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I asked Jack Guynn and
Bob Eisenbeis what issues you would like me to address
this morning. They suggested that events associated with
the failure of Enron have refocused attention on a number
of accounting issues.1
In an economy as large, diverse, and
complex as ours, sound corporate governance-- including
the accurate measurement of corporate performance--is
essential if our nation's resources are to be directed to
their most efficient uses. There can be little doubt that,
on the whole, both, as employed in the United States in
recent decades, have been of very high quality. We simply
could not have achieved our level of economic performance
if capital were allocated on the basis of grossly
inaccurate information.
But the very complexity and dynamism of
our system requires that we constantly evaluate the tools
employed for measuring corporate performance to ensure
that they adapt appropriately to the evolving financial
and economic environment. In that regard, the increasing
use of stock option grants to employees has raised new
challenges for our accounting system.
Such options are important to the
venture capital industry, and many in high-tech industries
have counselled against making any changes to current
practices. They argue that the use of options is an
exceptionally valuable compensation mechanism; that
recognizing an expense associated with these grants would
reduce the use of options, harming high-tech companies;
that the effect of options on fully diluted earnings per
share is already recognized; and that we cannot measure
the costs of options with sufficient accuracy to justify
their recognition on financial statements.
These are important concerns. This
morning, I would like to address them and other related
issues. The seemingly narrow accounting matter of option
expensing is, in fact, critically important for the
accurate representation of corporate performance. And
accurate accounting, in turn, is central to the
functioning of free-market capitalism--the system that has
brought such a high level of prosperity to our country.
Capitalism expands wealth primarily
through creative destruction--the process by which the
cash flow from obsolescent, low-return capital is invested
in high-return, cutting-edge technologies. But for that
process to function, markets need reliable data to gauge
the return on assets.
Measures of profitability, however, can
only be approximate. Although most pretax profits reflect
cash receipts less cash costs, a significant part of
profits results from changes in the valuation of items on
the balance sheet. The values of almost all assets are
based on their ability to produce future income. But an
appropriate assessment of asset value depends critically
on a forecast of forthcoming events, which by their nature
are uncertain.
A bank, for example, books interest paid
on a loan as current revenue. However, if the borrower
subsequently defaults, that presumed interest payment
would, in retrospect, be seen as a partial return of
principal and not as income. We seek to cope with this
uncertainty by constructing loan-loss reserves, but the
adequacy of those reserves is also subject to a forecast.
Similarly, depreciation charges against income, based on
book values, are very crude approximations of the decline
in the economic value of physical plant and equipment. The
actual decline will not be known until the asset is
retired or changes ownership. Another example is the
projection of future investment returns on defined-benefit
pension plans, which markedly affects corporate pension
contributions and, hence, pre-tax profits. Thus, how one
chooses to evaluate the future income potential of the
balance sheet has a significant effect on current
reported earnings.
The estimation of earnings is difficult
enough without introducing biases into the calculation. I
fear that the failure to expense stock option grants has
introduced a significant distortion in reported
earnings--and one that has grown with the increasing
prevalence of this form of compensation.
As I noted at the outset, some view the
current treatment of option grants as having been a major
aid in raising capital to finance the rapid exploitation
of advanced technologies. While the vital contribution of
new technology to the growth of our economy is evident to
all, not all new ideas create value on net. Not all new
ideas should be financed. In recent years, substantial
capital arguably was wasted on a number of enterprises
whose prospects appeared more promising than they turned
out to be. This waste is an inevitable byproduct of the
risk-taking that generates the growth in our economy.
However, the amount of waste becomes unnecessarily large
when the earnings reports that help investors allocate
investment are inaccurate.
Stock-option grants, properly
constructed, can be highly effective in aligning the
interests of corporate officers with those of
shareholders. Such an alignment is an essential condition
for maximizing the long-term market value of the firm.
Regrettably, some current issuance
practices have not created the alignment of incentives
that encourages desired corporate behavior. One problem is
that stock options, as currently structured, often provide
only a loose link between compensation and successful
management. A company's share price, and hence the value
of related options, is heavily influenced by economy-wide
forces--that is, by changes in interest rates, inflation,
and myriad other forces wholly unrelated to the success or
failure of a particular corporate strategy.
There have been more than a few
dismaying examples of CEOs who nearly drove their
companies to the wall and presided over a significant fall
in the price of the companies' stock relative to
those of their competitors and the stock market overall.
