Background:  In March 2003, the Financial Accounting Standards Board (FASB) began a review of the accounting treatment of stock options issued to employees as part of their compensation. The resulting March 31, 2004 proposed Statement of Financial Accounting Standard would require companies to expense these options in their annual statements. Final adoption of the FASB proposal is expected during the fourth quarter of this year.

In response, Rep. Richard Baker (R-LA) introduced H.R. 3574, the Stock Option Accounting Reform Act, which would effectively block the proposed FASB standard. The bill, which has 124 co-sponsors, requires companies to expense only stock options granted to their top officers, specifies how stock options should be treated in financial reporting and requires an economic impact study of mandatory expensing before any accounting standard could go into effect. Sen. Mike Enzi (R-WY) introduced an identical bill, S. 1890, which has 21 co-sponsors.

Status:  The House Financial Services Committee approved H.R. 3574 on June 15. The full House is expected to consider it later this summer.

Discussion:  Valuing employee stock options has been controversial for many years. Options allow the holder to buy a set number of shares at a fixed price on a future date. Unfortunately, placing a value on these options is anything but simple.

Because stock prices fluctuate, the value of an option can vary widely over time. Currently, companies can list options as a footnote on their financial statements, but FASB would require them to deduct their value from annual earnings. FASB says that this would force companies for the first time to disclose all of their compensation costs. Opponents question the valuation method and claim that expensing could cause annual earnings to appear unstable and inaccurate. 

However, over the last few years, stockholders at a number of companies, including several hi tech firms, have called for options to be expensed. International accounting regulators have also required this step.

Accounting is more of an art than a science. Non-cash items such as depreciation and stock options are valued by agreed upon methods that are developed by professionals and imposed upon all publicly traded companies. It is a matter best handled by experts rather than through a congressional debate that is more likely to favor the politically connected than to be decided on the merits of the issue. Options clearly have a value, and failing to expense them, despite the difficulty of doing so, distorts financial statements.   

Action item:  Congress should not attempt to micro-manage specific accounting issues. That task should be left to FASB or similar organizations.

This brief was prepared by Heritage Research Fellow David C. John.

The "Regulation In Brief" is produced regularly by The Heritage Foundation, providing concise summaries of key regulatory issues, along with links to key background material on each issue. If you wish to be removed from the "Regulation In Brief" mailing list, please e-mail Margaret Hamlin at Margaret.Hamlin@heritage.org.

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