By DAVID MOON, Moon Capital Management
There is an accounting battle being waged over the treatment of stocks
options. The details would bore (or confuse) most people. The
resolution will have no impact on the profitability or operations of a single
Many companies include as a part of certain employees’ compensation an option
to purchase the company’s stock. If the price of the stock later
increases, the employee has the ability to buy the stock at a price below the
market price, then simultaneously sell it, realizing a risk-free profit on the
transaction. It is not uncommon for stock options to account for much, if
not most, of some executives’ total compensation.
Companies that give their employees stock options deduct the value of the
options as an expense on their tax return. But when you look at the
financial statements they present to investors, the options are not treated as
expenses. This will come as a surprise to some readers, but companies do
keep at least two sets of books, one for the IRS and one for their
When a CEO like Intel’s Craig Barnett argues that options are “imaginary
expenses” (as he did in a March 31 Wall Street Journal editorial), how can his
opinion not be clouded by the amount of his personal wealth that result from
those options? Barnett exercised 384,000 options in January, netting him
about $10 million in cash. Was this an “imaginary cash?” I suspect
neither his banker nor his wife would think so.
Opponents of expensing options are quick to point out that when an option is
granted, estimating its then-current market value is an inexact process.
That is true. But companies make estimates all of the time on their
financial statements. Loan loses, inventory valuation and shrinkage,
pension expenses, medical expenses, mortgage prepayments - all of these items
require companies to make estimates.
Others argue that since options are so widely used in certain industries
(startup businesses and technology companies, for example), expensing options
would create a heavy burden on the reported earnings of those companies,
resulting in a decrease in the values or prices of those stocks. If that’s
true, then investment analysts must be shallow. How an option is
reported has zero impact on a company’s value. Expensing options simply more
properly describes the nature of the transaction.
Expensing options would ultimately lead to less volatility for stock prices
because reported earnings would more closely reflect economic reality, rather
than some accountant’s executive-inspired fiction. Simply saying than an
option doesn’t have a real economic cost doesn’t make it true. If you have
two dogs and call one of them a cat, how many cats do you have? None,
because calling a cat a dog doesn’t make it a cat.
As with other financial scandals, the root of the problem is that people are
willing to take short cuts and ignore real issues when those issues stand in the
way of some desired outcome, like putting another $10 million in your bank
David Moon is president of Moon Capital Management, a
Knoxville-based investment management firm. This article
originally appeared in the News Sentinel (Knoxville, TN).