They, nonetheless, reaped large rewards because the strong
performance of the stock market as a whole dragged the
prices of the forlorn companies' stocks along with it.
Stock or options policy should require
that rewards reflect the success or failure of
managements' decisions. Grants of stock or options in lieu
of cash could be used more effectively by tying such
grants through time to some measure of the firm's
performance relative to a carefully chosen benchmark. Many
corporations do tie the value of stock and option grants
to relative performance, but most do not. To be
sure, an untied option grant can be thought of as an
option whose value moves with the performance of the
corporation relative to the competition, coupled
with a call option on, for example, the S&P 500 stock
index. It can be argued that the latter is merely another
form of compensation that helps firms retain valued
employees. I am sure that is right, but does a
compensation system tied to the overall stock market serve
a company well?
Let me now turn to option accounting. A
stock option is a unilateral grant of value from existing
shareholders to an employee. It is a transfer through the
corporation of part of the market capitalization owned by
existing shareholders. The grant is made to acquire the
services of the employee, and presumably has a value
equivalent to the cash or other compensation that would
have been required to obtain those services--what
economists call the opportunity cost of employing those
services. That value is obviously a function of when, and
under what conditions, the option can be exercised. To
assess the cash equivalent of the option, only the market
value of the option at the time of the grant matters.
Subsequent changes in the value of the option are not
relevant to the exchange of labor services for value
received, just as future changes in the purchasing power
of cash received for services rendered do not
affect the firm's compensation costs.
The accurate measurement of input costs
is essential for determining whether the corporation
earned a profit from its current activities. That
determination was relatively straightforward when all
receipts were cash and all expenses were cash costs. But,
changes in balance-sheet valuations based on fragile
forecasts have become a more important element in
determining whether a particular corporate strategy was
successful. And, as a consequence, cost estimation has
become ever more problematic. But the principle of
measuring profit as the value of output less the value of
input is not altered by the complexity of measurement.
To assume that option grants are not an
expense is to assume that the real resources that
contributed to the creation of the value of the output
were free. Surely the existing shareholders who granted
options to employees do not consider the potential
dilution of their share in the market capitalization of
their corporation as having no cost to them.
The particular instrument that is used
to transfer value in return for labor services is
irrelevant. Its value is not. Abstracting from tax
considerations, one must assume that the value is the same
for the employer irrespective of the nature of the
instrument that conveys it--which could be cash or its
value equivalent in the form of stock, free rent, a
college annuity for one's children, or an option grant.
The ability of options to substitute for
cash obviously rests on an expectation by an employee that
the price of the company's stock will rise. Expectations
of stock price movements, in turn, appear to be
significantly influenced by recent stock price behavior.
Thus, there is little surprise that stock options gained
considerable favor as a form of compensation with the
steep rise in stock prices in the late 1990s. Similarly,
one might reasonably expect that in an environment with
slower stock price gains, option grants would no longer be
so favorably viewed by employees as a substitute for cash.
As a consequence, more cash or its equivalent might then
be required to fund labor services.
One may argue that, because option
grants are fully disclosed and their effect on earnings
can, with some effort, be estimated reasonably well,
financial markets in their collective wisdom see through
the nature of any bookkeeping transactions. Hence, how
expenses and profits are reported is of no significance,
because nothing in the real world is altered. Cash flows,
for example, are unaffected. The upshot of this reasoning
is that stock prices should be unaffected by whether
option grants are expensed or not. Clearly, most high-tech
executives believe otherwise. How else does one explain
their vociferous negative reaction to expensing if its
only effect were to change the book profit reported to
shareholders?
I fear they may be right. Indeed, most
American businesspeople must believe expensing is more
than bookkeeping. Current accounting rules encourage firms
to expense option grants. However, only two of the S&P 500
firms reportedly chose to do so in the year 2000. If
expensing does indeed matter, at least some of the
unsustainable euphoria that surrounded dot-com investing
at its peak may have been exacerbated by questionable
reported earnings.
The measure of diluted earnings per
share currently reported by corporations partially
reflects the number of shares that employees could obtain
with vested but, as yet, unexercised options. Some have
maintained that this is all that is required to capture
the effects of option grants. Clearly, this adjustment
corrects only the denominator of the earnings per share
ratio. It is the estimation of the numerator that the
accounting dispute is all about.
