House of Representatives Supports Giving US Corporations Away for Nothing

Barring surprises, back to international taxation, particularly expatriate US corporations, tomorrow.

Today, I want to write about the financial accounting when a corporation pays an executive with stock options. This is not a new topic, and I have nothing new to add to the debate, but it is important, and the issue is hot again, as to be discussed below.

Under current financial accounting rules, when a company pays an executive with a stock option, the company is not required to show any expense (cost), ever. The executive may exercise the option and get millions of dollars worth of stock for nothing (that she then may sell for even more) and the corporation's books say that the executive got nothing. All of the other shareholders got their percentage ownership of the company diluted, with an associated loss in value of their shares. A portion of the company's assets has been transferred to the executive. The company gets an income tax deduction. But financial accounting says that the executive's compensation cost the company nothing.

Business, particularly high-tech business, views the current accounting as a deity: There is no real cost, they say. Proper accounting would discourage innovation. Bad statements help US companies compete with their honest offshore rivals. It is hard to value stock-based compensation. Shameless nonsense! There are difficult timing and measurement issues involved, but these concerns are no excuse for never showing any cost.

The Financial Accounting Standards Board (FASB), the glorified trade association that the SEC lets sort of police accounting principles, considered changing these rules in the early 1990s. Senator Lieberman pushed through a Sense of the Senate Resolution that FASB's authority would be rescinded if they did anything about stock options. FASB caved.

Many blamed the recent corporate scandals, like Enron, in part on stock option accounting: The accounting rules encouraged companies to pay executives with stock options. But, when most of an executive's compensation is stock-based, that gives the executive an unhealthy incentive to focus on manipulating the price of the stock rather than managing the company's business.

In February, FASB's European competitor, the International Accounting Standards Board, required accounting for compensatory stock options. With this cover, in March, FASB again proposed more reasonable accounting rules here. And, this time, the House last month passed a bill that would reverse FASB. Hopefully, the Senate will resist the opportunity to once again put its imprimatur on misleading financial statements, but……

This entry was posted in Law: Everything Else. Bookmark the permalink.

13 Responses to House of Representatives Supports Giving US Corporations Away for Nothing

  1. Mel says:

    Technically a stock option isn’t an expense but that doesn’t mean that it shouldn’t be reflected in the company’s financials. My opinion is that these options are in effect the issuance of new stock at some future date. By this reasoning, the shares should be incorporated into the calculation of earnings per share since the new shares will at some point dilute the shares currently on the market.

    Analysts state that accounting income is the best way to value future earnings. In order to properly understand these numbers, all shares issued should be included.

    Since diluting EPS by including stock options would have a negative impact on EPS, it should have the effect of limiting this as a means of hiding this kind of action.

  2. GeorgeMundstock says:

    Mel, I should have mentioned that, under current US accounting rules, the bargain element in an outstanding stock option, while having no effect on earnings or on regular earnings per share, is treated as stock outstanding so as to reduce diluted earnings per share.

    You say that an option “technically” is not an expense. How is an option different from the employer company paying the employee cash and the employee using the cash to buy an option?

  3. pgl says:

    Defenders of APB # 25 would say rational investors know the true cost of employee stock options. Maybe they’re right but then this undercuts their spin that SFAS 123 would lead to reductions in stock prices. But thanks for bringing this up as my twist on arm’s length pricing seized on this very issue (see Angrybear.blogspot.com on Thursday).

  4. wcw says:

    I find the options accounting teapot to be incredibly amusing. When intelligent people claim options are ‘free’ at the same time the CBOE trades large volumes of them for prices above zero, how can you do anything but laugh? As a non-accountant, I am not an expert. Still, it would seem to me that if a corporation gifts a financial asset worth $x to an employee, that it should record an expense equal to $x on its income statement.

  5. Fresh says:

    In my opinion, dilution is not the only effect. The spread loss on the options amounts to money foregone against a de facto secondary. Shareholders would have otherwise enjoyed an influx of equity capital representative of current market prices, had the corporation not written a “call” and lost money. For the accounting to be “most conservative” and in my opinion correct, a corporation should restate shareholder’s equity to the tune of previous spread losses.

    If the value of the option is going to be determined by current market prices, then there is a rigid degree of correspondence between this vehicle and a company’s access to and participation in the secondary market. Printing shares off at par undermines the operations of the secondary market, when no pursuant equity capital is raised. To say that these shares come at no cost to the company is some sort of cognitive illusion.

  6. KevinCA says:

    George: I agree that the current accounting standard isn’t the right approach. Warren Buffet was right when he said (paraphrasing) if it isn’t an expense, what is it?

    The practical problem, as you alluded to, is that the US Congress is going to heel to the demands of the business lobby.

  7. Mel says:

    The reason that I stated that I don’t think of a stock option as an expense is because what is changing hands in the process is not an asset such as cash but an equity interest in the enterprise. If a venture capitalist is given stock in return for cash we don’t seem to have a problem classifying the transaction. Isn’t something similar happening when stock options are issued? The employee’s labor is becomes a surrogate for the cash in my analogy.

    Of course, if the labor being exchanged for equity is of the quality that Ken Lay provided to Enron, or if the size of the option far outstrips any reasonable estimate of what’s being provided in exchange, I too have a problem seeing this as a benign event. My earlier answer was directed at what might be called a more reasonable exchange of equity for labor. Perhaps the stupidity of the directors in granting these absurd stock options should be classified as an “Extraordinary Event” in the Equity section of the Balance Sheet by the auditors and reported as such in the audit report. Alas, today’s auditors aren’t cut from the same cloth as the “Father of Accounting”, Fra Paccioli. (sorry for the pun)

    I had forgotten that stock options were already included in fully diluted earnings per share. Thanks for correcting me on this.

