House Votes to Block Stock Option Mandate

Yahoo! News (AP) ^ | 7/21/04 | Marcy Gordon

[Baby Bear]

WASHINGTON - The House voted Tuesday to override a rule that would require companies to count stock options against their profits, but a key senator promised to block such action in that chamber.

The House vote was 312-111, with 198 Republicans and 114 Democrats voting for the bill that would block a proposal by the rule-setting board for accounting. The board is seeking to force publicly traded companies to record as an expense all forms of share-based payments to employees, including stock options.

The rule change proposed by the Financial Accounting Standards Board in March could dramatically reduce the reported earnings of many big companies, particularly in the high-tech industry where stock options for employees have been popular.

Federal Reserve (news - web sites) Chairman Alan Greenspan (news - web sites), a proponent of mandatory expensing and FASB's proposal, told senators at a Banking Committee hearing Tuesday, "I would be most concerned if Congress intervened." Of the rule-setting board, he said, "I think they do a good job. It's a tough job."

That committee's chairman, Sen. Richard Shelby, R-Ala., agreed with Greenspan's stance. He derided the House action as "political interference" in the work of independent accounting experts. "I will continue to fight any effort to pass similar legislation in the Senate," he said.

To buttress FASB, four senators brought forward a resolution reaffirming the board's independence and urging the Senate not to intervene in its rule-setting process. The four, all prominent advocates for mandatory expensing of options, were Republicans Peter Fitzgerald of Illinois and John McCain of Arizona, and Democrats Carl Levin of Michigan and Richard Durbin of Illinois.

The House-passed measure, sponsored by Reps. Richard Baker, R-La., and Anna Eshoo, D-Calif., would limit required expensing of options to those owned by a corporation's top five executives. It also would allow newly public companies to delay expensing for top executives in the first three years.

Advocates of mandatory expensing also include Securities and Exchange Commission (news - web sites) Chairman William Donaldson, billionaire investor Warren Buffett (news - web sites) and the Big Four accounting firms.

Some blame stock options for fueling recent corporate abuses. They say options entice executives to manipulate earnings to pump up stock prices and then sell their lucrative personal holdings. Still, options remain a popular compensation tool to help motivate employees, who can buy shares at a fixed price and sell at a profit if the company's stock rises.

In House debate, supporters of the legislation insisted that a mandate to count options against the bottom line would complicate income statements, discourage startup companies and hurt the economy by stifling future innovation.

"It would have a negative, real-world policy impact" and "choke off job growth," said Rep. Pete Sessions, R-Texas.

Backers also said it was impossible to determine the value of options.

The FASB proposal answered the call for accurate financial statements that came after a string of corporate scandals, starting with Enron.

But supporters of the bill maintained Tuesday that the rule would unfairly punish an estimated 14 million rank-and-file employees for the abuses of a few top executives who manipulated earnings.

Companies now need not record the cost of options as an expense on their financial statements, though hundreds have begun to do so voluntarily. Instead, they must only include the potential cost in a footnote, making it difficult for investors to gauge their impact on earnings.

Not requiring options to be expensed "runs the grave risk of inflating a company's profits and misleading investors," warned Rep. Alcee Hastings, D-Fla.

Fighting mandatory expensing are members of a lobbying coalition that includes Agilent Technologies, Cisco Systems, Coors Brewing, Dell, General Mills, Intel and Sun Microsystems. Also opposed are the Nasdaq Stock Market, home to numerous big high-tech companies; the National Association of Manufacturers (news - web sites); the U.S. Chamber of Commerce (news - web sites), and the Business Roundtable, which represents chief executives of the largest U.S. corporations.

If the FASB proposal is approved, it would take effect Dec. 15.

FASB Chairman Robert Herz said last month the panel may delay a final rule because corporate America already is facing deadlines to implement other new regulations enacted in 2002 in response to the scandals. Donald Nicolaisen, the SEC's chief accountant, has said FASB should consider delaying the rule to 2006.

___

The bill is H.R. 3574.

On the Net:

Congress: http://thomas.loc.gov/

Financial Accounting Standards Board: http://www.fasb.org

[fooman]

Good this is a bad idea. It will discourage innovation and private equity if it makes it through.

[KarlInOhio]

Companies would be a lot more profitable if they didn't have to report any of their expenses.

Right now companies are reporting an estimate of the current cost of stock options. In most cases this estimate is $0. Just about any other value would be more accurate reporting to the companies' owners than that. I see no problem with a company having $100 million of potential liability in stock options having to report it accurately.

