Editor's note: This is a reply to a recent e-mail from U.S. Senator Peter G. Fitzgerald about a proposed bill on the treatment of stock options.
Dear Senator Fitzgerald:
Thanks for sending that opinion piece from Tuesday's edition of the Washington Post, the one that billionaire investor Warren Buffett wrote about expensing stock options. I especially liked his opening paragraph, in which he describes how the previous record for “mathematical lunacy by a legislative body” was held by Indiana's House of Representatives, which tried (and failed) to redefine the mathematical value of “pi” in 1897 in order to make life easier for schoolchildren.
I know that you and other U.S. senators, including Senate Banking Committee chairman Richard Shelby, are concerned – as Mr. Buffett is – about a bill that is making its way through the U.S. House of Representatives, which would legislate how companies deal with stock options. And I know that all of this is taking place against the backdrop of a powerful lobbying effort by U.S. technology companies, who are opposed to a proposal from the Financial Accounting Standards Board (FASB), that would require all companies to expense options.
As you probably know, we in Canada recently adopted an accounting standard similar to the one that the FASB is proposing. As of January 1 this year, all Canadian public companies must record the cost of issuing stock options on their books as an expense. Although the amount of opposition to this move wasn't quite as dramatic here as it seems to be in your neck of the woods, there were still plenty of observers and analysts who argued that this approach was wrong-headed, time-consuming, anti-competitive and dangerous (not necessarily in that order). I'd like to assure you that they were wrong, just as the forces behind the House bill are wrong.
The bill seems to be an attempt to find a compromise between those who believe that not treating options as an expense distorts a company's financial picture, and those who believe that requiring companies to expense them will make it harder to attract qualified employees. Under the proposed law, only the top five executives in a company would have to have their stock options expensed, and for the purposes of calculating those option costs, their volatility would be defined as zero.
As Mr. Buffett notes in his piece, this is absurd. Either stock options are an expense or they are not; they can't be an expense for some employees and not for others. If they are a cost, as Mr. Buffett and others (including Securities and Exchange Commission chairman William Donaldson and Federal Reserve Board chairman Alan Greenspan) argue they are, then they should be treated as such. In every other case where a company gives something to an employee as an incentive to work — whether it be a salary, a bonus or a free trip to Hawaii — it is accounted for as an expense. And if it involves stock, then the price volatility can't be zero.
Opponents of option expensing, however, say it is precisely this fluctuation in price that makes the FASB proposal unwise. They say because the value of an option fluctuates along with a company's stock, it is impossible to arrive at an exact value for the expense incurred. Mr. Buffett's response is a good one: "So what?" he says. "Estimates pervade accounting." Companies routinely estimate the useful life of software, corporate jets, equipment and other items, Mr. Buffett says, not to mention pension costs — which require estimates of mortality rates, investment returns, etc.
In other words, just because there are flaws in both the Black-Scholes valuation model (co-developed by Canadian-born economist Myron Scholes) and the fair value model, doesn't mean that it would be better not to value options at all. Mr. Buffett warns that it is "better to be approximately right than precisely wrong." Options clearly have a cost, no matter how difficult it might be to define, because companies that use a lot of them — such as Intel — spend billions of dollars every year buying back their own shares in order to compensate for the dilutive effect of those options.
Despite these arguments, companies such as Intel continue to resist the move to expensing options. They continue to pressure both the FASB and the U.S. Congress (as I'm sure you know), just as they did in 1994 when the topic first came up. At that time, the FASB proposed a similar requirement to the one that is on the table now, but eventually caved in to criticism from the technology industry and watered down its proposal. Under the new rules, companies were only required to describe how expensing options might affect their results (which they do in fine print at the end of their reports).
As the Ontario Teachers Pension Plan said in a recent joint letter to the FASB — in which it and other institutional funds encouraged the U.S. body to adopt the expensing of options — several leading Wall Street brokerage firms and analysts have said that doing so should have no negative effects on either individual companies, the technology sector or the U.S. economy as a whole. As Mr. Buffett writes, "just as the schoolchildren of Indiana learned to work with honest math, so can option-issuing chief executives learn to live with honest accounting." In closing, Senator Fitzgerald, if and when the current House bill on stock options comes to the U.S. Senate for a vote, I hope you and your colleagues will give it the treatment it deserves, just as the Indiana Senate did in 1897.
Sincerely,
Mathew Ingram
© The Globe and Mail
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