TCS Daily


Europeans May Outfox U.S. on Options

By James K. Glassman - October 14, 2004 12:00 AM

The group that sets U.S. accounting rules decided yesterday to delay for six months its plan to force companies to treat stock option grants as immediate expenses.

But supporters of a thriving high technology sector should not get their hopes up. The Financial Accounting Standards Board (FASB), at the same time, emphasized that it was not backing down in its crusade for options expensing, and it rejected a compromise plan offered by Qualcomm, Cisco Systems and Genentech.

"FASB's decisions," said Rick White, who heads the International Employee Stock Options Coalition, "amount to nothing more than a postponement of a fundamentally flawed expensing standard that will grossly overstate the value of employee stock options." He's right.

But by contrast, earlier this month, the European group that is considering similar changes decided to adopt a far more reasonable, research-oriented approach to options expensing.

It appears that the Europeans, who often choose rigid regulation over market solutions, may adopt more flexible accounting standards that will encourage the use of options. At the very least, the Europeans are raising the right questions and aren't rushing to judgment, as FASB has.

One reason is obvious: A less doctrinaire position on options will give the Europe a major competitive advantage in high tech over the United States. That's something for us to worry about.

It's true that yesterday's decision by FASB, an unelected board headquartered in Norwalk, Conn., could give the Senate time to stop the dangerous expensing measure. The House voted in July, 312-111, to block the FASB move. In recent weeks, 53 Senators have taken a similar position, but the measure is being held up by one powerful Senator, Richard Shelby (R-Ala).

There's no doubt that Congress has a legitimate role here. It has responsibility for the economy as a whole. FASB does not.

In its decision yesterday, FASB agreed that, instead of requiring expensing to begin in the first quarter of 2005, the date would be pushed back to the third quarter. The delay had been advocated by the Securities and Exchange Commission, which has its own raft of accounting revisions to enact - required by the Sarbanes Oxley law. The SEC isn't objecting to what FASB is trying to do. Instead, the commission didn't want companies to be burdened with too many regulatory changes all at once.

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Bill Donaldson, chairman of the SEC, which has jurisdiction over FASB, supports expensing and has urged Congress not to intervene. It's another case of Donaldson's taking positions at odds with those of free-market advocates.

Donaldson, appointed by President Bush, has been under criticism from conservatives for frequently siding with the two Democrats on the commission against the two Republicans, has come under criticism from conservatives.

In his only pronouncement on the subject, Bush supported the current options rules, not the expensing change FASB wants. His Democratic opponent, John Kerry, has switched his position on the issue.

In a speech on the floor on March 10, 1994, the last time options expensing was a hot topic, Kerry said that the SEC should "compel FASB to take another approach to stock options." Kerry noted that "FASB already requires companies to report their earnings-per-share based on a total number of shares that includes all the stock options they have granted."

He added, "There is no more compelling testimony to the damage the FASB rule will do these companies than the testimony of the venture capital community.... This might be acceptable is some greater public purpose were served by the FASB rule, such as the provision of a clear benefit to the investing public. But...it is difficult to find such a benefit in the current FASB proposal."

Today, however - in a familiar pattern for the Massachusetts Senator -- Kerry backs FASB.

As for the delay, the Financial Times said this morning, "Silicon Valley has been granted a stay of execution."

"Execution" is the right word. The plan to force options expensing will have seriously adverse effects on U.S. technology companies.

And don't think the Europeans haven't noticed.

Earlier this month, the European Commission's Directorate-General for Enterprise decided to take a more thorough approach to the same question, rather than rushing to judgment and dismissing the objections of businesses and policymakers, as FASB has done.

DG Enterprise, in an Issues Paper, noted that "a recurrent problem that became apparent during the consultation process on a draft version of [the options rule] was a lack of a universally agreed method of calculating a fair value for employee stock options."

No kidding! That is the problem in the United States, too. How do you put a definitive number on something - a stock option issued to an employee - that will certainly fluctuate over the years before it can be exercised and that could end up being worth zero (as many tech options have)?

This question first came up when FASB's predecessor looked at the options question more than 30 years ago. The solution that emerged was to require companies to put vast amounts of information about option grants in the footnotes of their financial statements and to show the dilutive effect of options if they were granted.

That made sense, and it worked perfectly well for analysts and investors who wanted to determine what a company was worth. But, in the wake of Sarbanes-Oxley, hardliners saw their opportunity to push through a pet project. An options-expensing proposal, with weak intellectual foundations, was constructed.

Again, look at the contrast with Europe.

The European directorate, in a paper, asked, "What effect would [the expensing proposal] have on companies' access to capital markets? Is there a risk that IPO's would become more difficult? What would be the likely effects on employee stock options plans of such companies? Would there be negative effects on venture capital markets?"

The directorate reported that "academic research shows a positive correlation between the employee stock options and entrepreneurship" and that "available research shows that stock options contribute to higher productivity and return on investment."

And that is the point. Expensing will cause high-tech firms, especially, to abandon the use of options.

A study by Bear Stearns, using data from 2003 annual reports of companies in the Standard & Poor's 500-Stock Index, illustrates the problem vividly. Bear Stearns found 112 firms that "early-adopted fair value expensing of employee stock options." ("Fair value" is accounting jargon for using techniques like Black-Scholes to expense options when they are granted; the approach used by most companies currently is called "intrinsic value.")

Bear Stearns found that, "excluding Microsoft, the companies in this sample decreased the aggregate number of options granted in 2003 by 40 percent compared with 2002 grant levels." In all, three-quarters of the companies cut their options grants.

This is precisely the disaster that many high-tech executives predicted. The new rule will change behavior. Companies will cut back on their use of options, which - according to the firms themselves, which should know - have been an incentive to hard work and imagination.

The attitude of some of FASB backers is: So what? As one of them said, "Where can these people [that is, the ones attracted by options in the past] go, after all?" In other words, if the world becomes a non-options-issuing cartel, the U.S. will not be at a competitive disadvantage.

But Asia is certainly not playing the FASB game. China encourages options-issuing in its latest Five-Year Plan. And now it appears that the Europeans are not rushing to expense either.

In fact, the Europeans appear to be outfoxing the United States on options accounting. Will Americans wise up?


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