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Saiz, Jennifer --- "Expensing the Cost of Executive Option Schemes: Case Studies in the Australian Healthcare Industry" [2003] JlLawFinMgmt 4; (2003) 2(1) Journal of Law and Financial Management 29


Expensing the Cost of Executive Option Schemes:

Case Studies in the Australian Healthcare Industry

By Jennifer Saiz[*]

Abstract

This paper provides a contribution to the literature on executive share options by reporting the results of detailed case research conducted by the author in relation to two publicly listed Australian companies from the health / biotechnology sector. These sectors are chosen as the focus for the case studies reported in this article because of the relatively high degree of reliance placed by corporations within this sector of the economy on options as part of overall employee remuneration. The case studies demonstrate the material impact the inclusion of the cost of options would represent in relation to reported earnings were this to become a mandatory financial reporting requirement. The case studies also highlight the poor quality of disclosures being made in relation to options. It is concluded that significant reforms of reporting and disclosure policies would be beneficial.

1 Introduction

This paper examines various issues related to the expensing of executive option schemes, with focus on two companies in the Australian Healthcare Industry: CSL Limited and the Mayne Group. The study considers the expensing of options, the impact of expensing options on reported profits, regulatory requirements and transparency issues regarding the disclosure of options, using these companies as case studies.

Share options are issued to executives in their remuneration packages to better align the interests of shareholders and managers. By linking some part of executive remuneration to share price performance, the argument goes, managers are incentivised to make decisions that increase shareholder value. This implies that without such incentives managers may be inclined to make decisions that increase their personal utility at the expense of the utility of shareholders.

There is currently no requirement that companies record an expense in their books to recognise the transfer of value from the accounting entity to employees when these employees have been granted options with positive fair value. There has been concern in some quarters that the failure to record the expense associated with executive stock options has created a bias in the use of these instruments to levels that are suboptimal[1]. There has been a growing degree of advocacy for the recognition of an expense in the accounts of companies to refl ect the substance that options granted to employees are a form of compensation and as such should be accounted for in a similar manner to other forms of compensation.

The health care industry has not been excluded from market scrutiny regarding option-based remuneration. A recent report from Salomon Smith Barney reveals that the American healthcare sector’s exposure to options is profound, having a potential negative impact of 8.1%[2] on reported profits. This makes the health care industry the second most options impacted sector following the Information Technology sector. The significant amount of options usage in this sector is due to the strong competition for skilled employees. Employers argue that the talent pool in growth sectors such as biotechnology and health care is shallower in Australia than the United States. The costs and risks of replacing management are consequently higher in Australia in these fast-growing sectors. Thus, the retention of skilled executives is critical to the advancement of the Australian health care industry and as such, many health care companies utilise employee options in partial substitution for or to complement salaries in order to retain the most qualified employees. Another possible reason for the increase in executive options in this sector is the high capital costs associated with the research and development (R&D) necessary within the industry. Consequently, by issuing options health care firms can utilise less capital towards retaining staff. Therefore, more capital is accessible to support the R&D functions and enhance growth.

This paper proceeds as follows: Section 2 provides a brief overview of the arguments for recognising expenses associated with executive options schemes, section 3 reviews the increase in options use in Australia and compares the current regulatory requirements in Australia and the United States for the accounting treatment of options and their disclosure[3]. Section 4 presents an accounting framework that takes into account the ‘true and fair’ valuation of options and section 5 presents the sources of data. Sections 6 and 7 present the CSL case study and Mayne case study respectively. Section 8 concludes the paper.

2 Background

Accounting standards seek to measure and report faithfully the economic events and transactions that have occurred during the reporting period - both favourable and unfavourable[4]. Those favouring the expensing of stock option costs argue that if stock options represent a transfer of value from the reporting entity to employees in return for services provided, then the accounting treatment of options should refl ect this reality[5]. Given that companies can issue warrants in the market and receive the fair value of those warrants in the form of income, there is an opportunity cost associated with the granting of stock options to employees. To the extent that options substitute for other forms of remuneration and act as an incentive to recruit and retain talented employees, they should represent a compensation expense to the issuing entity.

Those against the expensing the cost of employee option schemes generally base their arguments on technical difficulties associated with obtaining accurate valuations of options or that the reporting of diluted earnings per share captures the impact of such schemes on reported earnings. Technical difficulties typically revolve around assumptions regarding life of the options (where the vesting date does not match final maturity), the requirement in some schemes that performance hurdles must be met to qualify options for vesting, and the lack of liquidity in employee options. On the first argument, it is well accepted that accurately assessing the economic life of many assets for the purposes of financial reporting is difficult, and users of financial statements accept a tolerance for uncertainty over the lives of some assets. The same arguments appear justified for estimating the life of options granted to employees for the purposes of valuation. Performance hurdles apply in some schemes, and while these may add complexity to the valuation of options, robust valuation techniques can be used to value options carrying such performance hurdles[6].

