TCS Daily

Overcooking the Books

By Joshua Livestro - December 18, 2003 12:00 AM

Until recently the world of accounting was to most people as 1939 Russia was to Winston Churchill: "a riddle wrapped in mystery inside an enigma." All that changed in November 2001 with the breaking of the Enron scandal. Suddenly, the accounting profession was front-page news everywhere. In Brussels and Washington, Sarbanes-Oxley became the talk of the town. Complete accounting illiterates found themselves discussing the relative merits of US GAAP and IAS. And even the guy on the 34 bus could tell you that it was vital for auditing and consultancy services to be strictly separated.

This brief but intense period of public scrutiny was followed by a flurry of legislative activity by the two main bodies responsible for regulating the accounting profession, the International Accounting Standards Board (IASB) in London and the Financial Accounting Standards Board (FASB) in the US. Among the proposals currently being discussed by both bodies is an idea that was rejected by the US Congress in the early 1990s: compulsory expensing of employee share option schemes. In its board meeting later this week, the IASB will conclude a six-month review of the issue. All the signs are the Board is ready to take the decision to move towards mandatory expensing. This would require all companies to include an estimate of the costs of their employee share option schemes as an expense in their annual income statements. It would also cut off the alternative route, currently used by most firms, of including information about these schemes in the footnotes to their annual accounts.


Supporters of expensing usually present two arguments in favor of making it mandatory. The first is a technical one, based on the presumption that share options are an integral part of the wage costs of a company. The inclusion of a figure for these costs in the annual accounts, the argument continues, would be a move in the direction of producing a more realistic annual earnings figure. Supporters of this argument claim that this would help to make the accounts more transparent and more reliable, which, if true, would benefit shareholders.


Cynics might argue that it is difficult to see how merely transporting certain data from the footnotes to the income statement itself could be interpreted as a radical improvement of a document's transparency. A more fundamental technical objection to expensing is that the standard Black-Scholes options pricing model -- named after the 1997 Nobel Prize winner in economics Myron Scholes and his colleague Fisher Black -- doesn't work with employee share options schemes. And so far, nobody has been able to produce an acceptable alternative. Boosting investor confidence is certainly important. But it is doubtful whether expensing would actually achieve that. It would do little to make income statements more transparent. And unless the experts manage to solve the calculation conundrum, it would almost certainly make those statements not more but less reliable.


The second argument in favor of expensing is basically an argument against share option schemes for executives. Echoing the technical argument, opponents argue that such schemes hide true boardroom wage costs. Beyond that they argue that such schemes actually offer an incentive to executive officers to boost the value of their options artificially by manipulating their company's earnings figures. As the Enron case made clear, this is not just a hypothetical scenario. But mandatory expensing would have made little difference in that particular case. The problem wasn't in the rules but in the people applying those rules, not least the accountants who helped to hide the abusive practices in the Enron boardroom.


It is correct, however, to assume that expensing would have resulted in lower earnings figures in the case of Enron. In fact, mandatory expensing would lead to considerably lower earnings figures for all companies that run such schemes. A 2002 report by Merrill Lynch showed that in 2001 mandatory expensing would have lowered average profits for 30 major companies in the microchip industry by as much as 70 percent. Most large companies would struggle to explain to their investors that this artificial adjustment of their earnings figures doesn't really reflect the underlying strength of their operations. But for small high tech companies that usually run budgets on a wing and a prayer, expensing would be a mortal blow. In the tug of war for the best young graduates, these companies simply cannot compete on salary or working conditions. What they do offer, however, is an outside chance of striking it rich through share options if the company makes a successful entry into the stock market. The introduction of expensing would almost certainly mean these companies would no longer be able to operate such stock option schemes. Without the ability to attract the right staff, the microchip miracles of the Silicon Valleys of this world would quickly turn back into the sandy dust of which they were made.


The man in charge of deciding whether Europe should follow the IASB in adopting expensing is European Commissioner Frits Bolkestein. One of his favorite sayings is that there are many problems worth political discussion but few problems worth political action. As most around him are losing their heads in the post-Enron frenzy, we can only hope he will remember this basic truth. There may be many problems with boardroom culture and accounting practice. But whatever these problems may be, introducing mandatory expensing certainly isn't the answer.

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