FASB is Still Wrong about Stock Options

by William A. Niskanen

William A. Niskanen, an economist, is chairman of the Cato Institute and author-editor of a forthcoming book, After Enron: The Major Lessons for Public Policy.

Added to cato.org on May 14, 2004

This article appeared on cato.org on May 14, 2004.

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Shortly before April Fool's Day, the Financial Accounting Standards Board (FASB) issued an exposure draft of a new accounting rule that, if approved, would require that all forms of share-based compensation be accounted as a cost in the period they are granted. The press release on this exposure draft says:

Under the Board's proposal, all forms of share-based payments to employees, including employee stock options, would be treated the same as other forms of compensation by recognizing the related cost in the income statement. The expense of the award would generally be measured at fair value at the grant date.

On this issue, the accounting gurus at FASB are wrong on all counts. Let me count the ways, (for this purpose treating stock options as representative of all forms of equity-based compensation):

  1. A stock option is not like "other forms of compensation." Stock option are an incentive for future performance; they are not, like a bonus, a reward for prior performance.

    2. William A. Niskanen, an economist, is chairman of the Cato Institute and author-editor of a forthcoming book, After Enron: The Major Lessons for Public Policy.

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  2. Stock options have no "related cost" in the period they are granted, in that there is no cash outlay or share dilution at that time. Stock options are a contingent dilution of the outstanding shares -- contingent on such conditions as the future price of the stock, whether the employee meets the restrictions on the exercise of the option, and whether and when the options are exercised. The options dilute the outstanding shares only when they are exercised and only when the total value of the outstanding shares has increased.

  3. There is no objective way to measure "the fair value (of options) at the grant date" unless someone creates a market in which such options are bought and sold. The general practice of firms that now expense options is to use some formula to estimate how much other people ought to be willing to pay for the options, but this estimated value is not an objective measure of their market value and may differ enormously from the value of the options when exercised. Moreover, the FASB has not specified any formula to estimate the value of the several forms of equity-based compensation, in which case the proposed rule does not increase the comparability of the earnings statements among firms.

  4. FASB also asserts that their proposed new rule "would achieve substantial convergence in this important area between U.S. and international accounting standards." That is correct but is not a sufficient case for the new rule. We should exercise similar caution about an international harmonization of accounting standards as we should about a proposal to harmonize tax codes.

  5. Finally, the logic of the proposed ruling would require firms to restate their earnings for all prior years in which options were granted unless, by accident, the market value of the options when exercised turns out to be the same as the estimate of their value when granted.

I find it difficult to believe that the FASB has even begun to think seriously about the several implications of their proposed rule.

The comment period for the exposure draft ends this summer on June 30. FASB Chairman Robert H. Herz stated that "we expect the proposal will draw interest from a broad spectrum of respondents, (and) we welcome all input." I hope this is true, but I doubt it; FASB has been committed to the expensing of options for many years, despite the strong opposition of many firms. The only significant prospect for stopping this proposed rule is that Congress would delay its implementation, as they did a decade ago.

I am not happy about relying on Congress to set accounting standards. But I am also not happy about allowing a private monopoly to set accounting standards with the authority of the Securities and Exchange Commission. My preference would be to authorize each stock exchange to set the accounting standards for all firms listed on that exchange, in which case the FASB would be only one of several competing accounting advisory groups.

In the meantime, let me repeat my conclusion that the FASB's proposed new rule on equity-based compensation arrangements is wrong on both timing and valuation grounds. Stock options and other forms of equity-based compensation dilute the outstanding shares only when they are exercised, not when they are granted. And the accounted value of these forms of compensation should be based on their market value when exercised, not on some non-objective formula when granted. In this case, the tax authorities have it right. The FASB has still not agreed about how to value equity-based compensation when granted because they are wrong about the timing issue.