The Accounting Onion

Are Stock Options an Efficient Form of Executive Compensation? - No!

Have you noticed how a large number of companies curtailed or eliminated their stock option grant programs when FAS 123R became effective?  You frequently hear proponents of stock option programs spout the line that stock options, like nothing else, provides incentives for management to create value for shareholders.  Well (can you hear Ronald Reagan?), that's a myth, and I'll prove it with a simple example:

The CEO of a company has one asset at the beginning of the year, $1,000,000 cash, and his only job is to decide how to invest the money.  The CEO's only compensation is in the form of an option to acquire 20% of the company at the end of the year.  The option is granted at the beginning of the year, and has an exercise price of $200,000.  (Note: since 20% of the company is worth $200,000 at the beginning of the year, we see that the option is granted at the money.)

The CEO has found only two projects to choose from, as follows:

• Project A will pay $1,050,000 for certain at the end of the year.  Therefore, the executive's option to purchase 20% of the company would be worth $10,000 (= 20% x $1,050,000 - $200,000).
• Project B has a 10% chance of paying $2,000,000 at the end of the year, and a 90% change of paying $500,000.  Therefore, its year-end value is $650,000, and the executive's option would be worth nothing 90% of the time, but $400,000 (=20% x $2,000,000 - $200,000) 10% of the time.

Which project do you think the CEO will choose to invest in?  For sure, a lot of CEOs would be tempted to choose the value destroying Project B.  It also stands to reason, that the higher a CEO's cash salary (zero in this case, but rarely observed in reality), the more attractive a CEO would find Project B.

The point of the example is to demonstrate that the risk characteristics of options do not align with the risks that accompany holding shares of stock.  That's why so many companies have replaced options with shares, post the effectiveness of FAS 123R.  If the CEO's salary in my example was, say, shares of stock for 5% of the company, we could safely say that the CEO would always choose Project A--the choice in line with shareholders' interests.

OK.  I've now demonstrated that stock options as a form of executive compensation are inefficient.  Imagine the huge transfers of wealth from shareholders to managers in the supposed name of shareholder wealth creation, when just the opposite was happening. 

The analysis I have provided you is not groundbreaking, so it must be asked what has driven the propensity to award options?  For sure, the fantasy accounting under APB 25, which allowed companies to portray options as if they were costless to shareholders, was a huge factor.  Anyone (the APB, FASB, SEC and Congress--to name the principle classes of culprits) who had any involvement in establishing or perpetuating such a ridiculous accounting rule should feel ashamed for their complicity in a vast scheme to deceive the investing public and impair the competitiveness of the U.S. economy.

Before I conclude this post, I need to provide two caveats.  First, and more important, I am not saying that stock options are inefficient under all circumstances.  Labor markets may dictate that stock options be a part of the pay package for many key employees.  I am only pointing out the inefficiences created by giving stock options to executives who allocate corporate resources.  For other key workers, it is often the case that stock options are an essential means of retaining their employment. 

Second, rightly or wrongly, the tax laws do create some bias toward the granting of stock options. I'll be addressing that issue in a post soon to follow this one.

IAS 1: The Myth of 'Fair Presentation'

---

Would you like your staff to learn more about IFRS? 
Click here for a sample in-house training agenda!

---

I speak U.S. GAAP most of the time, so when I prepare to deliver courses on International Financial Reporting Standards (IFRS or IAS are basically interchangeable acronyms), I begin by re-reading some of the key standards, focusing especially on those that may have been recently revised.  That took me to IAS 1 this evening (and by the way, one of my recent posts was on one of the recent changes to that standard).