With respect to the lack of liquidity in employee options, it is true that employee options cannot be transferred to third parties and as such carry less liquidity than comparable warrants or options traded in the open market. However, if the purpose of accounting statements is to refl ect the impact of transactions from the perspective of the accounting entity (and not those with whom it contracts), and employees are willing to accept options in their compensation packages in lieu of cash wages, then the relevant cost is the fair value of the options from the perspective of the issuing firm. With respect to the earnings per share (EPS) dilution argument, opponents of the expensing of options argue that the expense will introduce a double-hit to the EPS. Diluted-EPS refl ects the impact on the denominator if in-the-money employee options were exercised and the company used the cash proceeds to buy shares in the market to deliver to executive. The dilution component represents the net increase in shares after the cash proceeds from exercise are hypothetically used to acquire shares in the open market to facilitate delivery. From a theoretical perspective, there is no difference between an entity issuing shares for cash and using the cash to pay employees for their services from issuing shares directly to employees. Generating enough earnings to offset the EPS impact must compensate for the dilution impact of granting options in the same manner that companies must generate sufficient earnings to pay the employee and achieve a target level in profits. Conceptually, there is no difference in requiring service from an employee in exchange for the options given. Further, the diluted-EPS figure includes only in-the-money options, and thus excludes options that may carry economic value despite being out-of-the-money. Finally, if diluted-EPS does accurately capture the cost to shareholders of executive option schemes, then why not report the associated expense in the statement of performance where it is easily conveyed and understood to all users of financial statements?

In Australia, the expensing of employee options is supported by the Financial Executive Institute (FEI), the Australian Shareholders Association (ASA) and the Investment and Financial Services Association (IFSA). These organisations assert that options can and should be expensed utilising their fair value, rather than intrinsic value. The Australian Government’s Corporations Law Economic Reform Program (CLERP) proposes that the expensing of options ultimately becomes a requirement under Australian Accounting Standards.

In addition to the economic arguments for the expensing of employee options, there is growing concern that the lack of recognition of options as an expense and the lack of disclosure and transparency associated with these instruments provides incentives for senior executives to make decisions that may be against the interests of shareholders. For instance, there is evidence that suggests CEOs make opportunistic voluntary disclosure decisions (i.e. accelerate the disclosure of bad news and delay announcements of good news) around the granting of options that maximises their stock option compensations[7]. In this manner, a CEO would release negative news immediately before the granting of options - any fall in share price would result in options being granted to executives at lower strike prices. Similarly, management may profit by granting options when they believe the firm is undervalued[8]. Other studies find a positive correlation between the release of good news and the exercise of options by employees[9]. These actions may result in a transfer of wealth from existing shareholders to senior managers.

Opportunistic behaviour may not be limited to the granting and exercise of options. There is growing evidence that managers may structure the dividend policy of their firms to maximise the value of their option grants[10]. Specifically, there tends to be a decrease in dividends after the adoption of executive stock option plans, which suggests that management may set the dividend policy lower in order to enhance capital growth and thus increase the value of executive options. Furthermore, there is growing research on how stock options affect management’s decision to repurchase shares[11]. Share buybacks create value when the shares are bought at a price lower than their intrinsic value[12]. Share buybacks are utilised as a vehicle to reverse the dilution caused by excessive granting and exercising of options - which increases the value of an executive’s options[13]. While the end result in terms of share price may be neutral for existing shareholders, repurchases may nevertheless shift precious cash resources away from real investments[14]. Underlying corporate governance initiatives concerning the expensing of options and the full disclosure of the nature of option plans is the belief that expensing the cost of employee options will lead to a more transparent view of the financial position of the accounting entities. As such, one benefit from improved disclosure may be the minimisation of managerial opportunistic behaviour that is presently linked with executive options. Moreover, such initiatives would allow shareholders greater insight into company performance and assist in more informed decision-making.

While there has generally been improvement in the quality of disclosure in company reports, there is still insufficient information to present a ‘true and fair’ view of the worth and the nature of the options granted to shareholders. Section 300A of the Corporation Act (2001) Cth imposes on ASX listed companies an obligation to disclose details concerning the amount of options provided to each director and the top five highest paid executives. However, the value of such options is infrequently set out and disclosures relating to options are usually far from comprehensive or systematic in their format. Moreover, disclosures rarely include the justification for the issue of options or the amount of options granted. This may explain ASA’s recent complaints relating to the option plans of 30 companies due to lack of transparency, particularly with respect to the necessary performance criteria.

3 Employee Option Schemes in Australia and the United States

This section reviews the growth of options in Australia and the current regulatory perspective regarding employee option schemes in the United States and Australia. One of the main motivations for granting employees stock options is to better align the incentives of senior managers with those of shareholders. Employee stock options schemes grew significantly during the 1980s and consequently became a desirable pay component for senior executives. The introduction of the Fringe Benefits Tax in Australia in 1986 had a large impact on the structure of executive pay[15]. It meant salary packages would have higher cash components and fewer benefits, with relatively higher rates of performance pay. As a result, companies began awarding executives in the form of cash bonuses and incentives according to job complexity, performance and the market.

Since the introduction of the Fringe Benefits Tax, the increase in the granting of options in Australia has been profound. In a CSI survey in 2001, 66 per cent of companies reported that they have options plans in place for their CEOs and senior executives, while the figure was only 45 per cent in 2000. This trend is evident in the health care industry as well, with the top ten heath care firms[16] in Australia all maintaining employee option schemes. Though an upward trend is visible in the use of options in Australian companies, it still does not compare with the 98 per cent of the top 200 American companies offering share plans[17]. Taylor and Coulton (2002) argue that the “excessive use of options” is directly linked to the lax accounting treatment of options[18].

The issue of accounting for executive stock option compensation has been controversial in the United Sates. The official agency that oversees accounting rules, the Financial Accounting Standards Board (FASB) issued SFAS 123 Accounting for Stock Based Compensation in October 1994 to replace the accounting treatment under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. However, the hostile response from corporate America thwarted the efforts of FASB to mandate the use of fair value accounting for stock options. Currently, FAS 123 encourages, but does not mandate recognition of compensation costs based on the ‘fair value’ method and APB Opinion No. 25 can be used when accounting for options issued to employees.

