Last month, we criticized the misguided push to converge because it has focused so much on aligning U.S. GAAP and IFRS that it has diverted attention away from much bigger problems created by indisputably deficient standards. This column specifically shows how both GAAP and IFRS come up woefully short of providing capital markets and other statement users with information they need to make rational decisions about a company's prospects and its managers' trustworthiness.

Out of the very long list of possible bad examples, we chose employee options for a couple of reasons. One, options accounting has been a lightning-rod issue for decades, because the status quo treatment fails to illuminate controversies over excessive executive compensation. Just last spring, proxy disclosures triggered a flurry of media articles challenging mega-million-dollar executive pay, which always includes a large options component. Thus, debates about excessive compensation often morph into complaints about unconscionable option grants.

Two, GAAP and IFRS option standards are essentially identical and are not dinosaurs from way back but are less than 10 years old. If neither the Financial Accounting Standards Board nor the International Accounting Standards Board could come up with a better solution in modern times, there is little reason to expect them to suddenly start producing good standards going forward, unless, of course, they're insulated against political pressure from those who want to bury their faces in the option-feeding trough.

Fat chance.

 

A BIT OF HISTORY

From the 1970s, GAAP did not recognize any expense for typical option grants because the intrinsic value method identified a cost only if the option exercise price fell below the stock's value on the grant date. Of course, that condition never happened because it would trigger immediate tax liabilities for recipients.

It isn't surprising that option use exploded because this spuriously "favorable" treatment hid the resulting real expense. It produced a proverbial no-brainer for managers, because they could pay themselves with options without reducing reported income. Simplemindedly believing that reported earnings per share drives stock prices, they gorged themselves without counting the calories of wealth they pinched from shareholders.

In the mid-1990s, FASB tried to expense options, but was beaten up so severely by intense lobbying that the first iteration of SFAS 123 only recommended expensing. That weak surrender lasted nine years until 2004, when SFAS 123R mandated an expense treatment.

 

STILL A BAD ANSWER

So, are things now copasetic because options are expensed? Not exactly. Actually, not even close. While some expense is better than none, what we have now under both GAAP and IFRS falls way short of reflecting the total wealth transferred between the company and option recipients.

Even though the standards require using an option-pricing model to measure that wealth transfer, the total cost is frozen at the grant date and never reconsidered. Companies report the same expense whether the the stock price shoots way up, way down or stays the same.

In fact, the grant date method produces reported income results no different from what would occur if the compensation was a deferred cash bonus equal to the initial option value. This result is totally misleading and, we fear, the boards knew it would happen.

What we have here is a perfect case of uniform accounting that does not produce comparable or reliable descriptions of how much wealth passes from shareholders to employees. So much for the oft-repeated assertion that the world needs uniform standards. What it needs are truthful standards.

 

LIABILITIES OR EQUITY?

The highly flawed rationalization behind this treatment assumes that granting options instantaneously transfers equity in the employer to the recipients. Next, that assumption is combined with unchallenged dogma that financial statements must not reflect subsequent changes in the value of equity instruments, including stock and options. The result is failure to report the full negative outcome of options-based compensation. In effect, the boards decided to report as if there are no subsequent changes in the options' value. Of course, if that were so, managers would not accept them as compensation!

The boards' analysis also ignores the obvious truth that unexercised options are not equity because their holders don't have owners' legal rights to vote and receive dividends or a proportionate share of residual assets after liquidation.

Instead, options are derivative obligations with unlimited downside risk for shareholders because the employees can buy lots of shares at amounts well below their current market price.

Clearly options have all the characteristics of liabilities under FASB's Conceptual Framework, because they are probable future sacrifices that the company is presently obligated to make because of past events. Therefore, employee stock options should receive the same derivative liability treatment used for all other call options.

 

OPTIONS AS LIABILITIES

Suppose reporting standards actually did require employee options to be treated as derivative liabilities. How would this approach change issuers' financial statements?