This current post is about a portion of IAS 1 that has survived since the original version was published in 1974.  It is no different from U.S. GAAP in any important sense, but the language makes a better target for me to tell you about one of my pet accounting peeves:

"Financial statements should present fairly the financial position, financial performance and cash flows of an enterprise. The appropriate application of International Accounting Standards, with additional disclosure when necessary, results, in virtually all circumstances, in financial statements that achieve a fair presentation."(IAS 1, para. 10)

In other words, "fair presentation" can only mean compliance with the rules of IAS.  There is no difference between a statement claiming "fair presentation in accordance with IAS" and "presentation in accordance with IAS."  Since both statements mean the same thing, inclusion of the word "fair" is just another pretentious device to make IAS seem more than it is--to wit that financial statements presented in accordance with IAS are merely the output of an exercise in following rules. It is patently clear that some of these rules unfairly obfuscate and misstate (see my post on IAS 23); and other rules, by their construction, make it impossible to determine fairness (see my post on IAS 21 and FAS 52 as well as my earlier post on IAS 1).

But what about the phrase "virtually all circumstances," you ask?  If application of a rule does not result in fair presentation, doesn't IAS require--or at least provide an opportunity--to fix things?  Answer: that's just another red herring.  Ask any Big Four auditor, and they will tell you that they allow no departure from the rules, if you want a 'clean' opinion--and the same goes for U.S. GAAP.

One of my late great teachers was fond of saying that "fairness is not an economic concept."  As much as the IASB and FASB would like us to think otherwise, it's not an accounting concept either.  I'm not saying that financial statements aren't useful, but I am saying that, given the rules we have, it is not reasonable (in fact, impossible) to regard them as "fair"--especially in the way that regular folks understand the term. 

---

Would you like your staff to learn more about IFRS? 
Click here for a sample in-house training agenda!

---

The Four Sins of Stock Option Backdating

I have a weak spot in my heart for my former students--especially if they were also my tennis or cycling buddies.  Chris, of the cycling variety, recently sent me this email message:

...So, today I was reading some posts on the Greg Reyes trial/verdict (he was the CEO of Brocade ...  I must confess that I've heard all the fuss, but don't really understand it (and haven't followed it very closely) ... was wondering what you make of it all.

Chris, I'm not going to remark about the specifics of the Brocade case, and would rather give you a broad outline of the general issues underlying illegitimate stock option backdating.  The following simple example is representative of the types of transactions that have been questioned:

The board of directors of BD Company met on December 1, 20x1, on which date the market price of BD was $50 per share.  The board authorized the granting of one at-the-money option to BD's CEO, to vest over two years. The CEO instructed the vice president of human resources to backdate the option to November 1, on which date the market price of BD was $40 per share.

The stock option backdating scandal involved four kinds of ripoffs, which I'll describe more fully below:

1. Shareholders ripoffs--By selecting a date in the past on which the stock price is lower than the current stock price, options are deceptively granted in the money.  In my simple example, the effect is to transfer more value to executives than the board of directors intended.  In some cases, the board may actually participate in the backdating scheme.
    
2. Accounting fraud--Options that were effectively granted in the money (because the real grant date is not the backdated one--it's the date the board authorized the award) are accounted for as if they were granted at the money.  Under APB 25 (recently superseded, but in effect during the halcyon days of scandal), expense is measured at the intrinsic value of options at their grant date. (I'm oversimplifying here, but am being specific enough to make the point.) In my simple example, recording zero expense overstates net income by $10, which is the intrinsic value of the option. Often, the accounting fraud has not had a material impact on earnings, except that it was an essential to misstate earnings in order to cover-up the shareholder ripoff (See #1, above).
   


3. Tax fraud--In addition to backdating grant dates, there is strong evidence of executives backdating their exercise of options to a date on which the stock price was low. In so doing, they could reduce the amount of payroll taxes they owed, and reduce the amount of profits they realized on exercise from being taxed at ordinary rates.  If they could then manage to hold the stock for at least a year, they would eventually pay taxes on the rest of their profits at the lower capital gains rate. 


4. Inadequate SEC regulations created a loophole the size of Arthur Andersen--Under SEC rules (promulgated under Section 16a of the Securities and Exchange Act of 1934), executives have to report (i.e., publicly announce) their personal acquisitions of financial instruments issued by their company, and also derivatives underlying those financial instruments.  Until Congress forced them to tighten the loophole (one of the many good things accomplished by SOX), executives had as much as 40 days to report the transactions.  In effect, that gave executives a window of more than a month from which to cherry-pick the lowest share price for option backdating purposes.  A funny thing happened when the report due date was shortened to two days: backdating disappeared. 

