Options, Schmoptions

by | Dec 31, 2004 | POLITICS

Well, it finally happened. The Financial Accounting Standards Board — the group that determines so-called “generally accepted accounting principles” for financial reporting — has ruled that companies must report the costs of stock options on their income statements. The NASDAQ tumbled yesterday when the news came out, because technology companies are the heaviest issuers of […]

Well, it finally happened. The Financial Accounting Standards Board — the group that determines so-called “generally accepted accounting principles” for financial reporting — has ruled that companies must report the costs of stock options on their income statements. The NASDAQ tumbled yesterday when the news came out, because technology companies are the heaviest issuers of stock options. This new rule is sure to reduce their reported earnings in the future.

Tech companies have been fighting this rule change tooth and nail. In fact, they’ve been fighting it for over a decade. There’s still a bill before the Senate that could yet blunt the effect of this rule change. But barring its last-minute enactment, the tech industry has finally lost this war. In the post-bubble, post-Enron world, it was only a matter of time until the accounting profession demanded the closing of a loophole that gave companies the chance to compensate executives and employees — sometimes extravagantly — without recording it as an expense.

Should you believe the inundation of media reports about the new options rule that you’ve already undoubtedly heard? Most of them are reciting the same dreary statistics about how the new rule will cut earnings at this or that high-profile technology company by this or that number of billions of dollars. You’d think that Silicon Valley is about to sink into the San Francisco Bay.

And should you believe what the usual cast of ready-made “experts” has to say about this? You know the type — the ones who seem to have nothing better to do with their expert time than get quoted in the financial media every day? A particularly smarmy one told the press late yesterday, “All of your favorite former high flyers from the 1990s — it turns out that they were never really all that profitable.” In other words, “I’m so smart and you’re so stupid.”

No, don’t listen. If you want to invest in technology stocks, don’t let this news get in your way. What the media and their experts are missing is that nothing in this new rule about options expensing has the slightest thing to do with reality. It’s just about how companies report reality.

And it’s not even much of a change about reporting. For years now everything an investor has needed to know about options has been reported, by FASB rules, in the notes of every company’s financial statements. The only difference now is that options expensing comes out of the footnotes and into the income statement.

Does even the smarmiest expert think that investors (other than himself, of course) are so stupid that they would value companies any differently depending on whether a piece of information is on page 6 of the annual report or page 20?

Obviously investors make mistakes. In the late 1990s and in early 2000 investors made a lot of them — especially about tech companies. Indeed, this was the heyday of options issuance by those companies. But in all those crazy years, everything about options that the new rule requires to be reported was already being reported. Any investor who wanted to know the facts had complete access to the facts.

So even if investors are stupid, this rule change isn’t going to help. When there’s an investment bubble going on, people are going to whip themselves into a speculative frenzy no matter what statistics you throw at them, or what size typeface those statistics are printed in.

No, the bubble years weren’t about lack of information about options. They were about the overestimation of the scope of the growth potential of technology companies in the age of the Internet. That’s what drove stock prices so ridiculously high in relation to earnings; future earnings were simply overestimated. Adjusting those wild expectations for the expense of options would have been like spitting in the ocean — it would have made no difference at all.

Of course, those same crazy years were the ones in which option-holding executives and employees became millionaires — and even billionaires — thanks to those options. When their stock prices went through the roof, so did the value of their options. To capture that value, the option holders had to exercise their options for stock and then sell the stock to pay their taxes. So when the bubble burst, angry investors looked back resentfully at what it seemed those option holders did — they sold stock in their own companies right at the top.

Looking back, it seems clear that a lot of people made too much money on their options — out of all proportion to their executive talent. Simply put, they got lucky. So, as you’d expect, there’s been a movement ever since to curb the number of options that are issued. Some companies, like Microsoft, have discontinued their options programs altogether.

But it’s not because of some meaningless accounting rule — it’s because companies are beginning to rethink whether options are as great an idea as everyone once thought they were.

An important detail in all this is that the FASB’s new option rule requires that companies estimate the value of their options the day they are issued, and use that estimate as the reported expense. The reality is that options expenses don’t have any economic reality until the day the options are exercised, which could be years in the future — and that’s likely to be a very different value than the initial estimates.

In some sense, this rule is the equivalent of letting a company put profits into its income statement based on nothing more than an estimate of what those profits will be in the future. Believe me, you’d go to jail if you did that. But now you’ll go to jail if you don’t do the very same thing with respect to expenses.

Thankfully, companies will still have to report the details of their outstanding options: issue dates, expiration dates and exercise prices. So careful analysts can still arrive at accurate calculations about true options expenses — just like they could have done before this new rule was enacted.

So as we get to the end of the year, here’s my suggestion for a New Year’s resolution: no more rules. We have enough of them already, and they’ve long ago ceased to mean anything. Yet we have to spend so much time wringing our hands over them.

Let’s drop the rule-making for a while and get back to actually running companies, and investing in them.

The above is an “Ahead of the Curve” column published December 17, 2004 on SmartMoney.com, where Luskin is a Contributing Editor.

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Don Luskin is Chief Investment Officer for Trend Macrolytics, an economics research and consulting service providing exclusive market-focused, real-time analysis to the institutional investment community. You can visit the weblog of his forthcoming book ‘The Conspiracy to Keep You Poor and Stupid’ at www.poorandstupid.com. He is also a contributing writer to SmartMoney.com.

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