The original intent of FASB was to require executive options to be recognised as a prepaid compensation expense based on their fair value at the date of grant and amortised over the vesting period. The fair value method recognises both the intrinsic and time value of the option. In contrast, the APB Opinion 25 only requires the use of the intrinsic value method (no recognition of time value) in recognising a charge against earnings for stock grants on the date the options are issued. Therefore for an option with a fixed exercise price, which is usually set against the share price at the date of grant, there is no intrinsic value. Consequently, there is no charge against earnings. Thus, companies that are not expensing options are understating their compensation expense, which overstates earnings.

Presently, US companies that choose not to capitalise and amortise the cost of options are required to disclose in the notes to the accounts the fair value on the grant date and the effect on net income and earnings per share had the FASB guidelines been followed. In addition, SFAS 123 does require that the terms and conditions of executive stock options be disclosed in the year of granting and subsequently in all years until they are fully vested. If there are any modifications to the terms of the options (i.e., repricing, reloading, extensions) the benefits associated with the modification should be included in the year of alteration.

Few companies in the United States are following the FASB standard and reporting the expense on their income statements, with most choosing the pro forma disclosure approach permitted under FASB. A survey of the 100 companies in the S&P 100 in 2002 found Boeing to be the only company that utilised the fair value method of accounting[19]. All other companies utilised the intrinsic value method of accounting and issue options at or above the exercise price, thus avoiding the recording of any expenses in their profit and loss statements. While a number of other companies have since followed Boeing, such as Coca-Cola, the number remains small.

Regardless of the method used to determine total compensation expense, firms must disclose the status of executive option plans at the end of each period presenting including[20]:

(1) the number of shares under options
(2) options exercised and forfeited
(3) the weighted average option prices for each category
(4) the weighted average fair value of options granted during the year
(5) the average remaining contractual life of the options outstanding
(6) the method used to determine fair value and significant assumptions

The decision of Australian directors to implement an employee share option scheme is regulated to an extent by the precepts of the Corporations Act (2001) Cth. The Corporations Act (2001) Cth requires directors to act in the best interests of the company and, therefore, of the shareholders as a whole[21]. As employee options schemes impart favourable conditions to employees (i.e. receiving shares at a discount), the terms of the options should not be so favourable that the scheme is not in the interest of the shareholders. The directors must believe that the ‘cost’ to other shareholders is offset by the ‘benefits’, whether due to the power to attract or retain staff, motivate staff, or otherwise[22]. The Corporations Act (2001) Cth prohibits that an officer or director improperly use information to gain an advantage for himself or herself[23]. Therefore, when directors participate in the employee share option scheme more care must be taken to ensure exceptions to insider trading rules apply[24].

In comparison to the disclosure regime in the United States, the Australian requirements are more fl exible and allow directors to present information that better refl ects a “true and fair” financial condition of the company. While the Corporations Act (2001) Cth requires ‘details’ of options, there is no uniform disclosure policy[25]. A cursory review of current disclosures in Australian annual reports demonstrates the frequent failure by firms to present clear and consistent information regarding options granted and vested. As encountered in this study and other Australian research, the lack of executive share option disclosure makes it very difficult, if not impossible, for a valuer to arrive at an accurate estimate of the cost to the firm[26].

Increased disclosure is mandated under Section 300A of the Corporations Act (2001) Cth for directors and top paid executives. The fair value of options granted should be included for these officers, but there are no requirements for the disclosure of option values of other employees. Although there is no requirement for the fair value of employee options to be measured and recorded as an expense against profits, applicable Australian accounting standard AASB 1027[27] makes it mandatory for companies report both basic and diluted earnings per share. Australian companies are required to include the dilutive impact of the outstanding ‘in the money’ options - not due to impact of options on profits, but rather the increase in the number of shares.

There has been criticism by the Australian Securities and Investment Commission (ASIC) concerning the failure of companies to comply with the changes under the Corporations Act (2001) Cth, particularly the omission of option values from required remuneration disclosures[28]. The lack of publicly available information on executive options has been noted in several recent parliamentary committees and has prompted Government Ministers to urge that the Financial Reporting Council direct the AASB to deal with the valuation of executive options as a high priority[29].

General information regarding options must be included in either the Director’s Report or the notes to the accounts as per AASB 1028. The requirements for Australia include:

(1) the number of options granted over unissued shares
(2) the issue price or the method of determining the issue price
(3) the grant date
(4) the expiry date
(5) the terms in which the instrument becomes vested
(6) any rights that option holders have under the options to participate in any share issue or interest in the company
(7) number of options exercised

There is no specified disclosure requirement on performance hurdles. However, the ASX Listing Rules mandate that any new shares issues be reported to the exchange under an Appendix 3B report.

4 Stock Option Valuation and Accounting

In this paper the expense associated with employee option schemes is calculated on a mark-to-market basis over the life of the options. The fair value of an option plan is estimated on the date of grant and amortised over the life of the option as compensation expense. Options are subsequently valued at the end of each reporting period, and incremental gains or losses are amortised over the remaining life of the options. This continues each period until the options expire or are exercised. This method may cause the direction and magnitude of recurring option compensation expense item to vary greatly depending on changes in the fair value of the options and the time remaining until maturity.