That last point, above, doesn't get a lot of press, but it rankles me the most.  I had criticized the SEC for years about the 40-day window--not because I was aware of the backdating frauds, but because I didn't see why investors had to wait so long to receive important information about executives trading in their own shares.  Of all the wonderful things Arthur Levitt tried to accomplish as SEC chair, I don't know why this one wasn't on his radar screen.  After all, it was during his watch that the SEC first floated the idea of accelerating the due dates of annual reports.  (Dear Mr. Levitt, if you perchance should read this, I would consider it an honor to publish your response.) 

Based on the number of SEC investigations and the academic research that exposed this repulsive scandal, there must be hundreds of executives who betrayed the trust of their shareholders with the some criminal indifference that possessed Enron's top guys.  Also similar to Enron, there are likely just as many dupes and facilitating lawyers, accountants, board members, etc. as there were executives who profited directly.  For those Pollyannas amongst you who thought that Sarbanes-Oxley was an overreaction to the crimes committed by a few, I hope the stock option backdating scandal has transported you closer to my world.

So, Chris, you owe me one ... or maybe I owed you one.  It doesn't matter.      

FSP APB 14-a: How Long Should it Take to Close a Loophole the Size of Arthur Andersen?

APB 14 was promulgated in 1969 when we were still pretty much in the dark ages with respect to the valuation of derivative financial instruments.  The Opinion addressed two issues, one of them being the accounting for convertible debt. Since the debt features were inseparable from the option to obtain shares (i.e., you gave up the right to the debt payments if you exercised the option to receive shares), separate accounting for the debt and equity features could not simultaneously value both components of this particular hybrid financial instrument. 

Thus, the APB found it in their hearts to allow that convertible debt would be accounted for as if it were straight debt--so long as the debt features were not set at nominal levels.  The rule was chicken salad for companies, for to account separately for the debt and equity components of convertible debt would have meant reporting interest expense at higher rates. 

Apparently, though, the earnings game knows no bounds, as CFOs soon began to tinker with the features of their convertible debt with the objective of circumventing the recognition of potential EPS dilution that could result from additional share issuance.  Eventually, the EITF 'jumped on their bandwagon in EITF 90-19 by conveniently making a bogus connection between cash-settled and equity-settled convertible debt.  But, as I just explained, the APB's justification for single instrument accounting was that if you exercise the option, you lose the cash; but, in a cash-settled option you don't have to give up cash to get the value of the shares. Notwithstanding that annoying detail, the EITF allowed that cash-settled equity conversion options, and variations thereof, could also be accounted for as a single debt instrument, and to sweeten the deal, would also be given more favorable EPS treatment than equity-settled convertible debt.   

"Questions Were Raised" ... "Mistakes Were Made"

Now, 17 years later, here is what the FASB has to say about EITF 90-19:

"Because of the proliferation of such instruments in the marketplace over the past several years, questions were raised [how beautiful the passive voice!] as to whether the accounting guidance in Issue 90-19 appropriately reflected the economics of those instruments." (Proposed FSP APB 14-a, para. B2)

Are we to believe that the EITF, FASB and SEC were unaware of these "questions" 17 years ago? The EITF was tasked earlier this year to finally take their chicken salad off the menu, but evidently they couldn't bring themselves to be the ones to deprive their constituency (basically, the clients of the large audit firms) of something that tasted so good, and could be swallowed practically without chewing.  So, the FASB gave its staff the dirty work, and the result is proposed FSP APB 14-a (in other words, it's not yet a done deal).   

The Even Bigger Issue that Keeps Me Blogging

Ed Teach of CFO.com has written a fine article explaining that separate accounting for the debt and equity features will be required, with the result being that reported interest expense will increase and EPS will decrease by adding shares to the denominator of the diluted EPS calculation.  Ed closes the article by quoting a bigwig investment banker lamenting that the new FSP would effectively put an end to cash-settled convertible debt. 

