Much has been made of reporting stock option compensation as an expense on the income statement. Although the current method used has its flaws, reporting an expense is more realistic than saying there is none. But little attention has been paid to the balance sheet impact of stock options. In fact, the current accounting method essentially says there is no effect (retained earnings are reduced but the same amount is added back to another line in shareholder equity with no impact on total assets, liabilities or shareholder equity.)
We believe the current method is incorrect. An option gives its holder the right to buy a share of stock from the company at a discounted price at a future date. The company is obliged to issue the share at a below-market value. This obligation, like any obligation, should be considered a liability. Only when it is redeemed should it shift from being a liability to being equity. Consider it this way: if the company issued its employees an IOU as part of their salary, it would be counted as a liability until paid. Why should options be any different, as they are in essence an IOY for a portion of the employee’s salary.
Accountants and managements would have to debate for years to determine the proper amount of liability and how to record it. Fortunately, investors can use a back-of-the-envelope approach to get a reasonable estimate. The minimum value of these options is the intrinsic value, or the difference between the current share price and the exercise price. This value understates the true liability but is easy to calculate. Like the reported expense, it may not be perfect but it is better than nothing. More sophisticated investors can simply estimate the Black-Scholes option value of all outstanding options and use that for the liability instead.
Consider the following table, which was provided by Ansys (ANSS) in their recent 10Q.
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Even at the minimum valuation of the options, we can see that they represent a $137 million future liability for Ansys. Investors should adjust the balance sheet to reflect this liability by adding $137 million to liabilities and reducing shareholder equity by the same amount. Doing so will affect such ratios as debt/equity and return on equity. If you use any of those in your investment process, be sure to make this adjustment first. It will give you a truer idea of the company’s situation, especially if you are comparing it with other companies whose option issuance is much higher or lower than that of the company in question.