President Bush and his beleaguered SEC chief, Harvey Pitt, have gotten “behind the market” on the issue of how corporations account for stock options given to CEOs and other employees as part of their compensation packages.
Being “behind the market” is a term that economists use to describe the Federal Reserve when it is reacting rather than acting.
For example, if the Fed hesitates to tighten money supply in the face of obvious inflationary pressures, long-term lenders, such as mortgage firms, will raise rates spontaneously to protect themselves from inflation. The Fed may have to play catch-up as a result, eventually raising interest rates higher than if it had acted in a timely manner.
Now, like a central bank caught napping, the Bush administration is losing credibility and may eventually have to take stronger action than if it had acted with more resolve early on.
Coca-Cola said Sunday that it would begin treating the cash value of options given to employees as an expense. The Washington Post, a minor firm in comparison to Coke, announced a similar move. Billionaire investor Warren Buffett has advocated this measure for years as have his fellow plutocrat George Soros and Federal Reserve chairman Alan Greenspan.
Although I have not conducted a poll, I think it is fair to say that a wide majority of economists favor expensing options. Options obviously are of value to employees. They obviously cost the company something. Markets work best when information is bountiful and accurate. If companies are giving something of value to CEOs and others, the cost of that something should be fully reflected in accounts presented to the investing public.
It also is apparent that most accounting professors and practicing accountants favor the move. The whole purpose of accounting is to organize information in a useful manner that provides as much information as possible.
Although individual accountants in specific firms may feel pressure to use their skills to obscure rather than illuminate, the long-run historic thrust of their profession is in the direction of truthful, useful information.
So if accountants, economists and such stalwarts of capitalism as Greenspan, Soros and Buffett agree that stock options should be listed as an expense, why does the Bush administration still oppose requiring the measure? There are two possible explanations: incompetence and political pressure.
Just this past Sunday, SEC head Pitt argued that requiring firms to expense options would choke off innovation by high-tech start-up companies. It is true that such firms, which usually are cash-poor, use options extensively to attract skilled managers. Such firms often do not have the funds to offer much in direct pay to key executives during their early years when their technology is still being perfected.
By providing stock options that will be worth a great deal if the firm is successful, they attract and motivate people who are willing to take large risks for large rewards. These people would not hire on for the paltry salary available.
But no proposed rule requiring the expensing of options would ban this practice. Nor is there any implicit tax subsidy in the current treatment of options. Yes, expensing options would make the firms profits as reported to investors look a lot worse. But the majority of venture capitalists and others who invest in long-shot high-tech startups are well aware of the quantity of options offered and their likely eventual effect on earnings.
Disclosing the options on financial statements would just make the situation clearer to all, regardless of insider status or financial sophistication.
Administration officials also have stressed that determining the value of specific options can be complicated. True, but Coca-Cola seems to have found a workable method. There are standardized methods that even small firms could use to estimate value and these estimates can be adjusted to actual cost at the time they are exercised.
One analogy is that millions of firms, large and small, estimate depreciation of machinery and equipment using standardized accounting methods. And when the asset is finally disposed of they book a capital gain or loss if the actual value at disposal varies up or down from the book value on the depreciation schedule. This is not rocket science.
Pitt and Bush seem to be arguing that markets are harmed by transparency. That runs counter to everything economists have learned over the past 200 years. They are getting way “behind the market” on this issue and soon will have to run to catch up.
© 2002 Edward Lotterman
Chanarambie Consulting, Inc.