That last part really gets me. A popular tactic of 'financial management' owed its existence to a bad accounting rule.  Where have I heard this before? What portion of the productivity of enterprising managers has been wasted in self-interested quests to devise financial arrangements whose sole or main benefit is the exploitation of accounting rules that have been tailor-made for exploitation? 

In too many cases, the FASB and SEC should be held to account for the vast destruction of capital that has occurred by allowing abuses like this one to go on for far too long.  In addition to cash-settled securities, examples that easily come to mind are defined benefit pension plans, executive stock options, so-called 'special purpose entities,' ill-conceived mergers and acquisitions, ad nauseum.

Sadly, I don't anticipate that I will be running out of topics to blog about anytime soon.

FAS 52: Forex Gains and Losses from Holding Dollars?

I noticed that 'FAS 52' has been the most popular search term leading web wayfarers to seek inner peace from the Accounting Onion (click here for my earlier FAS 52 post).  I play requests, so here's a riff on another ineffable result from applying FAS 52 (or IAS 21 if IFRS is your bag). 

As usual, let's start with a simple example:

Company Alpha is based in the U.S. and presents its financial statements in dollars.  Company Beta is Alpha's British subsidiary.  Beta holds U.S. dollars (USD); and since its books are kept in GBP, it has to remeasure its USD holdings into an equivalent amount of pounds--just as it would to record any transaction involving payments in a foreign currency.  Over time, if the value of the dollar changes, Beta must recognize foreign exchange gains or losses on its GBP standalone income statement. 

In consolidating Beta with Alpha, it wouldn't take an undergrad accounting student too long to figure out that Beta's dollar-denominated bank accounts should be treated no differently than Alpha's.  Therefore, Beta's foreign exchange losses on the USD should not be carried through to Alpha's consolidated income statement, right?  WRONG. 

Sadly, reason cannot substitute for a sleep-inducing reading of the rules.  FAS 52 requires that Beta's foreign exchange gain or loss on holding USD cash must be expressed in dollars and carried through to the consolidated income statement. The ludicrous effect is that dollars held by subsidiaries are accounted for differently (i.e., exposed to foreign currency fluctuations between the GBP and USD) than the same dollars held by a parent company. In other words, some dollars are just dollars, but dollars on a ledger over the border are ... ummmm ... special.  So far, not a big issue you may think, but now consider that the principle-devoid rule I have just described extends to all dollar-denominated receivables and payables booked by the subsidiary, including intercompany amounts. Yes, a company can report a profit or a loss merely by lending money to its foreign subsidiary.   (If dumbstruck, I suggest you pause to avoid permanent injury to your brain.)

So much for substance over legal form: FAS 52 rules mean that consolidated presentation for all assets and liabilities depends on whose ledger an asset or liability is booked--an unabashed departure from the most basic principles governing consolidated financial statements.  The reason for this is -- never mind, there is no good reason.  The FASB's reasoning, such as it is, begins with the patently false assumption that a subsidiary may operate in a manner so disconnected with its parent that dollar exposures are no different than exposures in other currencies.  The resulting rule is so outlandish, it has shocked (but not awed) too many unwitting accountants, including `a recent client.  These gentle and smart individuals are my excuse for the gap in posting, because I spent three beautiful days indoors in New England, helping them understand (to the extent one can) FAS 52.   I'm betting this slight exposre to the massive dose of radiation I had to administer to my client has led you to question whether accounting resides in our world or Alice's Wonderland.

Revised IAS 1: A Balance Sheet By Any Other Name ...

---

Would you like your staff to learn more about IFRS? 
Click here for a sample in-house training agenda!

---

The International Accounting Standards Board on September 6 issued a revised version of IAS 1, which for the most part tweaks the presentation of financial statements to get them looking a little more like those produced by U.S. GAAP.  IAS 1 also changes the titles of the financial statements, ostensibly to more clearly reflect the function of those statements. The term balance sheet, for example, has been renamed "statement of financial position."   