[fooman]

That is the point, the liability (unlike debt) is contigent on the company doing well.

The confusion comes in due to the BS model. This is a market pricing tool for outsiders and should not be used to discourage risk takers.

[Moonman62]

Federal Reserve (news - web sites) Chairman Alan Greenspan (news - web sites), a proponent of mandatory expensing and FASB's proposal, told senators at a Banking Committee hearing Tuesday, "I would be most concerned if Congress intervened." Of the rule-setting board, he said, "I think they do a good job. It's a tough job."

Why does Greenspan still have a job?

[snooker]

" Why does Greenspan still have a job?"

Really good question.

Stock Options drive innovation in startup companies and keep the talent in large. If investors aren't smart enough to figure out what shares are outstanding, maybe they should try something else, like bonds.

Expensing option is a sure fire way of insuring tech jobs go offshore. Big companies are all for it, generally, because it limits your competition.

[fooman]

You win post of the DAY!

Of course, in the money options should be reported on the income statement with exercising assumed. This lowers reported EPS.

In other words, there is no free pass in CORRECTLY reporting options....

[Moonman62]

Big companies are all for it, generally, because it limits your competition.

I agree. The big shocker in this article is that the Business Roundtable is against it, even though they only represent the largest corporations, and they usually support big government, too.

[fooman]

If you are a big company, why would you want successfull startups around?

[Southack]

"In House debate, supporters of the legislation insisted that a mandate to count options against the bottom line would complicate income statements"

The press has done a lousy job explaining how expensing options impacts the old accounting books.

Ordinarily, you only write the expense of options into your books when someone exercises them...and you wait until that moment because it was only a piece of paper prior to that point.

What Congress has been trying to change is what the press now calls "expensing options," however. This confuses laymen; makes it sound as though options weren't expensed in the past, but they were...they just weren't expensed until someone used them.

This change will force companies to start making *GUESSES* and writing those financial GUESSES into their acocunting books. Why?! Because this new "Expensing options" change will compel every company to write off the cost of their options when they are issued, *BEFORE* anyone knows their real cost.

You see, most options are worthless pieces of paper. Only 10% of all options issued are ever "in the money."

So in the past, companies have simply waited until those 10% of in the money options were "exercised." At that point, the companies knew the precise expense, and that's when they then write the expenses into the old accounting books.

Not so with this new rule change. Now companies have to guess at all 100% of option expenses upfront, and then they have to constantly revise those guesses as people straggle in over time exercising those 10% of options that make it into the money.

So this whole "expensing options" fad is going to screw up corporate accounting. For the 10% of options that ever cost a company anything, Congress is trying to force guesses into our books that we KNOW will statistically be wrong for at least 90% of all options.

The upside to all of this is that companies are about to become more profitable by paying less in taxes.

Because of this rule change, I can issue 40 year stock options that are, in reality, worthless...but the government forces me to add the "expense" of these options into my accounting books for this current year.

That raises my paper expenses, which lowers my current tax bill (more expense = less profit that can be taxed).

But my company isn't out any money for those 40 year stock options. Certainly not this year. So I end up with *MORE* money left in my bank accounts than what the government allows me to call "profits." I can earn interest on that extra money, invest it, or do whatever. It's mine.

In effect, I can now print all of the tax deductions that I need to keep my tax bill low and my bank accounts stuffed.

Oh yeah, it will screw up corporate accounting for ever Amen, but behind the new dust from this rule change will emerge vastly more profitable private companies...and no doubt public companies will manipulate their tax burdens with this trick on occassion, too.

8 Legislative Days Left Until The AWB Expires

[mpreston]

True, stock options enable startup companies to attract talent and drive innovation. The problem is that as the company matures and stock options continue to be given to employees, managements goal is to maximize stock price and not organically grow the business. One would think that the best way to increase stock price would be to grow the business, but that's not always true. In the end the investor is left holding the bag.

The solution is somewhere in the middle - allow startups to issue stock options that are not expensed becuase they are hard to value and then transistion to expensing them as the company matures and stock price can then be determined as a multiple of earnings.

[fooman]

Very interesting point! Post of the week!

Of course, private companies cannot use the bs model, becasue there is no 'traded' price, nor is there a sigma

[Dog Gone]

I hadn't thought of that angle about reducing corporate taxes. That's an excellent point.

And I think the proposed change to the accounting rules is utter nonsense.

