Option payments are costs: Bush et al undermine capitalism as they aid PAC donors

Great Debates
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Originally posted by Flowbark in the OP: *Recent accounting scandals reveal a very bright line between those politicians who serve the public trust and those who serve corporate managers cum PAC donors. *

Such unambiguous and uncontroversial litmus tests applying to large numbers of politicians are fairly rare in US politics, and I was delighted when I thought that I had found one.

I recognized that I used strong language in the OP. After reading Manhattan’s killer post, I am bummed to concede that my position did not appear to be justified: there appear to be defensible objections to the Levin amendment. Those objections are misguided, IMHO, but they are there. Rats, drats and double-drats. (Defensible objection: signaling the FASB to set rules on expensing stock option compensation might encourage them to lock the US into an expensing method with unintended and perverse consequences.)

Nonetheless, I look forward to additional discussion on whether stock options should be expensed. It is, IMHO, a great (though rather technical) debate.

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First, let me propose a couple of principles:

  1. Accounting transparency not only demands full disclosure, it must also allow for comparisons between the firm and industry as well as between the firm and the market average. So placing an accounting category that amounts to 2 and 1/2 percent of total profits in a footnote is inadequate. Yet that is the current treatment of stock option compensation.

  2. Expenses should be recorded for the period for which they are accrued. In other words, if somebody works for you in the year 2000, and you agree to pay her in the year 2001, you should expense the cost in the previous year (2000). This rules out Manny’s #4, “Value the options at exercise, not granting.”

Revaluation: Problem or no problem?

Now, Manny said, *Imagine a company having a credit to earnings because their stock fell 90% last year and all of last year’s options are now worth a lot less! *

Um, if you agree to pay out $10 if the stock goes up and $0 if the stock goes down, it seems to me that your liability has fallen when the stock drops. So I don’t see a problem with your scenario. It seems appropriate to revalue your liabilities periodically. If those liabilities vary negatively with the stock price, so what? [1]

Admittedly, I’m currently a little fuzzy on the relationship between the income statement and the balance sheet. Also, I would like to inquire:

Are outstanding stock options currently put in the balance sheet, as msmith implied?

Manny on the Black-Sholes scenario: There are various tweaks to the formula that different compensation consultants use, but there’s no consensus which means you could shop consultants to get the results you want.

A rule that allows shopping would violate Flowbark’s principle of comparability.

I suppose the FASB could mandate a method, but I’m not sure you solve much by doing that. Also, the valuation would not be useful for comparisons between companies, because the input varies so much from firm to firm. And of course there is the whole re-valuation problem above. Not to mention that it takes a PhD to understand it.

Let’s assume that the FASB mandates a non-optimal method. As long as the methodology is standardized, that would allow for valid cross-firm comparisons, right? Or not right?

I addressed the re-valuation problem, above: I don’t see it as a problem. At least not yet.

PhD: Hey, it “creates jobs”. :wink:

More naive questions for Manhattan: Stripping out a well-defined line item is pretty straightforward, right? And there’s something called a cash flow statement, ya? So the creditors should be groovy with the SEC Black-Sholes scenario, ya? (Or nah?)

I could go on, but I think I’ve written enough for now. I should stress that I am not saying the Black-Sholes scenario is best, merely that it is superior to the current system.

[1] I recognize that this is a peculiar liability in that it is a demand for equity rather than cash.

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Sorry I let this drop. But let’s be honest – if you had to do this kind of crap for a living, would you want to do it on the weekends, too? :wink:

OK. Answers to questions:

What’s the harm in revaluing? If a company does it just right, nothing is really wrong with it. But two things to keep in mind. By introducing estimates, it just creates an opportunity for companies to monkey with earnings. You’d be surprised how many companies “made their numbers” last year simply by boosting the expected return on their pension funds. Again, I don’t like estimates except when absolutely necessary. The second thing is that you’re introducing a line item that doesn’t really reflect the economics of the business, which is what you were trying to fix by expensing options in the first place. In the particular instance, things might get just perverse – a company’s “earnings” might go up because real earnings went down, sending the stock into a swoon.
Are outstanding stock options currently put in the balance sheet? Oh, geez. I’m afraid that I don’t have a better answer for you than “most times.”

So the creditors should be groovy with the SEC Black-Sholes scenario, ya? Well, maybe. Again, this is an area fraught with estimates. It should be pretty easy to find the pension monkeying-around in the cash-flow statement or the footnotes, but it’s often not. Yeah, a pro can do it (but not like it), but if it’s not helpful to the average investor, what is really gained?

I think the way this movie ends is that options will be expensed somehow, and that it will be in a pretty simple way that will work for a few years until the re-valuation issue gets big enough for someone to squawk about (companies won’t initially be allowed to do it, they’ll be the squawkers here).

But I think it’s a mistake for Congress to get involved in the process.

BTW, Here’s a neat article by executive compensation gadfly Graef Crystal on Coke’s program (which uses a method I hadn’t thought of) and which talks about some of the problems raised in this thread.