There has been considerable debate concerning the date on which the valuation of options should occur. There is a current push by the AASB to recognise the fair value of options on their vesting date, at which time it should be recognised as an expense, with the credit going to shareholders’ equity account. As pointed out by Brown and Yew (2002), this proposal by the AASB stands against the growing impetus within the international community to value options at grant date[30]. Under the fair value method in SFAS 123 and the likely direction of the IASB, a compensation cost is measured at the date of grant and recognised over the vesting period.

Moreover, many argue that valuing at vesting date misrepresents the initial value of the option. Research indicates that the recognition of options on the vesting date rather than grant date would have almost halved the average charge against EPS in financial year 2000[31]. Importantly by holding off on recognising the cost until vesting, the ‘matching principle’ tenet of accounting is being defied. In this manner, there is no recognition of the expense of options over the period in which the majority of benefits would be realised. As such, a poorly performing company would realise little or no value at vesting period, which would misrepresent the initial value granted to employees[32]. On the other hand, the successful firm would be hit with a large expense at vesting. The expense combined with the dilution factor would disadvantage these firms, while less successful firms would hardly notice the impact.

Rather than limiting the value of the options to the vesting date, this paper values the option on grant date and each financial reporting period until the instrument is exercised or expired. At any time during the life of the option, the firm could have instead sold its shares in the open market and receive more cash than the exercise price. Thus, the opportunity cost refl ects the value of options up to and including the date of exercise. The period between the vesting to the exercise of the option constitutes an implicit contract between the employee and the firm. The longer the employee holds the option, the greater the potential for a larger reward for service. As such the fair value of options is calculated at the date of grant and recalculated at the end of each reporting period and the date of exercise or lapse. This ultimately refl ects the cost of options as far as shareholders are concerned.

The revaluation of option plans at the end of each reporting period minimises the arguments that opponents of expensing options have. For instance, many argue that options may never vest or may lapse prior to expiry date. The incremental adjustments of the worth of the option plans will be refl ected in the corporate accounts in order to present a ‘true and fair’ version of financial accounts. The strength, wide-acceptance and simplicity of the Black-Scholes option-pricing model made it the preferable valuation tool for this research. It is also the methodology recommended under SFAS123.

Measurement of total compensation expense depends upon assumptions made about the variables in the chosen optionpricing model. The inputs that are needed for the Black- Scholes valuation methodology are as follows:

The expected life of the option has a significant impact on the valuation of options. The FASB (1995) recommends the expected time to exercise rather than time to expiry for valuation. For the purposes of this study the assumption is made that the options will not be exercised until the expiry date. The assumption that an option would be held until the expiry date is based on rational decision making by economic agents. However, the early exercise of options is rather pervasive, which makes the assumption questionable. This pattern of early exercise brings up troubling questions regarding why executives exercise their options early. Yermack (2001) points out there is more than risk aversion and diversification behind this decision - insider information may be at the core of the decision to exercise early[33]. The assumption that the exercise of options will be held off until expiry, may initially overstate the value of option plans. However, that value would simply be readjusted on the exercise date.

5 Data

This study focuses on the valuation and disclosure of executive options of CSL and Mayne Group issued during July 1, 1996 through to June 30, 2002. Data on executive options were obtained from the annual reports of the companies. Data was obtained on the number of options outstanding, the exercise prices and time to maturity for all of executive stock option plans of the selected companies. At the outset of the study, data availability and collection became problem. In Australia, the generally lax approach to options disclosure has resulted in disparate information being presented in annual reports. Data on the number of options granted or exercise prices were not always disclosed. As such, data triangulation was required from a number of sources, such as releases to the Australian Stock Exchange (ASX) or the financial press. Volatility estimates were calculated from historical return data for the companies.

To provide an indication of the difficulty in accessing information related to option schemes, some specifics on each company are provided. In the case of CSL, the exact date of option grants were not provided in the annual reports. In these cases, the assumption that options were issued on the first day of market trading in the month was made. In Mayne’s case, the date and amount of options granted in 1997 and 1998 were not included in annual reports. The dates of the granting of options were estimated using the information in the 1999 Annual report, as were the number of options issued. Since neither company included the amount exercised per exercise date[34], appendix 3B releases to the ASX were accessed. In all cases, the most conservative assumptions were made.

6 CSL Limited: Case Study

The decision of CSL to implement equity compensation in 1994 was based on facilitating a cultural change, from the former public service orientation of the employees and management to that of a for-profit enterprise. As stated below in an Australian government forum, the shift was to align the employees with the market:

The essence of the shift was to ensure a strong focus on the company’s responsibility to shareholders, and a need for it to be profitable, competitive, and efficient in order to meet the needs of both shareholders and the market. The introduction of employee share ownership within CSL was a major tool in providing that cultural shift[35].

During the period of study, CSL was operating two option schemes, the Senior Executive Share Ownership Plan (SESOP) and the Revised Senior Executive Share Ownership Plan (SESOP II). The SESOP was implemented in August 1994, while the SESOP II was implemented in November 1998. The basic difference between the two is that SESOP extended an interest free loan to employees to purchase the options on the date of the grant. SESOP II did not require the options to be purchased until the date of exercise, at which time a loan would be extended to the employee. By 2002, SESOP II had replaced the SESOP scheme. Table 1 lists the option plans evaluated in the study. Only the option plans that were issued during the time period between 1997 and 2002 were evaluated. The number of options outstanding in 2002 represent 2.8 % of total CSL shares outstanding.