I don't know about you, but that high falutin title can't fool me!  It's a fact that no balance sheet prepared in accordance with IFRS (or GAAP for that matter) ccould be legitimately considered a 'statement of financial position.'  Here's just a few reasons why:

1. Operating assets such as inventory, plant, equipment and land are measured at historic cost.  As past costs, they are no indicator of current 'position.' They merely communicate an expectation that old investments will cover those costs that have not yet been expensed.
2. Some assets are measured in terms of their current 'position' to generate future cash flows, but total assets is nothing more than a summation of apples and other things so dissimilar (see my earlier post on FAS 52) it would be a kindness to call them oranges.  The rulemakers' euphemism for a little of this and a little of that is 'multi-attribute approach'--e.g., historic cost for inventory and PP&E, net realizable value for receivables, present value for some investments, fair value for other investments, random numbers for 'hedged items', and more (or less, depending on your point of view). 
3. A statement of financial position should be reasonably complete, but far too many assets and liabilities are excluded by extant accounting rules.  What could you learn about a consulting firm's most critical asset--its collective brain power and experience--from its 'statement of financial position' prepared in accordance with IFRS?  Answer: nada, nichts, bubkes.   

A balance sheet by any other name still smells the same--and nothing like a rose.  The IASB's all-too-obvious concern with pretension reveals far too little sense of urgency for resolving issues that really matter to investors.

---

Would you like your staff to learn more about IFRS? 
Click here for a sample in-house training agenda!

---

Credit Rating Agencies and Auditors Have Something in Common: Independence Problems

Sarah Johnson of CFO.com has written a nice summary of congressional concerns about the independence and role of credit rating agencies arising out of Enron and now, the subprime loan debacle. 

Accounting and finance researchers have documented in numerous studies that rating agencies consistently lag market assessments of credit quality that is reflected in securities prices.  Is the reason due to the conflicts of interest of the kind pointed out in the article, or that too much is expected of the rating agencies, even in the best of circumstances?  It is probably a little of both, so SEC investigations won't help to fix the problem--unless it leads them to undo the lucrative franchise they created for credit rating agencies in their own regulations.  At the very least, if credit assessments are provided to potential investors through SEC filings, they must come from experts that meet strict independence requirements.

But, as with auditors, it is impossible to be truly independent from the person who signs your paycheck, so maybe the SEC should hire the rating agency and pass on the cost to the issuer. Until then, the most reliable credit ratings will be ones that investors pay for themselves.

FAS 158: Funded Status is Padded with Company Shares

FAS 158 makes it look like the 'funded status' of defined benefit  post-employment benefit plans are now transparent.  Actually, they are not.  To see why, consider the following three transactions:

1. Company A purchases 500 shares of its own stock on the open market at $30 per share.
2. Company A contributed $1,500 to its defined benefit pension or retiree healthcare plan and instructs the trustee of the plan to purchase 500 shares of Company A stock on the open market.
3. Company A contributes 500 shares of its own stock to its defined benefit pension plan.

Transaction #1: Everyone who has taken Accounting 101 (and passed) knows that the 'treasury stock' resulting from the first transaction is presented as a deduction in shareholders' equity on the balance sheet. It would be nonsense to present your own stock as an asset, just because you purchased it back from shareholders.

Transaction #2 and #3: But, very few know that a company can, within limits, report that it is satisfying its pension funding obligations merely by printing stock certificates.  That's because FAS 87 and FAS 106 permit the reporting of the 'investment' by the pension trust in Company A stock as an asset--albeit well hidden, because it is netted with the company's pension liability. 

What kind of company would fund a pension plan with its own stock?  Certainly cash-strapped companies.  The effect on employees is to compound their financial risk: as the company goes south, so goes job security and pension security. 

What kind of accounting standard setter would permit such an aburd accounting practice?  I'll leave the answer to that one for your own ruminations.  But there can be little doubt about the consequences. The favorable accounting treatment allowed companies in trouble to delay their day of reckoning by literally papering over the gap in their pension funding with stock certificates hot off the press.  When finally called to account, obligations had become much greater, and assets had become much smaller. 

