The Great Stock Options Battle

Not that you'd know it from the headlines, but the great battle for stock option accounting is under way.

While we're worrying about whether or not mutual fund companies stole from shareholders, the opening salvos of Option War II have been fired. By the time we're done, the level of rhetoric is sure to be nothing short of phenomenal. So let's get this straight: Employee stock options are neither the greatest thing ever invented nor the tools of Beelzebub. Accounting for stock options is not going to destroy life in America as we know it. Companies will not collapse due to the need to expense stock options.

Here we go again
If Congress gets out of the way and allows the Financial Accounting Standards Board (FASB) to do its job of making the standards of accounting, the FASB intends to release an exposure draft in February stating that every American company will be required to show an expense for employee stock options in 2005. By so doing, the FASB will close a historical loophole that treats one form of compensation differently than any other.

A decade ago, Congress, led by Sen. Joe Lieberman of Connecticut, threatened to pull official recognition of the FASB if it tried to push through a requirement to expense. The FASB blinked, and company usage of stock options took off like a shot. We're back to that point again.

The scandals and declining quality of corporate accounting, the public's tiring of the compensation executives receive regardless of company performance have emboldened the FASB to join the fracas once again.

You're going to see gross pieces of stupidity, such as Calif. Sen. Barbara Boxer's statement that "we can't stand by and let accountants wearing green eye-shades decide who is going to get the American Dream." If this sounds like a talking point spoon-fed by a lobbying group, consider this component of a letter-writing campaign sponsored by the American Electronics Association (AeA), a major high-tech lobbying group:

AeA has concluded that, if companies are forced to expense options, current stock option plans will be severely reduced or completely eliminated for rank and file workers.

You know why AeA can make such a claim? Because its member companies, which include such tech behemoths as Cisco (Nasdaq: CSCO  ) , Intel (Nasdaq: INTC  ) , Apple (Nasdaq: AAPL  ) , and Applied Materials (Nasdaq: AMAT  ) , have overwhelmingly told it that's what they would do. So you end up with a strange, vaguely menacing quote by Boxer that is completely unresponsive to the actual issue. Imagine this conversation:

FASB: We'd like to expense stock options.

AeA: Well, if you do that, we're going to take them away from rank-and-file employees.

FASB: We have nothing to do with that. We don't make outcome-based decisions. Unexpensed stock options are mistreated from an accounting perspective, and we'd like to improve the accounting.

AeA: It will cost us billions of dollars!

FASB: No, it won't. Expensing changes how companies report their earnings, but from an economic perspective, it changes nothing.

AeA: We won't be able to attract employees anymore!

FASB: We're not taking stock options away; we're requiring that they be expensed. You can attract them exactly as you do now.

AeA: But the costs are not knowable!

FASB: Estimation methodologies are used in nearly every single account in GAAP. We are running a test program to determine the cost of collecting the data with Coca-Cola (NYSE: KO  ) , ExxonMobil (NYSE: XOM  ) , CVS (NYSE: CVS  ) , and Yahoo (Nasdaq: YHOO  ) . Siebel Systems (Nasdaq: SEBL  ) and Lockheed Martin (NYSE: LMT  ) have expressed interest in taking part as well.

AeA: Siebel?!? That's one of ours!

FASB: Don't worry, they're still opposed to expensing.

AeA: Whew. We've lost a few. Don't know what they put in the water up in Seattle.

FASB: You mean Microsoft (Nasdaq: MSFT  ) and Amazon.com (Nasdaq: AMZN  ) ? Glad to have 'em. Amazon's expensing, Microsoft's gone a different route with restricted stock. In both cases, they're adhering with what are already considered accounting best practices.

AeA: They're taking away options! We told you that's what would happen!

FASB: Again, that has nothing to do with us. Microsoft decided to switch because it had so many underwater options that employee morale was declining. They're still granting equity to employees.

Boxer: See? The green eyeshade folks want to take away your dream!

There is nothing at all in the FASB proposals calling for limiting the use of stock options. Companies have the ability to continue to issue options, just as they can use a number of other ways to create stock ownership among employees, including restricted stocks and employee stock purchase plans.