Some have argued
against option expensing on the grounds that the Black-Scholes
formula, the prevailing means of estimating option
expense, is approximate. It is.2
But, as I indicated earlier, so is a good deal of all
other earnings estimation. Moreover, every corporation
already implicitly reports an estimate of option expense
on its income statement. That number for most companies,
of course, is exactly zero. Are option grants truly
without value?
As I noted earlier, critics of option
expensing have also argued that expensing will make
raising capital more difficult. But we need to remember
that expensing is only a bookkeeping transaction. To
repeat, nothing real is changed in the actual operations
or cash flow of the corporation. If investors are
dissuaded by lower reported earnings as a result of
expensing, it means only that they were less informed than
they should have been about the true input cost of
creating corporate revenues. Capital employed on the basis
of misinformation is likely to be capital misused.
Critics of expensing also argue that the
availability of options enables corporations to attract
more-productive employees. I am sure that is true. But
option expensing in no way precludes the issuance of
options. To be sure, lower reported earnings as a result
of expensing, should it temper stock price increases,
could inhibit option issuance. But, again, that inhibition
would be appropriate because it would reflect the
correction of misinformation.
It is no more valid, in my judgment, to
assume that option grant expense is zero than to
arbitrarily assume depreciation charges are zero. Both
assumptions, excluding interest, increase reported pretax
earnings. Both imply that the inputs that produce valued
corporate outputs are free.
One issue that has complicated the
discussion of option expensing is the different way it is
handled for tax accounting. Under tax law, when options
are exercised, the value realized by an employee--that is,
the difference between the share price and the strike
price--is a deductible compensation expense for the
company. The amount of this compensation for tax purposes
reflects a rise in the price of the stock after the option
grant.
Any such price changes
are of no relevance in judging the cost of purchasing
labor services, though they do affect the tax liability
and possibly the after-tax earnings reported to
shareholders of the firm that granted the option.3
How capital gains and losses associated with these
transactions should be reflected in reported earnings is a
separate issue.
I want to emphasize that expensing in no
way inhibits the legal authority to issue options. Yes, if
investors take currently reported earnings as real,
expensing will reduce a corporation's perceived earnings
and conceivably its stock price. Employees, accordingly,
will consider options less valuable and presumably fewer
will be issued. But confusing markets is neither helpful
nor permanent. If underlying corporate input costs are
real, they cannot be obscured indefinitely.
As I indicated earlier, the continued
popularity among employees of option grants as a
substitute for cash compensation requires a persistent
expected uptrend in a company's stock price. Should
compensation shift more to cash, the trend in reported
earnings growth would decline relative to an earnings
trend in which options have always been expensed. Such a
shift presumably would make option expensing more
attractive to the corporation.
With an accounting system that is, or
should be, measuring the success or failure of individual
corporate strategies, the evolution of accounting rules is
essential as the nature of our economy changes. As the
measurement needs change, rules must change with them.
This does not lend itself to hard-wired legislation, which
makes flexibility of rule-making difficult. We would be
best served, in my judgment, by leaving issues such as
option grant expense to regulatory bodies and the private
sector.
There is a legitimate question as to
whether markets see through the current nonexpensing of
options. If they do, moving to an explicit recognition of
option expense in reported earnings will be a nonevent.
The format of reports to shareholders will change
somewhat, but little more will be involved. Making an
estimate of option expense requires no significant
additional burden to the company.
If, however, markets do not fully see
through the failure to expense real factor inputs, market
values are distorted and real capital resources are being
diverted from their most efficient employment. This
would be an issue of national concern.
Clearly then, the greater risk is to
leave the current accounting treatment in place. If
markets have seen through the accounting, required
expensing of option grants will have no effect on the
nation's capital allocation. If, however, expensing does
affect market values, a continuation of current accounting
practice could be costly to capital efficiency.
Some very notable developments in our
corporate sector in recent years, most strikingly evident
in the collapse of Enron, have unearthed deficiencies in
corporate governance. These are being addressed through
market repricing and regulatory initiatives.
Despite evident shortcomings that have
emerged from time to time, as I noted at the outset, we
should not lose sight of the fact that these arrangements
over the decades have effectively promoted the allocation
of the nation's savings to its most productive uses.
Generally speaking, the structure of business incentives,
reporting, and accountability has served us well. I am
confident that we will make the changes needed to ensure
that these structures continue to serve us well in the
future. |
