Posted 11:26 AM by Robert

Earnings And Options And Mr. Buffett II

One of the core justifications for expensing options (and one often employed by Mr. Buffett) posits that where there is a liquid market in the stock underlying the option, a reasonable value can be placed on the dilutive effects of the option - and not reducing current earnings by that much (that is, not expensing the options) therefore is "dishonest accounting." If that is true, then as the underlying stock price falls or rises, ongoing adjustments can also be made - and "honest accounting" requires that they be made. If the stock price increases after the options are originally issued, then the company will forego more when they are exercised. The date of issuance is arbitrary as far as investors are concerned.

Even in Mr. Buffett's world executives focus on what their options are worth currently much more than they do on what the options were worth at the time of their issue. "Honest accounting" should put executives and investors on a level playing field. In short, Mr. Buffett's position leads to the conclusion that options should not only be expensed - they should be marked to market in each accounting period. But such a policy would couple the earnings of a company inextricably to its stock price - and it is hard to imagine a bigger divergence from "honest accounting" than that. It is not that hard, for example, to imagine a successful company having years of profit essentially erased year after year by mark-to-market-options accounting as the stock price rises - with the end result of all this "honest accounting" being a highly solvent company with, say, One Billion Dollars in cash, but which had never had any current earnings.

Most people retreat from that horror - and the result is proposals to treat the options expense in the balance sheet on a historic basis as a fixed reduction in retained earnings. But that leads to problems if the options submerge over time and when they expire. For example, non-liquid assets such as real property are carried at historical cost - but when the asset is sold the gain (or loss) is taken into the income statement in the then-current period. If that were done with options, a company would experience a huge surge in phantom "earnings" when its submerged options expired or otherwise terminate. That would be intolerable. So a further distortion is generally introduced: increasing retained earnings in the balance sheet and bypassing the income statement entirely. (Of course, if the company is issuing options continually, this problem may repeat itself continually.) That's all a real gift to the likes of Berkshire-Hathaway.

Mr. Buffett often castigates executives as having a keen awareness of the value of the very options they are arguing are beyond valuing. His argument ignores the difference between the legal standard required for valuing an option ("reasonable basis") and the personal standard required for sustaining a hunch. For example, Mr. Buffett may have had a personal hunch that he would one day be worth many billions of dollars, and have fought strongly for that hunch - but he would have had no reasonable basis for putting that hunch in the Berkshire-Hathaway SEC disclosure documents. Put another way: Perfectly rational and talented people (including many executives and Mr. Buffett) often fight for things and believe in things for which they have no "reasonable basis" as the SEC defines that term. And Mr. Buffett is wrong therefore to suggest that just because executives are willing to fight for their options are if they have great value that those executives would feel comfortable stating their value in a legal, public disclosure document.