Expensing Isn't the Only Option: Alternatives to the FASB's Stock Option Expensing Proposal

I. INTRODUCTION For the second time in just over a decade, the Financial Accounting Standards Board (FASB) proposed a rule requiring companies to treat stock options as an expense on their income statements.1 A heated debate over the issue has raged among shareholder rights activists, accountants, economists, industry leaders, and venture capitalists. Opinions have polarized into two camps. Advocates blame stock options for the Enron, Worldcom, and other high profile accounting fraud scandals. They reason that the lure of lucrative gains drove greedy executives to artificially pump up the value of their company's stock. According to this camp, requiring companies to expense options will lead to lower earnings reports and hence fewer option grants. By removing the options, the incentive to commit accounting fraud is also removed, so the theory goes. At the other end of the debate, many economists and technology industry leaders argue that options are an integral and unique characteristic of American capitalism that has led to technological innovation and world economic leadership. They agree that expensing will reduce the number of options, but only for rank and file workers and not executives. Instead of discouraging fraud, they contend that the decrease in option incentives will derail an innovative form of wealth sharing and threaten America's dominance as a technology leader in the global economy. In addition to the debate over whether options produce accounting fraud, there is a more fundamental question of clarity in accounting. Will the proposed FASB rule lead to better financial information for investors? The FASB contends that the present system does not accurately reflect the true financial picture of a company. Since the company gives the employee a valuable equity instrument, the FASB argues that the option should be expensed at the date of grant using a sophisticated option pricing model developed by economists. By implementing the rule, the FASB seeks to bring American standards in line with those of the International Accounting Standards Board (IASB). Opponents counter that no expense should occur because no money leaves the corporate coffers when a grant is made. Moreover, they argue that FASB's option pricing models, used to value options, are too unpredictable and subject to too much manipulation to accurately measure the expense. Leading economists, even those who are against the idea of granting options to employees, agree that option pricing models are inaccurate. The opponents of the FASB contend that the results from option pricing models are likely to confuse investors rather than help them in the investment decision. With so much money at stake and the politicians thoroughly engaged in fighting it out for their particular constituency, the real issues have increasingly become clouded in blistering rhetoric and finger pointing. Newspaper reports and columnists characterize any challenge to the FASB's new rule as being in favor of greedy CEOs and fat salaries for executives.2 The truth is that both sides have a legitimate point of view. The unfortunate result of the media hype, however, is that the specter of a handful of morally lax executives making millions off of options threatens to derail one of the most effective methods of wealth creation for rank and file workers. The compromise legislation in Congress does little to add clarity to financial statements since it creates a double standard for expensing options. In this article, I trace the history and analyze the arguments behind each side of the option debate. As a framework for the analysis, I adopt the categorization methodology used by Professor Margaret Blair in her review of reforms spawned by the corporate scandals that erupted in 2001.3 Professor Blair splits the types of reforms into two general categories: 1) Those reforms "enhancing the quality of information," which for purposes of this article I will refer to as "Information Reforms" and 2) '"Rules of the Game' reforms," which shift power from management and directors to shareholders. …