Analysis of Stock Option in Bristol Myers Squibb - Thesis Example

Analysis of Stock Option in Bristol Myers Squibb ACCT 411 Accounting Theory Stephanie Ibach Zhiying Yvonne Chen ID: 200204942 Bachelor of Applied Business Administration – AccountingJR Shaw School of BusinessApril 2, 2010Executive SummaryThe Bristol Myers Squibb (BMS) has been effectively using the employee stock options plans as incentives to the employees. Employee stock options (ESO) are regarded as incentive tools in the world of finance where the company tries to align the goals of the organization with the goals of the management in order to increase profitability and productivity of the organization.

Under ESO, the employee can exercise the options to gain the shares of the organization at a lower price than what is prevalent in the market and benefit from it. The company uses these plans to increase the motivation of the employees and in turn affect the market efficiency. It also uses them to decrease the turnover of the human capital in the organization. An analysis of the organization’s stock options policy reveals information that is promising for investors and the concerned stakeholders.

The organization has been using stock options as a large part of their compensation at the executive level. Employees after meeting the criteria set by the organization are allowed to own options and exercise them over a period of 10 years. ESO allows the employees to hold stock options below the market price. The sound corporate governance policy requires that the board meeting and the shareholder’s meeting can decide upon the re-pricing of the options and this cannot take place without the approval of the concerned.

The company has been able to decrease the moral hazard relating to the issue of stock options and has provided huge incentives to its employees apart from cash compensation. The morale of the employees is all time high due to the compensation package that they are offered. The company is looking forward to striking major deals and re-establishing its name as a bio-pharmaceutical in the world. Table of ContentsExecutive Summary iiIntroduction 4ESO carry a moral hazard with them, if properly implemented, with sound accounting policies implemented throughout the organization; it is bound to create success for the organization and its employees.

Disclosure of proper information increases accountability on the part of management and restricts them from any incorrect actions that they might take. They can be used to decrease moral hazard, increase employee motivation and increase market efficiencies. BMS, with the help of sound corporate governance policies has effectively handled to issue of stock options, taking all the advantages that they possibly can. 16Works Cited 17Mun, J. Valuing Employee Stock Options. John Wiley and Sons (2004) Pg 299 17IntroductionThe paper is organized to provide a basic understanding of how the Employee Stock Option (ESO) works in a Bristol Myers Squibb (BMS).

The paper also discusses the major functions of ESO and why the company is employing ESO as a tool for increasing the motivation for their employees, decreasing the turnover rate and the payment of executive compensation; apart from all the other reasons. The paper also presents some of the attributes of ESO, outlining the moral hazard that is associated with the issuance of stock options. The effectiveness of stock option is also discussed later, after which of their policy is gauged with the help of certain factors associated with ESO.

The conclusion is presented in the end discussing the effectiveness of the current strategy along with recommendations for the company to alter their strategy where ever applicable and necessary. Methodologies ESO serve as non-cash compensation and an increase in the price of stock provides direct benefit to the employees, holders of such options. Therefore, the employee holding such an option would work in a way that moves the direction of the stock price upwards. To induce a profit increasing behavior, other stakeholders such as lawyers, suppliers etc, directly related to the organization, can also be provided such profit sharing options, to induce positive behavior in them.

In simple terms, if the employees feel that their positive behavior is directly going to benefit them in the form of extra value in the stock that they hold, they will work harder for it. However, there is lack of concrete evidence regarding the directly proportional relationship between granting stock options to an employee returning a superior performance; great ambiguity surrounds this statement (Judith, 2008). There is another picture through which these options are viewed. There is a moral hazard of attached to it; moral hazard is defined as the conflict of interest that might be present between the two stakeholders that are involved in a scenario.

Strictly in terms of accounting, moral hazard is the conflict of interest that might be between the management and the shareholders in light of the issuance of stock options (Ashvin, 2008). For example, a member of the management, holding the stock options, would try to artificially try to increase the stock price in their favor. The fact that employee start working for their own selves, making such decisions that would just benefit the stock value of the organization, forgetting the other goals set by the organization.

