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April 1, 1994
"A Compromise Could End the Stock Option Hysteria"
San Jose Mercury News
By Timothy Taylor
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ACCOUNTING standards are necessary, of course, but talking about them generally produces what one of my friends calls "the MEGO effect" -- that is, My Eyes Glaze Over. Yet last Friday, to the astonishment of bookkeepers everywhere, a dispute over accounting standards provoked an actual public rally at the San Jose Convention Center, with marching bands, gesticulating speakers, an animated crowd and all the trimmings.

The rally addressed an issue that lies tenderly in the affections of Silicon Valley: stock options. Under present accounting standards, companies can grant stock options with zero effect on their corporate earnings.

To the Financial Accounting Standards Board, the federal suits who set guidelines on such matters, this practice makes little sense. After all, FASB reasons, if a corporation is paying out something of value -- like a stock option -- then it should show up on a company's income statement as a cost, reducing the level of corporate earnings.

Silicon Valley high-tech companies hate the FASB proposal. If it takes effect, they fear that companies now using stock options will be forced to choose between a rock and a hard place.

If a firm keeps on using stock options, then the FASB proposal will cause its earnings to drop. Lower earnings generally mean a lower stock price, which makes it harder for a young company to raise capital by selling stock.

But keeping earnings high by trimming back on stock options presents an ugly scenario, as well. After all, options provide a direct financial incentive for entrepreneurs to take the risk of starting a company, and for managers and employees of a company to devote their creativity, intelligence and energy, not just their 40 hours a week, to increasing the company's profits and its stock price.

Perceiving a choice between less capital or fewer incentives, it's little wonder that Silicon Valley is up in arms. But despite some of the more florid predictions of disaster from local business people, my suspicion is that a compromise with the FASB proposal that would last for at least a few years is readily available.

In this deal, business would agree to provide considerably more detail about their stock options in annual reports and quarterly statements, including the quantity of stock options granted, the price at which the options could be exercised, the length of time that people must hold the option before exercising it, the time people typically choose to hold the option before exercising it, the effect of stock market volatility on the option, and so on.

There is presently no requirement to report this sort of broad information on a company's entire stock option policy. Even strong opponents of this particular FASB proposal seem open to taking this step.

In exchange for having all this information publicly announced, FASB would hold off (at least for a few years) on insisting that firms must calculate the cost of options, and subtract that cost from earnings. I can imagine four reasons why FASB might assent to such a compromise.

First, FASB probably doesn't have the raw power to force through an accounting change that is so intensely disliked. If industry keeps squawking, FASB should be receptive to some sort of deal.

Second, the underlying purpose of accounting standards is to provide a full and accurate financial picture of a company. If FASB assures that detailed information about a firm's stock options is openly announced, it will have accomplished its basic task of assuring that investors have sufficient information in this area.

Third, the main reason for the traditional practice of treating stock options as if they had zero cost is that it is so difficult to figure out what the cost actually is to a company of granting an option to buy stock. FASB has used recent developments in the economic theory of option pricing to develop some formulas, but such calculations still have a number of theoretical and practical problems.

Thus, FASB might welcome a cooling-off period of a few years where it would gather the newly available data on stock options, test out different formulas for valuing the options, and consider how the various formulas would have affected corporate earnings.

The Silicon Valley business community has been correct in pointing out that the FASB formulas for calculating the cost to a company of issuing a stock option are likely to be complex, questionable, and changeable. Such formulas could easily confuse accounting statements, rather than clarifying them.

However, the high-tech community needs to face the fact that stock options have substantial value, even if that value is tricky to measure. Therefore, FASB is correct to insist on the general principle that outside investors have a right to know, in detail, how a company's stock option plan functions.

Some business people seem to believe that if they release information about stock options, but don't subtract a cost for options from their "official" level of earnings, then the stock market will only pay attention to the earnings. That's foolishness. The stock market will pay attention to all available information, and will make adjustments according to whatever information exists about stock options, whether the FASB plan passes or not.

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