From financial year 2000 onwards, options expired 7 years after grant. In 2000, the expiry dates of the four option plans issued in 1997 were shortened to 5 years, while the 1998 options and one option plan in 1999 were extended to 7 years. No information was presented in the 2000 Annual Report to explain the change in the life of the option. Furthermore, CSL does not specify vesting dates for the option plans. The only information provided concerning vesting is that performance hurdles for the economic entity and employees must be met before the options can be exercised. This is discussed in greater detail later in this section.

The options listed in Table 1 pertain to at most 144 employees, all of which are either executives or directors. Non-executive directors, however, are not entitled to share options or other performance based incentives. Short term or profit related bonuses and benefits are clearly inappropriate for non-executives, because of corporate governance issues and the long-term nature of their advisory role. In view of the current climate and attitudes, and the various literature that suggests that executive options may encourage irresponsible behaviour, at worst, or short-term attitudes, at best, CSL’s decision on non-executive remuneration seems to be aligned with shareholders interest.

As discussed in Section 5, the expensing of options in this case study is estimated utilising the Black-Scholes Model at the end of every year. Recall, that the fair value of the option is estimated at grant and revalued at the end of every reporting period. Consequently, the incremental increase or decrease in value is allocated to the option expense per year. Upon the exercise or lapse of the option, the final value is estimated and the corresponding credit or debit adjustment is made to the option expense. Table 2 presents the summary of expenses of CSL’s option plans per year.

The increase in the cost of options in fiscal 1999 and 2001 correspond to the profound increase in share price performance. The increase relative to the All Ordinaries and the Health Care Index demonstrates the superior performance in the market place of CSL. Additionally, the amount of options from 2000 to 2001 included in the study doubled from 1,087,000 options outstanding to 2,148,000 options respectively. In mid to late 2002, the expense decreased as the share price began to decline and the differential between the strike price and the share price diminished.

Table 3 indicates that CSL would have reported substantially lower net income and EPS if it had used the fair value method to account for employee stock options.

1 Profit per tax is from CSL Annual Reports.
2 Adjusted profit before tax is the estimated option expense minus profit before tax.
3 The historical company tax rate is utilised for a more applicable comparison of the option adjusted profit and the reported profit. Tax rates were obtained from the Australian Treasury website.
4 CSL’s reported profit after tax is modified to refl ect the applicable historical tax rate.
5 Diluted EPS corresponds to CSL’s reported profit modified to refl ect the applicable historical tax rate.
6 As per CSL Annual Reports 1997 to 2002.
7 Adjusted EPS is the adjusted profit after tax divided by the number of shares.

The impact of expensing options is most profound in the later years of the study in 2000, 2001, and 2002. The hit to profit in 2000 and 2001 is 21.1% and 26.2% respectively. Consequently, the impact to EPS is also dramatic. Considering the highly material impact on profit levels, shareholders that simply look at the financial statements may be misled regarding the financial performance of CSL. Excluding the lack of information regarding the fair value of options, the disclosure of the pertinent information regarding options at CSL has improved slightly since the beginning of the period of study. For instance, from 1997 to 1999, CSL included did not provide information on the date of grants and there was no mention of performance hurdles. By 2000, this information was being disclosed to shareholders.

Table 4 captures the trend in disclosure by CSL from 1997 to 2002. As indicated, there is a significant amount of information still unavailable to shareholders. Of most relevance to shareholders who may want to value the cost of options, is the lack of detail regarding the valuation of options, particularly concerning the assumptions made to determine the fair value. Shareholders have no means of determining the value of the options for themselves without extensive data gathering and the need for an undesirable number of assumptions.

Disclosure is also lacking with regards to performance hurdles. The only information presented in terms of performance hurdles for all executives is that hurdles exist. However, no discussion is presented on them. The significance of the hurdles is that no vesting dates are presented from fiscal 2000 to present. Since there is no information regarding hurdles, it is assumed that once an employee meets the performance hurdles, the options vest. Considering the significance of the hurdles, it is surprising that there is so little information disclosed. If in fact options vest as soon as performance hurdles are met, CSL option plans are too shortdated providing the executive an opportunity to exercise almost immediately. If CSL presented the information concerning options in a clear and consistent manner than shareholders would not have to spend time questioning the basic aspects of the plan.

CSL’s annual reports contain little information on the criteria for the selection of executives to receive options and how the percentage of options as per base salary is determined. CSL does, however, indicate that the Remuneration and Human Resources Committee review remuneration of senior executives within the company. Remuneration is determined as part of an annual performance review having regard to market factors, a performance evaluation process and independent remuneration advice[36].

Another instance where disclosure by CSL is deficient is with respect to the change of the expiry dates of Option Plan 1 through 7, as indicated in Table 1. Although CSL extended and decreased the life of their options, there was no modification to the value of their options. Whereas in the United States, under FASB Interpretation No. 44 any changes to the life of the option results in a new measurement of compensation cost as if the option were newly granted, Australia does not have such a requirement[37]. By extending the life of the option the value of the instrument increases, as there is more time to exercise the option and take advantage of the volatility associated with the underlying share price. In not providing shareholders with insight to the decision, corporate governance concerns arise - in particular concerning whether employees are benefiting from an only upside situation at the price of the shareholder.

