Experts Call Expensing Stock Options Improper Accounting

Newswise — A University of California, Berkeley management journal became the focus in reopening the debate on stock option expensing last week when it published a position paper calling on the Securities and Exchange Commission (SEC) to repeal the Financial Accounting Standards Board's (FASB) new standard requiring the expensing of employee stock options.

Thirty of the nation's leading experts in accounting, economics, business, and finance signed the paper to express their concern that financial statements are being impaired, not improved, by this rule. The thirty signatories include three Nobel Prize winners in economics, two former CEOs of "big four" accounting firms, two former secretaries of the treasury, and dozens of leading academics. Among the signatories is Dean Tom Campbell, dean of UC Berkeley's Haas School of Business, who noted that the paper represents his personal views, not those of the university or the business school.

The position paper, entitled "Expensing Employee Stock Options is Improper Accounting," appeared last week in the Summer 2006 edition of the California Management Review, which is published by UC Berkeley's Haas School of Business. California Management Review Editor David Vogel noted that the journal welcomes the opportunity to publish responses to this position paper.

"Mandating the expensing of employee stock options is one of the most radical changes in accounting rules in history, and we believe the FASB and the SEC have made a mistake," said Kip Hagopian, a veteran venture capitalist and principal author of the position paper. "We are concerned that the SEC did not hold its own hearings on this rule, and we are asking the Commission to reopen this issue for review and debate."

"The SEC rule poses an obstacle to proper accounting," said Dean Tom Campbell. "Allowing for a serious open debate of the accounting merits of this rule is what California Management Review has offered to do, and it is exactly what author Kip Hagopian and we signatories are asking the SEC to do."

Following are key findings from Expensing Employee Stock Options is Improper Accounting:"¢ An Employee Stock Option (ESO) is a "gain-sharing instrument" in which shareholders agree to share their gains (stock appreciation), if any, with employees; "¢ A gain-sharing instrument, by its nature, has no accounting cost unless and until there is a gain to be shared;"¢ The cost of a gain-sharing instrument must be located on the books of the party that reaps the gain; "¢ In the case of an ESO, the gain is reaped by shareholders and not by the enterprise; so the cost of the ESO is borne by the shareholders; "¢ This cost to shareholders (which, not coincidentally, exactly equals the employee's post-tax profit) is already properly accounted for under the treasury stock method of accounting (described in FAS 128, entitled, "Earnings per Share" ) as a transfer of value from shareholders to employee option holders; and "¢ Neither the grant nor the vesting of an ESO meets the standard accounting definition of an expense. Moreover, ESOs can be granted only to employees, are not transferable, and are cancelable at the will of the company (by terminating the employee). Consequently, they cannot be sold on the open market. And to sell them to employees defeats their purpose. Thus, companies do not forgo any cash when they grant ESOs, so their issuance cannot be an opportunity cost.

"With the appointment of three new commissioners, including the new SEC Chairman Chris Cox and the new Chief Accountant Con Hewitt, we feel the timing is propitious to reopen the debate on expensing options," said Clarence Schmitz, one of the signatories and a retired national managing partner at KPMG. "Thirty of the leading minds in accounting, economics and business weighed in on this issue. We're confident that our case against expensing is solid and are hopeful that it will be well received by the SEC."

To order a copy of the position paper and list of signatories, go to http://cmr.berkeley.edu/order.html.