This is Part Two of a two-part series written by Miller and Bahnson. Part One appeared in the last edition of Compliance Week, on May 11.
Our previous column explained how FASB's proposed new standard on option expensing is outmoded and incomplete (see box at right).
The main problem is that it reports only the grant date value as expense over the vesting period. The same expense is reported whether the options' value goes up (way up) or down (way down). If their real value goes up and the options are exercised, the issuer will reap a huge tax savings, but FASB won't allow it to appear on the income statement. And, if the value goes underwater, the issuer will have to report a big increase in reported tax expense for the year in which the options lapse. All-in-all, we think many managers and others will agree with us that FASB's method is far less than optimal.
If the standard passes, you will have no choice as a manager—you will have to comply with GAAP and report the amounts that FASB requires. But we have a few items of advice.
Don't Fall For Faux Numbers
Whatever you do, don't believe that those income statement numbers are useful when you analyze your company's compensation policies. As we have shown, they will either overstate or understate the actual compensation cost and your reported tax expense won't equal the taxes that you actually pay.
In other words, those numbers won't help you make good decisions. If we were with you in person, we would ask you to raise your right hand and swear that you will never fall for the faux numbers that FASB will make you report.
Aim High
If you can't believe the numbers, then why would you think that those who read your statements would swallow the same message hook, line and sinker? You can be sure the capital markets are just not going to use the reported amounts, at least collectively, although some individuals will never get a grip on the weaknesses of FASB's method.
Don't cater to ignorant users, though. Instead, aim to satisfy the needs of your most influential and most experienced financial analysts and institutional investors because they will drive the market value of your stock. If they are completely and truthfully informed, then your stock price will approach that magic equilibrium where it is neither too low (most common) nor too high (not likely).
Thus, managers have the task of finding better ways to communicate to users just what has been happening to the options, and, therefore, to the value of your company's shares.
It turns out that we have been spending quite a bit of time working on this idea and we think we have come up with both a better understanding of what options do to a company and a better way to account for those effects.
At the heart of our idea is the fact that options are derivative liabilities. They look like equity, but they aren't; after all, option holders don't have any of the rights of owners, like voting and receiving dividends. Furthermore, this liability is wide open in terms of its possible values, and it is payable on demand whenever the option holders pony up the cash and ask for their shares. Unlike equity claims, these liabilities cannot be brushed aside—they simply have to be paid.
And, what do we mean by "paid"? Conventional wisdom says that the only obligation of the company is to issue shares. If so, how could options be liabilities? We think there is more to add to the sentence: The obligation is to issue shares at a discount below their prevailing market value on the exercise date. That discount is the true cost of options, and—as everyone knows—the amount bounces all over the place.
If options are demand liabilities and their value is highly volatile, we know that useful accounting would put them in the liability section of the balance sheet and then mark them to market at every reporting date. Furthermore, we would report an expense whenever they're revalued up and an expense reduction whenever they're revalued down. Now, some managers will object to the volatility of reported income. We suggest that the volatility is real and exists whether it is desired or not—the only ways to avoid it are to not issue options, or to hedge them.
And, we would mark the deferred tax asset up and down in proportion to the change in the option liability. This way, the reported tax expense over the options' life will exactly equal the taxes paid—no muss, no fuss, and no telling half-truths to cover up other half-truths.
Trust us: This method will provide all the information that the capital markets need. In addition, it will provide all the information that compensation committees and consultants will need to evaluate the effects of past option grants and the potential benefits of future grants as well.
But, if FASB cannot be convinced to change its plan (and we doubt that it will consider any changes in light of the struggle it's faced to get this far), we offer up our third piece of advice:
Go Beyond FASB
Specifically, go beyond the minimum requirements and publish supplemental disclosures that report the current market values of all your outstanding options. Provide a schedule that explains the change between the beginning and ending market values, including such things as new grants, repricing, forfeiture, lapsing, and exercising.
The more clear you make it, the more the markets will appreciate your candor; they'll also face less risk and won't have to spend any time trying to figure out what happened and the value of those options. Because of the lower risk, greater trust in your reports, smaller information processing costs, and the greater reliability of the estimates, the consequence has to be a higher stock price.
Of course, you could always pursue the other status quo alternative of reporting as little as possible, hoping fruitlessly that the markets will react to the absence of useful information by bidding up your stock's market value. (That's sort of like putting your product in a can with no label and hoping that customers will pay more for it than they would if they knew what is inside.)
We hope you'll step away from the outmoded reporting strategy of keeping secrets and crossing your fingers. It makes a whole lot more sense to figure out what the markets need and then give it to them.
We think we have done the first part, providing you with the rationale for action—the next step is yours. We encourage you to take it, now, before FASB acts, but certainly after.
The last thing you want anyone to do is to act on lousy numbers.
The column solely reflects the views of its author, and should not be regarded as legal advice. It is for general information and discussion only, and is not a full analysis of the matters presented.
What did you think of this column? If you'd like to react or respond, we urge you to write a letter to the editor.
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