Another interesting aspect of the disclosure CSL provides is in regards to the interest-free loan that it extends to executives and the directors to purchase options. This loan serves to limit the employee’s liability to repay to no more than the exercise price of the options at the time of repayment. CSL does not include this loan within the remuneration of executives and directors. The reduction of risk associated with the acquisition of shares in such schemes would seem to render them compensatory in nature and thus the benefits of any issues to directors and the top five executives should be valued and disclosed as remuneration in accordance with s. 300A, Corporations Act (2001) Cth[38].

In general, the notes to the accounts in CSL fail to present clear and consistent information regarding the granting of options, i.e. decisions behind remuneration including option grants, the exact criteria to enable the exercise of options, and the assumptions involved in utilising the Black-Scholes Model. As demonstrated in Table 4, there is a lack of transparency regarding performance hurdles. Executives at CSL are provided with longer-term incentives through the SESOP and SESOP II to “align the executives’ action with the interests of the shareholders”[39]. In the case of the Managing Director, an individual, long-term performance incentive has been given to him, with his two option plans having an exercise price of $0.01, in order to “encourage him to conduct the Company’s business with a view to the Company’s share price outperforming an appropriate ASX industrial Index progressively over a period of ten years and for him to remain with the company over that period[40].” The initial concern regarding the intended performance of executives centres around issuing options with strike prices that are dramatically lower than the market price of shares, i.e. $0.01, is that no additional productivity is necessary to add value to the options, thus defeating their stated purpose as an incentive.

Although the annual reports following fiscal 2000 mention that an appropriate index average is used to measure performance, the disclosure does not include the precise performance measure. The annual report does state that if the company under performs ‘the said ASX index’ over a relevant period, no amount is payable to the CEO. However, there are no inclusions in any of the annual report that specify if and when the performance hurdles have been met. Moreover, the performance hurdled of other executive options is vaguely mentioned in this statement, “Performance hurdle for both the economic entity and employees must be met before the options can be exercised”[41]. This lack of disclosure on the performance hurdles will limit the ability of a valuer to develop a reasonable estimate of the cost to the firm. Additionally, it does not present enough information for shareholders to assess whether the criteria establishes challenging benchmarks that further the competitiveness of the firm.

The link to the performance of CSL relative to others in its industry through an index comparison is a far better measure of CEO and executive performance, as share prices are generally affected by greater market forces such as global economic boom or slowdown, that may not necessarily have much to do with industry, company or individual performance. CSL’s performance until January 2002 has been superior to the All Ordinaries and still remains above the Health Care Sector[42]. However, without the precise performance hurdle, there is minimal transparency in the vesting of options.

7 Mayne Group: Case Study

Mayne implemented equity compensation in 1988 in order to relate reward to individual performance. As such a part of total reward for senior executives is ‘at risk’ as a performance based bonus via options. Mayne Group currently has an Executive Share Option Scheme (ESOS) open to all senior executives. Although Mayne extends share plans to directors and non-executive directors, there are no non executive directors currently[43] participating in the ESOS. Similar to CSL, Mayne’s decision not to reward non-executive directors is in line with IFSA’s recommendation as it does not uphold best practices in corporate governance.

Each option granted is exercisable from four years after its grant date, at any time before expiration. The expiration of options is 58 months after grant. However, options granted after July 1, 1999 may be extended from 58 months to 10 years under the absolute discretion of directors. Moreover, directors also have the power to vest options earlier than the stated four years.

From 1997 to 1999, there is no detailed information provided on the issuance of options. In these annual reports, there is simply a note stating that there are a certain number of options outstanding, but the exercise price, expiry or grant dates are not provided. Therefore, the quantity of options per plan cannot be derived for those years. Instead, due to the limited information, the number of options per plan as provided in the 2000 Annual Report was assumed as the base case in 1997 to 1999. In this manner, the most conservative approach in the valuation of options is undertaken. Table 5 delineates the number of options issued and outstanding during the period from 1997 to 2002. The number of options outstanding in 2002 represents less than 1% of issued share capital.

Table 6 below presents the summary of expenses of Mayne’s option plans per year. As the value of Mayne’s share price has never reached the highs of late 1998, there have been several incremental downward adjustments to the value of options granted in 1997 and 1998. Fiscal 2000 witnessed share prices plunge to one-fifth of the highs in late 1998, and as such the option expense in that year turned negative.

As the options issued in 1997 to 2000 continued to diminish in value, Mayne issued significantly more options at the end of fiscal 2000 and 2001. Although Mayne’ share price remained depressed relative to the All Ordinaries and the Health Care Index, during this period, Mayne’s share price increased, which enhanced the value of the executive options in 2001. A decrease in Mayne’s share price during 2002 weakened the value of options issued in 2001, even though several option plans were issued in 2002.

Table 7 presents the effect of the ESOS on income and EPS if Mayne had utilised the fair value method to account for the ESOS.

Due to the declining trend in Mayne’s share price during the course of this study, as opposed to the continual upwards trend in CSL’s share price, Mayne’s option plans have not impacted EPS significantly. The greatest impact to EPS is estimated to have occurred in 1998 with an estimated decrease in profits 4.03% had the expense associated with outstanding options been brought to account in the calculation of profit and loss.

The full value of the potential option expense is not captured in the above table, as directors have the power to make executive options more valuable. As Mayne’s share price has declined there is a provision for Mayne’s directors to increase the value of out-of-the-money options by extending the life of the options. This increases the reward of executives even though their performance, as measured by the company’s share price, is decreasing. Moreover, if these options are extended, there is no requirement under existing AASB standards which makes it necessary to disclose this fact. The Corporations Act (2001) Cth principle of presenting a ‘true and fair’ view of a corporation’s financial position and performance might be invoked to require that such data be reported, but this would be a weak rather than a hard stimulus.