Also, all other incentive plans except for this are expensed in accounting standards, whereas stock options receive favorable treatment. ESO also face many corporate governance challenges including the compensation philosophy of the organization as well as financial disclosure policy of the organization (Mun, 2004). Managers, in trying to make the stock price go up, would influence the published results that would in turn influence the stock price and benefit the employees in the end. There is increasing evidence that valuation companies are increasingly using the options expense in the valuation of an organization.

Current Stock Options Policy In BMS, the exercise time period is 5 years. At the time of exercise, if the stock price is higher than the exercise price at which the option holder can get the stocks, they can capitalize on the net increase; exercise their option, sell the stocks at market price and earn the net between the exercise price and market price. The issuance of ESO make the market more efficient and people work harder to make sure the stocks of their companies soar higher in the market and they benefit from it.

The stock option policy of BMS has a sound stock option policy. They have been providing their employees with stock options in the previous years. The company’s ESO plan allows the employees who have are full time and have spent a considerable time in the company, to own the option plans. According to the analysis the company in December 1996, provided 400 options to employees who are eligible for it. However, in recent times, due to a drop in stock price on account of the prevailing recession, employees did not exercise many of their options.

Even the CEO of the company, in 2009, has received a lower compensation then before (AP, 2010). This decreases the moral hazard as the CEO is getting a lower compensation than before and hence is suffering at the relatively mediocre performance of the company. As far as the reprising strategy of the company is concerned, the company follows a concrete policy governing stakeholder’s rights. It is under company policy that they will not reprice the options of the company before the prior approval of the stockholders; this change may be either a reduction in the exercise price of the options or to exchange options of any sorts (restricted stock, director stock options, etc) or any other consideration (BMS, 2010).

This restriction helps the company maintain decorum and a sound financial control over the health of the company. The rights of the existing shareholders are guarded; moral hazard is decreased and the proposition helps to increase market efficiencies.Why BMS Use Employee Stock Options BMS used ESO to gain superior performance from its employees, to that they can all benefit from the increasing shareholder’s value. The significance of stock options arises in the fact that they are beneficial for both the company as well as the management.

BMS uses ESO for a number of reasons. a. Initial alignment of management incentives: The company uses options to align the management’s wants with the organization’s wants. ESO provides the owner of the stock with an option to exercise the option and get the option at the strike price at a later date. This provides an incentive to employees to work towards organizational goals, as their goals of achieving profits will be linked to the increase in the value of the organization, translating into the stock price.

Therefore, the organization provides stock options to improve management’s performance for a good five years, until the strike price, aligning management and organizational goals. This in theory should work for the organization. However, to keep the incentive going, the organization should follow reprising strategies at the time the stock prices are going down or below the strike price. This phenomenon provides the employees with incentives to work harder. The company’s patent of their second best seller drug PLAVIX (company website) is sure to get the concerns going up of the stakeholders in the company.

However, the current CEO’s gestures to keep the company’s competitive edge intact should be able to hold their market position steady after 2012.b. Attract and retain key personnel:The main reason for which ESO was started was to attract and maintain the precious human capital. When companies align compensation plans with performance, it has shown that the performance of the employees has increased. Feeling directly beneficial from their own hard work, employees tend to work harder, more efficiently, resourcefully towards increasing the value of the organization.

This is exactly why BMS has been granting stock options to their employees. Their human and intellectual capital is their competitive advantage in the pharmaceutical business. Stock options form a huge part of the compensation package of key personnel in the company (Tiare, 2010). A probable reason for this is that, for an employee to qualify for ESO, they have to spend a considerable amount of time in the company; career oriented individuals at the start of their careers are more likely to switch jobs for a better future than the ones in the mid-lives. c. Facilitate the payment of high levels of executive compensation:Higher levels of management such as the CEO or other executive positions are required to pay a high value compensation package, in order to drive the company forward.

