We have written so many times about options since 1996 that we've lost count, but we do know that we have regularly criticized the existing rules with the hope that the Financial Accounting Standards Board would produce something better when it re-examined the issues.
For those who haven't heard, FASB published a revised standard in December that requires options to be expensed. Unfortunately, the bad news is that the board just tinkered with its 10-year-old recommended method, and did nothing to address its readily apparent flaws, which deprive financial statement users of useful information. It's our view, and increasingly the opinion of others, that the users are not much better off than they were under the old APB opinion.
FASB's compromise, while disappointing, is just what we expected. For years, the board has battled intense political pressure, mainly from managers addicted to options and obsessed with preserving their ability to take value out of the firm without reporting an expense. However, in recent years, FASB was also pressured by others, including the Securities and Exchange Commission, and the International Accounting Standards Board, which had acted earlier to require expensing and was waiting for its American friends to act.
The ongoing and heated debate over getting an expense (any expense) on the income statement diverted virtually everyone's attention from the bigger goal of finding the most useful way to measure and report not only the expense, but also the options' impact on financial position and cash flows.
Although we and others weren't able to convince FASB to abandon the familiar, it is imperative that a clear message be received by regulators, the financial analyst community, the management corps and the public accounting profession that the new standard shines only a dim light into the murky depths of options-based compensation. The consequence is the same old regrettable scenario that users who want the full truth must improvise their own sub-optimal estimation methods to help them guess what management knows but won't report.
Ironically, most managers will simplistically think that they've done enough by begrudgingly complying with the letter of the law, and auditors will show them the least they have to do. The press is also uninformed about these flaws, and is indifferent now that the controversy was "resolved" by FASB's vote.
Even so, the press may occasionally stumble across an options story, despite not knowing exactly what happened. Consider the recent Wall Street Journal article about managers who accelerated option-vesting dates before the new standard kicked in so that they could avoid reporting an expense. The writers knew something was wrong, but never quite put their fingers on the fact that the managers were spending stockholders' money in order to put out incomplete and misleading financial statements, not to mention lining their pockets. They never suggested that the actions were all in vain because the markets know what is going on.
So, one more time, we'll describe the new standard's defects to explain why minimum compliance produces minimum stock prices. Our hope is that some will adopt a different strategy.
The first flaw is the board's fixation on the income statement that causes the expense to be measured in a vacuum apart from financial position. The total compensation under SFAS 123 is estimated as of the grant date and fixed, nailed to the floor to never change, except for slight actuarial adjustments. The balance sheet shows nothing until the grant date value is amortized into earnings over the vesting period, with offsetting credits to an options equity account. This deficient picture just doesn't report the whole expense or the liability to the grantees.
Amortization continues unchanged through the vesting period, without any regard to what is happening with the options' value. If it goes up or plummets, reported compensation expense is unaltered. It's like dressing for an outing based on a year-old Farmer's Almanac forecast - you might be OK, but you're likely to be over- or underdressed. How much more sensible would it be to look out the window and observe today's real conditions before deciding what to wear? In the same way, how much more useful would it be to report today's real value, instead of the obsolete grant date value?
Despite FASB's insistence that the total expense is set in stone on the grant date and parceled out over the vesting period, the actual cost is incurred throughout the options' life, and its amount cannot be known until they lapse or are exercised.
If they lapse, the original reported expense is left intact, never offset by unreported gains from the decline in the value of the now-worthless options. If they are exercised, the actual full cost is the difference between the strike price and the shares' market price at that date. This amount will virtually never equal the grant date value. Under the board's method, however, all that's reported is what was assumed on the grant date.
In the meantime, as events unfold, SFAS 123 reports this meaningless grant date value as equity on the balance sheet. In fact, options are derivative liabilities with fluctuating values. Furthermore, once the options vest, they become demand liabilities. This option "overhang" reveals the dilution created by the options, because its balance reflects the value transferred from shareholders to the option holders. Although this number is unquestionably relevant, it isn't reported anywhere.
We always thought that the amount would be significant, but we didn't know just how big until David Zion of Credit Suisse First Boston estimated last year's total liability for the S&P 500 to be approximately $347 billion. Check out the amounts for Cisco ($13.7 billion) and Intel ($11.2 billion), perhaps the two most strident opponents to expense recognition. There is no doubt that putting option liabilities on balance sheets would dramatically move reported financial position closer to reality and further from fantasy.
SFAS 123 is also flawed because employers are not permitted to report the full tax savings arising from exercise. For most options, employers get a deduction in the exercise year equal to the discount between the stock's market value and the strike price. However, the board's new standard forces the company to report as if it deducts only the original grant date value.
Suppose the tax liability without options is $100 million, and that exercise produces a tax savings of $40 million, of which only $10 million is due to the original grant date value. Under SFAS 123, the company reports tax expense of $100 million, with credits to a deferred tax asset of $10 million, the actual tax liability of $60 million, and paid-in capital of $30 million. Bottom line: The reported tax expense is permanently overstated by $30 million.
Remember, the official spin is that the revised SFAS 123 produces a more complete income statement. Don't believe it.
To make matters even worse, the cash flow statement must report an operating cash outflow for taxes of $90 million, far more than the real $60 million. The $30 million difference is buried in the financing section as an imaginary inflow. This treatment totally obscures reality.
So, what is to be done? Don't expect FASB to address these flaws anytime in the next hundred years or so; they're exhausted and handcuffed by the politics.
However, nothing can prevent competent managers from providing supplemental information that users want and need, thereby reaping the benefits of lower capital costs and higher stock prices. In particular, they would serve users by reporting the following items: the entire option liability, the ongoing expense (equal to the change in the liability's value), the real tax expense, and the real cash flows.
It's regrettable that once again the most useful information is not in the financial statements, where it belongs. It won't even be in the footnotes, except for those published by innovators who understand that capital markets crave useful information, not politically expedient words and numbers that have no meaning.
The bad news is that FASB didn't get the job done. The good news is that the few, the brave and the wise will rise up and provide what's needed.
Paul B.W. Miller is a professor at the University of Colorado at Colorado Springs, and Paul R. Bahnson is a professor at Boise State University. The authors' views are not necessarily those of their institutions. Reach them at paulandpaul
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