So, while Barbara Boxer and the AeA attempt to scare high-tech workers into thinking that the boogeyman is going to come and take away their piece of the pie, the argument is really much simpler than that: Stock options are compensation. Compensation is an expense. There is a component of employee stock options that is paid in lieu of cash. Income statements should reflect what this non-cash compensation is. (See EPS: A Dangerous Fiction.)

It's not rocket science
This theory is not complicated. Let's take lottery tickets as a rough approximation. Each lottery ticket has a cost associated with it, usually $1. It also has an expected payout, which varies on a state-to-state basis, but averages about 52%. In other words, before the numbers are announced, every single lottery ticket in existence has an expected value of $0.52. It doesn't matter what the numbers are a day later, whether you're holding a Big 6 winner or a dud, or even if you win but fail to claim your prize -- the moment you've plopped your money down, that ticket is worth $0.52. What's your "expense" for each lottery ticket? $0.48.

Options work essentially the same way. On the day they are granted, they have an expected value. Whether they end up out of the money a decade later doesn't change what the expected value is on issue, nor would it matter if the stock goes up so much that they are worth substantially more. Those issues can be modeled, but they are not knowable, making them consistent with dozens of other components of an accounting statement. The FASB has proposed using a binomial model, which they believe will fix some of the limitations of the Black-Scholes option pricing model, the most prevalent model in use today.

Fed Chairman Alan Greenspan summed up the debate this way:

Some have argued against option expensing on the grounds that... the prevailing means of estimating option expense, is approximate. It is. But... so is a good deal of all other earnings estimation. Moreover, every corporation already implicitly reports an estimate of option expense on its income statement. That number for most companies, of course, is exactly zero. Are option grants truly without value?

The Senate holds hearings today to discuss a bill that would once again place political limitations on the FASB's ability to make decisions on what constitutes good accounting. AeA and other well-heeled lobbying groups have already spent enormous sums pressing their cases on why this is a disaster for American entrepreneurial spirit -- as is their right to do. While I find their arguments bankrupt and their attitude decidedly anti-shareholder, they've got the kind of currency that counts in the halls of Washington: big dollars.

In their recent book Financial Reckoning Day, Bill Bonner and Addison Wiggin describe the rise and collapse of the Mississippi scheme mania in 18th century France. John Law's sponsor, Phillip II, regent of France, watched as his paper currency and stock issuance scheme seemed to erase France's debts in a matter of a few months. Bonner and Wiggin write:

Using the flawless logic of politicians throughout the ages, Phillip II must have thought: People have gained confidence in the banknotes; the notes appear to have provided a convenient way for the government to borrow... the paper money both traded at a premium and appeared to be reviving France's stalled economy. Why not print more?

The "why not," of course, is this: Dilution kills. And when the value is not measured, there is nothing stopping massive dilution. When I read that passage, I immediately thought of Brocade (Nasdaq: BRCD  ) and its 19% dilution of investors in one calendar year from options. And Cisco.

Many investors in these and many other companies with enormous options programs are oblivious to the risk of their stocks underperforming due to massive options overhangs, because it's not measured in the income statement. What's measured is monitored. Since options expensing will show investors a truer measure of what it costs to maintain a company's employee base, it's something that should be done sooner rather than later.

If expensing stops certain companies from issuing excessive amounts of options, more's the better. If companies follow through on their threat to cease encouraging equity ownership by their rank and file, then the shame is theirs.

Congress wants to hear from you
Our elected officials tell me over and over when we discuss this issue that they hear from the lobbying groups almost daily, but they almost never hear from individual investors. Please take a minute to go to Congress.org and write your representatives to tell them to let the FASB do its work. Heck, if you disagree with me, write 'em anyway. It's good practice. And come let us know what you think on the Fool News & Commentary discussion board (free trial required).

You're going to hear a great deal of Sturm und Drang over options expensing over the next few months. Don't believe it. The issue is quite simple, and expensing is the right thing to do.

Fool on!
Bill Mann, TMFOtter on the Fool Discussion boards

Welcome to the world, Nikhil Ketan Trivedi. Bill Mann owns none of the companies mentioned in this story. He appreciates feedback at billm@fool.com. The Motley Fool is investors writing for other investors.


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