The disclosure of the Mayne Group’s ESOS has improved since the beginning of the study. Initially, the amount of options granted and their respective exercise price were not disclosed. Mayne, however, does not provide clear and consistent information regarding the valuation of options. Similarly to CSL, there is a lack of detail regarding the assumptions made to determine the fair value. Shareholders have no means of determining the value of the options for themselves without extensive data gathering and making considerable assumptions. Mayne also provides insufficient information regarding the justification for the grant of options, the amount of the grant or how the options fit with the executive’s total remuneration. Disclosure concerning performance hurdles should ideally include the benchmark and the criteria by which executives are unconditionally entitled to exercise their options.

The lack of disclosure is also apparent in the overlapping ranges of option prices of Option Plans 1-3 as shown in Table 9. Each one of these plans consists of smaller parcels of options, each with a corresponding exercise price. These overlaps made it near impossible to accurately assess from the Appendix 3Bs, which options corresponding to which plans (Plan 1-3) were exercised. Moreover, a weighted average strike price for each plan would have clearly presented the option plans to shareholders. In 2001 Mayne changed the range of strike prices in Option Pan 1-3 without an explanation. This necessitated more assumptions concerning which options belonged to which plans. In one respect, the lack of detailed information served to camoufl age the exact remuneration of executives and the value of the options.

As demonstrated in Table 8, Mayne’s option schemes appear to be poorly designed. For example, Mayne does not report the existence of clearly defined performance hurdles. Only in the 2000 Annual Report is there any mention of performance hurdles. However, the exact performance hurdle is not stated, simply a reference to the satisfaction of certain ASX 100 hurdles. The performance hurdle mentioned is not applicable to every executive, but further details are not provided. Performance hurdles are not mentioned in any other year.

In fiscal 1999 and 2000, Mayne Group repurchased 12.3m and 8.3m shares respectively, on the open market. The cost of each repurchase totalled $64.1m (1999) and $39.3m (2000). During the period between 1998 and 2000, Mayne issued 5.5m shares due to the exercise of options. Moreover, throughout 1999 to 2000, there was an additional 10m options outstanding over shares. Although, Mayne released no statements indicating that the purpose of the buyback was due to the exercise of options, it is interesting to note that the firm repurchased shares in the open market in 2000 ($4.73) for a greater price than the weighted average exercise price received from shares ($4.36). Additionally, the repurchase of shares was financed through debt as noted in the 2000 Annual Report.

Furthermore, Mayne Group decreased their dividend payout ratio from 96% (30 cents) to 77% (17 cents)[44] in 2000. In 2001, the payout ratio dropped further to 49% (13 cents). As mentioned previously, firms may decrease dividend payments in order to strengthen the value of options. However, the evidence available with regards to Mayne is not conclusive. Mayne’s share price has been performing poorly, and the repurchase may indicate management’s view that the shares are undervalued.

Mayne’s continued commitment to decreasing the number of outstanding shares is evident in their recent announcement that they will begin buying back 75 million shares, which will cost Mayne approximately $280m and consequently increase their gearing.

8 Conclusion

It is the contention of this paper that the expensing of options will increase the transparency and consistency of corporate reporting, giving a more accurate refl ection of the financial position of companies. As such, the proposed accounting model serves to support the Corporations Act in its support of true and fair representation of a firm. The case studies of two Australian companies in the healthcare sector have demonstrated the potential impact that the expensing of options may have on profit levels and consequently on EPS. In not including the compensation expense associated with options, shareholders are left with inadequate information with which to judge the value of their interest in the firms.

The case studies also demonstrate the lack of disclosure currently in place with respect to options. Neither Mayne nor CSL clearly stated the objective of the option schemes or how the option schemes refl ect the responsibility of the executives. As per the guidelines of IFSA, the option plans were not sufficiently transparent to ensure ready external determination that the plans are designed in such a way as to enhance the likelihood that the company performs well for shareholders through long-term growth and increasing shareholder value. In fact, the performance criteria for each of the companies studied were vague, if they existed at all. Disclosure requirements need to be tightened significantly with respect to executive stock option schemes.

Along the lines of disclosure and expensing of options is the questionable behaviour that may be manifesting itself in these organisations. CSL appears to have extended the life of options with no disclosure and granted options at such a low strike price that the incentive to perform is low. Mayne increased its debt burden to repurchase shares, while decreasing dividends, which may offset dilution due to the exercising of options. These actions are entirely legitimate and in line with the Corporations Act. However, lack of transparency and details surrounding these transactions serves to question the motivation behind them. It is feasible that if the expensing of options was performed and detailed disclosures provided there would be less concern over the potentially opportunistic behaviour by senior executives in firms.

References

[1]. Coulton, J., and Taylor, S., 2002, “Accounting for Executive Stock Options: A Case Study in Avoiding Tough Questions”, Australian Accounting Review, Vol. 12, No. 1: 3-10.

[2]. Salomon Smith Barney, The Impact of Options, March 2002.

[3]. The United States regulatory framework regarding options is discussed as CSL has operations in the United States, and as such disclose notes to their accounts to satisfy US GAAP.Moreover, although both countries have inadequate accounting requirements, the comparison serves to demonstrate the lag of Australia to reach similar disclosure requirements and valuation.