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Oh, and here’s another article by Crystal where he agrees that Congress isn’t equipped to have a horse in this race.

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Manny:

I Kind of think an issuer should expense its own options.

I don’t see why they shouldn’t be forced to treat it just like the expense of purchasing a piece of capital equiptment. They should need to create surety to meet their potential obligation and they should certainly be allowed to finance and depreciate it just like they would a truck.

They create surety to meet the obligation which is an asset, and then they depreciate it. That surety could be stock or an option, or what have you as long as it meets the present obligation.

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manhattan Thanks for having a look at my thoughts.

Broad Points
There are multiple ways of reflecting stock option compensation in profits, all of which are superior to the status quo. IMHO of course.

Since all methods are problematic, regulatory flexibility is crucial (I’m defining the FASB as regulators in this context).

Congress is already involved. If they do nothing, that would send a signal, just as saying, “Figure something out Mr. FASB” would send a signal.
It’s possible that at the end of the day, stock option compensation will decline in favor of cash or stock grants.

For another thread perhaps: existing stock option compensation schemes are not designed to promote managerial efficiency; they are designed to satisfy managerial avarice. Source: Bebchuk et al “Managerial Power and Rent Extraction in the Design of Executive Compensation”. Available at http://www.law.harvard.edu/programs/olin_center/papers/366_bebchuk.htm . Summarized in The Economist a couple of weeks ago.

Tangent
Here’s another approach. Require each firm to publish, in addition to its number of shares outstanding and shares that it’s permitted to issue:

  1. Number of shares outstanding, including all options granted,
  2. ditto, including options currently “in the money”. (published quarterly)
  3. ditto, including options that satisfy certain FASB standardized criteria (eg. options that will be in the money if the stock price grows at 8% or whatever, as specified by the FASB.)

That way, issuing a stock option would not affect earnings: instead, it would affect a comparable metric of earnings per share.

Happy creditors. Happy stock analysts. Maybe.

Complications
There are many.

Broadly speaking, there is the risk that Congress will lock us into a framework that proves problematic.

But there is another problem that Manny’s second link did not address. That concerns a market failure peculiar to US equity-driven capitalism. There exists insufficient incentive for owner-oversight when the transactions costs of selling one’s share are low and the bulk of the benefits of individual oversight accrue to others.

For this reason, corporate governance is and will remain a joke. Let me make a prediction. Today, many huge firms permit the Chief Executive to lead the Board of Directors. This is hilarious: they don’t even try to create the appearance of independent oversight. My prediction is that the situation will be qualitatively the same in 5 years, notwithstanding today’s jawboning.

THEREFORE, depending upon institutional shareholders or the various Boards of Directors to get us out of this mess is a fantasy. The effort must come from big government, either directly through Congress or indirectly through the FASB. Blemishes of the latter institutions notwithstanding.

Those wishing to fix the market failure directly are directed to Plan 9 from the OP in this thread.

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Here are some random thoughts

  1. Thank you posters, for all your intelligent insight on this question.

  2. I tend to think that stock options should be shown as costs, but I do not consider the failure to do so to be a cause of the current market meltdown. It’s not an Enron-like finagling.

  3. Like others, I do think there should be at least fully detailed disclosure, which would permit investors to properly reflect options in their analyses.

  4. There are other types of stock dilution. Should they be shown as costs as well?

  5. Since the company does not get a tax deduction for issuing stock options, CEOs will scream at reflecting them in their P/L. (We saw a similar debate over discounting liability insurance losses, a few years ago.)

  6. No doubt FASB could choose some valuation formula. Black-Scholes will give a value, although quite a range is possible, depending on which assumtions are used. A cow-orker did that that calculation for my 10-year options. One problem with with his calcualtion is that it assumed the entire 10 years would be potentially available. However, when an employee leaves the company, the options must be exercised. It’s hard to factor in the uncertainty of the employee leaving, paticularly since that event and the stock price may be dependent variables. Still, with enough assumptions, it could be done.

  7. I would prefer to see this matter handled by FASB or the SEC. I do not want Congress to muddle up technical matters in this area (nor in other technical areas, such as medicine, education, etc.)

  8. In general I think stock options are good for the economy. They help turn workers into owners, which tends to improve company performance. I do not want to see options discouraged.

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Where to begin?

  1. Alan Greenspan and Warren Buffet both have some experience with these issues and both advocate this reform. Sentence #1 is simply false.

  2. Full disclosure is of course important. But so is providing company accounts that are comparable across firms and can be summed up to form industry and market measures.

  3. There is TONS of opposition to this reform, as noted in this thread. It appears that executives believe that a more transparent presentation of the accounts would hurt the stock price and their paychecks. (Source: the Economist). Indeed, this demonstrates that industry believes that restating their accounts may hurt their stock price, which in turn indicates that misleading accounting affects resource allocation.

  4. Most investment money is either institutional or associated with the top 1% income group. I am puzzled by the suggestion that “investor education” is the proper response to this policy challenge.