Expensing Options: An Overblown Storm
By David Henry
Perhaps no draft of an accounting standard has ever been as widely anticipated as the plan laid out Mar. 31 by the Financial Accounting Standards Board to require companies to expense the value of employee stock options. Proponents had gleefully looked forward to seeing FASB take up the issue since energy giant Enron's 2001 collapse fueled recriminations over accounting games played during the tech stock bubble.
Opponents, largely from tech companies, which have frequently used options to pay employees, had dreaded the day for just as long. One tech-industry trade association, the American Electronics Assn. (AeA), even arranged to airlift 70 members into Washington to lobby against FASB when the proposal was due out.
Yet like an approaching hurricane that generates more advance warnings than damaging winds, FASB's proposed rule probably won't cause a lot of additional change. Some 500 publicly traded companies have already started expensing options, or said they will. Many have begun shifting toward other non-option-based pay schemes that are likely to deliver more motivational bang for their compensation bucks. And investors, who can already look up option costs in the footnotes of companies' quarterly financial reports, seem to have grown accustomed to factoring the values of options into what stocks are worth.
The conventional wisdom had been that FASB would set off an ugly battle in Washington when it proposed its expensing rule in a repeat of what happened 10 years ago. Then, company executives were so successful lobbying Congress that FASB backed down in the face of veiled threats that it might lose funding and be stripped of its authority to oversee the generally accepted accounting standards by which publicly traded companies are expected to abide.
Then and now, FASB members believed that when something of value is paid to someone it should be counted as an expense, even if it isn't cash. Options that grant the right to buy shares at a pre-set price seem to fit that definition handily. Yet tech startups with lots of revenue but not a lot of earnings had long argued that nonexpensed options were one of the few ways they could attract talent while on the path to profitability.
Executives of many of the same tech companies that worked to stop FASB last time, including Cisco Systems (CSCO ) and Intel (INTC ), have been trying to stop this drive as well. Back then, tech employees even took to the streets in Silicon Valley to protest at a hearing held there by FASB, which is based in Norwalk, Conn. Similar protests could happen again in June when FASB holds another hearing in the San Francisco area.
Already, tech executives have made noises that they might have no choice but to send more jobs to India if they have to expense options. And, like last time, members of Congress have scheduled hearings on the accounting issues and filed bills to rein in FASB.
Representative Richard H. Baker (R-La.) announced just hours after FASB posted its draft on Mar. 31 that he will hold hearings on its impact before his capital-markets subcommittee of the House Committee on Financial Services. He says the rule could stifle new companies and job creation. "I fear FASB is beginning to stand for Flatten All Startup Businesses," he said.
Still, this time around observers doubt FASB will buckle again -- or have to. Current board members generally view the 1994 episode as a debacle that must not repeat itself. It damaged FASB's credibility as a principled rulemaker and weakened the board's resolve to back rules that corporate executives might not like, even if they would help investors.
In the interim, many experts agree, executives have become even more aggressive in their ploys to use accounting rules to pump up earnings to drive up stock prices -- and their options payoffs. FASB Chairman Robert Herz has been stoically saying for months that part of his job this spring will be going to Washington to be publicly harangued.
Besides will power, FASB has momentum on its side. Not only have nearly 500 companies volunteered to begin expensing options but they've generally seen no bad consequences from doing so. A study of 335 of those companies by Towers Perrin, a compensation consultant, found no impact on their stock prices.
The proposed rule would likely reduce reported earnings of S&P 500 companies by less than 3%, according to analysts at Bear, Stearns & Co. That's down sharply from the 18% hit they would have been felt had the rule been in effect in 2002. The reason for the decline: Other earnings have increased, and companies have been issuing fewer options and apparently shifting to other forms of pay.
At the same time, despite the efforts of U.S.-based tech-industry lobbyists, the International Accounting Standards Board recently adopted a similar expensing rule that will apply next year to more than 7,000 companies listed in Europe.
In Washington, too, the odds have changed. In this election year, political strategists say it isn't safe for most politicians to side with arguments for less stringent accounting, since corporate scandals are still on trial in several high-profile court cases. Insiders say without a push from GOP leadership, House Financial Services Committee Chairman Michael G. Oxley (R-Ohio) is wary of moving along a bill sponsored by Baker that would limit FASB's rule.
While that bill claims 85 co-sponsors, they include only 11 of the 37 Republicans on the committee. A companion bill in the Senate has even less support. Says J. Edward Ketz, an accounting professor at Penn State: "Washington will not interfere as it did in the 1990s.... Neither party wants to be painted as aiding and abetting future accounting scandals."
Though FASB has been collecting comments on expensing options since November, 2002, and has held 35 public meetings on the topic, it says it will take comments on this draft for 90 more days. It plans to issue the final rule in the fall, to take effect with the start of the New Year. The winds of resistance may still be swirling in Silicon Valley, but it appears the worst of the options storm has already passed.
Henry writes for BusinessWeek in New York