TCS Daily

Needed: The Atkins Diet

By James K. Glassman - January 9, 2004 12:00 AM

Paul Atkins yesterday became the first SEC commissioner to criticize openly a proposal to require companies to treat employee stock options as current expenses.

Atkins began by questioning whether the Financial Accounting Standards Board, which has aggressively pushed the change, is truly seeking to address a serious accounting problem.

"Is there a significant investor outrage or concern out there about this issue? Are there cadres of investors who are clamoring that they don't understand the footnotes disclosure regarding the effect of options on a company? And is there a fear that the current disclosure method provides unclear or unreliable information about the dilutive nature of options?"

Without saying so explicitly, Atkins clearly implied that the answer to these questions was almost certainly "no."

He later said, "Much of my comments here require a look back at the original threshold question. That is, what is the problem that people are trying to solve? And does the FASB direction fix the problem? I'm not sure that the presented fix doesn't create more problems."

Atkins's remarks came at a conference at the American Enterprise Institute, where two economic papers were delivered attacking the proposal, now under consideration by the Financial Accounting Standards Board (FASB).

Atkins used strong language to express his fears that FASB's intentions were not strictly related to its mandate of improving accounting standards. Instead, he said he worried that "FASB is basically getting into an area that's more of a political issue." The commissioner stopped short of opposing the FASB proposal, but he sent a clear message that he had deep concerns about it.

The theme of the conference was summed up in the first of the papers, which concluded that "the establishment of new accounting rules for expensing options would likely do more harm than good." That paper was authored by Charles Calomiris, Henry Kaufman Professor of Financial Institutions at Columbia University, and Glenn Hubbard, another Columbia economist who, until last year, served as chairman of President Bush's Council of Economic Advisors.

Calomiris, in fact, said he saw no benefits at all from the FASB proposal, but many dangers, including the strong possibility that investors would be misled about the value of options. In commenting on the paper, Deen Kemsley, a Columbia accounting professor, said that the new FASB rules would make it easier for unscrupulous corporate executives to manipulate financial statements.

The other paper -- by Kevin Hassett, director of economic policy studies at AEI, and Peter Wallison, an AEI fellow who formerly served as general counsel to the Treasury Department --raised serious concerns about the proposal -- both economic and legal.

All the economists who spoke at the conference agreed that the current system for options accounting, which allows discussion in footnotes as an alternative to immediate expensing, provides investors with the information they need to make informed decisions.

But the comments of Atkins drew the most attention. Speaking only for himself and not for the commission, which holds sway over FASB but does not write accounting rules, Atkins said, "My own fear about where this is going is that FASB is basically getting into an area that's more of a political issue than a technical or accounting issue. My fear is that the pressure on this issue is meant to address a corporate governance failure on the part of the board than to rein executive compensation."

He continued, "One thing that I am certain that FASB should not be in the business of dictating what type of compensation should be paid by corporations to their employees."

Advocates of the current system, put in place in 1972 after FASB's predecessor concluded that "stock options could not be reliably valued," have contended that politicians and others who are pushing for mandatory expensing are mainly concerned -- not with accounting accuracy -- but with changing the behavior of corporate management.

For example, in today's New York Times, columnist Paul Krugman, a crusader for options expensing, writes, "It's now clear that options were a big motivator for corporate fraud.... Has Congress moved to require that issuing them be counted against profits? No."

In fact, FASB, which, unlike Congress, directly writes the accounting rules, is moving very quickly -- and opposition to expensing comes not merely from the Republican Senate and House but from leading Democrats, including Gov. Howard Dean, the frontrunner in the race for his party's presidential nomination.

Still, FASB has made headway, in part because the Bush Administration has been strangely silent. The AEI conference indicated that the tide may be turning. Atkins and others at the conference sent the board a clear signal to slow down. Wallison, for instance, said that FASB should defer requiring the expensing of stock options "until a workable model is found."

It is unlikely that one will. In their paper, Hassett and Wallison showed that different options-valuation methods might be appropriate for different stocks but that a single method will not work for all stocks. The most widely used method, Black-Scholes, was not meant to be applied to broad-based stock-option plans, and several of the panelists displayed its glaring deficiencies.

"Does it make sense," asked Wallison, "to require the expensing of employee stock options when no one knows how to do it?" Wallison said that the advocates of expensing -- in Congress, FASB and the SEC -- seem to live in a "parallel universe." He said, "This is an inside-the-Beltway issue. It deals with a meta-reality."

Atkins also took issue with systems for valuing options. "I have yet to meet anybody who suggests Black-Scholes is a good, or even fairly good, indicator of the value of long-term compensation options," he said. Atkins also criticized the "binominal method," a close alternative to Black-Scholes.

"Accounting professionals and FASB readily acknowledge," he said, "that both of these methods are not perfect and frankly are far from it. But they argue that since options are clearly an expense, putting some value for them in [financial] statements is better than putting no value for them at all.

"So my question is, 'Should we say that our ultimate guiding principle and that of FASB's Generally Accepted Accounting Principles is that close enough is good enough for government -- or accounting -- work.

"As Peter [Wallison] and Kevin [Hassett] point out in their paper, there are many benefits that employees receive from their employers that are not expensed on income statements largely because we cannot value them appropriately. And stock options, I think in some cases, fall into this category."

Besides trying to improve corporate governance, which is beyond its mandate, FASB may have another reason for pushing for options expensing, said Atkins.

"I also fear that this change is coming about not simply to improve accountability or to provide more reliable financial information to investors" but instead, he said, as "part of a basic horse trade" in order to bring U.S. accounting standards in line with those of Europe.


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