Posted 2:50 PM by Robert

Awful and Terrible Words

Among the harassed population of Chief Financial Officers of American public companies, it is possible that at the moment the most terrifying words are "... as defined [or determined] in accordance with generally accepted accounting principles, as in effect from time to time."

Why should these words be terrifying? Because that phrase - and phrases similar or equivalent to it - appears in bank credit agreements, bond indentures, stock option grants, executive employment agreements, "permitted investments" definitions for mutual funds, corporate charters, shareholder agreements, state statutes and countless other repositories of financial text, each of which reflects a deal cut at a time options did not need to be expensed under generally accepted accounting principles. And now Congress is thinking of changing that.

Consider one example: Corporation has a bank loan. The bank credit agreement states that the loan will be in default, or new borrowings will not be permitted, or dividends will not be paid, or payments on debt subordinated to the bank loan will not be made, or any number of other contingencies will be triggered, if the corporation’s earnings drop below a certain stipulated number, where the credit agreement also states that the term "earnings" is defined [or determined] in accordance with generally accepted accounting principles, as in effect from time to time. Suppose the corporation is, say, a software company not in nearly as good shape as when the credit agreement was signed, a software company which has never expensed its executive options. If expensing those options would require reducing earnings below the point stipulated in the credit agreement, the corporation would be in default under its bank line. This might trigger defaults under other facilities (so called "cross-defaults") and any number of other dreadful consequences to the corporation, including a possible downgrade of any public debt it may have. So if Congress requires that generally accepted accounting principles be modified so that executive options must be expensed, that could have serious consequences for such a company.

Similarly, if an executive's employment agreement grants him bonuses or other compensation based on company earnings, and those earnings are defined under generally accepted accounting principles as in effect from time to time, such Congressional action will have serious consequences for the executive.

That seems like a high price to pay for a matter that is supposedly driven by disclosure considerations, especially since such a new definition will not provide useful additional disclosure. For one thing, there is no one way to value an option. That problem has already surfaced in connection with the proposed Congressional "reform" legislation: How much "expense" should the law require be reflected in the balance sheet for options? But the reason there is so much disagreement about valuing options is not that options are misunderstood, it's that they should be valued in different ways for different purposes and under different circumstances.

What this means is that regardless of what Congress does, analysts will simply replace the plug figure for options used in the official balance sheets with the analyst's own calculation, using whatever methodology the analyst thinks is appropriate. Once the parameters of the option are public, the rest is superfluous to equities analysts.

The above discussion provides at least one answer to KausFiles question:

[I]f nobody's fooled by burying the options in the fine print, and a change would have no effect, then why have so many corporations, especially in the tech sector, lobbied so furiously to maintain the current arrangement? Are they fools? Obviously it makes a difference to them -- presumably because many investors look at reported profits and don't recalculate them after reading the footnotes....It's not as if there was irrational overinvestment in tech or anything!

Moreover, the answer proposed above proceeds without the need to assume companies are crooks or investors are too stupid to have not recalculated earnings after reading the footnotes.

So why is it so important for Congress to re-write a million corporate deals in the name of additional disclosure that the investment community doesn't care about?

UPDATE: The differences between the positions of Warren Buffet and Jack Welch on the benefits of options are revealing. Mr. Buffet appears to favor relatively simple companies in which high-powered executives are not really needed, so that heavy reliance on stock options is not needed. Mr. Welch has busied himself more to the other end of that continuum.