They are an essential part of the compensation package of CEOs today; this is also a move to retain the quality individuals in the organization. In a US firm today, if the CEO’s compensation is $1 million cash, he/she will be rewarded about $10 million worth of shares. There are other options provided to CEO’s in their compensation packages; including a boastful retirement plan, an executive jet etc. Also, to match to the high levels of executive compensation, there is a high chunk of stock options that is provided to the CEO, to align the goals of the company as well as the person (EconomicExpert.com, 2010).

Under the USA’s rule in 2008, the company has to reveal significant information regarding executive compensation. The equity based compensation has to be revealed, their grant date or reward etc (Regulatory Pulse, 2008). Most of the BMS CEO’s compensation comes from stock options. The exact amount isn’t available, however, its value in 2008 was $15.7 million and it went down to $10.9 million, due to decreasing stock prices. Looking at the CEO’s total compensation for the year, stock options make more than half of the compensation package (Linda, 2010).

Moral Hazard of ESOA moral hazard is a situation that tempts the managers to act in immoral or unethical ways. Unfortunately, ESO likes the example create a moral hazard which can have dire consequences. For example, the CEO’s compensation is directly tied to short-run stock price, since there’s limited period during which it can be exercised. CEO is therefore motivated to take actions that will hold the stock’s price up as the approaches. Suppose management knows something that if is released to investors, would cause the stock’s price to drop.

The price would personally cost the CEO a huge part of compensation if this happens before CEO could exercise the option. As a result, CEO is quite likely to suppress the information until the exercise date or till he exercises the options so that he is able to benefit from it.Even worse, in order to increase the stock’s price so that the CEO is able to benefit from the increase in stock price, he/she might fabricate false information that makes the company’s future look brighter than it actually is.

Such misinformation could take the form of lying about the success of research projects, the strength of the company’s competitive position, the probable results of lawsuits, and most importantly about the company’s financial results. Information asymmetry would occur where the market would be working on information which is not true and mispricing is likely to occur in such a situation.The Link between Stock Price and Reported Financial Performance: The stock prices go up and down, based as people buy and sell shares in the stock market.

If an investor thinks that the company is faring well, he or she will try to buy the stock. Now, the only way the investor can know about the situation of the company is either through business news, or through informal ways; the most prominent way is through the financial statements. Looking at the financial position of the company through financial statements, the investor will buy the stock. Similarly, if the financial position depicts that the company is in danger, they would want to take the money out of the stock as soon as possible so that they may not lose money.

This action will be replicated by all those who have a similar thinking. Hence a good reported financial performance is bound to replicate the event of investors buying the stock. Also, the investors and market assume that the financial statements would provide the actual developments of the organizations in terms of financial statements. That is the reason that financial statements are used to understand the position of the company and then make an informed decision. A good financial performance would make the investors and market to go for the stock; on the other hand, a bad one would make the investors and market stay away from the stock.

The options of BMS are influenced by information investors regularly receive regarding the company including projections about produces and markets, competition, the economy, and government actions. The investors expect that the information that is being transmitted is true and will reflect the company’s position. The market tends to focus on the current financial results as indicators of the future; they are sales revenue, earnings per share and debt. This means stock prices can be artificially inflated or held up despite poor performance by publishing deceptive or misleading financial statements that make results in these areas look better than they really are.

Such statements generally inflated revenues and EPS and hide debt. When it comes to BMS, the organization has done well as no scandals of misreporting have been reported as yet. BMS has done well in the recent past; most investors are willing to believe it will do well in the future.Producing Misleading Financial Statements Unfortunately, producing deceptive financial statements that may hold stock price up isn’t difficult. The accounting rules for financial reporting for GAAP are filled with gray area, so there’s some latitude in reporting results that can be technically “correct” but will misleading.

Further, in large companies, it’s possible to produce misleading or even fraudulent reports in which the deceptive entries aren’t discovered for years because of the size and complexity of the organization. This can produce a cascading series of misstated reports as executives strive to keep stock price up year after year. This affects the knowledge of the investors as those who are not able to point out these misstatements in financial statements might value the organization on the basis of the provided information.

