Expensing’s Seven Lives

  • Mercury News (reg req): Panel OKs measure to block expensing. A congressional committee overwhelmingly approved legislation Tuesday that would block a proposal to force companies to deduct the cost of stock options.

  • This is a cheap vote by committee members for legislation they surely suspect will never become law. It shouldn’t become law.

    The system has worked to the vast benefit of Silicon Valley companies, which understandably want to keep the gravy train rolling, but now they should do the right thing. The time has long since passed when companies should honestly reflect the value — the cost to shareholders — of stock options in their income statements.

    Shareholders will understand, if reported earnings drop due to expensing of options, that nothing fundamental in the company has changed. Today, profits are overstated, and shareholders seem to grasp that without much trouble. They aren’t as stupid as the tech industry seems to think.


    Posted by: on June 16, 2004 11:36 AM

    Sorry, Dan, but it’s not possible to “honestly reflect the value — the cost to shareholders– of stock options”. To do so requires a prediction about the future, together with a prediction about human behavior (that is, how many optionees will cash in their options, for what price, and when).

    With options that are traded on the open market, it is possible to determine that option’s value, based on what someone will pay for it. With employee stock options, it’s guesswork.

    Nevertheless, Black and Scholes came up with a formula. The problem is, their formula was for options openly traded on the futures market. Their assumptions are violated since options can’t be sold; they have to be exercised by isolated, emotionally involved individuals that don’t behave like the economically rational automatons in the textbooks.

    The Black-Scholes formula makes a lot of assumptions, like interest rates remaining constant and known, efficient markets, no dividends paid, and the like. So in the end, we’re talking about replacing one fake number with another fake number.

    Given this, I wouldn’t worry too much about it, except that it’s helping to bring historic Silicon Valley practice of widely dispersing stock options to an end. If options become a more expensive perk to hand out, the execs will reserve the perk for themselves. A lot of engineers in the valley managed to make the down payment on their houses from stock options; this will no longer happen.

    Posted by: on June 16, 2004 10:57 PM

    A lot of accounting methods are artifical. Anything other than “cash” accounting, for the most part, is artifical. Accounting works because everyone applies rules and methods consistently.

    The formulas for valuing options may be flawed, but it will work as long they are in the ballpark and all companies follow them consistently. If shareholders can understand how tech company inflate their numbers without expensing options, surely they can understand the formulas’ flaws?

    GM is expensing options. Why can’t tech companies do the same?

    If “it isn’t fair” because tech companies enrich more rank-and-file employees than old-economy companies, perhaps we should consider whether it is fair this Valley’s engineers priced everyone else out of the housing market.

    If stock options truly cannot be valued accurately, then it should change into something that can be correctly valued. (Such as real freely-tradable options on a real stock market) Otherwise it is giving companies the right to manipulate their books. Do we want *that*?

    Posted by: MiC on June 25, 2004 03:02 AM

    Nice article, keep up!

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