First, compensation expense would be immediately recognized for the options' full value at the grant date, instead of being smoothly spread over the vesting period.

Second, the derivative liability would be subsequently marked to market with the offsetting debits or credits reported as adjustments to current compensation expense. Thus, the cumulative total expense over the options' life would equal the full value received by the employees on the exercise date.

Third, the balance sheet would unambiguously reveal the size of the options "overhang," which is how much wealth the shareholders are presently obliged to distribute to the employees. We defy anyone to extract that relevant information from today's impenetrable footnotes.

 

THE EYES OF TAXES ...

Compounding the insufficiency of GAAP is the treatment of income taxes. Because the tax law has the employer deduct the options' value as of the exercise date instead of the grant date, a permanent difference between book and tax income is created. In a bizarre twist dating back decades, the permanent savings from deducting the excess of the real cost over the grant date value is not credited to earnings but to additional paid-in capital. Huh?

Consider this paradox: Even though Congress understands how much options really cost, accountants obliviously report too little compensation expense and too much tax expense!

 

NON-TRUTH AND CONSEQUENCES

Under GAAP and IFRS, diligent statement readers slog vainly through mind-numbing abstruse disclosures to glimpse at best a fuzzy picture of the total value transferred to employees. What should bother every honest accountant is that this lack of complete information utterly fails to provide an effective check on option use that would prevent it from spiraling to obscene levels. Clearly, these inferior standards have enabled negative management behavior.

We have a favorite saying, "What you measure, you manage," which has this corollary: "What you don't measure, you don't manage." These thoughts aptly describe a powerful force behind the tremendous growth in exploitative executive compensation.

Specifically, useful accounting information should not only help statement users understand companies' performance, but also force managers to be accountable. Because full accountability is lacking for options under GAAP and IFRS, no one should be surprised that executives accept the two boards' engraved invitations to dive headfirst into the feeding trough and take outlandish pay for themselves.

Accountants are not innocent bystanders. This black mark impacts the entire profession because it figuratively looked the other way while FASB and the IASB acquiesced to pressure and failed to force managers to 'fess up to the full amount they pilfer from shareholders. (Not all compensatory option plans are unethical, but surely most are.)

 

A NON-ACCOUNTING SOLUTION

Certainly, one way to bring about more rational use of options is to force managers to tell the whole truth about how much they are taking for themselves. However, we have another way to change their behavior, specifically by having the corporation pay intermediaries to provide options and assume the risk. This arrangement would eliminate existing practices that subject stockholders to unlimited downside risk for the options' future value and the possibility of massive dilution upon exercise.

We propose that a financial intermediary would serve as an "option fund." Instead of issuing its own options, a corporation would pay an upfront fixed cash amount to a fund to write and issue third-party options to employees according to the compensation plan. The fund managers, not the shareholders, would assume the risk of future option value increases, which they could then mitigate by hedging.

Look what would happen. First, shareholders would know the option plan's precise cost because it would be unambiguously measurable and reported from the onset. Second, companies would have no further liability or risk for the options. Third, current share value would not be diluted because the company would not be obliged to issue new shares. Fourth, both shareholders and managers would be wholeheartedly and honestly pulling for share value to increase.

In effect, this arrangement looks to us like a winning solution, because the premium paid to the fund would insure the corporation and its owners against a very high possible cost.

 

THE BOTTOM LINE

Capital markets need high-quality financial statements to help them figure out what's going right or wrong. At the same time, GAAP and IFRS should reinforce ethical stewardship over firm resources by clearly displaying the consequences of managerial decisions. Unfortunately, today's weak disclosure requirements do not overcome poor GAAP and IFRS, and thus invite managers to keep plunging back into the options trough.

More than that, everyone should be sobered and frustrated when they assess the minuscule return for the massive time and energy that has been wasted on IFRS convergence and adoption in the U.S.

Just think how much better off the whole world would be if that effort had been directed toward actually improving accounting for options and resolving so many other financial reporting issues.

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