Reid May Lead on Stock Options

In the discussion of winners and losers from Election 2004, one organization that may have suffered a big blow has been overlooked. This is the Financial Accounting Standards Board (FASB), the private group chosen by accountants and financial executives that has power over the <?xml:namespace prefix = st1 ns = “urn:schemas-microsoft-com:office:smarttags” />U.S. accounting standards.<?xml:namespace prefix = o ns = “urn:schemas-microsoft-com:office:office” />


FASB has a rule now scheduled to go into effect in June to force companies to estimate the value of stock options and expense those options against their reported earnings. But despite the concern that this will hurt the effort for emerging firms to offer broad-based stock options to employees, FASB has refused to even consider the economic effects, saying that this is outside the group's mandate.  And since the Securities and Exchange Commission's practice is to defer to FASB in setting accounting standards that public companies must comply with—using the rationale that accounting professionals are the experts—the expensing rule will likely have the force of law. This leaves Congress as the only body that can stop this mandate that could deliver a devastating hit to new companies with the potential to be the next Microsoft or Home Depot.


Last July, the House of Representatives passed 312-111 the Stock Options Accounting Reform Act to push back FASB's ruling. But the measure became stalled in the Senate, due to the efforts of lawmakers such as Richard Shelby, R-Ala., and Carl Levin, D-Mich, who argue that Congress should defer to FASB since it is the accounting expert.  


But there is a new dynamic in the senate due to the defeat of South Dakota Sen. Tom Daschle and the elevation of Nevada's Harry Reid to Daschle's title of Senate Democratic Leader. It just so happens that while Reid is a dyed-in-the-wool liberal on nearly every issue, he sees eye-to-eye with those who say that stock options are a key to America's entrepreneurial system.


“FASB's proposed rule would hurt small business and investors and do nothing to ensure our nation's accounting standards,” Reid said in a statement reported in the Las Vegas Review-Journal. Reid is an original co-sponsor of the Senate companion bill to stop FASB's forced expensing.  


In this and other statements, Reid has shown a good understanding of the twin flaws of the FASB fiat:  FASB's expensing standard would result in both hits to economic growth and innovation and less accuracy for shareholders. As Princeton economists William Baumol and Burton Malkiel have noted, “[I]t is virtually impossible to put a precise estimate on the option's value.” This is because a stock option when it is issued to a worker is worth little or nothing. Unlike other options that are freely tradable, a stock option will only have value if the company grows and produces good returns for shareholders. So expensing the issuance of stock options against current earnings could mislead shareholders by holding earnings artificially low. The dilution of shares that options could cause in the future is not fixed by pretending that they cause a hit to earnings in the present. The potential dilution is already transparent to shareholders in a company's reports, and depressing earnings through questionable accounting devices is just as deceptive as artificially pumping them up.


Reid is also correct in pointing out who would really by hurt by mandatory expensing. While sold as a way to reduce excesses at the top and Enron-like shenanigans, expensing would do little reduce executive compensation. Executives are in high demand, and companies will always find some way to compensate them. What mandated expensing will likely do is crush broad-based stock options in entrepreneurial firms. The businesses whose earnings would suffer the most from expensing's artificial hit would be the small companies that, like Microsoft and Home Depot did in their early days, rely on options to attract and retain a broad base of talented employees. This would hurt the very middle-class workers Democrats claim to champion. Cashiers who accepted options in the early days of Home Depot are now millionaires.




Expensing advocates will no doubt point out that, yes, Home Depot  and Microsoft, as well as some other tech companies, have recently decided to expense stock options. But now these companies are big enough that they can afford to expense without taking that large a hit in their earnings. What public policy should be focused on is opportunities for employees and shareholders of the next Microsoft and Home Depot to prosper with the companies. With Reid leading the Senate Democrats, it is all the more likely that, at least in this policy area, there will be bipartisan support for the entrepreneurial culture that makes America so unique.


And his elevation from Whip to Democratic Leader, is similar to “going from cabinet secretary to president,” says John Palafoutas, senior vice president for domestic policy at the American Electronics Association, which organized recent “fly-ins” of tech entrepreneurs to Washington, DC to register their opposition to the expensing standard.


As Senate Minority Whip, Reid had influence over the Democrats. But as Minority Leader, he can, like Daschle, set the agenda. And given his strong beliefs on the subject, opponents of expensing such as Palafoutas speculate that stopping FASB will definitely be part of Reid's agenda.


Promoting employee ownership is a proud Democratic Party tradition. The late Louisiana Sen. Russell Long championed tax changes that encouraged employee stock ownership plans (ESOPs) as a way of giving workers a piece of the rock. Democrats and Republicans who value employee ownership cannot allow FASB to harm another innovation that gives workers a stake in their businesses. With Reid at the Senate Democrats' helm, this could be a new era of bipartisanship in accounting reform.