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June 17, 2004

Is Hertz a Zero or a Hero?
by Brady Willett

Used sensibly unexpensed stock options are a unique form of compensation that can attract talent. Used sensibly expensed stock options are also a unique form of compensation that can attract talent. It is estimated that between 1995 and 2003 nearly $215 billion of options expenses went unexpensed (S&P 500). To the average investor it isn't sensible to allow billions of dollars in compensation to stay off the income statement.

It has been nearly 2-years since Robert H. Herz was appointed Chairman of the Financial Accounting Standards Board (FASB). During this time Mr. Herz has talked a big game - one of his original platforms was a push towards principle-base accounting - but he has not managed to catch many headlines. In fact, beyond quickly punching out some much needed reform on off balance sheet schemes - something that was easily accomplishable following Enron - Herz has basically been cowering in corner; waiting/hiding from his one true calling.

"We issued a preliminary document for public comment about the accounting for stock-based compensation in November 2002." Herz.

Although there is nothing 'preliminary' about it, under Herz's command the stock option issue has progressed slowly -- until now. Come June 30, 2004 FASB will be done talking. FASB wants options expensed next year. Throwing a wrench into this plan, The House of Representatives Financial Services Committee just voted to restrict any expensing standard from FASB. After many battles, the war may soon be decided...

Origins of The Stock Options Nightmare

In 1972, the Accounting Principles Board (APB) - predecessor of FASB - issued APB Opinion No. 25. At first glance the title of Opinion No. 25 - Accounting for stock Issues to Employees - suggests that the APB wanted to curtail the practice of unexpensed stock issuance. As it would turn out, however, since the APB couldn't figure out how to account for stock options they instead unwittingly condoned the issuance of unexpensed stock. As Mr. Herz astutely suggested last year, the APB basically opened up a loophole, which is the main reason why the options saga is still raging today.

"Opinion 25 measures stock issued to employees using the "intrinsic value based method." Under that method, compensation cost is the excess, if any, of the quoted market price of the stock at grant date or other measurement date over the amount an employee must pay to acquire the stock (Opinion 25, paragraph 10). The consequence of using the intrinsic value based method is that stock options are frequently issued with the quoted market price of the stock at grant date equal to the amount an employee must pay to acquire the stock and, thus, no expense is reported in the financial statements." Hetz - PDF

After opening up this loophole the APB, and now FASB, fought for justice*. Mr. Herz continues: "in 1984, the FASB undertook a project to reconsider the issue. In 1993, after several delays in the project, the FASB issued an Exposure Draft"...And in 2004 FASB will try again.

* Stock options 'justice' is all about correcting the original wrongdoing from the APB. Quite frankly, as impossible as it is to predict the future cost of stock options, it is simply irresponsible to permit companies to never record any expense on stock options.

Why Doesn't Craig Barrett Listen?

Being an investor my opinion on stock options is simple: I would like to see corporations expense all forms of compensation so I do not have to wade through what is sometimes hundreds of pages to research potential/actual earnings and/or future dilution scenarios. Silly me, I think financial statements should be produced for investors.

On the day when FASB unleashed its latest attack (March 31, 2004), Intel CEO Craig Barrett wrote a commentary in the Wall Street Journal warning about the pitfalls of expensing. This was not the first time Mr. Barrett voiced his dissent. Rather, while 'earning' his many, many millions in options Barrett has found the time to write and testifying on options to anyone who would pay attention to him.

Suffice to say, of specific interest is Mr. Barrett's June 3, 2003 Testimony to The House Committee on Financial Services. In this rehearsed testimony Mr. Barrett says: "Let me outline a plan for comprehensive stock option reform...First, all employee stock option plans should be approved by shareholders"

This just in Mr. Barrett - Intel shareholders do not approve of your ongoing plan not to expense stock options!

How does Mr. Barrett respond to 54% of Intel shareholders voting to expense? He says "It would be imprudent to move forward today without knowing what the expensing format is going to look like". Well, prudence be damned! After all, all employee stock option plans should be approved by shareholders.

Am I nitpicking? Did Mr. Barrett simply mean that shareholders should approve how many options he gets but he will decide whether or not they are an expense? You decide.

Common Sense Says Expense

When anyone - especially Mr. Barrett (who is the world's foremost anti-options loudmouth) - argues that stock options should not be expensed what they are really saying is that investors are nothing but a bunch of nitwits. To be sure, the comical argument that startup firms need the printing press that is unexpensed stock options to acquire and keep employees contradicts the most popular anti-options argument (which is that current standards adequately inform the investor about a companies stock option activities). Think about it: how can anyone argue that investors fully understand non cash compensation and in the next breathe argue that these same investors would not stand for these non cash charges showing up in the income statement? At the threat of repetition, Greenspan summarizes this conundrum quite well:

"One may argue that, because option grants are fully disclosed and their effect on earnings can, with some effort, be estimated reasonably well, financial markets in their collective wisdom see through the nature of any bookkeeping transactions. Hence, how expenses and profits are reported is of no significance, because nothing in the real world is altered. Cash flows, for example, are unaffected. The upshot of this reasoning is that stock prices should be unaffected by whether option grants are expensed or not. Clearly, most high-tech executives believe otherwise. How else does one explain their vociferous negative reaction to expensing if its only effect were to change the book profit reported to shareholders?" Alan on Options

Does Mr. Barrett believe that Intel shareholders are stupid? Perhaps. At minimum, he doesn't believe that shareholders read and/or understand the 'See accompanying notes' at the bottom of Intel's Income Statement. Remember, although jumbled and not very congruent from 10K to 10K, all the options data is already in the footnotes.

FASB Must Win, Or Else

What FASB could have done is threatened companies with expensing stock repurchase plans (granted, this would difficult to do), and then agree to toss out this initiative if corporations called off their attack against stock options. After all, besides the enriching the greedy execs, the main reason why certain companies love issuing unexpensed stock options is because they can use massive buy backs to counter the dilutive impact of stock options (in other words, management likes to compensate employees and themselves without ever negatively impacting the income statement). Given that certain companies also like to use buy backs to massage EPS, any hint from FASB that repurchase plans should be limited/expensed would give FASB more hand.

However, instead of attacking in this round about manner, FASB has taken its sweet time to push through its current options proposal. As such, instead of possessing hand, FASB now finds itself desperately trying to save face. To the average investor the time lapse is utterly ridiculous: FASB takes more than 2-years to pass something that has been on the shelf for decades?

It's pretty simple guys: expense options or fold up shop. Investors have read all of Barrett's, and Laurel-and-Hardy's (aka. Hassett and Glassman's) opinions, and they still say expense already.

In short, dropping the ball in 1972 resulted in 32 years of investor injustice. If FASB doesn't win this time around you have to question both the institutions relevance and its existence. Hertz openly acknowledges that "FASB has no power to enforce its standards." Mr. Hertz should aggressively try and change this or be responsible enough and admit that since FASB does not make any of the really important decisions that they should not exist at all. At least if the SEC and Rep. Baker are in full charge of setting accounting standards - Baker previously passed a mutual fund bill with a 118-2 vote (nothing good for the investor ever gets only 2 votes of dissent) - investor's will know to keep their guard up especially high.

Brady Willett
FallStreet.com

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