Maxim Integrated Products, Inc. along with other organization has implemented expensing employee stock options as required by FASB Statement 123(R). The issue presented is whether expensing employee stock options under fair value rules accurately reflect the company’s true financial condition and what would be an appropriate way to assess the company’s performance when valuing the its stock. Case Data Maxim Integrated Products, Inc. designs, develops, manufactures, and markets a broad range of linear and mixed-signal integrated analog circuits.
It. granted stock options to its employees in order to give them the right to buy a specific number of shares of the company stock at the price the company specified at the time of employment. This is a form of compensation made my Maxim that enabled them to keep their financial performance and to attract top notch engineers employees by offering compensation that goes beyond one’s salary. Stock option compensation is important for Maxim as it attracts and retains top qualified employees and help to boost the company’s productivity.
In addition, by using stock option compensation Maxim maximizes the value to its shareholders by reducing the expense for employee compensation. Under the new rules the company won’t be able to reduce the expense for employee compensation as it will be required to expense the options. The new requirements would have an effect on the way employees are compensated but will still remain a primary motivational and recruiting factor for most high-tech companies. Any changes in the form of compensation would still need to be expensed whether it is cash based or restricted stock grants and should not have a significant effect on the net income.
In the past the company had expensed employee stock options using the intrinsic value method, which recognized stock options compensation costs as the difference between market and exercise prices of the options at the grant date. Under the intrinsic method the company did not recognize expense for the stock options issued with an exercise price equal or less to the stock’s price at the grant date. The effect on income of the stock options was only disclosed as part of the financial statement notes. Under the FASB
Statement 123(R) the company is required to start expensing stock option grants using the fair value method in the quarter that they are incurred. If stock options were expensed during the previous years, the expense as percentage of the net income for the company was going to be 45% for 2003, 34% for 2004 and 28% for 2005. Expensing Stock Options: FASB vs. APB25 The FASB issued the Statement 123(R) that indicated that their preferred recognition of the fair value of employee stock options as an expense item starting in the year of grant along with wages, salaries, bonuses and other similar cash items.
What this means and the goal here is to calculate the stock option expense based on determining the value of the employee stock options on the date of the grant. They recommend achieving this goal by utilizing the Black-Scholes option pricing model or the binomial model. Both methods allow significant latitude in valuing the options by changing a set of assumptions for the expected holding period, interest rates, stock price volatility and the dividend yield. Any changes in the assumptions used will result in different value used for expensing the stock options at their grant date.
Previously, despite the recommendation made by the FASB, Maxim elected to follow the APB 25 accounting standards or the intrinsic value based method which is basically the difference between the current price of the stock and the strike price. This means that Maxim allowed their employees to purchase stock at a discounted price or at the price at the time employees were employed. Therefore, if the employee was to exercise the stock option and the discount is large, the employee can exercise the option and earn a large profit.
In addition, if employees were to exercise their options, it would increase the number of shares outstanding of the company’s stock, and in turn, the company’s earnings per share will be lower. Another example of this method is that if the company’s stock price of $20 were issued options with a strike price of $20 or higher, Maxim would have no expense to report in their financial statement and therefore, there would be no impact on the company’s earnings. With this, the FASB issued the SFAS 123 which is a standard that requires organizations to use the fair value approach.
However under the new rules, Maxim would have to count employees stock options as an expense or intangible asset that will reduce the company’s net income overall. Alternatives The first alternative is to evaluate the company using the financial reports as required by GAAP and the new FASB rule 123(R). The second alternative is to evaluate the company using the pro forma earnings generated using the intrinsic method for stock options expensing and using the free cash flow as suggested by the Chief Executive.
The third alternative is to evaluate the company using a mixed set of criteria that includes the free cash flow, the pro forma earnings and an own estimation of the effect of the stock option compensation on the company’s performance and share dilution. Decision Criteria ?Accuracy in representing of the company’s financial condition ?Within capabilities and resources for timely evaluation ?Consistency with methods for evaluating other companies ?Flexibility in evaluating unique circumstances Alternatives Evaluation
The first alternative where we use the GAAP conforming financial statements will present the true value for the employee compensation in the quarter that it is incurred. The fair value method, despite considerable latitude in the option valuation, will more accurately present the cost of the employee compensation, although it would not properly represent the actual cash based company expenses. Using this method will reduce the time necessary for evaluating the company and minimize the resources required.
As all companies are now required to furnish statements conforming to the new rule, accurate comparisons with the evaluations of other companies will be most easily achieved. Evaluating unique circumstances where cash flow needs are important would be hindered. The second alternative would accurately represent the company’s cash based situation and cash generating capabilities but would not show the true value of employee compensation expenses and will discount the required future share repurchases and share dilution.
Due to the significant effect of the stock options expense on the net income Maxim’s CEO has suggested that the free cash flow would be a better measurement of the company’s performance. Free cash flow is a useful indicator for the company’s ability to cover its obligations but not for valuing the company. For investors the net income would still be the best indicator of the company’s performance. In addition the tone and substance of the comment are not appropriate for a CEO. Declining net income can be explained with expensing stock options but stating work-around is not suggestive of executive behavior.
The added burden to evaluate a non-standard set of financial statements would increase the time necessary for performing a company analysis. In addition, the non-conformity with the financial statements of other companies will invalidate the comparison with other companies within the industry. The alternative though would allow for an analysis of company’s unique circumstances and focus on its cash generating capabilities. The third alternative would allow for the most accurate representation of the true financial condition of the company.
It would include the cash generating capabilities and the pro forma earnings power with an adequate estimation of the employee based compensation. The addition of a separate estimation of the expense for the stock options will increase the resources necessary to perform the estimation and evaluate all the separate financial statements. Comparison with other companies in the industry will be impossible without a time consuming joint analysis or preparation of separate analysis for each company. This method though would allow for the inclusion of all unique company circumstances.
Recommendation The first alternative using the GAAP conforming financial statements is the most sensible approach for evaluating the company’s performance. While it is not the most flexible method for evaluation, it allows for a timely and efficient evaluation by utilizing the fewest resources. As GAAP is the reporting standard for other companies it allows for straight forward approach in for comparisons with other companies in the industry. The change in reporting Maxim’s employee compensation to the GAAP standard should not ave a significant effect on the stock price as professional stock analysis are already accounting for cost of stock based compensation as reported by disclosures in the annual report. The standard adoption might have a minor effect on the perception of the company’s profitability by the general public and consequently minor effect on its stock price. Overall, having a consistent standard is essential for establishing trust in the corporate financial reporting. Having the stock compensation expense recognized in a timely and open manner is essential and the adoption of the rule by FASB is a step in the right direction.