  8. Angry Bear says:

    “The executive may exercise the option and get millions of dollars worth of stock for nothing (that she then may sell for even more) and the corporation’s books say that the executive got nothing. All of the other shareholders got their percentage ownership of the company diluted, with an associated loss in value of their shares. A portion of the company’s assets has been transferred to the executive. The company gets an income tax deduction. But financial accounting says that the executive’s compensation cost the company nothing.”

    How is this possible? Certainly exercised options increase the number of shares outstanding (barring offsetting buybacks), so the denominator in earnings per share would necessarily be larger, and EPS would shrink accordingly, ceteris paribus. I’ve always thought that it’s the *unexercised* options that are the issue.

    As far as whether options are truly an expense (a silly question, of course they are), here’s a simple way to think about it: Company A and Company B have identical earnings and growth prospects, the same price, and both have 100m shares outstanding. Company B has ten million options poised to be exercised over the next 5 years; Company A has none. Which would you rather own 1 million shares of? Me, I’d prefer making $1.00 for every $100 the company earns to making just 91 cents. Call me crazy.

    AB

  9. Fresh says:

    AB
    Unexercised options are an issue, and a very big one at that.

    With regard to expensing options… the accounting for non-qualified stock options does not require a company to recognize money lost (spread loss) against the grant as an expense. The company receives a tax deduction for this amount, and its employees have their gains taxed as ordinary income, which Unca Sam just loves. And, this treatment of the gains as ordinary income is further indications as to why “wage” options should be expensed.

    With regard to your example on Companies A & B… in the world of stock option grants… they will not have identical earnings and growth prospects. Company B, which grants options, will have the luxury of not expensing the options, allowing it to pay its employees less in base salary (In the hay days new hires were more interested in options than salary). The cheaper work force will give Company B the appearance of higher margins, to be valued by the market as a more profitable business model. As Company B’s stock price starts to climb, it can then beat out competitors on price, increasing share… and revenues… and earnings… against the backdrop of a business model with a higher valuation. Not expensing the options has an exponential impact on Company B’s prospects, and probably results in the purchase of Company A in three years.

    This dynamic is amplified in tech-land, where the valuation of prospects are all about the great and glorious future, and the appearance of high margins seems to be a state of nature, especially with regard to chips and software (or businesses that face a declining cost of production curve or no incremental production cost at all).

    Sorry for the long winded reply. You may have already known this stuff. It’s hard to tell from one post, and this information needs to be out anyway.

  10. pgl says:

    AB: I’m going to try to explain APB25 GAAP accounting even though I’m not a CPA and most CPAs can’t answer simple questions. Think of trying to value options ex ante (time of grant) v. ex post (time of exercise). Tax law under section 83 does the latter. GAAP wants to try to do the former. On average, ex post should equal ex ante although there can be wide differences between the two. SFAS 123 suggests we do ex ante right. APB25 does only the intrinsic value of options but not the time value. Since the former is usually zero for at-the-money-grants, APB25 clearly underestimates the ex ante value. This could be OK if there was some true-up (CPA fancy term) for the difference between the (mis)estimated ex ante value and the ex post value. But GAAP accounting fails to do this. Now how could anyone defend such nonsense? My only answer is some folks get paid a lot to flat out lie for their clients. Alas.

  11. pgl says:

    Your attempt at claiming options are not an expense fails for the following reason. Compensation packages often include shares of the company as part of what the employee (especially upper management) receives. Accounting treats this consideration as an expense precisely for the same reason why options should be treated as an expense when they are at least exercised. Because the company typically has to go out into the market and pay cash to buy the shares to honor its compensation promise. Since granting shares at below market prices are clearly expense, why is not granting the option to buy a share at below market prices not an expense? Don’t be so easily fool by the fancy talk of the advocates. Either they know less than they pretend to know – or they know they are trying to deceive you.

  12. GeorgeMundstock says:

    A few thoughts on earnings per share (eps): Yes, under current US rules, stock options impact diluted eps when granted and real eps when exercised. But they do not impact earnings. In some high-tech companies, the economic cost of options, whenever accounted for, would cut earnings at least in half. Thsi is real important . EPS effects are not enough.

  13. GeorgeMundstock says:

    Mel, Why options are an expense: Think of the bookkeeping. When an employee earns compensation, cash goes down and there is an expense (usually). When stock is issued to a venture capitalist, cash goes up and equity goes up. When stock is transferred to an employee for nothing (let’s duck the timing issue in PGL’s comment orf 8/4), capital is transferred to the employee. What is the offsetting bookeeping entry? It should be an expense (usually)

    By the way. I looked at a transalation of Luca Pacioli’s book. He was not the father of accounting. He was an academic mathematician. He was trying to justify to his duke why the duke should subsidize the study of mathematics, which was considered a form of Arab mysticism in the western world back then. The book showed how math is useful — in engineering, architecture, etc. Accounting was a small chapter. It had been around for at least a hundred years. The Medicis kept double-entry books. Pacioli was just the first guy to write it down in a form that survived.

Leave a Reply

Your email address will not be published. Required fields are marked *

Notify me of followup comments via e-mail. You can also subscribe without commenting.