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Monday, March 15, 1999

An Investment Opinion
by Alex Schay

What Are the Options?

About three-quarters of the way through Warren Buffett's 1998 Letter to Berkshire Hathaway (NYSE: BRK.A) shareholders, the oracle of Omaha engages in an uncharacteristic diatribe. Although the annual Buffett letter has always been liberally sprinkled with poignant quips, this time around the avuncular tone of old is put on hold for a number of paragraphs as Buffett expounds on some accounting shenanigans that are clearly of concern to him. As always, the underlying interest group that's represented is the shareholder community at large.

Here, Buffett gives readers his assessment of the changing accounting ethos in corporate America:

"It was once relatively easy to tell the good guys in accounting from the bad: The late 1960's, for example, brought on an orgy of what one charlatan dubbed 'bold, imaginative accounting' (the practice of which, incidentally, made him loved for a time by Wall Street because he never missed expectations). But most investors of that period knew who was playing games. And, to their credit, virtually all of America's most-admired companies then shunned deception.

"In recent years, probity has eroded. Many major corporations still play things straight, but a significant and growing number of otherwise high-grade managers -- CEOs you would be happy to have as spouses for your children or as trustees under your will -- have come to the view that it's okay to manipulate earnings to satisfy what they believe are Wall Street's desires. Indeed, many CEOs think this kind of manipulation is not only okay, but actually their duty."

In the Buffett letter, a fair amount of digital ink is devoted to the subject of options accounting -- consistent with the overarching theme that many CEOs and auditors have vehemently fought against the replacement of "option fiction with truth." The topic is broached by means of an accounting line item in the Berkshire financials. The pro forma statement of income (as if General Re had always been a part of Berkshire) indicates a $63 million increase in compensation expense for 1997 as a result of the termination of General Re's longstanding option plan in favor of a cash plan with matching economics.

What? America's premier business savant pitted against a management compensation system that gives those with a hand on the corporate rudder a "stake" in the business? How can this be? Buffett's basic statement on the matter is as follows, "Though options, if properly structured, can be an appropriate, and even ideal, way to compensate and motivate top managers, they are more often wildly capricious in their distribution of rewards, inefficient as motivators, and inordinately expensive for shareholders."

Let's begin with Mr. Buffett's last "potential" criticism. Expensive for shareholders, how's that? Options bear no explicit cost to the firm that uses them. Employees pay the exercise price, they pay the tax, and the company in question gets some much-needed cash from both the employees and the IRS (through reduced taxes). The piece de resistance, however, is the fact that companies do not recognize any expense on the income statement, nor any liability on the balance sheet.

These are unassailable facts. However, as we've outlined at length in previous columns, if a company is actually buying back higher priced shares in order to offset the share quantity dilution imposed by the issuance of options, then that should really be viewed as cash paid for employee compensation. In instances where the firm buys back shares at higher market prices, any increase in equity that might have resulted from option exercise is upset by the treasury stock cost from the buyback. While shares outstanding may have been brought back into line (to the pre-option exercise amount), stockholders equity will have been beaten down to levels below the initial option transaction. Hence, the stock buyback ends up decreasing the book value of shares and the net worth of shareholders. Does this really address Mr. Buffett's criticism though? In a word... no.

Brace yourself. We are about to delve into the ramifications of an intellectual position that is unprecedented in corporate America, for its internal consistency, as well as its ethical underpinnings!

Buffett states quite baldly that current accounting principles on the options matter are "outrageous," and don't reflect the reality of doing business. And this really goes to the heart of the matter. Mr. Buffett, rather than choosing to take advantage of "what is," (an almost necessary credo in the business world today) has translated his own prescriptive ought, or "what should be," into the reality of how he structures transactions.

Just because the accounting profession as a whole decides to endorse something as wrong-headed as the current options treatment doesn't mean Buffett will partake, even if it means penalizing his own earnings. Dilution is not the issue, it's the possible overstatement of earnings that results from the use of options "for free" that really rankles the Chairman.

"Charlie and I, however, have trouble being philosophical about unrecorded costs. When we consider investing in an option-issuing company, we make an appropriate downward adjustment to reported earnings, simply subtracting an amount equal to what the company could have realized by publicly selling options of like quantity and structure. Similarly, if we contemplate an acquisition, we include in our evaluation the cost of replacing any option plan. Then, if we make a deal, we promptly take that cost out of hiding."

Objections to this shoot-yourself-in-the-foot-accounting usually mirror those "unassailable facts" that I mentioned in a previous paragraph. After all Mr. Buffett, you don't have to deal with options in a rational, consistent, and ethical manner.

Dale Wettlaufer penned a column not to long ago entitled, "We Love Buffett." At the risk of engaging in some nauseating cheerleading, this is a great example of why I love Warren Buffett. I'm sure some readers at this point are holding out for some statement concerning the "shareholder friendly" element of options. They can't be that bad if so many companies employ them as incentives for their employees, right? Understanding that their proper accounting treatment and their ultimate utility are two very different issues, Buffett's criticism that options are "inefficient motivators" is worth exploring.

Again, it's important to note that Buffett's overall option comments bear a unique qualifier. That is, he opens his general statement on the matter by asserting that options "can be appropriate, and even ideal." I assume he means that when they are tied to value creation and not just share price metrics.

"Readers who disagree with me about options will by this time be mentally quarreling with my equating the cost of options issued to employees with those that might theoretically be sold and traded publicly. It is true, to state one of these arguments, that employee options are sometimes forfeited -- that lessens the damage done to shareholders -- whereas publicly-offered options would not be. It is true, also, that companies receive a tax deduction when employee options are exercised; publicly-traded options deliver no such benefit. But there's an offset to these points: Options issued to employees are often repriced, a transformation that makes them much more costly than the public variety."

Investors quoting the "alignment of interests" scripture in favor of options, often overlook this "repricing" point. In terms of investment, equity holders bear the cost and risk of an initial outlay, management doesn't. Consequently, if the stock price suffers, management only gets hurt to the degree that they forgo an opportunity. Investors are hurt all the way down. Finally, if the share price should suffer, and options are indeed "repriced," as is often the case, what do equity holders get? Do they receive a discount on their purchase price after the fact? Do they get some kind of rebate on new shares? The answer, of course, is no.

Overall, investors should just say "yes" to a reading of the 1998 Berkshire Hathaway Letter to Shareholders. As usual, it lives up to the billing.

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