by Paul B.W. Miller and Paul R. Bahnson
What an exciting time to be alive and to be an accountant!
Never before have so many accounting issues been in the news. Never before have we been able to say, "FASB," to our friends and assume they know what the acronym stands for. Besides the fact that accounting is now cool, we see signs of progress that are consistent with our new quality financial reporting paradigm.
But for the tragic backdrop, we would be amused by the transparently hypocritical calls from members of Congress who have remembered that investors are voters and who suddenly believe that expensing stock options is a good way to look like they’re doing something about corporate greed. They’re way behind us.
Going back 6-plus years, the second column in this series described the outcome of SFAS 123 ("Winners and losers surface as stock comp smoke clears," February 12, 1996). For those who don’t remember, FASB proposed mandatory expensing in 1994 but collapsed under outrageous pressure from corporate managers using hired guns from Congress. The list of FASB’s opponents included some prominent members, most notably Sen. Joseph Lieberman, who still has his eye on the Oval Office.
Despite our disgust, we’re pleased that others have finally noticed that the emperor is indeed naked. A few managers, like the small boys in the fairy tale by Andersen (Hans Christian, not Arthur), are crying out, "Options should be expensed."
The ruse that options aren’t compensation remained intact only through an unprecedented collusion among top CEOs, Congress, regulators, auditors, the media, investment bankers and even institutional investors. Somehow, they have perpetuated the obviously false notion with bluster, nods, winks, PAC money and large consulting fees to auditors.
Anyone with a shred of intellectual honesty or a sliver of ethical backbone must admit that giving options to employees creates an expense. After all, giving options to anyone else creates an expense and paying employees with anything else creates an expense. It was only by a collective force of misguided wills that respectability was attributed to the view that options given to employees are different. What utter nonsense! Yet the conspiracy survived a half dozen years and still continues.
Against that backdrop, a wonderful thing is happening. In the week of July 15, news trickled out that some CEOs suddenly decided to begin expensing options. AMB Property Corporation went first, followed quickly by Coca-Cola, BankOne and Wachovia. AMB is significant because of its youth and its location in the Bay Area, the epicenter of options mania. Before this column appears, more will surely make the switch. So, what are our points?
First, Congress is full of hypocrites and opportunists. (Like, duh!)
Second, Congress doesn’t even need to act, despite the media-created crisis. Indeed, we want legislators to simply drop the issue and force managers to choose between FASB’s preference for expensing and the discredited route of disclosure. We would like the market to have an additional signal to help them distinguish trustworthy managers from those who want to hide the truth.
Third, this shift is consistent with the QFR concept of unforced improvements in financial reporting. In fact, our recent book advocates the simple first step of expensing options. Thus, we applaud, even embrace, the epiphany that’s occurring before our eyes. However, we consider this tiny trend to be a mere baby step because FASB’s preferred method is grossly deficient for describing both the initial and ongoing effects of options.
Briefly, it measures the options’ value as of the grant date and then systematically allocates it to expense over the years in the vesting period while crediting an equity account. Although the method acts as if the grant created a prepaid cost, it reports no asset and no obligation to the employees.
In effect, FASB’s best effort produces off-balance-sheet-financing by applying a centuries-old and otherwise discredited matching model. It also underreports the employer’s tax savings from exercise. (As an aside, we’re disappointed that the renascent adopters of expensing will only apply it prospectively to new options. If they were serious about truth-telling, they would apply it retroactively to all outstanding options.)
As for us, we have not yet heard a persuasive argument against the interpretation that granting options creates a liability to deliver stock worth more than the strike price upon exercise. That debt is obviously contingent on a number of factors, all of which the market carefully weighs much more completely than a simple formula based on the strike price and the stock’s value.
As a result, only the options’ current market value is a complete and continuously updated measure of the contingent debt to the employees. It’s clear to us that the grant date should produce an entry, but we think that it should debit compensation expense and credit an option liability. No phony off-the-books prepaid asset and no disappearing off-balance-sheet liability.
Furthermore, employers will provide the most complete and useful information if, and only if, they continuously mark their option liability to market. If the options’ value increases, credit the liability, debit compensation expense, end of entry. If the value decreases, debit the liability, credit compensation expense and you’re done.
If management reprices the options, credit the liability and report more expense. This approach is useful because it continuously reveals the full and ever-changing impact of options on earnings and financial position. Most important, the liability method doesn’t produce an artificially smooth expense when the options’ value changes because it doesn’t keep allocating the outdated initial cost of options after they go underwater or zoom in value.
Finally, when options are exercised, the employer credits equity for the issued stock’s full value, debits the liability, debits cash and debits/credits expense for the remainder. (Without going into details, the liability method also gets tax expense right.)
We would love it if both FASB and IASB would apply this liability model. However, our conversations with their people show that they don’t support requiring, or even recommending, its use. However, the QFR paradigm shows that nothing can keep wise managers from voluntarily providing this useful information.
Despite this frustration, we’re pleased that this no-brainer issue is back on the table. The current voluntary move toward recognition is positive, even very positive, because it shows that at least (and at last) some managers realize that more complete information reduces uncertainty and produces lower capital costs and higher stock prices.
What’s still missing is broad support for the liability method. No other approach will reveal the full truth as well as reporting the market value of this neglected debt to the employees.
This bizarre episode in institutionalized deception may now be behind us but let’s not overlook another obstacle - the unhealthy tendency to wait for Congress to identify and mandate useful and complete accounting principles. We can guarantee you - it will NEVER happen.
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