[4]. Pacter, P.FASB’s stock option accounting problem: correcting a serious fl aw, March 1994.

[5]. Pacter, P.FASB’s stock option accounting problem: correcting a serious fl aw, March 1994.

[6]. See Carrett, P and B. Wong, (2001, “Executive options: valuation and projection methodologies” Institute of Actuaries Biennial Convention, Queensland, Australia.

[7]. Aboody, D. and Kaznick, R., 2000, “CEO Stock Option Awards and the timing of voluntary disclosures”, Journal of Accounting and Economics, Vol. 29: 73-100.

[8]. Financial World.Stealth Compensation. Financial World: NY, February 1992, pp. 74.

[9]. Yermack, D., 1997, “Good Timing: CEO stock option awards and company news announcement”, Journal of Finance, Vol. 52: 449-476.

[10]. Lambert, R. A., W. N. Lanen, and D. F. Larcker, 1989, “Executive stock option plans and corporate dividend policy”, Journal of Financial and Quantitative Analysis, Vol 24: 409-425.

[11]. Fenn, G. W. and N. Liang, 2002, “Corporate payout policy and managerial stock incentives”, Working Paper, Federal Reserve Board Washington DC.; Weisbenner, S.J., 2000, “Corporate Share Repurchases in the 1990s: What role do stock options play? “, Working Paper, Federal Reserve Board Washington DC.; Klassen, K.J. and R. Sivakumar, 2001, “Stock Repurchases associated with stock options do represent dollars out of shareholder’s wallets, Working Paper, University of Waterloo.

[12]. Yermack, D., 1997, “Good Timing: CEO stock option awards and company news announcement”, Journal of Finance, Vol. 52: 449-476.

[13]. Fenn, G. W. and N. Liang, 2002, “Corporate payout policy and managerial stock incentives”, Working Paper, Federal Reserve Board Washington DC.; Weisbenner, S.J., 2000, “Corporate Share Repurchases in the 1990s: What role do stock options play? “, Working Paper, Federal Reserve Board Washington DC.; Klassen, K.J. and R. Sivakumar, 2001, “Stock Repurchases associated with stock options do represent dollars out of shareholder’s wallets, Working Paper, University of Waterloo.

[14]. Bens, D.A., V. Nagar, W. Guay, and M.H.F. Wong, 2002, “Real Investment implications of employee stock option exercises”, Journal of Accounting Research, University of Chicago, Vol. 40: 359-406.

[15]. Holburn, E., “Executive Pay - The Stock or Share Option”, CSi Communications, 2001.

[16]. Based on market capitalisation.

[17]. Holburn, E., “Executive Pay - The Stock or Share Option”, CSi Communications, 2001.

[18]. Coulton, J., and Taylor, S., 2002, “Option Awards for Australian CEOs: The who, what, and why”, Australian Accounting Review, Vol. 12, No. 1: 25-35.

[19]. Salomon Smith Barney, The Impact of Options, March 2002.

[20]. CFRA, Accounting for Fixed Employee Stock Options, October 23, 2000.

[21]. S 181(1)

[22]. Warren, H., 2000, Deacons Lawyers, Briefing Paper No. 1: Employee Share and Option Schemes.

[23]. S182-183

[24]. Warren, H., 2000, Deacons Lawyers, Briefing Paper No. 1: Employee Share and Option Schemes.

[25]. Coulton, J., and Taylor, S., 2002

[26]. Maller, R., Tan, R., and DeVyver, M., 2002, “How might companies value ESOs?”,Australian Accounting Review, Vol. 12, No. 1: 11-24.

[27]. AASB 1027, Earnings Per Share, Australian Accounting Standards Board.

[28]. Stoddart, E.K., 2001, “Options in Valuing Equity Compensation Benefits”, Australian Accounting Review 11:49-61.

[29]. Stoddart, E.K., 2001, “Options in Valuing Equity Compensation Benefits”, Australian Accounting Review 11:49-61.

[30]. Brown, P. and E. Yew, 2002, ”How do investors regard ESOs?”, Australian Accounting Review 12: 37-43.

[31]. Brown, P. and E. Yew, 2002, ”How do investors regard ESOs?”, Australian Accounting Review 12: 37-43.

[32]. Brown, P. and E. Yew, 2002, ”How do investors regard ESOs?”, Australian Accounting Review 12: 37-43.

[33]. Yermack, D., 2001, “Executive Stock Options: Puzzles, Problems and Mysteries”, Stern School of Business, New York University, April 5, 2001.

[34]. No exercise dates were provided in Mayne or CSL’s annual reports.

[35]. Parliament of the Commonwealth of Australia, (2000), CSL submission No. 6, p.2.

[36]. CSL, 2002 Annual Report.

[37]. CFRA, Accounting for Fixed Employee Stock Options, October 23, 2000.

[38]. Stoddart, E.K., 2001, “Options in Valuing Equity Compensation Benefits”, Australian Accounting Review 11:49-61.

[39]. CSL, 2002 Directors’ Report.

[40]. CSL, 2002 Directors’ Report.

[41]. CSL, 2002 Annual Report.

[42]. This is true even though CSL’s share price has fallen from $50 to $19 over a 6-month period.

[43]. As at the time of writing.

[44]. Payout ratios and dividend amounts obtained from Comsec website.


[*] Commonwealth Bank of Australia. The views expressed in this paper are those of the author and do not necessarily represent those of the Commonwealth Bank.


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