Tell the Truth, Unless It Hurts

Tell the truth, unless it hurts—or unless it’s politically dangerous. “We can’t stand by and let accountants wearing green eyeshades decide who is going to get the American dream,” said Senator Barbara Boxer (D-Calif.) before a Silicon Valley lobbying organization. And, in a letter jointly written with 14 other senators, Senator Mike Enzi (R-Wyo.) said that FASB’s procedures are “seriously flawed” and it should “back up a step and do the critical thinking and analysis that we should expect” before changing the rules. The letter further says that a rule which would require companies to deduct stock option costs from earnings would “eviscerate” compensation plans that distribute options to all employees. These statements were provoked by FASB’s decision to consider adding stock option accounting (yet again) to its agenda.

Since then, FASB has decided to do so, and I applaud and fully support that decision. If, however, FASB had decided not to address this issue, I would have understood: It would have been because of the concern over a repeat of the political pressure FASB faced when the issue was last debated in the mid-1990s. That debate resulted in a compromise that required only the disclosure of options, rather than proper accounting. Now that FASB has decided to revisit the topic, we will again see significant political pressure brought to bear to keep FASB from changing the current antiquated accounting rules.

Senator Enzi says “do the critical thinking.” I cannot think of any accounting subject that has been thought about critically more than stock option accounting. Moreover, unlike many legitimate debates on accounting issues, I’ve never heard an accountant convincingly support, on the merits of the accounting, the current rules. Rather, the Senator’s comments are nothing more than another threat, and a thinly veiled one at that.

In no way do I mean to speak disrespectfully of the FASB members who reached the “compromise” the last time. I believe they did the only practical thing at the time, in the face of Congressional leaders and others who threatened to put them out of business. Because of this pressure, the SEC even gave up its support of this much-needed rule change. Why the pressure? High-tech (and other) companies said they liked the current rule, which was written in 1972 and was itself a compromise. (I admit that most accounting firms also supported this view.) The companies said the current rule worked because it was understood, it had served the public well for many years, and it was simple to apply.

But not so! First, it was not well understood. In fact, only a few professionals in the national offices of large accounting firms really understood it. It was so well understood that in 2000 the FASB issued an interpretation to assist understanding and to curb abuses. Did this guidance—the longest interpretation FASB has ever issued—make the rule understood? No. FASB’s Emerging Issues Task Force (EITF) has since had to consider and conclude on more than 50 implementation issues regarding this interpretation.

Second, the rule had not served the public well. It encouraged companies to develop stock option plans for their executives which were less economical for companies and their current stockholders. Those plans often led to executives realizing significant increases in wealth for reasons that had little if anything to do with their efforts.

Last, the rule was not simple to apply. The only simple thing about the rule was the real reason companies wanted to maintain it: to avoid recording a major expense in their income statements.

If these companies had to record as an expense in their income statements the cost of the options given to employees (this being in many cases a very significant part of employee compensation), they feared their stock price would drop. Is this a reason to mislead current investors by not recording a significant cost of doing business? No. A changed stock option accounting rule, requiring that the options be measured and recorded as an expense in the income statement, would only allow investors to see what management has given to the employees. The investors have a right to know; it’s their company.

In the mid-1990s, these companies made these arguments and prevailed because of the political support they were able to attract. Now, when Congress is increasingly scrutinizing and criticizing accounting, these politicians should switch sides or, better yet, stay out of it.

It would seem that Congress would be compelled by its own words and actions to fully support FASB in changing the rules for stock option accounting, but I doubt that that will happen. Rather, now that FASB has courageously decided to engage in the battle to change the rules, I expect that it will continue to face the wrath of those who are content to not tell the truth when it hurts (the companies) or when it is politically dangerous (the politicians). Indeed, Senator Enzi and 12 other senators wrote a letter to the SEC in March, requesting that the SEC undertake a study to examine footnote disclosures to determine the accuracy of the disclosed valuations that were performed using the Black-Scholes valuation method—an exercise I believe is impossible. The politicians are trying to stop the much-needed change to the rules by arguing that the Black-Scholes valuation method is inaccurate. They even suggest the method could be “precisely wrong.” Yet it is the method often used by companies in setting the value of compensation packages for their executives. It may not be perfect, and I would support research to develop a better method, but not at the cost of delaying change. The only approach that is precisely wrong is the current rules for stock option accounting.

I would expect nothing different from the companies; they view the continuing misstatement of their income as a survival measure. Very disappointing, however, are the politicians. These are the same politicians that criticize accounting standards setters for not developing standards that lead to fair financial reporting, and that criticize auditors for not standing up to inappropriate pressures from their clients. I see much of the same thing going on here. Enzi and the other senators end their letter to the SEC by stating, “[I]nvestor protection now demands that the SEC undertake this important research to ensure that any decision-making by the FASB is based on an impartial review of all the facts.” I guess so. Shame on them.

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