Title

Expensing Isn't the Only Option: Alternatives to the FASB's Stock Option Expensing Proposal

Abstract

This paper reviews the arguments for and against the Financial Accounting Standard Board's (FASB) proposal to require that corporations expense options. It identifies two major goals of the proposed rule -- 1) clarity in financial statements and 2) a reduction of corporate fraud by removing the incentive of options. To address these two goals, I adopt a framework of Information Reforms v. Rules of the Game Reforms. The article starts with a history of FASB Statement No. 123 Accounting for Stock-based Compensation and also analyzes the Congressional legislation that attempts to block the measure, the Stock Option Accounting Reform Act. I review the opinions of leading economists on the accuracy of the option valuation schemes advocated by the FASB and conclude that the models are too easily manipulated to advance the FASB goals of clarity in accounting. I conclude that neither the FASB proposed rule nor the Congressional legislation advances the goal of clarity in financial statements.

The article suggests alternative measures that would better serve the interests of investors. I argue that a more accurate solution to the expense problem would be to adopt the IRS method for valuing stock options -- intrinsic value at date of exercise. This accounting method tracks the cash flow out of the corporation since it reflects either an actual repurchase of shares issued by the company or a lost opportunity cost. In addition, I propose that corporations be required to only use fully diluted, in-the-money capitalization when computing EPS. This measure would address the FASB's concerns that the employee is given a valuable equity instrument at date of grant without there being a reflection in the company's financials.

Finally, I review the literature that analyzes the impact of the FASB proposal on companies and the economy as a whole. The data shows that the FASB measure will not result in a reduction of corporate accounting fraud and the measure will result in a loss of productivity among American firms that use options to incentivize workers. I argue that the FASB proposed rule should be considered independent of considerations such as a reduction in fraud. The measure should solely be considered as an Information Reform, which by its nature is meant to improve the clarity of information rather than modify behavior. Modifying the behavior of executives who commit fraud or boards of directors who make large option grants requires more fundamental Rules of the Game Reforms rather than Information Reforms. Typical Rules of the Game Reforms would shift the power from management and the Board of Directors to shareholders and might include restrictions on the sale of executive stock so as to better align the interests of shareholders and employees.

Disciplines

Accounting Law | Administrative Law | Banking and Finance Law | Business Organizations Law | Economics | Labor and Employment Law | Securities Law

Date of this Version

August 2004