Information asymmetry occurs when there is more information with the one party when compared to the other party that is involved. Therefore, in such a case the information that is circulating in the market is not true and may affect the decision of the concerned personnel in a negative manner. Also, if the management knows that re-pricing of the stock options is about to take place, they would increase their efforts in a positive manner as it will help them gain more after repricing of the stock.

Financial market participants such as the investors should be provided with equal knowledge of the truth of the situation. Providing misleading statements is like fabricating a good picture of the organization in front of investors; however, in actual terms it is not so. It poses great threat in decision-making processes as the stakeholders are thinking they are making decision according to the right information that has been provided, in actuality it is not so. This may lead to poor-decision making and financial losses for the ones concerned.

Who is Responsible for Financial Statements The entire moral hazard issue that is under discussion actually worsens because top management is ultimately responsible for producing accurate financial statements. That means the CEO, assisted by the CFO, decides what goes into the company’s annual report to shareholders and the investing community. There is some oversight by auditors and boards of directors, but the bulk of the responsibility along with the ability to manipulate results, is left to the CEO and CFO, two people who have a lot to gain from high stock prices.

In other words, top executives to some extent have the power to enhance their own wealth by cheating on financial reporting. The agency problem has always been recognized, and safeguards are in place that is supposed to protect stockholders’ interests. BMS understood that the primary watchdogs have been auditors and board of directors. a. AuditorsAuditors are Certified Public Accountants (CPA) who is employed by BMS to examine (audit) their financial records in order to provide a comfortable level of assurance that the books have been keep properly, in accordance with GAAP.

Auditors’ written options are included in annual reports and provide a level of assurance to investors that BMS’s books are correctly and honestly kept.The assurance is not, however, absolute; because it would be prohibitively expensive to audit all of BMS’s transactions. Hence a statistical sampling of transactions and controls is examined, which along with the here to fore unquestioned integrity of the auditing profession, was thought to be sufficient to give a reasonable level of confidence that the financial statements of public company was correctly stated.

The auditor succeeded in undermining the role of CPA firms as guardians of public trust.a. Board of DirectorsBMS is technically run by boards of directors. It is a practical matter; the board appoints senior management, including the CEO, and delegates the routine running of business to them reserving only major decisions. BMS Board consists of inside and outside directors. The inside directors are the senior executives, including the CEO. The outside directors are drawn from the different banks, law firms, accounting firms, and other companies.

The outside directors are supposed to act as a check on the authority of the inside directors who are also company executives. Their presence is intended to bring an independent objectivity to corporate decisions that might be lacking if all of the board members were all insiders.BMS have committees that are responsible for specific tasks in running companies. The audit committee is responsible for the relationship with the CPAs who form the audit of the firm and indirectly for the internal accounting controls that are in place to keep the company’s financial records and statements honest and correct.

The compensation committee approves the pay packages of senior executives including the CEO and CFO. These committees are crucial to controlling the agency problem.Analysis of Effectiveness Just like there are two sides to a coin, there are issues related to stock options that are voiced by experts regarding the accounting matters of an organization. Even some of the experts have helped the CEO as responsible to artificially inflate the stock price in order to gain from the call options that they own.

However, they have taken profound measures to decrease the moral hazards relating to the issuance of stock options. Decrease moral hazard:The agency problem can arise when employees are awarded with stock options. This is usually happening when management and control come together. In ESO, a moral hazard that exists is that employees and executive compensation receivers are shielded from negative behavior of the stocks, however, have much to gain as the stock prices rise. The company should take further efforts to decrease the moral hazard associated with the stock options.

Since there are many ways of valuing options, and a different mindset of employees when compared to market makers further complicates the issue. Since the stock price of BMS has gone down, it has reduced the notion of moral hazard attached to the stock options. The company has also restricted the transfer of shares under any circumstances, unless directed by the board of directors, as mentioned on the company website, to further decrease the moral hazard. Auditors and board of directors ensured the financial statements were fairly presented.

