal1991,Jones199,Robertson1995).However,in otherAustraliansettingswhereamarktomarketaccounting approachhaslongbeenthenorm,itsapplicationisnolonger seenascontentiousnorhasitsapplicationcausedobservable havoc(Carlin00). We provide three basic data items in Table 4. The first oftheseisourestimate,expressedinmillionsofAustralian dollars,oftheper-periodexpenseassociatedwiththeoptions schemesoperatedbyoursampleoflistedcorporations.The second item is the sum of the before tax operating profits reportedbythesubsetofcompaniesinoursamplewhichhad executive options schemes in each particular period. The final itemexpressesourestimateoftheexpenseoftheexecutive options schemes we identified in each period as a proportion of the reported before tax profits of the companies we identified ashavingexecutiveoptionsschemesinthoseperiods. Thoughasdiscussedtheapplicationofamarktomarket approach to the estimation of option expenses has resulted innoticeablebetweenperiodsvolatility,themoreimportant consideration is that the average impact of options related expensesacrossallcompaniesandyearswereviewedwasin the order of 3% of the before tax profits reported by companies usingoptionsschemes.Whilethisislowerthansomepublished estimates of the average impact of expensing the options schemesofsamplesofU.Slistedcompanies11,theeffectis materialnonetheless1. 5. Conclusions Ourdataprovidesapreliminaryoverviewofthefrequency of use, size and potential cost impact of executive options schemesusedbylargelistedAustraliancorporations.Though inthispaperwedonotprovideevidencerelatingtoimpacton corporateperformance,governancequalityandriskbehaviour associatedwiththeseschemes,ourdatamakesitplainthatin ExecutiveOptionsSchemes anAustraliancontext,executiveoptionsschemeshavebeen and remain economically significant and an important subject forcontinuingresearch. Table 4 ­ Expense $ M November005 41 GuyFord&RichardPetty References 1. WallStreetJournal,7March00. . Merrill Lynch, Global Industry Research Note, 7 May 00,AccountingforOptions. . ThebillwasintroducedtotheU.SSenateonFebruary1, 00.Itwasnotpassedintolaw. 4. Thisdideventuate,intheformofAustralianAccounting StandardAASB,ShareBasedPayment.Knowledgeof theimpendingstandardwaswidespreadbyearly00. 5. As to which, see the data we set out on the frequency of newspaper articles in major Australian newspapers devotedtoexecutiveoptionsinTable. 6. We initially set the commencement year for our study as 1996, but found that financial statement disclosures relatingtooptionsweresofragmentedandinconsistentin thatyearthatitwasnecessarytoselectalateryearasthe commencingperiodforthestudy. 7. Oneotherformofevent,lapses,alsoprovidesameasure ofturnoveractivityincorporateoptionsplans.However, in the context of our sample of companies and the timeframeofouranalysis,lapsesrepresentedonlyaminor phenomenon,dominatedbygrantsandexercises.Bearing thisinmind,andforreasonsofspace,wedonotdiscuss lapsesinthispaper. 8. Wehavediscussedtheseissuesingreaterdetailelsewhere. See;Carlin&Ford,004. 9. Data extracted from the Factiva database, set to `all dates', `Australia and New Zealand', `major Australian newspapers', `executive options'. 10.A representative example is Australian Accounting Standard AASB - Share Based Payment, which specifically recognises the use of the Black-Scholes and Binomialapproachestotheestimationofthefairvalue ofoptionsasatthedateofgrant.IntheUnitedStates, FAS1alsorecognisestheuseofmodelssuchasBlackScholestoassistwiththeinitialprocessofestimatingthe fairvalueofoptionsgrantedpursuanttoexecutiveoptions plans. 11.MerrillLynchpublishedastudyin00inwhichthey estimated the impact of expensing the options schemes ofallcompaniesintheDowJonesIndustrialIndex.They concludedthattheaverageimpactonthe001earnings ofthatgroupofcompanieswouldhavebeen7%.(Merrill Lynch,00.) 1. Thesumofourexpense(andexpensereversal)estimates foroursampleofcompaniesbetween1997and004is approximatelyAUD$6.Billion. 4 JournalofLawandFinancialMangement-Volume4,No. This page left blank intentionally November005 4 ExecutiveOptionsSchemes This page left blank intentionally 44 JournalofLawandFinancialMangement-Volume4,No.