TCS Daily


Unhatched Chickens

By Stephen W. Stanton - August 7, 2003 12:00 AM

Securities and Exchange Commission chief William Donaldson recently put his clout against the President who appointed him and behind the burgeoning movement to require expensing of stock options. At a recent speech he gave in Washington, Donaldson was asked, "The president believes that options are not an expense, is he right or wrong?" Donaldson replied "Well I haven't exactly heard him say that." Donaldson went on to say that "It's clear to me that there is an expense associated with stock options ... we've got to reflect that value in the profit-and-loss statement."

 

Donaldson should check in with the White House. The Wall Street Journal reported in April of 2002 that "President Bush himself said stock options shouldn't be treated as a corporate expense."

 

And the President's view is understandable, since it's not at all clear that options should be treated as an expense. There is no question that options have value.  It's just that nobody really knows exactly what that value is. 

 

The basic argument in favor of calculating and reporting stock options as an expense says that people are willing to forego some cash compensation in exchange for stock options and that the options granted to each employee have a total value roughly equal to the amount of cash that the employee is willing to forego. If a company does not reveal the value of options-based compensation, only the cash portion of compensation expenses will be reflected on the income statement.  Operating earnings may appear artificially inflated because real expenses are missing. As such, investors need (and deserve) to know the true expenses of the company to make informed decisions about a company's future cash flows and, by extension, fair market value. 

 

That sounds sensible enough at first glance, but this argument is overwhelmed by the opposing case. There are several practical reasons expensing stock options is a bad idea.

 

First of all, the number of slices has nothing to do with the size of the pie.  Stock options never affect operating earnings directly.  They merely create the potential that future earnings will be split into more slices.  Options affect shareholders' equity, not profits.  Indeed, that is exactly how options have been reported for years.  So expensing options is a lie, basically.  It is merely an attempt to ignore the new slices and depict a smaller pie shared among the pre-option crowd.

 

It's important to remember that accountants are not nannies.  They cannot protect investors from foolhardy investing decisions and we shouldn't encourage investors to believe that accountants can do their homework for them.  They already provide the raw data regarding stock options.  In fact, the summarizing all of this data into a single number will actually reduce transparency, the opposite of what expensing advocates claim they want to happen.  Investors must be able to crunch the numbers applying their own assumptions.  All the information they need is in the notes have long been an integral part of the financial statements. And if you are not sure how to value a company's outstanding stock options, you should probably ignore financial statements and skip investing in specific companies altogether.  Buy a broadly diversified, low cost index fund.

 

Besides, there are other demons lurking in the footnotes.  For example, a company may sell put warrants in its own stock, giving away even more shareholder money when the stock price collapses and accelerating the decline.  It is unwieldy, if even possible, to capture all of these risks on the face of the basic financial statements.  That is why financials have notes in the first place.  Just as you should check the fine print before taking a new prescription drug or leasing a car, same with buying a stock.  And investors know this.

 

Any price given to restricted stock options will be precisely wrong.  Any numerical value assigned to non-cash expenditures necessarily involves a high degree of subjectivity and arbitrariness.  It is true of depreciation and amortization, as well as thornier issues of revenue recognition and in-kind swap arrangements.  Could your parents predict your adult height and weight when you were five years old?  Better example:  Can you predict your exact date of death?  (If so, why do you have insurance now?) 

 

Lastly, there will always be a need for "buy side research", the industry term for "buyer beware".  This goes beyond the obvious problem of the fox guarding the chicken coop.  There is no point in stock picking unless the buyer believes he or she has unique insight about a firm's prospects.  Will Microsoft, now trading for just about $26 per share, more than quadruple in value over the next 4.2 years?  The popular Black-Scholes formula computes a value for this possibility based on past stock price movements.  You may disagree with it.  But the Financial Accounting Standards Board wants that number (or one like it) in the financials. 

 

Equity markets went through the roof in the 90's.  When stock prices advanced faster than expected, option holders gained a larger share of corporate wealth than shareholders expected.  They sold their shares, sometimes they bought a pro basketball team or two, and left other investors holding the bag when the markets fell back to earth.

 

Now the angry mob wants to see heads roll.  They may be willing to settle for a rule change.  They are told expensing options is a quick fix, a proverbial nicotine patch that will ease companies out of their addiction to options. They complain that hiding expenses in the footnotes encourages executives to give away options too freely.  But to them we should say "When was the last time you voted your shares?"  Each share of stock gives its holder one vote in the company.  Simply vote them out if they are giving themselves too many options. 

 

Counting chickens before they are hatched is usually a bad idea.  That is precisely what stock options expensing is: The mandatory counting of unhatched financial chickens.  The President understands that.  Let's hope his head of the SEC understands that, too.

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