"There are only two ways of telling the complete truth—anonymously and posthumously."Thomas Sowell

Thursday, July 14, 2005

Employee Stock Options & the FASB Fiasco

More than a year has passed since I last criticized The Financial Accounting Standards Board (FASB) for what later became a mandate to U.S. companies to "expense" employee stock options. Law and economics scholar Jim DeLong – a powerful early critic of this ill-fated “expensing” crusade -- has written a terrific “We told you so” update on some unintended consequences it has already produced.

For background, here are a few excerpts from my April 2004 piece:

“Public companies would be required to first estimate the "fair value" of such options at the time they are granted, and then subtract that estimate from revenues as if it were a known and current expense (rather than an unknown and future expense). . . . This proposed blurring of the critical distinction between actual costs today and possible costs tomorrow matters most to cash-starved younger firms whose earnings are typically reinvested in expanding the firm. There are two reasons: First, deferred expenses are particularly preferable to immediate expenses whenever revenue is expected to be higher in the future. Second, expenses that are contingent on both a higher stock price and employee retention are always preferable to larger fixed salaries from a stockholder's point of view. The fashionable trend of switching from options to restricted stock, by contrast, transfers risk from executives to stockholders -- dilution is immediate and restricted stock retains value even if the stock falls. . . . If the unique benefits of stock options in linking risk and reward are artificially discouraged by mandating an artificial redefinition of costs, that will reduce the information and comparability of reported earnings by increasing the portion of earnings that depends on inherently crude estimates constructed with assorted subjective techniques . . . . The FASB proposal to require companies to treat the estimated fair value of stock options as an actual and current expense rests on a dubious conjecture about what the cost of stock options to stockholders really is and when it occurs. In reality, the estimated value of options to employees at the moment they are granted is not at all the same as the cost to shareholders if and when those options are later exercised. The FASB scheme looks like a risky way to repair some problem that has yet to be seriously defined.”


Kathy Hutchins said...

Alan -- in your view, does the appointment of Chris Cox to the SEC herald any rollback of this nonsense? Larry Kudlow is bullish on Cox, but I don't know enough about the expensing rule or FASB's regulatory relationship with SEC to know if that's something over which Cox will have any direct control.

Benjamin Zycher said...

In a simple world, it should not matter what the accounting rules are, or how certain costs are treated on the books, except perhaps for varying tax implications and the like. It strikes me that the market should be able to see through the accounting veil.

Kathy Hutchins said...

Is there uncertainty about how to follow the rules or fear that failure to intuit what FASB wants will lead to fines? (I assume there are penalties for not following the rules -- criminal, civil, both?) Are individual accountants liable if FASB doesn't like the way a balance sheet's been presented?

I know very little about corporate financial rules, and finding myself in the same room with Mr. Reynolds and Dr. Zycher trying to act like I'm not a moron is making me a little uneasy.

James Elliott said...

At least you have an MA in economics. Imagine how the rest of us feel sometimes.