Securities analysts urge Senate for expensing of stock options

[Declan McCullagh <declan () well com>]

                                                September 14, 2004



The Honorable Richard Shelby
Senate Committee on Banking, Housing and Urban Affairs
534 Dirksen Senate Office Building
Washington, D.C. 20510


Dear Senator Shelby,

I am writing to ask you to vigorously oppose S. 1890, the so-called 
“Stock Option Reform Accounting Act.”  Your opposition to this so-called 
“reform” is a strong statement in favor of investor protection and 
shareholder rights.

As you are aware, the House of Representatives last month passed (H.R. 
3574) that would intervene in the independent accounting rule-making 
responsibility of the non-partisan Financial Accounting Standards Board 
(FASB), which supports the treatment of employee stock options as an 
expense to the company.

In other words, FASB supports reality over fantasy, and the investor’s 
right to know over management’s right to hide.

In this post-Enron, post-WorldCom world, in which investors suffered 
unprecedented losses from companies hiding their true liabilities, it is 
unconscionable that any company would stand up and argue that its 
ability to attract and reward employees is contingent on its ability to 
dupe the owners of the company – its own shareholders – into thinking it 
is compensating its management and others less than it really is.  But 
that, as it comes down to it, is exactly the position of the supporters 
of S. 1890 and H.R. 3574: “We can’t make money if we have to report our 
true expenses.”

As an organization committed to financial transparency and integrity in 
capital markets, we urge you to let FASB do the job it was set up to do, 
without Congressional interference, and to encourage your colleagues to 
do likewise.  We strongly believe this is the right course of action for 
investors everywhere, for the following reasons:

1.  FASB was set up as an independent, non-political body, precisely to 
allow accounting experts to make decisions based on what presented the 
most complete and accurate picture, not what provided special interests 
the most favorable treatment.  Following a deliberative process marked 
by exhaustive study and open dialogue by a non-political and objective 
group of experts, FASB reasonably concluded that stock options are a 
form of compensation and, as a cost of the production of goods and 
services, are expenses to be accounted for in financial statements.

2.  Financial statements exist, first and foremost, to allow investors 
to make well-informed decisions. They must not become a sales tool for 
management.  They must represent a fair and accurate picture of the 
company as it is, not as management would like others to believe it is.

3.  Investors generally support the ability of companies to issue stock 
options to employees in a responsible matter.  That is not the debate 
here.  The debate is whether the options should be measured and 
recognized as compensation in the full light of day, or buried in the 
footnotes where only the resourceful will notice them.

4.  Stock options are compensation.  Oftentimes, executives and other 
employees accept stock options in lieu of cash compensation.  When 
compensation is paid in cash, it is expensed.  When paid in goods or 
services, it is expensed.  When stock options are awarded to 
non-employees, such as attorneys, for services rendered, they are 
expensed.  Therefore, why should stock options issued to employees not 
be subject to the same accounting treatment?

5.  Failure to recognize stock options as an expense overstates net 
income.  (Do you hear echoes of Enron and WorldCom here?)  This is 
because failure to recognize stock option expense understates not only 
the cost of compensation, but also the cost of production.  For example, 
as FORTUNE has reported, if the online auction firm eBay had reported 
the cost of its stock option grants, its net income from 1999 to 2003 
would have been $13 million, not $840 million.  By not accurately 
measuring compensation and net income, investors’ ability to compare 
companies with different compensation structures is impaired, and the 
performance of companies that rely heavily on stock options is 
overvalued relative to those that pay their employees in cash or other 
“hard’ assets.

6. Essential financial information should be transparent and accessible 
to even the least astute financial statement reader, not buried in a 
hidden footnote.  Proponents of S.1890 assert that the information on 
employee stock option awards is already provided in the footnotes to the 
company’s financial statements.  But if companies already generate stock 
option information for a footnote, then why can’t that information be 
made available within the body of the financial statement?  The answer 
is because on the income statement, the number will affect the bottom 
line, and that is what these companies want to avoid.  They want to 
continue to say they made more money than they really did.  Should the 
FASB be forced to support this fantasy?

7. Companies trust estimates in every other line item on the financial 
statements.  Their arguments that option values cannot be estimated are 
specious.  Anyone who understands financial reporting understands that 
each and every number on the financial statements, including “cash and 
cash equivalents,” can be an estimate.  The values of receivables, 
inventories, fixed and intangible assets, as well as pension 
liabilities, lease obligations, etc., are based on recorded historical 
costs, which are adjusted, either initially or over time, using various 
assumptions and estimation methods.

Companies trust these valuation methods in other areas.  For example, 
trillions of dollars in options are traded globally utilizing estimates 
based on the Black-Scholes model or other option valuation techniques. 
In addition, when compensation contracts with executives and other 
employees are being negotiated, these same models are applied to 
ascertain the number of options the employee will receive.  If the 
measurements provided by these models are good enough for those who 
accept stock options in lieu of other compensation, they are reliable 
enough for investors.

8.  This is a reiteration of No. 1, above, but it bears repeating: 
accounting standards should be set by FASB, not the United States 
Congress.  An independent entity free (ideally) from political 
pressures, FASB is the authority to set accounting standards.  This 
sentiment was echoed in the Sarbanes-Oxley legislation, the aptly 
titled, “Public Accounting Reform and Investor Protection Act” of 2002.

Again, thank you for your unwavering leadership, which has proven vital 
to investors everywhere.  If there is any additional information that 
our membership or I can provide you or your staff, please do not 
hesitate to contact us.


Sincerely,




Thomas A. Bowman, CFA
President and CEO
The CFA Institute


cc: Sen. Paul Sarbanes, Ranking Democratic Member
Members of the Senate Banking Committee






CFA Institute is a non-profit professional association whose membership 
includes 71,000 securities analysts, money managers and investment 
advisors worldwide, including the world’s 57,000 holders of the 
Chartered Financial Analyst professional designation.
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