As Congress departed after finishing its business for the year, another issue was playing out behind the scenes in government and on Wall Street that could have even further-reaching implications for investors and corporations.
Recently, the Financial Accounting Standards Board issued a rule requiring corporations to report the issuance of stock options as an expense beginning in the third quarter of 2005. FASB is to be commended for having the courage to take a look at the thorny question of stock options.
However, if they are to provide real clarity to investors, their inquiry must get past the issue of "expensing" and examine what stock options truly mean to the shareholders and to the bottom line.
The financial impact stemming from the issuance of stock options cannot be simply classified as a cost to a corporation. Those in favor of expensing argue that options represent a cost to the corporation because the company has forgone the opportunity of selling the stock on the open market. However, opportunity costs are not genuine accounting costs when it comes to measuring the financial performance of a company, because they do not subtract from realized gain.
Conversely, options do provide a benefit to the corporation by allowing it to retain extra cash that would otherwise be used for salaries. Options also yield a direct financial benefit when employees pay cash to the company to exercise them. These fundamental points make expensing or not expensing options irrelevant, as neither provides the full picture to the investor.
These cash benefits of stock options to the corporation are not taken into account under the current accounting requirement. Nor will they be taken into account under the proposed rule.
Some portfolio managers believe that they enjoy an advantage over competitors because they actually understand the economics of employee stock options, while other experts and investors do not. It is time that FASB and the Securities and Exchange Commission act to remove the reading of "tea leaves" by a small group of experts on Wall Street, and empower the average investor with information and insight to make better decisions.
Powerful forces have aligned on both sides of the "expensing" divide. Shareholder groups and good-government champions such as Sen. John McCain, R-Ariz., were right to call for a solution to fix the current system, which keeps options off the books and investors in the dark. Leading technology companies were also right to argue that a draconian rule requiring the "expensing" of options would not only be cumbersome, but would, more importantly, lead to inaccurate earnings reports.
Recently, over 50 U.S. senators sent letters to SEC Chairman William Donaldson asking the SEC not to implement the rule issued by FASB, and arguing that more time is needed to evaluate alternatives.
Senate Majority Leader Bill Frist, R-Tenn., and others have appropriately called for a federal study on stock options so that we can get beyond the black-and-white lens of the expensing debate.
For the sake of both investors and corporations, the SEC should see to it that FASB develops a principles-based methodology that understands that the issuance of stock options can have both a negative and a positive effect on a company's shareholders in any given quarter.
Fortunately, such a methodology already exists - SSEq, or Steady-State Equivalence.
Measuring earnings is not an exact science. Rather, it is a snapshot estimate of the earnings power of company performance, given that certain basic financial conditions remain the same. Historically, this has been done by using an income statement, or profit-and-loss. To estimate per-share earnings, the P&L expenses equity-based compensation, and then divides the resultant net income by the number of outstanding shares.
This traditional orientation is grounded in the understanding that investors do invest, but only after considering what return a company is currently generating.
The problem with expensing equity-based compensation, and FASB's proposal to expense employee stock options, is that it treats equity-based compensation as a cost to the corporation. This dramatically distorts the bottom-line figure that is ultimately divided by the total number of shares to yield per-share earnings.
It bears noting that equity-based compensation entails a dilution cost for shareholders, and it is in some sense correct to say that if a company gives away a 5 percent equity interest, the shareholders have suffered a loss equal to 5 percent of the company's capitalization.
However, if a company hires a new chief executive and the market capitalization increases by 5 percent as a result, isn't it equally correct to say that the shareholders have gained 5 percent? No one would think to include the latter gain in reported earnings, for several reasons, the most important of which is that, from an accounting perspective, company earnings and capitalization are largely different animals. If the latter gain is excluded from the earnings calculation, then logically, the former loss should be excluded also.
Accurately measuring quarterly earnings power is like trying to measure the thickness of a sheet of paper with a ruler - it's all but impossible. SSEq assumes that the same conditions will repeat, but it calculates earnings using mathematics and computer simulation, essentially producing a stack of 200 sheets of paper and then using algebra to determine the thickness of a single sheet. This single sheet, derived from a procedure akin to the medical practice of taking a culture and duplicating it to accurately examine the result, is the SSEq per-share earnings estimate.
In the cases where a corporation pays all its earnings as dividends and gives employees simple stock grants as compensation, SSEq takes the net income of the company in the current period - with no equity-based compensation expensing. It then divides the net income figure by the total number of shares outstanding to obtain a "per-share earnings/dividend." It then discounts that figure by a percentage appropriate to the company's shareholders.
The methodology then performs the same function, projecting for 200 periods into the future, accounting for an increase in total shares at the same rate as the period under consideration.
During this projection, continuous diluted interests of the shareholders as of the start of the current accounting period are tracked. These tracking results are then converted into SSEq per-share earnings.
In the case where a corporation uses employee stock options as compensation, SSEq performs the same function described above, repeating it 200 times and simulating the company's receipt and reinvestment of employee stock options strike-price premiums. The present value of these reinvestments is calculated and is included in the final SSEq per-share earnings figure.
The differences between SSEq per-share earnings and generally accepted accounting principles per-share earnings as reflected under employee stock option expensing can be significant, and differences of up to 30 percent are not unusual. The reason for this difference is that, unlike the simplistic arithmetic used by current GAAP methods, SSEq distinguishes between accounting costs and opportunity costs, and employs concepts of modern financial theory to provide a more realistic per-share earnings power metric for the investor.
Investors have been kept in the dark for far too long about the true effects of stock options on earnings power. Now that FASB has set the wheels in motion, it is essential that we place sound policy before politics as usual by installing the most accurate and dependable method available.
The integrity and clarity of our financial markets depend upon it.
Joel Jameson is an economist who has spent the past 25 years developing computerized mathematical models for use in corporate finance, marketing, logistics and national defense. He is the founder of Silicon Economics, a company that integrates economic theory and technology for businesses.