[snooker]

... and if you can't read the income statement, hire someone who can, or buy CDs.

Like with campaign finance reform, clear and open public reporting is the key. If stock options are always accounted for on the company's income statements, then everyone knows what is going on. That way nothing is hidden and dilution of public shares is clear and out in the open.

Shareholder elections take care of the rest.

[fooman]

This will turn into a bonanza for Large Cap companies, Lawyers and accountants.

So there will 'jobs' in that sense, but the other real jobs will be left out.

[snooker]

It does always seem to come down to do you want to do real work and produce real product, or chase ambulances.

As a country we should never lose sight that small businesses drive the economy. Making it easy and cheap for entrepreneurs to get going is what is at the heart of our economic miracle engine.

Notice that in Iraq in order to get their economy going, the CPA was passing out small denomination loans, at real cheap rates(none), to businesses to buy stock and open storefronts.

So you wonder, if Greenspan is so out of touch with reality, why is he still at the fed. As I recall, he was the one who couldn't see that a doubling of the oil price would have a negative effect on the economy. He just kept cranking up rates until the economy crashed good and hard.

[Nick Danger]

Because of this rule change, I can issue 40 year stock options that are, in reality, worthless...but the government forces me to add the "expense" of these options into my accounting books for this current year.

I'll bet you don't get this lucky. "The books" as presented to the public under Generally Accepted Accounting Principles (or this kind of law) are not the same as "the books" as reported to the IRS. The IRS has a totally separate list of rules. Check the fine print, and I'll bet you find out that this law reduces earnings on the annual report, but does no such thing on the tax return. I'll bet it's rigged so that on the tax return, the options can't be expensed until the company actually knows what they cost.

There's another game that this introduces, and it's a potentially scary one. Let's say that while operating as a privately-held, venture-backed startup, I issue options hither and yon, "expensing" them at the lofty share price of $10 per share. I hire a consultant to write me CoverMyButt memo stating that, in his expert opinion, $10 per share is a reasonable estimate for what this company might be worth in five years.

So my earnings statement looks like hell. I'm losing money hand-over-fist. But the VC's don't care because none of it is actually cash-out-the-door. It's all paper hoo-hah caused by this law.

So three years later we go public, the VC's get out and make a fortune, and the stock is on the NASDAQ at $7.

Now things start to go South. Sales aren't meeting forecasts, some Big Guy got into the business sooner than we thought any of 'em would, and the future looks bleak.

But not the earnings statement. The earnings statement looks fine. We're showing the blessed quarter-to-quarter rise in earnings that Wall Street loves to see.

That's because the CFO, exercising prudence, has noticed that certain employees who were issued early stock options are no longer with the company, which means they will never vest their options. So we can go back now and un-do that expense we put in there when we issued the options. Lo and behold, this looks just like profit on the earnings statement. It isn't until you read Footnote 57 that you learn that "the company recognized earnings of umpty-three million related to the reversal of expensed options which have expired unexercised."

So what this does is create a little "coal sack" off to the side that a CFO can tap into to bump the earnings a bit whenever prudence dictates that it would be prudent to have more earnings than we really have.

You watch... there will be at least one "buncha people got burned badly" stock scandal 5 to 10 years from now, where the gimmick was pulling out old stock options and un-expensing them.

[fooman]

yep. This change will create all kinds of new distortions at great cost..

[Southack]

"That's because the CFO, exercising prudence, has noticed that certain employees who were issued early stock options are no longer with the company, which means they will never vest their options. So we can go back now and un-do that expense we put in there when we issued the options. Lo and behold, this looks just like profit on the earnings statement. ... So what this does is create a little "coal sack" off to the side that a CFO can tap into to bump the earnings a bit whenever prudence dictates that it would be prudent to have more earnings than we really have."

Yes, it's called sandbagging (or "smoothing" if you aren't from around these parts).

FNM and FRE enagaged in such smoothing, er, sandbagging for years by deliberately misusing derivatives. But not every company can misuse derivatives like Fannie Mae.

On the other hand, *every* company can misuse stock options with this new accounting rule change.

7 Full Legislative Days Left Until The AWB Expires

[itsahoot]

allow startups to issue stock options that are not expensed becuase they are hard to value and then transistion to expensing them as the company matures and stock price can then be determined as a multiple of earnings.

Even easier, just issue the stock, at the current price, the employee can then either bet on the future or take the money and run.

They really don't want the people to know when they issue millions of stock options to worthless board members.