Taking Stock of Expensing

At the start of next year, barring any surprises, public companies will have to list employee stock options as an expense on their income statements.

Finally, after a host of public comments and ludicrous political bashing, the accounting world's independent rulemaking body, the Financial Accounting Standards Board (search), has its rule ready to go.

But Rep. Richard Baker, R-La., has other ideas. Baker has introduced legislation that would pre-empt the FASB rule, institute expensing for only the five highest-paid executives at public companies and prohibit further expensing rules from taking effect until an economic impact study can be performed.

Why would Congress get this involved in FASB's rulemaking procedures? What would drive business executives to push for this legislation? Finally, why would they care about FASB's expensing rule at all? A quick look at how we got to this point sheds some light on these questions.

First, companies use stock options -- securities whose values rise and fall with the company's stock price -- to compensate employees. They currently disclose these transactions only in the footnotes of their financial statements. FASB aims to make the compensation more transparent by placing it squarely on the income statement.

The recent push for expensing came shortly after the fall of Enron in December 2001 (though the campaign, in various forms, actually can be traced to the 1970s). Members of Congress argued that if companies had been expensing in the pre-Enron days, the wave of corporate meltdowns might have been averted.

But the abuses by executives at Enron (search), WorldCom (search) and Tyco (search) dealt with fraud, not stock options. Laws already exist against fraud. People prepared to disregard those laws for profit will similarly disregard any new laws or regulations Congress or FASB devise. But this isn't enough to get Congress to pass up a chance at grandstanding.

And, of course, the real question is this: What does this all mean to the values of the companies? Has every public company been improperly valued for the past 30 years because of the accounting rules? If so, would not huge takeover opportunities now be available? Both sides seem to have ignored economics here.

Consider two companies with $1 million in operating income. Company A has $800,000 in depreciation expense -- money it can write off its taxes as its equipment grows older and loses value -- and Company B has $100,000. Under expensing advocates' reasoning, Company B is more profitable and a better investment. In reality, Company A has much better cash flow because depreciation is a non-cash expense that lowers the company's tax bill.

Yet expensing opponents suggest corporate executives would do anything they could to show as little depreciation as possible. After all, depreciation expense depresses earnings.

The analogy between depreciation and option expenses applies because both are non-cash expenses that reduce taxes. Still, because options are equity instruments -- they confer ownership and don't add to debt -- those in favor of expensing argue that there has been no check on managers' willingness to issue options.

They equate issuing options to spending "free money" and claim that greedy executives have issued them without regard for anything but their own bank accounts. Such a trick would be worthy of the finest alchemist. No executive can blindly issue claims on his company's stock without diluting his shareholders' (and frequently his own) wealth.

So why all the fuss from Silicon Valley? Why should people there worry if this is just a non-cash expense, one that investors easily can account for? One key could lie with the Sarbanes-Oxley Act (search).

Passed in 2002, Sarbanes-Oxley holds executive officers directly responsible for the accuracy of their financial statements (under the threat of rather severe penalties). The term "accuracy" is particularly relevant here because it's difficult to put a value on employee stock options. The notion that anyone can put any price he desires on these options, as if it is written in stone, is pure fantasy.

Technology companies tend to issue large amounts of options both to bulk up compensation when the firms are small and growing and as incentives to get employees to share in ownership. The spectacular ups and downs of these firms mean their options run the risk of having the largest "revaluations." Consequently, they also run the greatest risk of giving off the appearance of impropriety.

True, Sarbanes-Oxley requires a "knowing and intentional" violation, but anyone who thinks prosecutors (or trial lawyers) will let such a small detail stop them pays little attention to the U.S. legal system.

Determining whose earnings are "accurate" is difficult enough without adding option expensing to the mix. So although it is disturbing that Congress is trying to dictate accounting rules, after seeing Sarbanes-Oxley, it isn't surprising. Just unfortunate.

Norbert Michel, Ph.D., is a policy analyst in the Center for Data Analysis at  The Heritage Foundation, a Washington-based public policy research institute.