04.14.04

Expensing stock options

Posted in Politics at 3:40 pm by Craig

So I’ve been complaining privately a lot recently about the idiocy of expensing employee stock options through a company’s P&L. I thought I’d lay out my thoughts here for a wider audience, and see if anyone can explain to me why I’m thinking incorrectly on this. Here’s an extract from the FASB publication on the subject (available here):

C13. The Board reaffirmed the conclusion discussed in paragraphs 74-91 of Statement 123 that compensation cost should be recognized for employee services received in exchange for valuable equity instruments, including equity share options. That cost should be recognized as the employee services received in exchange for the instruments are used in the issuing entity’s operations. Some opponents of required recognition of compensation for equity share options assert that because an award of equity share options results in neither an outflow of assets nor the incurrence of a liability, that award should not result in a recognizable cost. However, the Board believes that an entity receives assets - employee services - in exchange for equity share options. Because an entity cannot store services, they qualify as assets only momentarily unless those services are capitalized as part of another asset (as permitted by U.S. GAAP). An entity’s use of an asset results in an expense, regardless of whether the asset is cash or another financial instrument, goods, or services.
C14. Some opponents of required cost recognition also contend that the issuance of an employee share option is a transaction directly between the recipient and the preexisting shareholders. The Board disagrees. Employees provide services to the entity - not directly to individual shareholders - as consideration for their options. Carried to its logical conclusion, that view would imply that the issuance of virtually any equity instrument for goods or services, rather than for cash or other financial instruments, should not affect the issuer’s financial statements. For example, no asset or related cost would be reported if shares of stock were issued to acquire legal or consulting services, tangible assets, or an entire business in a business combination. Moreover, it is a longestablished practice that, even if a stockholder directly pays part of an employee’s cash compensation (or other corporate expenses), the transaction and the related costs are reflected in the entity’s financial statements, together with the stockholder’s contribution to paid-in capital. To omit such costs would give a misleading picture of the entity’s financial performance. C15. To summarize, accounting for assets received (and the related expenses when consumed) has long been fundamental to the accounting for all freestanding equity instruments except one - fixed equity share options that have no intrinsic value at the grant date and are accounted for under the requirements of Opinion 25. This Statement remedies that exception.

Ok. So this is the basic explanation from the FASB as to why they think this change should be implemented. As I understand the reasoning here, although there is no outflow of assets, nor an assumed liability when an option is issued, that because something is received in exchange for the option grant, that grant should be expensed. I just don’t follow this logic. Let’s say a company issues an option to someone, but does not require services in return. That is, they issue the option, but cannot be said to be receiving an asset in exchange. Did that option “cost” the company the same as an employee option grant would? Ok, what if the company issues a grant to an employee, but that employee slacks off? Same option grant to another employee who works really hard and creates a lot of value. Both options expensed the same way? In the words of Scooby Doo: “Hrrr?”
Ok, so I don’t think the FASB argument makes any sense. But beyond that, the FASB argues that this new rule will somehow increase accounting transparency. “Hrrr?”. This rule actually serves to violate the 3 primary tenets of accounting: consistency, conservatism, and material accuracy.

• Consistency: Options are not a cash, or cash-equivalent medium. They do not in any sense affect the trading success or failure of a business. The effect of granting options on a company is to effectively dilute existing shareholders, not to reduce earnings. Having the issuance of options appear on the P&L will mean that it will be much harder to compare results for subsequent periods to each other – a quarter in which some options are granted might actually have been “better” for the company than another quarter which had a lower option-issuance “cost”, but worse trading results.
• Conservatism: accounting should not create complexity when there is no need to. Altering the P&L so that an investor has to manually “add back in” the “loss” attributable to issued options in order to evaluate the real trading performance of the company is perverse.
• Material accuracy: companies will be able to manipulate their earnings by issuing or cancelling options. This accounting manipulation essentially allows a company to depress earnings (for tax reasons, or for apparent consistency) in good years by granting options, and boost earnings in bad years by cancelling options. This can be used by companies which are private, but planning to become public in the future. Let’s say my new startup issues a huge number of cancelable options now – at super-low strike price. Fast forward 4 years to IPO time. Hmm, earnings aren’t great. I know! Let’s cancel some of those low-strike price options. Ah, much better. Now let’s get that prospectus out!

C4. Before 2002, most entities chose to continue to apply the provisions of Opinion 25 rather than to adopt the fair-value-based method to account for share-based compensation arrangements with employees. The serious financial reporting failures and allegations of misconduct by executives that came to light beginning in 2001 caused the attention of investors, regulators, members of the U.S. Congress, and the media to focus on accounting and financial reporting issues. Many of the Board’s constituents who use financial information said that the failure to recognize compensation cost for most employee share options had obscured important aspects of reported performance and impaired the transparency of financial statements.

This part also makes no sense to me – yes, the public at large, and investors, are pissed that executives were awarded huge pay packages while their companies tanked (or in the case of options, they were awarded huge pay packages while their companies continued to appear to do well). But how would expensing stock options, for example in the case of Enron, have prevented what happened, or made investors any happier? The problem at Enron was out-and-out fraud, not a lack of expensing stock options. Enron could have expensed all the stock options it wanted to, and just created more fictional revenue to make up the difference. From a historical point of view, can anyone enlighten me as to how these two issues (massive fraud vs options expensing) become co-mingled? I just don’t see the connection at all. I mean not at all at all.
So – can someone explain to me why I’m wrong and the FASB is right? I’m planning on performing the equivalent of civil disobedience on this one – I simply will not allow any business which I control to implement something that to my mind is perverse and obscures the true performance of a company from the shareholders. I don’t care how angry people are that senior executives make lots of money from stock options – that’s a fundamentally different issue from the way they are accounted for from the company’s side. If you don’t like the executive compensation plans awarded to executives by boards of directors’ compensation committees then elect directors who won’t do that. Dont just arbitrarily and stupidly change the accounts.

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