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

Back in April 2003, we published a column that roundly condemned members of Congress who were pressuring the Financial Accounting Standards Board to not move ahead with its proposal to expense the initial cost of options.

Now, in a bold move that’s a stunning setback for truth-telling, 312 members of the House voted on July 20 for the Baker bill that would directly establish really bad new generally accepted accounting principles for options, not only by limiting the expense to the value of grants to each entity’s top five executives, but also by mandating that volatility be ignored, thus driving the value for even those options down to zero.

This misguided and unconscionable vote firmly establishes the representatives’ commitment to the policy that deceptive financial reporting  serves the public interest. As hard as it is to believe, we are almost at a loss for words.

Rather than reinvent the wheel, we have decided to just re-run that original column. We invite you to re-read it, knowing now that 312 elected representatives believe that truthful financial reporting is worthless.

Then join us in our outrage.

Everyone certainly knows how the song “Old MacDonald Had A Farm” delights children but drives adults batty with its irritating refrain. Speaking of annoying repetition, FASB recently received two letters about stock options from some elected representatives. One letter, dated Jan. 30, 2003, came from 40 House members and the other (dated Feb. 14, 2003) was sent by Senators Michael Enzi, R-Wyo., Joe Lieberman, D-Conn., and George Allen, R-Va.

Both raise the same tired and inane arguments for keeping options off income statements that FASB heard eight years ago when it proposed — but backed away from — requiring the expense treatment. All that’s missing from these letters [and the Baker bill] is the E-I-E-I-O.

Heavily laden with hyperbole, the writers try to dupe FASB like some hayseed farmer into perpetuating the status quo of incomplete reporting. The rationale presented by Enzi and echoed by others is that “broad-based stock option plans are vital to economic productivity and employee advancement.” Enzi worries that “expensing options will inflict a fatal blow on broad-based stock option plans, which we believe should be encouraged, not eliminated.”

If options are that vital, our economy is worse off than anyone thought. First of all, FASB isn’t in the business of making policy, either for
or against using options. Second, the board is not making options illegal but simply considering whether income statement recognition of the expense is useful.

Third, who can prove that options really work? Many now assert that the recent accounting scandals are at least partially the fallout from risk-taking behavior induced by option-heavy compensation systems. An extremely risky project may look better to an option-holding manager who wins big if things turn out, but suffers no out-of-pocket penalty if they don’t.

Fourth, what does management admit about itself when it changes its behavior in response to new reporting requirements? If options are effective compensation, conscientious managers will use them regardless of the accounting treatment. If expense recognition alters their policies, aren’t managers confessing that they have used options only because they weren’t reported? Bah!

Both letters claim that expensing “lacks a clear and widely accepted rationale.”

What a cock and bull line.

The rationale is indisputable, as Warren Buffet has explained — options are compensation, compensation is an expense, and expenses belong on the income statement. Nevertheless, managers who have been feeding at the option trough hate to see it end.

We thought we had seen everything until we saw this dumbfounding passage in the House letter: “We believe it is important to express our strong concerns about an approach that would limit transparency, truthfulness and accuracy in financial reporting.” If we hadn’t known their conclusion, we would have thought they were arguing for expensing. If you can, follow their logic — by reporting less information, financial statements are more truthful and transparent. This convoluted thinking makes about as much sense as the pigs’ claim in George Orwell’s “Animal Farm” that all animals are equal, except that some are more equal than others.

The incredible spin continues: “Events of the past year have eroded investor confidence and contributed to significant concern about the adequacy of our laws, rules and policies governing corporate oversight, financial reporting and accounting practices. Restoring investor trust, revitalizing our capital markets, eliminating corporate fraud and abuse, and growing American’s economy are objectives each of us shares.”

Let’s get this straight — investor confidence in management is in the dumper because of obscure and misleading reporting, and the best way to restore public confidence is to perpetuate not recognizing options expense? That stuff belongs in the manure spreader.

If you ever need an emetic, just consider their timeworn bleating that diluting the earnings-per-share denominator for options is sufficient for describing their effects. We respond in three short words: “No, no, no.” For the denominator to reflect the full impact, the option holders must pay full market price for the stock. Because they don’t, they deliver a double whammy by increasing the number of shares while not maintaining the earning power of each share.

It is simply not valid to claim that everyone sitting at the table paid full value when the option holders didn’t. The shareholders need to know how badly they have been fleeced.

For anyone who still has trouble grasping that options are a real cost, consider that many managers avoid dilution by going into the market to buy shares at full market price to sell to option holders. This action creates the same economic result as paying cash compensation.

The legislators also feign sophistication by rolling out the hackneyed, pointless contention that the Black-Scholes pricing model is too imprecise. We call this tack the “B.S. argument.”

First — if the expense cannot be measured, then how can management responsibly impose it on the stockholders? Second, imprecision doesn’t argue against recognition as much as for developing other pricing models. Third, why would reporting exactly zero be more reliable than reporting approximately the real cost?

Fourth, they cannot expect anyone to believe they have even the vaguest idea of what Black-Scholes does or how it does it. Fifth, they have overlooked huge imprecision in other unquestioned accounting measures, including bad debts, depreciation, goodwill impairment, contingent losses and the cost of goods sold. Do they argue for leaving these charges off the income statement, too? In short, they’re slinging bull.

We’ve said it before and we’ll say it again: These weaseling arguments are at best ignorant, because they presume that the capital markets consist of sheep with money, dumbly following each other, instinctively reacting to the GAAP income statement, either by bidding a stock price up because of the larger bottom line without the expense or by bidding the price down because of the smaller bottom line with the expense. Whether expense is recognized or disclosed, the markets are sly like foxes and know exactly what to do with earnings numbers.

At worst, these public servants are openly advocating fraud because they want to benefit one party (managers/employees) while deceiving another party (the stockholders) by not telling the whole truth about compensation. These members of Congress are accomplices in raiding the hen house.

[At this point, the original column ran the names of the senators and representatives who signed the letters to FASB. Obviously, we can’t very well run the names of all 312 members who voted against honest and complete reporting. We urge you to find out if your local representative voted for the Baker bill and, if so, express your feelings, which we hope are like ours.]

These public officials either have been duped or are duplicitous. As shocking as the idea might be, it is even possible that they really know nothing about the issue but just signed the letters at the urging of other people with the goal of making some extra hay. In any event, do you want them shaping the laws of the land? If your senator or representative signed these letters, send them a copy of this column and vote for someone else in the next election. You deserve better and they need to get their hands dirty down on the farm. E-I-E-I-O.


We are optimistic that the Baker bill will be thwarted in the Senate, where it faces strong opposition. On the other hand, the proponents of propaganda will probably try to squeeze the Baker bill into other urgent legislation that will be voted into law at midnight on the closing day. Do what you can to get your senators to defeat this action. That is, if you think truth is a better policy than blatant deception.

Paul B.W. Miller is a professor at the University of Colorado at Colorado Springs, and Paul R. Bahnson is an associate professor at Boise State University. The authors’ views are not necessarily those of their institutions. Reach them at paulandpaul@qfr.biz.

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