   

SEC Posts Research Guide to Website

Understanding the SEC’s system of publishing rules and related literature is complicated; and finding the information you need from the SEC's website, www.sec.gov, is no picinic either.  Help has arrived in the form of an SEC posting to its website entitled “Research the Federal Securities Laws Through the SEC Website.” 

The new guide is much more than a roadmap to the securities laws; it contains valuable instructions and tips about finding rules, regulations, concept releases, interpretive releases and staff interpretations.  For anyone attempting to research an answer to an SEC accounting issue, or any question involving financial reporting and the SEC, this lucid document is required reading.

Here is More to Know about the SEC's Views on Executive Compensation Disclosures

In my earlier post on executive compensation disclosures, I reported that the SEC may have surprised, and frustrated, many by issuing comment letters to some 300 companies on their executive compensation disclosures. Although the SEC never said they wouldn't send out comment letters this year, that seemed to be the implied message.  Now, it will be interesting to see what the SEC does with the responses to their comments--whether any companies will be forced to amend the current disclosures, or whether they will be told to take the SECs comments into account for future filings.

The first indications of the SEC's concerns came last March, when Chair Christopher Cox (now rumored to be a strong candidate for attorney general) used his speech at a University of Southern California conference on corporate governance to provide guidance on preparing the new narrative disclosures on Compensation Discussion & Analyses (CD&A). The new executive compensation disclosure rules require narrative items to be succinct and understandable per the SEC’s ‘Plain English’ rules. But, according to Cox, far too many companies rendered over-long and difficult-to-read narratives. For example, a random sample of 40 CD&A’s averaged near 17 (the estimated number of years of schooling it would take to understand the content of the document) on the Gunning Fog index. A score of 17 is generally interpreted to be about the same level as an academic publication. Articles in the Wall Street Journal generally score between 11 and 12 on the index, and Mr. Cox stated that this would be an appropriate target for CD&A.

Many interpreted Cox’s comments to mean that the SEC would count pages, submit CD&A’s to mechanical tests, and hold companies to account for the results. Therefore, companies would have little choice but to do the same, and could expect that the SEC would require amended filings to achieve compliance with the Plain English rules. But, rumor had it that high-level SEC staff members believed that Cox had gone too far, perhaps by over-reacting to the spate of articles critical of companies’ first-time disclosures, including a featured article in the New York Times. In his own speech, John White, Director of the Division of Corporation Finance, ham-handedly downplayed Cox's earlier pronouncements, “I also think that criticisms of the length and the language of the new disclosures can go too far.” He stated that the SEC was seeking to establish a “layered” disclosure approach with CD&A as the top layer, serving to overview the quantitative tables and narrative disclosures to come.

In addition to addressing such questions of length, language and role of CD&A, White’s speech also provided commentary on the following areas of executive compensation disclosure:

• Lack of analysis—Although many companies made a good faith effort to provide analysis, the expectations on the part of Corp. Fin. for the second year will be higher, looking to see if companies answer the “why” questions rather than the “who, what, where and when.”
• Performance targets—Less than one-half of reporting companies disclosed specific performance targets used for annual bonuses or long-term incentive pay. “The staff has heard an almost unanimous chorus from investors—confirmed privately by many in-house and law firm counsel—that companies are not providing required disclosure about performance targets.” As part of the review process, companies “…should be prepared to provide the staff with an open and full justification of their decision not to disclose the targets.”
• Alternative disclosure when performance targets are excluded—The SEC staff is considering proposing additional rulemaking to “recalibrate the rules,” in order to help investors know if the targets are “real,” and not simply guaranteed awards.

Quotations in the financial press are not kind to the SEC's recent actions.  But, it seems to me that those companies and their cheerleading executive compesation consultants "doth protest too much." I am more than suspicious that ood faith compliance with the letter and spirit of the SEC's executive compensation disclosure requirements  will expose embarrasing, if not fraudulent (remember stock option backdating?), payments to executives.