by Paul B.W. Miller and Paul R. Bahnson

We were both encouraged and enlightened by an article in the December 2002 issue of Strategic Finance by Don Delves, a CPA and compensation consultant from Chicago. His paper, "Trend or Foe?" can be found online at Library.aspx?a=13&LibraryID=5089 .

The topic is stock options, and Delves takes a completely different tack from other authors. Instead of getting tangled up in the longstanding issue of whether options create an expense, he simply premises that they do.

What’s also different is his articulation of the ill effects of abusing options, which he attributes to the fact that generally accepted accounting principles don’t require them to be expensed. He makes another new point by explaining that the shortcomings go well beyond the problem of misleading investors and creditors with incomplete income statements and balance sheets.

By taking this approach, Delves sheds light in an area that has been cloaked in darkness for far too long. Although he is a CPA, he steps out of the accountant’s mindset and sees significant problems with options that go beyond the issues of how to measure their value and how to persuade management to tell the truth. This fresh approach delights us because he gives no weight whatsoever to the typical vociferous but flimsy arguments that are opposed to telling the truth.

His premise is simple: Options are costly. With these words, he, like us, declares that the full cost is not fully measured by options’ value on the grant date: "The true cost of an option is the spread between the exercise price and the market price on the date the option is exercised. This [amount] is typically much larger - often many times larger - than the likely accounting expense. (Conversely, the true economic cost can be much smaller if the stock price goes down - as far too many companies are painfully aware.)"

He asserts that this hyperfocus on grant-date measurement (common to both the Financial Accounting Standards Board’s preferred method and the International Accounting Standards Board’s current proposal) has, and will, continue to produce bad compensation decisions.

He asserts, "Someone has to be responsible for this [cost above the initial value] and for making sure that the company and the shareholders are getting a return on this investment. If the company is only taking [the original cost as the] expense, then the board must make sure that the rest of the cost is tracked and accounted for and that the executives who received this benefit are returning at least that much to the shareholders in improved performance."

He asserts that the lack of this kind of thinking has led to many abuses: "Millions of options have been granted to millions of people, and there are now billions of dollars in potential shareholder value that somehow slipped beneath the financial radar screen. And we’re discovering that, although it may be tough to reach consensus on value, the bills for our lack of true compensation measurement and management are now coming due."

In commenting on FASB’s ill-fated project leading up SFAS 123, he doesn’t mince words: "[The board] took such a concerted drubbing from a variety of constituency groups - including investors, CEOs, and Congress - that it only required the option expense to be in the footnotes to the financial statements. The belief at the time - or at least the rhetoric - was that our nascent technology sector would be hurt by an option expense. Now we must question whether it was hurt worse by not having the expense."

Warren Buffett’s Owner’s Manual for Berkshire-Hathaway stockholders gives similar advice: "We also believe candor benefits us as managers: The CEO who misleads others in public may eventually mislead himself in private."

Delves’ descriptions of the dysfunctional nature of options are illuminating. With regard to aligning management’s interests with the stockholders, he points out that options are different from stock because they have little, if any downside: "After all, if you’re invited to the poker table with the promise that you can only win, or at least break even, you’re much more apt to place wild bets and throw caution to the wind. More than one CEO has taken that bait."

He goes on, "Unfortunately, instead of making executives think and act like shareholders, we induced them to think and act like option holders - a much higher-risk and shorter-term orientation. While options aren’t necessarily a bad incentive, in very large numbers they create an extremely lopsided and unbalanced risk orientation. This can induce sub-optimal decision-making that’s clearly not in the best long-term interests of shareholders."

Perhaps there is no better example than Enron, where option-laden executives made high-risk decisions and then obscured the risk with convoluted and incomplete reporting. Now that more people understand how profligately options have been given away, how much risk they encourage managers to take, and how poorly they are reflected in financial statements, the capital markets are discounting stock prices more deeply than before.

A missing element in Delves’ discourse is a prescription for accounting fully for options’ cost and other effects. We have the answer, which we have articulated in this column previously. Specifically, the full cost is properly reported if, and only if, the balance sheet reflects a liability for all outstanding options, continuously marked to market.

The consequence is full recognition of the financial impact of dilution and the total cost (that difference between the option price and the stock’s value at exercise date). This method also reveals the volatility created by issuing highly risky derivatives.

Delves also evaluates several measurement models. While acknowledging that each suffers from some disadvantage, he isn’t hung up on precision, and debunks the whole issue: "There is no question that, by either deriving appropriate models or making more accurate assumptions for the inputs to these models, we can develop reasonably accurate and sophisticated estimates of the value of these vehicles." So much for the arguments that intrinsic value is good enough (dating back 30 years to APBO 25) or that anything less than full precision pollutes the income statement (Intel in 2002).

In looking ahead, Delves says: "Once we adopt an expense for options, it will start to become painfully clear that the only reason we granted them to so many people in such fantastic numbers was that they had a very special accounting treatment - they were basically free. So when this once unusual and arcane financial instrument loses its special status, companies will - I hope - start re-examining the effectiveness of their incentive systems and ensuring they are really getting what they are paying for."

Diplomatically, though, Delves doesn’t place the blame for this outcome on anyone in particular. Unlike him, we will allocate the responsibility among the following: the five members of FASB who folded under pressure, former SEC chair Arthur Levitt for failing to give them backbone, large accounting firm managers for not standing up against their clients, corporate managers for zealously pursuing dishonesty as a corporate policy, and the rest of the accounting profession for not thinking deeply enough about option accounting. Although FASB may act to require expense recognition if IASB goes first, the existing damage will not be undone. Nor will all future damage be prevented by the grant-date measurement method. Perhaps Delves can write another debate-debunking article on that point, too.

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