Will Reid Lead On Stock Option?

In the discussion of winner sand 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 monopoly power of the U.S. accounting standards.

FASB has an impending rule to force companies to estimate the value stock options and expense it against their reported earnings. It is part of the agenda of “convergence” with the International Accounting Standards Board (IASB), which came out with a similar standard for Europe that is now being reviewed by the European Union.

Force of law

But despite the concern that this will hurt the effort for emerging U.S. firms to offer broad-based stock options to employees, FASB has refused to even consider the economic effects. And since the Securities and Exchange Commission (SEC) automatically accepts FASB’s standards, the expensing rule will 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 is 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 blindly defer to FASB, since it is the accounting expert.

But there is a new dynamic in the Senate that has nothing to do with Bush’s reelection or the net gain of four new Republican Senators. Rather, it concerns 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. And his elevation from Whip to Democratic Leader, is similar to “going from cabinet secretary to president,” says John Palfoutas, senior vice president for domestic policy at the American Electronic Association.

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 Palfoutas speculate that stopping FASB will definitely be part of Reid’s agenda.

But caution is warranted. Though his convictions are strong, Reid hasn’t always made the arguments that would most persuade his fellow Democrats and others on the fence. But neither have Republican opponents of expensing.

In introducing his bill on the Senate floor late last year, Reid made this argument: (http://www.savestockoptions.org/pdf/reid04. pdf ) “Mr. President, we have to protect investors and stockholders by ensuring that our nation’s accounting standards are transparent, open and balanced. At the same time, we don’t want to choke the entrepreneurial spirit of start-up companies with too much bureaucratic red tape.”

Wrong case

Reid and Republican expensing opponents have made the argument that states that accounting standards for options must balance accuracy with economic impact. But this is the wrong case to make.

For 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, “It is virtually impossible to put a precise estimate on the option’s value.” This is because a stock option when it is issued 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 shareholder.

So expensing the issuance of stock options against current earnings could mislead shareholders by holding earnings artificially low.

The potential 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. Depressing earnings through questionable accounting devices is just as deceptive as artificially pumping them up.

The good news is that over this year, options defenders and Reid in particular have been gaining ground by broadening the attack from the economic costs to the accuracy of the FASB fiat.

“One of the most challenging issues surrounding this most contentious subject relates to whether employee stock options can be valued accurately and reliably,” wrote Reid in a letter last month to the SEC that was cosigned by 14 other Democrats, according to Dow Jones Newswires “Additional work on valuation is necessary to preserve stock options.”

There are rumors that options advocates may try to tie the Reid-cosponsored bill to a spending measure in the “lame duck” session that begins November 16. Should this fail, advocates would do well to spend their winter break refining the argument and fixing the bill for a new Congress.

The current bill is flawed in that it attempts a clumsy compromise with FASB by mandating that options issued to a company’s top five executives be expensed.

This was done to assuage concerns, particularly among Democrats, about executive compensation and abuse.

But this may have also hurt the bill by yielding to FASB the moral high ground.

It gave credence to the charge that Congress was trying to design accounting standards and allowed expensing advocates like Warren Buffett to pounce on the supposed hypocrisy of having different accounting standards for executive and employee compensation. Far better just to have a clean bill to repeal or deny funding to enforce the FASB rule.

Because, as Reid surely knows, expensing for the top five or for all employees won’t really reduce executive compensation and will 

do little to prevent more corporate shenanigans.

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. 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, as well as tech companies like Microsoft, have 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, in America and in Europe, should be focused on is opportunities for employees and shareholders of the next Microsoft and Home Depot to prosper with the companies.)

Employee ownership

Promoting employee ownership in the U.S. 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.

Meanwhile in Europe

While European countries have mandated for workers a greater role in management of companies, America has had some solid success in turning workers into investor and entrepreneurs, thanks to bipartisan initiatives with the support of pro-growth Democrats like Long. Democrats and Republicans who value employee ownership cannot allow FASB to harm another innovation that gives workers a stake in their businesses.

Reversing an accounting standard that misleads shareholders and hurts worker wealth would be a worthy act of bipartisanship. But it is only a first step. Critics are correct that Congress shouldn’t write accounting standards, but neither should FASB have an monopoly in setting the standards.

In 1994, Sen. Joe Lieberman, D-Conn., sponsored a bill that would have required the SEC to play a more active role in approving FASB’s standards.

The goal of making FASB accountable was worthy, but a better way would be to encourage competing accounting standards from the private sector.

Investor choice

Under this system, the government would still police for fraud. But investors could choose whether they wanted companies that subscribe to an accounting system that, for instance, treats stock options as an expense or handles them as just a noncash item that causes some dilution but also encourages a company’s growth.

Instead of convergence, companies listing on U.S. stock exchanges could choose American or European accounting standards, and investors could vote with their dollars.

With Reid at the Senate Democrats’ helm, this could be a new era of bipartisanship in accounting reform.