Posted 7:50 PM by Robert

Earnings And Options And Mr. Buffett

A prior post described certain ways in which Warren Buffett would apparently benefit, in a not entirely wholesome fashion, if the Security and Exchange Commission's requires that executive options of public companies be expensed. That post focused on the balance sheets. In the sultry post-Enron era, the mantra of many putative corporate governance reformers has been the importance of the balance sheet - with the corresponding evil of "off balance sheet" structured finance products established accordingly. Indeed, Mr. Buffett has used the Enron debacle to advance his view that expensing options is needed to avoid deceiving investors.

But Mr. Buffett has emphasized the effect of option expensing on corporate earnings, rather than the balance sheet, as evidenced in his most recent Berkshire-Hathaway letter to stockholders:

The Chicago Tribune ran a four-part series on Arthur Andersen last September that did a great job of illuminating how accounting standards and audit quality have eroded in recent years. A few decades ago, an Arthur Andersen audit opinion was the gold standard of the profession. Within the firm, an elite Professional Standards Group (PSG)insisted on honest reporting, no matter what pressures were applied by the client. Sticking to these principles, the PSG took a stand in 1992 that the cost of stock options should be recorded as the expense it clearly was. The PSG’s position was reversed, however, by the “rainmaking” partners of Andersen who knew what their clients wanted – higher reported earnings no matter what the reality. Many CEOs also fought expensing because they knew that the obscene megagrants of options they craved would be slashed if the true costs of these had to be recorded. Soon after the Andersen reversal, the independent accounting standards board (FASB) voted 7-0 for expensing options. Predictably, the major auditing firms and an army of CEOs stormed Washington to pressure the Senate – what better institution to decide accounting questions? – into castrating the FASB. The voices of the protesters were amplified by their large political contributions, usually made with corporate money belonging to the very owners about to be bamboozled. It was not a sight for a civics class.

That's remarkably intemperate language on Mr. Buffett's part - and it is language that focuses on the income statement. Current earnings are disclosed on the income statement, but are incorporated into next year's retained earnings - which are disclosed balance sheet. So it would very strange indeed if Mr. Buffett's concern focused entirely in the effect of how options accountings in the income statement distorts investor valuations - while disregarding or discounting any effect on public valuations from the effects of such "dishonest accounting" on the balance sheet.

But it is possible to effect Mr. Buffett's argument and reform through the income statement by assuming (contrary to the current obsession with balance sheets) that investors focus on the income statement, but essentially ignore charges to balance sheet items that bypass the income statement. Under this assumption, suppose eliminating "out-of-the-money" options is simply taken as a direct charge to retained earning at the time the options are terminate - and that the elimination has no effect on the earnings statement. Such an approach is not conceptually consistent with the justification for expensing the options and then carrying the original options charge on a historic basis on the balance sheet - but the "refome" could be imposed this way anyway. In other words, assume that accounting rules are "reformed" so that a company's original grant of options is treated as an expense and deducted from current earnings (in the earnings statement) - and that the effect of that charge is thereafter incorporated into retained earnings in the balance sheet, but when "underwater" options expire or are cancelled there is no corresponding increase in current earning resulting from any reversal of the charge in the income statement ether at the time the options slip under water or when they are terminated - but simply results in an increase to retained earnings, which is also assumed to be a balance sheet item which investors don't care about. Does this set of assumptions and reforms eliminate the advantage Mr. Buffett would otherwise obtain?

Well, it doesn't seem to. He still seems to benefit because the reasoning supporting his "reform" is based on the assumption that investors are misled by inflated "earning" when options are granted. That means that as a decline in the stock price causes the options progressively to fall "underwater" (because the assumed volatility of the stock over the life of the options yields a smaller positive contribution over the strike price in the corresponding Black-Scholes valuation) investors are "misled" in each accounting period by an under-reporting of current earnings equal to the amount of the options "submersion." That means that in each period investors see current earnings which are too low (under Mr. Buffett's assumptions) by the amount the options have slipped under water in that period. So (if Mr. Buffett is right) investors will undervalue the company when Mr. Buffett comes to buy it.

It appears that under such assumptions and reforms Berkshire-Hathaway will still do its own options evaluation, disregard all the accounting distortions the "reforms" have induced, eliminate the options after the acquisition, and realize a quick profit in the Berkshire-Hathaway stock price.

Next: Berkshire-Hathaway has more recently been concentrating on "sweetheart" minority investments. Does options accounting matter in that case?

UPDATE: More people seem willing to state publicly that expensing options isn't the answer. Much of the misquided mania continues, of course. Sadly, this pseudo-solution just distracts investors from the real problem: restrictions on the market for corporate control have aborted the most effective check on the pernicious consequences of the separation of public ownership (stockholder) from control (management). Of course, Mr. Buffett doesn't care about that. He is always an insider.