Should options be expensed?

The very idea that a "double-standard" exists rests on the flawed notion that tax codes and accounting standards are always in alignment. Hardly! TJ Rogers discussed this point in a WSJ editorial:

Part of the impetus for the bill has been what the senators have characterized as a "double standard" created by companies reporting two different sets of numbers. But for the source of the problem, the senators might look first in their own backyard. What troubles them is related to the fact that Washington requires companies to keep one set of books for the Securities and Exchange Commission and one for the Internal Revenue Service. But these two bureaucracies have never tried to coordinate their demands. Moreover, the problem is hardly unique to options: There are "double standards" in the accounting for revenue recognition, depreciation, reserves, vacation pay, foreign sales, compensation, and so forth. So what?

There are only two relevant questions: Are any companies or individuals legally avoiding fair taxes? And, are companies legally overstating their earnings? The answer to both questions is an emphatic no.

Profits realized by employees from options are treated like other wages paid by their employer, who is allowed to subtract them from company profits before taxes. This is the business expense that Sen. Levin is unreasonably painting as unscrupulous tax avoidance. Further, the tax liability for option profits, just as for wages, falls on the employee. There's nothing to "fix" in this straightforward transaction.

John McCain recently said in a Senate speech that "corporations can hide these multi-million-dollar compensation plans from shareholders . . . because these plans are not counted as expenses when calculating company earnings." Sorry, John: Shares outstanding, including options, are reported to investors quarterly and also dilute the earnings per share. And shareholders must vote to approve executive option plans before the options are granted.

John Doerr in a recent NYT editorial also criticized the bill:

"The proper purpose of any reform should be a clearer, more accurate picture of a company's financial health. Instead, counting options as expenses -- ''expensing'' them -- would actually distort and confuse that picture considerably."...

Current accounting rules correctly require that companies report their earnings per share on a diluted basis (i.e., counting the potential decrease in the ownership of existing shareholders due to the granting and exercise of stock options). If expensing were also required, the impact of options would be counted twice in the earnings per share: first as a potential dilution of earnings, by increasing the shares outstanding, and second as a charge against reported earnings. The result would be inaccurate and misleading earnings per share. ...

Another difficulty with proposals to expense options is that there exists no remotely accurate way to calculate the expense. Some proposals would expense options when they are granted -- without knowing whether the worker will ever exercise the options or what the future stock price will be. Other proposals would expense options when exercised, with any increase in the stock price over the option price being subtracted from otherwise reported profits. Thus, the better the company's stock performs, the worse the company's earnings will look. Surely, this makes no sense.

Accounting rules already require companies to disclose detailed information about their stock option programs. If new stock option legislation were enacted, the misleading understatement of corporate earnings would make it prohibitively expensive for most firms to continue broad stock option programs.

This would be a terrible mistake. Stock options have been crucial to venture-capital-backed companies that have created more than seven million jobs over 30 years and generated more than $1.3 trillion in revenue in 2000 alone. Today 90 percent of large companies issue stock options.

But I wonder if the fear of options accounting is over-stated. All of the economics academic that I spoke with about this issue can't understand the emotional opposition by the tech community to expensing options. If you believe that stock prices will fall once options are expensed, then you believe that either those stocks are currently over-valued because investors don't realize the impact of options or you believe that stocks will be under-valued because investors won't be able to understand the nature of the expenses. Both assume that markets are inefficient and ignorant. But this simply isn't the case: savvy institutional investors know how to read financial statements and balance sheets, and even if this confuses individual investors, arbitrage should keep the stock prices steady.

Of course, a stock price isn't the only thing that could be negatively impacted with a change in a company's reported earnings. Profitability is important for a general sense of stability for growth companies--and especially important for companies such as smaller enterprise software companies, competing against giants and trying to convince potential customers that they are viable and will be around for the long haul.

Reuven Brenner and Donald Luskin wrote an interesting article in The American Spectator advocating to put options on the balance sheet.

Other than an executive's fantasy of not having to disclose expenses, we don't see any arguments against this approach. We dismiss the typical op-ed columns that rail against expensing options under the banner of "options are good for the economy," no matter how they accounted for. Form matters, because it reflects reality, and brings clarity and transparency to important issues of risk. But on the other hand, we dismiss "options are evil" arguments that seek to impose expensing as a means of curbing options issuance. The question isn't whether options are good or bad—although we believe they are often quite useful. The question is simply how to best reflect this risky form of compensation in financial statements.

The balance sheet solution also resolves the debate about taxation of options expenses. The cumulative expenses recorded on the income statement would correspond exactly to the tax deduction to which the firm is entitled, ending the so-called "double standard" between expensing rules and tax deduction calculations targeted by Senators Carl Levin and John McCain in Senate Bill 1940.

Given the political environment--and the momentum in FASB and international accounting standards boards--Silicon Valley may have to choose between expensing options or sacrificing their tax benefit. They would be wise to choose the former.