Stock option expense jousting

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After hearing constant tirades about U.S. foreign policy offending "the world," a majority of American voters still decided in Election 2004 that sometimes America needs to follow its own path.

Now, another issue looms in which policy elites say America has to change its course, or else it won't get along with the rest of the world. As with the debate over Iraq, those who use the phrase "the rest of the world" are really talking about the countries of old Europe. And although this issue does not concern national security, it has much to do with America's freedom, competitiveness and unique entrepreneurial culture.

The issue is stock options, and an effort by an unelected group of accountants to change the law by fiat and force U.S. companies to take a hit in reported earnings.

In March, the Financial Accounting Standards Board (FASB), a private group selected by accountants and financial executives, ruled that by next year, U.S. companies must expense an estimate of the future value of stock options against current earnings. Since the Securities and Exchange Commission (SEC) adopts FASB's accounting pronouncements, this standard will have the force of law. Some companies that offer broad-based stock options as incentives for their employees say this could reduce their reported earnings by 40 percent.

Due to public outcry, FASB recently delayed the rule until June but otherwise refused to budge. Invoking Enron and other companies caught cooking the books, FASB and its supporters argue its standards will make balance sheets more transparent for investors. But a close reading of FASB's statements points to another agenda for this radical step: to have "harmonization" and "convergence" with the pronouncements of European accounting bureaucrats. The Europe-based International Accounting Standards Board has announced that, pending final approval by the European Union, all companies must expense stock options to list on EU stock exchanges by 2005, or 2007 if they also list on U.S. exchanges.

"To maximize the opportunity for international convergence" was a major reason for pushing through the new U.S. standard, said FASB Chairman Robert Herz in congressional testimony.

"The proposed statement would result in greater international comparability," said FASB of its ruling. Mr. Herz also warned Congress that if the U.S. doesn't move to expensing options in alignment with Europe, "we would be the odd man out."

Yet what is so bad about being the "odd man"? Twenty-five years ago, the U.S. was told it would have to go completely to the metric system or suffer grave economic consequences. Yet foreigners still want to do business with the "odd man" even if it's in pounds, gallons and inches. And America is indeed "odd" compared to the rest of the world in terms of its unparalleled levels of opportunity and prosperity. It's this "oddness" that attracts folks from all over the world, including old Europe, to come make a new start in the U.S.

But messing with the American innovation of stock options could put a damper on America's unique culture of entrepreneurship and risk-taking. And this, in fact, may be what European bureaucrats are counting on.

Most European companies don't utilize broad-based stock options, but they are a crucial part of America's economic engine, instrumental in the growth of companies from Microsoft to Home Depot. This new standard would either reduce earnings for innovative companies or reduce their use of stock options to attract and motivate employees. Either way, "it would reduce our competitive advantage," says John Palafoutas, the American Electronics Association's senior vice president for domestic policy.

Alfred Berkeley, former president of the Nasdaq stock market, also warned in a letter to FASB about the EU's hidden agenda. "Unable to unleash the the creative power of their own economies," he wrote, European bureaucrats "see options as unfair competition and need to pull us down to their own miserable levels of opportunity and performance."

And Europe's own recent corporate scandals cast doubt on whether converging to EU accounting standards would ensure any more transparency for the American shareholder. Without broad-based stock options, Dutch food chain Royal Ahold and Italian food conglomerate Parmalat both tanked after the discovery of massive alleged fraud in their corporate reports.

FASB already requires that a company's report disclose the issuing of options. But many experts say forcing companies to charge a future-based cost estimate of options against their current earnings would be inherently misleading for shareholders. Often the stock options won't be exercised by employees until years after their issuance. Sometimes they are never exercised. Princeton economists William Baumol and Burton Malkiel have written that "it is virtually impossible to put a precise estimate on the option's value."

Legislation to push back FASB's ruling passed the House of Representatives in July by a 312-111 vote, with bipartisan support. Congress may revisit the issue in the upcoming "lame duck" session. A companion bill remains blocked in the Senate, however, due to the flawed reasoning of a few lawmakers, including Richard Shelby, Alabama Republican, and Carl Levin, Michigan Democrat. Their main argument is that Congress should defer to the FASB's judgment. But FASB appears to have deferred its judgment to the European Union.

As a beacon of free enterprise, America must show the world how to foster entrepreneurship, not follow blindly policies that could push us off the cliff of European economic malaise.

Concerned Americans should tell their legislators that on both national defense and economic policy matters, there are times when America must "go it alone." Or at least go about its business without the express permission of old Europe.

John Berlau is the Warren T. Brookes Journalism Fellow at the Competitive Enterprise Institute.