Posted 10:53 PM by Robert

Expensing Options, Again

Zvi Bodie, Robert S. Kaplan and Robert C. Merton enthusiastically endorse the expensing of employee options in the Wall Street Journal today. Mr. Bodie is a professor of finance at the Boston University School of Management. Messrs. Kaplan and Merton are professors of accounting and finance, respectively, at Harvard Business School. Mr. Merton won the Nobel Prize in 1997 for his work on option pricing.

This is so much intellectual firepower that one wishes one could say that they really add something new, some insight more than their impressive credentials. But they don't. Worse, at least some of their arguments are downright disingenuous. For example, they argue:

Finally, some opponents of expensing employee stock options make two arguments that actually conflict with each other. First, they claim that it is enough to disclose the information in the footnotes to corporate financial statements as is done now. And second, they claim that to require that options be expensed would hurt companies, particularly high-tech firms that rely heavily on options as a form of compensation. But if deducting the expenses of options that are already disclosed in footnotes would drive a company's stock price down, then we have proof that the disclosure alone was inadequate to capture the underlying economic reality.

Well, ok. But what about people who argue that it is enough to disclose the information in the footnotes to corporate financial statements as is done now and don't think that to require that options be expensed would hurt companies that rely heavily on options as a form of compensation? It really doesn't take a Nobel Prize in economics to see that these distinguished authors have not answered the main argument, but have resorted to a disturbing and transparent rhetorical device to avoid it. It is even odd that this argument is placed at the end of the piece, since it is among strongest arguments offered by opponents of expensing.

The other arguments the authors spend most of their time refuting are almost straw men: grants of stock options do not involve cash outlays, expensing of stock options would be double counting, and employee stock options are worth less than publicly traded options because employees do not gain full ownership of the shares (do they mean "options," not "shares" here?) during their vesting period. Nor do the authors present the positions they are supposedly refuting in the best ways.

The authors' logic is simple, indeed it is exactly the same logic nearly every proponent of expensing options uses:

(1) "When a company issues securities whose value can be reasonably determined, accounting principles require that this value be recorded in the company's financial statements."

(2) The value of employee stock options can be reasonably determined.

(3) Therefore, value of employee stock options should be recorded in the company's financial statements.

What is most striking about the authors’ approach is the absence of any suggestion that expensing options as they advocate would actually bring additional useful information to the securities markets. Indeed, the approach seems to assume that expensing options would neither increase or decrease the amount of information conveyed, so that the matter may be treated as an academic algebra exercise culminating in the silly end of their article: "If the following true-or-false question appeared on an accounting exam, the answer is quite clear: Employee stock options should be expensed on a firm's income statement. True.". That final rhetorical flourish seems to reveal quite a bit more about the authors' thought processes than they appear to have intended.

I will set aside for other people the question of whether accounting principles have really been applied the way the authors suggest in connection with, say, convertible debentures. But I note that the authors seem to imply that the convertibility feature is expensed completely at the time the debenture is issued.

To apply their sylogism. the authors need to explain and do not explain - other than by assertion - why one or the other options pricing techniques is "reasonable" for purposes of preparing the balance sheet of a public company. It is surely not enough to argue as these authors do that investment bankers value options all the time and make important decisions based on those valuations, such as big mergers. Of course they do.

But that alone doesn't mean such valuation techniques provide a "reasonable valuation" for balance sheet purposes. "Reasonableness" in this context should require a consideration of how such valuations will be read and used by ordinary and professional investors. If the first will likely be misled by the inclusion of the valuation and the second will certainly disregard the valuation, how likely is it that the valuation is reasonable?

Simply put, the authors need to explain why in determining whether a "reasonable" valuation technique exists for purposes of applying the accounting principles to which they cite, no consideration should be given to the relative abilities of professional analysts to do their own calculation or the likely confusion expensing options would create in ordinary, non-professional investors.

All in all, an odd effort, in my humble opinion.