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FASB Requires Option Expensing

FASB has decided that companies must expense stock options awarded to employees.

I've written about the issue of stock option expensing many times in the past, so I feel obligated to comment. (Also, I was asked…)

I have been and remain strongly opposed to stock option expensing. The cost of options is borne by existing shareholders, not the company itself. The company and its owners are separate entities and should not be conflated.

I also believe that sophisticated investors will not be impacted by the expensing requirement, because they will be able to simply back out the bogus expense as they evaluate a company. (Many of the arguments of the anti-expensing crowd, such as that investors or industries would be hurt, are embarrassingly bad.)

FASB has decided that options should be expensed, but it has not specified the method by which to expense them. This is very poor. All the expensing methods have problems, which is admitted even by expensing proponents. Companies will have to choose among bad alternatives. Worse, Sarbanes-Oxley (among the worst laws Bush signed into law) requires that CEOs and CFOs certify the accuracy of financial reports and makes them personally criminally liable for inaccuracies. If they believe, as I do, that expensing is bad accounting, they're in a Catch-22: If they sign it, they're lying — but if they don't sign it, they're breaking the law. That isn't right.

(No nitpicking; yes, I'm assuming that the SEC will make FASB's recommendation a requirement, although that hasn't happened yet.)

If I was a CFO, and I had to expense options, here's how I'd do it. (This draws from the last of my earlier links.) I would expense options at the time they are exercised, not at the time they are granted, and I would do it by inventing two sham transactions: First, a cash payment to the employee for the spot price minus the strike price of the options. Second, the purchase by the employee of newly-issued shares for the full spot price. The result will be a cash expense ($spot-$strike) on the earnings statement and an increase in the company's assets ($spot) on the balance sheet. I regard the cash expense as entirely fake, and the portion of the asset increase beyond the strike price as also fake.

In the end, that would recreate the actual effect of exercised stock options: stock dilution to existing shareholders and an increase in the company's assets ($strike) … and the sham expense and sham asset increase, both equal to ($spot-$strike).

Yes, it's lying. But that's what FASB wants.

When I proofread this, I found and fixed a serious error. Take my expensing method with a grain of salt, I haven't spent much time thinking about it yet.

Tiny Island