by J. Edward Ketz

On Nov 19, 2003, Sens. Enzi, Reid, Ensign, Boxer and Allen introduced a bill in the Senate that purports to reform the accounting for stock-based compensation. If this is reform, I would rather see flotsam and jetsam.

The Financial Accounting Standards Board and the International Accounting Standards Board have issued drafts that will require all business enterprises to expense stock-based compensation. Managers will list all of their compensation, and not just their cash salaries. Given the rise of stock options over the last decade or so, this accounting standard will greatly improve financial reporting, as the truth about managerial compensation becomes published.

The Enzi et al. bill begins by calling for the expensing of stock-based compensation. While it has a worthy and correct inaugural section, the bill declines in quality thereafter.

Section 2, paragraph 1, states that the measurement of stock-based compensation will be limited to the five highest paid executives, even if the corporation has dozens of others earning bonuses via stock options. Clearly, this provision arbitrarily reduces the expense.

Section 2, paragraph 3, of the bill requires the pricing model “to determine the fair value of an option” by assuming that the “volatility of the underlying stock shall be zero.” Since I don’t know any stock whose price doesn’t change, I find this assumption demonstrably absurd.

In trying to find out why the senators would include such a patently silly clause in their bill, we need only understand that increased volatility enlarges the value of the option. Thus, the senators are providing a way for corporate managers to artificially decrease the measurement of their stock-based compensation. In fact, some recent empirical work shows that this decline might erase as much as 90 percent of the actual stock compensation expense!

Section 2, paragraph 4, of this proposal allows exemptions for “small business issuers.” My question is, why?

Since measuring and then reporting stock-based compensation is the truthful thing to do, why do the senators wish to allow some executives the privilege of prevarication?

Section 3 of the bill delays the implementation of any expensing requirement until an “economic impact study” is conducted. Specifically, the legislators want to assess the impact of truthful accounting on:

  • Expanding employee corporate ownership (which, presumably, they think is a lofty goal);
  • The hiring and retention of employees;
  • Research and development activities;
  • Economic growth in the U.S.; and,
  • The global competitiveness of American companies.

Incredibly, these members of Congress do not include creditors and investors in their list. Perhaps they do not care about the economic impact of any expensing requirement on them.I humbly submit, however, that the erosion of $8.5 trillion from the equity market (as estimated by Joseph Stiglitz in his book, “The Roaring Nineties”) constitutes prima facie evidence of economic impact.
And since creditors and investors sorely need truthful accounting — how else do we interpret the economic meltdown in 2001 and 2002? — we must assume that these senators are callous toward the investment community.

The global impact concern will soon be a non-issue. Since the IASB also promulgates the expensing of stock-based compensation, U.S. concerns will be on an equal footing with their European counterparts, which are committed to following international accounting standards.

Sen. Enzi earlier held hearings on this topic. Participants included FASB, which the committee lambasted for supporting truthful reporting that might hurt business managers, and various parties from the small business community. Tellingly, he didn’t bother to ask any representative from the investment community to testify. Apparently, losing $8.5 trillion doesn’t qualify as economic impact.

He falsely accuses the board of adopting the project with a “pre-ordained result in mind.” The senator instead should have praised the board for finally having the courage to defy cultural forces that desire to loot creditors and investors.

Evidently, enterprising managers are attempting to thwart good accounting standards-setting by offering campaign contributions to senators for derailing true accounting reform. As the only accountant in the Senate, Enzi should know better. His bill to undermine FASB, however, reveals his true colors. Perhaps he is no more reform-minded than Enron’s Ken Lay or Jeff Skilling.

Maybe, just maybe, true accounting reform rests on reforming the current system of campaign finance. Until we prevent corporate managers from taking shareholder wealth and sprinkling cash into the coffers of Washington politicians, we shall never clean up accounting or mutual fund scandals.

J. Edward Ketz is an associate professor of accounting and MBA faculty director at Penn State’s Smeal College of Business. He is also the author of ”Hidden Financial Risk” (Wiley, 2003).

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