June 29, 2004
By Norbert J. Michel, Ph.D.
At the start of next year, barring any
surprises, public companies will have to list employee stock
options as an expense on their income statements. Finally, after a
host of public comments and ludicrous political bashing, the
accounting world's independent rulemaking body, the Financial
Accounting Standards Board, has its rule ready to go.
But Rep. Richard Baker, R-La., has other ideas. Baker has
introduced legislation that would pre-empt the FASB rule, institute
expensing for only the five highest-paid executives at public
companies and prohibit further expensing rules from taking effect
until an economic impact study can be performed.
Why would Congress get this involved in FASB's rulemaking
procedures? What would drive business executives to push for this
legislation? Finally, why would they care about FASB's expensing
rule at all? A quick look at how we got to this point sheds some
light on these questions.
First, companies use stock options -- securities whose values rise
and fall with the company's stock price -- to compensate employees.
They currently disclose these transactions only in the footnotes of
their financial statements. FASB aims to make the compensation more
transparent by placing it squarely on the income statement.
The recent push for expensing came shortly after the fall of Enron
in December 2001 (though the campaign, in various forms, actually
can be traced to the 1970s). Members of Congress argued that if
companies had been expensing in the pre-Enron days, the wave of
corporate meltdowns might have been averted.
But the abuses by executives at Enron, WorldCom and Tyco dealt with
fraud, not stock options. Laws already exist against fraud. People
prepared to disregard those laws for profit will similarly
disregard any new laws or regulations Congress or FASB devise. But
this isn't enough to get Congress to pass up a chance at
And, of course, the real question is this: What does this all mean
to the values of the companies? Has every public company been
improperly valued for the past 30 years because of the accounting
rules? If so, would not huge takeover opportunities now be
available? Both sides seem to have ignored economics here.
Consider two companies with $1 million in operating income. Company
A has $800,000 in depreciation expense -- money it can write off
its taxes as its equipment grows older and loses value -- and
Company B has $100,000. Under expensing advocates' reasoning,
Company B is more profitable and a better investment. In reality,
Company A has much better cash flow because depreciation is a
non-cash expense that lowers the company's tax bill.
Yet expensing opponents suggest corporate executives would do
anything they could to show as little depreciation as possible.
After all, depreciation expense depresses earnings.
The analogy between depreciation and option expenses applies
because both are non-cash expenses that reduce taxes. Still,
because options are equity instruments -- they confer ownership and
don't add to debt -- those in favor of expensing argue that there
has been no check on managers' willingness to issue options.
They equate issuing options to spending "free money" and claim that
greedy executives have issued them without regard for anything but
their own bank accounts. Such a trick would be worthy of the finest
alchemist. No executive can blindly issue claims on his company's
stock without diluting his shareholders' (and frequently his own)
So why all the fuss from Silicon Valley? Why should people there
worry if this is just a non-cash expense, one that investors easily
can account for? One key could lie with the Sarbanes-Oxley
Passed in 2002, Sarbanes-Oxley holds executive officers directly
responsible for the accuracy of their financial statements (under
the threat of rather severe penalties). The term "accuracy" is
particularly relevant here because it's difficult to put a value on
employee stock options. The notion that anyone can put any price he
desires on these options, as if it is written in stone, is pure
Technology companies tend to issue large amounts of options both to
bulk up compensation when the firms are small and growing and as
incentives to get employees to share in ownership. The spectacular
ups and downs of these firms mean their options run the risk of
having the largest "revaluations." Consequently, they also run the
greatest risk of giving off the appearance of impropriety.
True, Sarbanes-Oxley requires a "knowing and intentional"
violation, but anyone who thinks prosecutors (or trial lawyers)
will let such a small detail stop them pays little attention to the
U.S. legal system.
Determining whose earnings are "accurate" is difficult enough
without adding option expensing to the mix. So although it is
disturbing that Congress is trying to dictate accounting rules,
after seeing Sarbanes-Oxley, it isn't surprising. Just
Norbert Michel, Ph.D., is a policy analyst in the Center for
Data Analysis at The Heritage Foundation, a Washington-based public
policy research institute.
First appeared on FOXNews.com
At the start of next year, barring any surprises, public companies will have to list employee stock options as an expense on their income statements.
Norbert J. Michel, Ph.D.
Research Fellow in Financial Regulations
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