Decrease Turnover:By providing incentive ESO plans to their employees, the company has tried to decrease the turnover of the organization’s human capital. Issuance of ESO allows the employee to take a part in the financial success and decrease the turnover. There are many hidden costs associated with the turnover of employees in an organization. ESO reduces such associated costs; one of the biggest is losing the essential human capital that is associated with the organization and can provide a competitive edge against competition (Jonathan, 2004).

The turnover of the organization is higher than the rest of the companies in competition. This is due to the fact that it provides ESO to people who have spent a considerable time in the organization. Therefore, the organization should make sure that they start their ESO at the start of the career to influence the employee’s performance from the start. Increase Motivation:As discussed above, the stock options provided to the employees are great tools for motivation. Although, in recent times, due to the financial and economical crisis that has engulfed the whole world, the stock prices have gone down; it has not diminished the morale of the organization.

They are continuing to strive forward with a positive attitude, knowing their constant dedication will help them in the form of financial rewards in the end. Even in times of recession, the company is doing well; hence the employees of the organization feel that there is hope and they can still benefit in the long term once this recession subsides and the economic cycle moves on (HRGuide, 2010). According to BMS’s financial statements (quarterly, 2008), there was a smaller number of exercising of options evident in the company’s financial statements, owing to the recessionary period.

However, the future of the organization looks bright and the employees should work for the benefit of the organization as it will help them gain in the end.Increase market efficiencies:BMS is using broad based Employee Stock Options as part of their compensation packages and hence has been able to generate loyalty, labor productivity, employment growth and stability. Employee stock options have another characteristic attach to them; they are said to increase market efficiencies. When owning stock options, employees have an option to buy a stock at an already decided price later in the future.

Therefore, for a certain price ‘x’ they would be able to buy the stock in the future. Now if in the future the stock price in the market is more than the ‘x’ price, they would benefit. In order for the employees to benefit from the stock options that they own, they would work harder to increase add value to the organization. Obviously, a lower cost of goods sold, better and efficient performance, more sales, a better image etc, would mean that the value of the organization would increase in the minds of the investors.

Employees know of this connection. So that it may be translated in a better stock price in the market. In this way, their organization becomes efficient; using minimum resources to provide the best results. If this action is imitated by all organizations, the market on the whole becomes efficient. Employees would be adding more values to the organization, with the minimum costs involved, so that in the end they are able to enjoy the fruits by buying the stock at ‘x’ price after the stock price has increased more than X.

In an overall situation, this will increase market efficiencies. The crux of the situation is that, Since ESO provide the employees to have an ownership, they increase their efficiencies in the organization to increase value of the firm. In such a mechanism, the market efficiencies increase. There is higher employment growth, average compensation levels are higher and productivity and profitability levels increase as a result (Douglas, 2007). The company should increase the research and development costs so that they are able to maintain their position in the market.

Granting more stock options to their employees is going to increase market efficiencies; more employees get a chance to benefit from greater stock price, so they increase their efficiency in the firm that may translate into an increase in stock price, which would eventually help them gain more value from their stock options. In this whole cycle, the market efficiencies increase.Conclusion ESO is a tool with great opportunities for both the employees and the organization. By aligning the management and the organization’s objectives, the companies are able to achieve profitability and higher levels of productivity.

However, the issuance of such ESO should only be done to induce incentives to the employees and not for any other purpose such as moral hazard. ESO carry a moral hazard with them, if properly implemented, with sound accounting policies implemented throughout the organization; it is bound to create success for the organization and its employees. Disclosure of proper information increases accountability on the part of management and restricts them from any incorrect actions that they might take.

They can be used to decrease moral hazard, increase employee motivation and increase market efficiencies. BMS, with the help of sound corporate governance policies has effectively handled to issue of stock options, taking all the advantages that they possibly can.Works CitedBooks:Frankel, Richard, and Lee,Charles M.C. Accounting valuation, market expectation ,and cross-sectional stock returns. Journal of Accounting and Economics 25, pp.283-319. (2005)Johnson, L. “2009 compensation for BMS CEO Cornelius falls 22 % amidst recession.

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