TCS Daily


An Un-Warren-ted Outburst

By James K. Glassman - July 6, 2004 12:00 AM

A strikingly mean-spirited piece by Warren Buffett appears on the op-ed page of the Washington Post today, arguing, mainly through hyperbole and innuendo, in favor of the expensing of stock options.
If it gets its way, the Financial Accounting Standards Board, an unelected group of accountants, based in Norwalk, Conn., will soon impose new rules that mandate companies to write off broad-based employee stock options as expenses as soon as they are issued -- even though there is no accurate way to determine the value of those options. (In many cases in the past few years, the value has been zero.)

If FASB succeeds, most of America's leading high-tech companies will abandon options as a form of compensation for employees below the very top rung. The result, many economists believe, will be a decline in U.S. competitiveness -- since options are highly effective at attracting managers and other employees who are willing to take big risks for big rewards.

The House of Representatives will vote shortly on a bill that restricts FASB's ability to wreak havoc with the U.S. economy in this matter. Buffett, in his astonishing screed this morning, contends that Congress wants to make itself the "Supreme Accounting Authority." Not at all. But Congress has responsibilities that FASB does not have.

Few have explained the justification for congressional intervention in the options issue better than Sen. John Kerry (D-Mass). In a speech on the floor of the Senate he reflected the opinion of many economists, saying that the FASB proposal, "by its nature...introduces uncertainty into the financial reporting process.... Thus, it is not clear to me what the investing public gains from the FASB rule."

Second, Kerry argued persuasively that the measure would adversely affect companies and their workers, especially "smaller companies that are creating new jobs in states like my own."

Kerry made that speech in 1991 and has since, as is his wont, changed his mind. But the FASB proposal, which failed 13 years ago but may succeed in today's post-Enron environment, is the same.

It tries to put a number on something -- the value of stock options issued far in advance of their exercise date to employees who may leave in the meantime -- that is inherently unquantifiable.

This is a real problem, but Buffett, in his op-ed piece, takes a cavalier attitude toward it. "Some people," he writes, "contend that options cannot be precisely valued. So what? Estimates pervade accounting." True, but there are ways to solve the options conundrum without insisting upon a single, erroneous number and hurting the U.S. economy in the process.

Indeed, up until now, FASB and its predecessor took a wise course. They gave companies a choice: expense right now if you wish or show the effect on earnings per share if options that are currently above water (that is, have an exercise price that's below the current market price) are turned into stock. Also, reveal practically every nuance of their issued options in extensive footnotes to their financial statements. Most businesses have taken the alternative of showing dilution and printing long explanations in the footnotes.

Using this information, analysts and investors are currently able to assess the value of the options well enough to price stocks. Reducing all the data to a single number won't help. It will hurt.

Certainly, however, this is a debatable proposition, and it would benefit from a sensible discussion on at least a moderately high intellectual plane.

Unfortunately, Warren Buffett, the greatest investor of the second half of the 20th Century, chooses in the Washington Post -- a newspaper of which his company, Berkshire Hathaway, is the largest public shareholder -- to play an entirely different game. He ridicules his opponents rather than engaging their arguments.

He starts off with the old story about how the Indiana House of Representatives in 1897 nearly legislated a new value for pi -- the ratio of the circumference of a circle to its diameter -- at 3 or 4 or some such. You can read about this tale, if you haven't heard it already at StraightDope.com.

Buffett argues that, until now, the Indiana House had set "the record for mathematical lunacy by a legislative body," but, if it passes the bill limiting FASB, then the record will "move east from Indiana" to the U.S. House.

A lengthy conceit, and what's its point?

Buffett is incensed that only options granted to the top five corporate officers be expensed. This is mathematically loony, he says, as is the more technical provision that, in calculating the value of options, their volatility be set at zero.

Buffett is simply being disingenuous. He must know very well that the reason for expensing only the top five officers is that the bill, sponsored by the chairman of a key House subcommittee, Rep. Richard Baker (R-La), is a compromise. Many House members, economists and other observers (me, included) believe that the current regime for treating options under Generally Accepted Accounting Principles is the best that can be achieved and ought to be left alone. As Kerry pointed out in 1991, the benefits are dubious and the potential costs are gigantic.

Unfortunately, many politicians want to make a change because, in the wake of corporate scandals -- and pressure from Buffett and others -- they worry their constituents think that executives make too much money and somehow hide it (even though compensation is reported each year in proxy statements and, thus, in newspapers and magazines). The Baker bill recognizes this political concern and so requires expensing only for the top five.

I agree with Buffett that the logic of expensing options only for the top five is faulty. But, as Buffett put it, "So what?" Compromises are often necessary; I wish they weren't in this case, but they are.

More significant, Buffett's piece does not address the thorny issue at hand -- which is not Congress's right to intervene or the inconsistency of just expensing options for high-up executives or not counting excess volatility in calculations. The thorny issue is what to do with a contingent cost that can't be quantified with accuracy. Provide lots of information, or reduce it to an inaccurate number.

My view, as readers of this website certainly know by now, is that "lots of information" is the answer. Buffett opts for the inaccurate number. Why? "So what?" is not a good answer. Nor is ridiculing the national legislature, which is trying to grapple with a difficult problem and has, in fact, come up with a darn good solution.


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