- The Washington Times - Sunday, July 21, 2002

Coca Cola, Bank One and The Washington Post will soon begin to "expense" the cost of employee stock options. In reality, what is being expensed is not an actual cost at all, but a wildly inaccurate estimate of the "fair" value when options were granted. And the ample information stockholders now receive about other companies' plans is about to vanish for these three.
For other companies, there is more than enough information about stock options in the annual reports. Joseph Stiglitz, writing in the Wall Street Journal, claimed stockholders have to "read through dozens of footnotes to find the implications of options." Actually, notes to financial statements are in full-sized type and full of tables. There is only one note about the plans, not dozens, and it usually requires two to six pages. Mr. Stiglitz also claimed companies conceal "how much their equity claims on the firm could be diluted by options." But that information is highly visible in diluted earnings per share.
The "footnote" shows how many options were granted and exercised at what prices, and how many old options were trashed because the stock fell or employees did not stay long enough to be vested. The footnote also provides a Black-Scholes estimate of the approximate "fair value" of newly granted options if they could be sold and hedged. It is this estimate not any actual cost that is about to be treated "as if" it were a cost by companies that adopt expensing. Other companies put such pro forma games in the footnote along with their purely hypothetical impact on earnings. The reason for not treating these estimates as real money was explained in Talbots' annual report:
"The [Black-Scholes] option pricing model used was designed to value readily tradable stock options with relatively short lives and no vesting restrictions. In addition, option valuation models require the input of highly subjective assumptions including the expected price volatility. Because the options granted to employees are not tradable and have contractual lives of tens of years and changes in the subjective input assumptions can materially affect the fair value estimate the models do not necessarily provide a reliable measure of fair value of the option."
Jeffrey Garten recently wrote in Business Week that employee stock options should "be charged against corporate income when they are cashed in." Unfortunately, the Financial Accounting Standards Board won't allow companies to do that. Instead, rules set down in 1995 by five of the seven FASB members only permit expensing of an estimate.)
Apologists for treating estimates as actual expenses, such as Warren Buffet, claim these estimates are no more problematic than estimating how quickly a machine will wear out. That formulaic analogy is an evasion. In the case of depreciation, we know the exact amount of expense. The only uncertainty is about how quickly the expense should be written off. The estimated fair value of unvested stock options, by contrast, do not provide the slightest clue whether the actual expense at the time options are exercised will turn out to be zero or some figure hundreds of times larger than "fair value" when granted.
There is no reason in theory or fact to expect estimated fair value to be even remotely similar to the actual expenses. Economists can also estimate the fair value of a lottery ticket, after all, but doing so tells us nothing about whether the jackpot will be paid, how large it will be or who will get it.
To promote its lottery-like accounting for stock options, the FASB invites companies that expense their estimates to do away with all the useful information required in every other annual report. In the name of increased transparency, all information about employee stock options from Coca Cola, Bank One and The Washington Post is about to vanish completely. In its place, a meaningless and unexplained estimate of "fair value" will be mingled with other operating expenses in a way that will make future earnings statements inherently indecipherable and inevitably incorrect. It is about to become very difficult to make an informed long-term investment in any company that adopts this politically popular accounting gimmick.
To make estimated fair value the basis for cost accounting seems a foolish deception. But to make such estimates the basis for limiting tax deductions, as the Levin-McCain bill would have done, would be dangerous nonsense. Exercised options are actual taxable income for employees and an actual deductible expense for employers. Estimates, on the other hand, are just estimates.

Alan Reynolds is a senior fellow at the Cato Institute and a nationally syndicated columnist.

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