Institutional Shareholder Services
1455 Research Boulevard, 4th Floor
Rockville, MD 20850
Not to be distributed without permission.
Please direct comments to Stephen Deane, Deputy Director of Publications
Free the IASB: Let the Real Magic Begin
When it comes to magic, Harry Potter could learn a trick or two from Corporate America. Imagine an illusion that allows value to leap like magic from shareholders pockets into the hands of company employees with nary a trace.
Sorcery? No, just bad accounting. The trick is deceptively simple. If a company pays its employees with cash, it must account for this compensation cost on its financial statements. If a company changes the currency in the pay packet to stock options, however, the cost goes Poof! It vanishes from both the earning statements and the bottom line.
How do accounting standard setters explain this legerdemain? Politics. Back in the mid-1990s, the Financial Accounting Standards Board (FASB) wrote new rules (known as statement 123) that would have restored logic and consistency to stock option bookkeeping. Sadly, FASB faced a firestorm of political criticism. The digital Chicken Little crowd cried that requiring expensing for options would cause the tech sky to fall. Lobbyists for the Billionaire Boys Club stormed Capitol Hill with fistfuls of campaign cash. Politicians responded eagerly with several bills that not only threatened to preempt statement 123, but to strip FASB of its authority.
Without the backing of large investors or the Securities and Exchange Commissiona failure that, in hindsight, former chairman Arthur Levitt called the biggest regret of his tenureFASB made a politically expedient compromise. It gave companies a choice: deduct the cost of options from income or disclose them as a pro forma statement in a footnote to the annual report. Not surprisingly, the overwhelming majority of issuers have chosen to continue to cloak their compensation costs.
Lets jump forward to 2001. The dot-com bubble burst. An estimated $2 trillion created by Silicon Valley firms vanished from the market. Many market observers blame investors irrational exuberance at least in part on the fuzzy math allowed under U.S. accounting rulesincluding stock option invisibility. This is one invisible hand that only distorts the capital markets.
Now a new sheriffthe International Accounting Standards Board (IASB)is riding into town and promising to run out the rogue reporting practices. This posse of national standard-setters from nine countries already has drawn fire. It has done so by listing the development of a global standard for stock option accounting on its initial agenda for harmonizing global accounting standards. Its showdown time, folks.
Within hours of the IASBs announcement, an angry mob began hooting, hollering and kicking up dust clouds. Its aim: to stop IASB from even considering the option accounting issue. Business heavyweights, including financial executives from General Electric Co., Pfizer Inc., and Cisco Systems Inc., led the pressure campaign. Their lobbyists convinced House Financial Services Committee Chairman Michael Oxley and other members of Congress to fire off threatening letters to the IASB and the FASB.
Opponents urge the IASB to adopt FASBs expedient compromise as a global standard. They conveniently forget that FASB declared option expensingcalled the fair value methodthe preferred mode. The Board continues to believe that financial statements would be more relevant and representationally faithful if the estimated fair value of employee stock options was included in determining an entitys net income, just as all other forms of compensation are included, FASB declared in its definitive Statement 123. Indeed, the FASB stressed its continued belief that mere pro forma disclosure is not an adequate substitute for recognition of assets, liabilities, equity, revenues, and expenses in financial statements
This time around, many institutional investors vow to speak out in support of honest accounting. In November, the Association for Investment Management and Research announced that more 80 percent of members responding to a survey said that stock options granted to employees are compensation and should be recognized as an expense in the income statements. These respondents equity and fixed income analysts of investment management firms and brokerage houses as well as portfolio managers are the consumers of the financial information, and their needs should shape the standards.
When corporations dont have to account for an expense, they dont manage it, comments Patricia McConnell, senior managing director at Bear Stearns. (Shakespeare made a similar point four hundred years ago: And borrowing dulls the edge of husbandry. Especially, we would add, when the borrower need not account for the cost.)
Option usage exploded in the absence of accurate accounting standards. Equity allocations to option programs have more than doubled over the past decade. If U.S. companies had been forced to account for the costs of stock options, aggregate diluted earnings per share would have dropped by about nine percent in 2000, according to a report by accountant watchdog Jack Ciesielski.
Annual burn rates at many firms now run at unsustainable levels. Employee stock compensation expenses would have jumped 65 percent for S&P 500 companies last year if they had treated options as an expense, according to a new study by McConnell.
The time is ripe for a vigorous debate on how best to measure the cost of stock options. What pricing models, for example, provide the most accurate measure of option value? How do we adjust the model to account for differences between employee options and publicly traded options? Should we take the measurement from the date of grant, vesting or some other milestone?
Legitimate questions like these are best explored in an open, transparent process, precisely the process that the IASB has commenced. The corporate community should jump on board this important discussion.
Finally, a word about American leadership in the global economy. The United States is the worlds natural leader. But leadership is not limited to unilateralism and an international agenda. Instead, leadership derives its strength from democratic policy debate and principles of fairness and transparency. Genuine leadership will benefit everyoneAmerica most of all.