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Stock-Option Options: The Debate Over Expensing
Stock-Option Options: The Debate Over Expensing
DeLong Op-Ed in National Review Online
April 03, 2002
The Enron affair has accomplished the seemingly impossible — it has riveted public attention on technical issues of accounting. As a result, all sorts of "reforms" are getting hitched to the scandal locomotive, from revised auditing standards to controls over pension investments.<?xml:namespace prefix = o ns = "urn:schemas-microsoft-com:office:office" />
Corporate America is reacting with equanimity to most of these. But on one issue the companies stand shield-to-shield like Greeks at Thermopylae: They do not want to be forced to classify the cost of stock options as "expenses" that must be subtracted from reported earnings.
The companies thought they won this battle in 1995, when the U.S. Financial Accounting Standards Board retracted a proposal that options be expensed. It allowed firms, instead, to put in footnotes providing a valuation of options based on the Black-Sholes model (the widely used mechanism for valuing options of all kinds) and providing a number for earnings per share on a fully diluted basis.
In 2000, however, the International Accounting Standards Board resurrected the idea, and it has gained momentum since Enron. Senator Carl Levin (D., Mich.) recently put in a bill that would have the effect of requiring that options be expensed, various investors' groups have joined the pro-expense camp, and the potent name of Alan Greenspan was recently added.
The companies, led by the high-tech and venture-capital forces that are the most adamant anti-expensers, are in for a serious fight.
Corporate America is right on this issue, but it has a problem because it must make a complicated argument while its opponents use a bumper sticker. In a scandal-driven milieu, the disadvantage is serious.
The bumper sticker is that everybody knows that stock options are a way of rewarding employees, especially top management. So why not simply call a spade a spade, or a paycheck a paycheck, and treat options as a compensation expense?
The complicated answer to this has several parts. First, the valuation question is intractable, especially for a non-liquid option. No model is satisfactory, so why change the current system of disclosure when the new numbers are not necessarily more accurate, and will certainly be more confusing? In any event, the cost to the shareholders is represented by the fully diluted earnings numbers, so requiring that the value also be expensed would be double counting.
Besides, if investors want more numbers, they can demand them. As the Financial Times reported on March 28, individual companies are already issuing special reports on the issue.
The second response is trickier, but more important. It concerns determining which set of earnings the value of the options would be charged against.
The usual assumption is they are a cost to be matched against earnings over the life of the grant, or possibly at the time of the grant. But not so fast. Most of the value of the modern company is intangible — intellectual property, market knowledge, customer contacts, and so on. A Brookings Institution project notes that as of March 2000, only 15% of the market capitalization of the S&P 500 could be ascribed to physical assets; the rest derived from intangibles.
Such intangible capital comes from the minds of employees. The market is recognizing that their efforts produce a stream of earnings in the future, not just current earnings. They are creating capital.
Therefore, dividing employee compensation into salary payments and capital stock simply recognizes the reality of the modern enterprise. Requiring that it all be treated as a current expense would be misleading because it would overstate current costs and understate investment.
Indeed, the use of stock options has grown immensely over the past two decades, apace with the growing importance of intangibles on corporate balance sheets. In 1978, intangibles accounted for only about 15% of market cap.
Besides the inherent difficulty of making this complex case in the political arena, the corporations have another handicap of which they are unaware.
They do not know that they are in a battle over fundamental political issues. They think the debate is all about the merits, and that once they explain their case their opponents will be convinced. Most of the high-tech community, which is most concerned because of its heavy reliance on stock options, is politically liberal, and thus confident in the honest intentions of a beneficent state.
They could win on the merits. Stranger things have occurred in Washington. But it is not clear that the pro-expense-the-options forces give a rap about the merits, and the companies are likely to find them bafflingly unresponsive.
Conservatives crow over expanding stock ownership, convinced that this will make society less favorable to government regulation. Their opponents agree, so anything that promises to check the diffusion of stock ownership, especially something as well camouflaged as an accounting standard, is appealing.
The press has noted support of some investors for the expense-options view, but, on closer look, many of these consist largely of pension funds for public employees and unions. They have no reason to promote widespread direct-stock ownership by corporate employees.
In this politically charged world, when corporate American argues that the proposed rules would discourage stock options, especially for lower-level employees, its opponents smile. And when the companies point out that the new rules would actually obfuscate the earnings numbers, the opponents are indifferent.
One should not underestimate the political power of the high-tech world, but they would be well advised to think through the nature of the conflict they are in.
Mr. DeLong is senior fellow in the Project on Technology & Innovation at the Competitive Enterprise Institute.