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SOARA - A Proposal Everyone Should Hate

The Stock Option Accounting Reform Act (S.B. 1890 / H.R. 3574) is an example of politics at its worst.

From its summary, the Act requires "an issuer of registered securities to show as an expense in its mandatory annual report the fair value of all stock purchase options granted to certain of its senior executive officers."

The Act is being advertised as a political compromise: Options granted to executives must be expensed, but options granted as part of a broad-based employee stock option program do not need to be. This legislation is calculated to mollify (1) those who see something wrong with the practice of granting unexpensed stock options to executives and (2) technology companies with broad option programs who fear expensing all options will be a significant hit on their reported earnings.

Both groups are wrong. I'll explain in a moment.

The fundamental question is: What is the proper accounting method for stock options? The SOARA answer is that, hey, everyone's right! The options that group #1 is concerned about must be expensed, and those that group #2 is concerned about don't need to be. The politicians make everyone happy, shake hands at the photo-op, and run for re-election. Let's celebrate!

However, they haven't properly answered the question. Their answer is that stock options should be expensed sometimes — it depends on who's getting them. Let me repeat that: it depends on who's getting them. This is absurd. Stock options do not acquire mystic qualities depending on the identity of their recipient. A stock option is a stock option, and their accounting treatment should be uniform. It makes no difference whether the option is going to an RCG or to the CEO. Making the accounting treatment of options dependent on the identity of their recipient is as plainly ridiculous as making the accounting of cash salaries dependent on who is being paid.

One thing that both proponents and opponents of stock option expensing should agree to without controversy is that their accounting treatment should be uniform. Either all stock options should be expensed, or none should. (The origin of the shares, e.g. from treasury vs. newly issued, may be a legitimate aspect of debate, but the identity of the recipient is clearly irrelevant.) Seen in this light, SOARA is clearly the wrong solution. It elevates a blatantly wrong answer to the status of law and puts the force of government behind it.

The proper accounting method for stock options is a matter of fact, not a matter of opinion. I have previously argued that stock options should not be expensed and that the opportunity cost argument in favor of expensing is wrong.

Stock options are a form of compensation and do have a cost, but the cost is borne exclusively by the existing stockholders and not by the company itself. The cost is expressed in stock dilution. Expensing options would double-count this cost — first by reducing earnings with a fictitious expense, and again by dilution. Diluted earnings per share would be hit twice, instead of just once.

The cost of stock options is already fully accounted for in dilution. They should not be counted as a company expense because they aren't a company expense. They're a stockholder expense. Period, full stop.

A company's balance sheet should record information about the company, not its owners. It would be useful to investors if the company published a table containing information about outstanding stock options, including details like their exercise prices and expiration dates. Let investors make their own estimates about the amount of dilution likely to materialize, but don't lie to them by recording company expenses that in fact, do not exist.

The opponents of expensing who support SOARA are wrong to think of that Act as a successful compromise. It is not. It is a complete capitulation. SOARA does not permanently protect broad-based option programs. It instructs the government to conduct a study of the economic impact of expensing broad-based option programs, but does not prohibit expensing them. If the government's study concludes that broad-based option programs should be expensed, they likely will be. Meanwhile and forever, SOARA mandates the expensing of executive stock options.

The only correct and principled opposition to stock option expensing — that options are factually not a company expense — has been abandoned by the supporters of SOARA. If they advocate its repeal in a few years (ha!) when the political climate has cooled, they will have denied themselves their most powerful argument. Their other argument, that expensing options would harm the technology industry, is both irrelevant and toothless: If expensing really was the factually right thing to do, then the technology industry deserves to be hurt… and opposition to expensing is reduced to the pathetic whimper of "please lie to me, because the truth hurts too much." I would be ashamed to be associated with that position. I am sympathetic to a third argument, that the value of employee stock options cannot be measured accurately, but do not think it is strong compared to the principled objection.

It is only acceptable to compromise when both sides have some claim to truth or justice. In this instance, however, the opponents of stock option expensing are completely in the right. (They are correct despite themselves, when they argue about protecting the profits of technology companies.) No compromise is necessary or advisable. The FASB, along with legislators, simply need to be educated.

Help me to do so.

Tiny Island