Trinity University

Robert E. Jensen, Ph.D.; CPA

Jesse H. Jones Distinguished Professor of Business

715 Stadium Drive

San Antonio, TX  78212-7200

 

Email:  rjensen@trinity.edu

Web Site:  http://www.trinity.edu/rjensen

This document commenced as a letter to Senator Schumer in reply to a letter to the Senator by Walter Schuetze.  Over time it has become a log of threads of my own thinking and messages from my friends.


Bob Jensen's threads on outrageous executive compensation are at http://www.trinity.edu/rjensen/FraudConclusion.htm#OutrageousCompensation

Frontline (from PBS) videos on accounting and finance regulation and scandals in the U.S. --- http://www.pbs.org/wgbh/pages/frontline/shows/regulation/view/
Note that one of the Frontline videos in about the options backdating scandals --- http://www.pbs.org/wgbh/pages/frontline/shows/regulation/view/
Also see the definition at http://www.biz.uiowa.edu/faculty/elie/backdating.htm


 

Comparisons of IFRS with Domestic Standards of Many Nations
http://www.iasplus.com/country/compare.htm

More Detailed Differences (Comparisons) between FASB and IASB Accounting Standards

2011 Update

"IFRS and US GAAP: Similarities and Differences" according to PwC (2011 Edition)
http://www.pwc.com/us/en/issues/ifrs-reporting/publications/ifrs-and-us-gaap-similarities-and-differences.jhtml
Note the Download button!
Note that warnings are given throughout the document that the similarities and differences mentioned in the booklet are not comprehensive of all similarities and differences. The document is, however, a valuable addition to students of FASB versus IASB standard differences and similarities.

It's not easy keeping track of what's changing and how, but this publication can help. Changes for 2011 include:

  • Revised introduction reflecting the current status, likely next steps, and what companies should be doing now
    (see page 2);
  • Updated convergence timeline, including current proposed timing of exposure drafts, deliberations, comment periods, and final standards
    (see page 7)
    ;
  • More current analysis of the differences between IFRS and US GAAP -- including an assessment of the impact embodied within the differences
    (starting on page 17)
    ; and
  • Details incorporating authoritative standards and interpretive guidance issued through July 31, 2011
    (throughout)
    .

This continues to be one of PwC's most-read publications, and we are confident the 2011 edition will further your understanding of these issues and potential next steps.

For further exploration of the similarities and differences between IFRS and US GAAP, please also visit our IFRS Video Learning Center.

To request a hard copy of this publication, please contact your PwC engagement team or contact us.

Jensen Comment
My favorite comparison topics (Derivatives and Hedging) begin on Page 158
The booklet does a good job listing differences but, in my opinion, overly downplays the importance of these differences. It may well be that IFRS is more restrictive in some areas and less restrictive in other areas to a fault. This is one topical area where IFRS becomes much too subjective such that comparisons of derivatives and hedging activities under IFRS can defeat the main purpose of "standards." The main purpose of an "accounting standard" is to lead to greater comparability of inter-company financial statements. Boo on IFRS in this topical area, especially when it comes to testing hedge effectiveness!

One key quotation is on Page 165

IFRS does not specifically discuss the methodology of applying a critical-terms match in the level of detail included within U.S. GAAP.
Then it goes yatta, yatta, yatta.

Jensen Comment
This is so typical of when IFRS fails to present the "same level of detail" and more importantly fails to provide "implementation guidance" comparable with the FASB's DIG implementation topics and illustrations.

I have a huge beef with the lack of illustrations in IFRS versus the many illustrations in U.S. GAAP.

I have a huge beef with the lack of illustrations in IFRS versus the many illustrations in U.S. GAAP.

I have a huge beef with the lack of illustrations in IFRS versus the many illustrations in U.S. GAAP.

Bob Jensen's threads on accounting standards setting controversies ---
http://www.trinity.edu/rjensen/Theory01.htm#MethodsForSetting

Comparisons of IFRS with Domestic Standards of Many Nations
http://www.iasplus.com/country/compare.htm


"A Much Needed Accounting Lesson for Two Senators," by Tom Selling, The Accounting Onion, August 8, 2011 --- Click Here
http://accountingonion.typepad.com/theaccountingonion/2011/08/a-free-accounting-lesson-for-two-us-senators.html?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+typepad%2Ftheaccountingonion+%28The+Accounting+Onion%29

August 8, 2011 reply from Bob Jensen

Hi Tom,

I was not aware of this pending legislation appreciate your calling our attention to more ignorance of our senators in Washington DC.

What would help your article is to introduce a better distinction between intrinsic value versus time value in the valuation of options and opportunity value/risk over time --- http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#IntrinsicValue 

In your illustration, the option is granted "at-the-money" such that there is zero intrinsic value to the company or the employee receives the contractual right (which may be in advance of both the vesting and exercise dates). The entire $2 total value is all time value on the grant date. Something of value (i.e., all time value and no intrinsic value) has been granted to the employee in lieu of higher wages even if the option's resale is restricted. This is the entire basis for the FAS 123R requirement that the option be booked as an expense on the date of granting the contractual right. Something of value was transferred from the corporation to the employee on the grant date. Of course there's an enormous problem of estimating time value on the grant date since the Black-Scholes model is known to be lousy when applied to employee stock options (since employees tend to be more risk averse regarding the tanking of time value).

William Brighernti has a practical solution for valuation of stock options using the Black-Scholes model ---
http://www.cpa-connecticut.com/sfas123r.html 
http://www.cpa-connecticut.com/IPIC.html 

I'm not at all clear why you, Tom, are arguing that FAS 123R makes an error (sausage) for not requiring a deduction for intrinsic value present value at the grant date. Firstly, the future intrinsic value is a great unknown and is generally, in my viewpoint, too uncertain to book at the date options are granted. Secondly, it's the employee who is bearing the financial risk of that intrinsic value which starts at zero when the option is granted.

The corporation (actually shareholders) will lose opportunity value if the granted option eventually gains in intrinsic value. But at the same time, the corporation (and its shareholders not receiving stock options) gain opportunity value if the gain in intrinsic value arises from the added efficiency, creativity, and motivation of employee to create this intrinsic value for his or her options. In other words, shareholders did not really lose the entire entire intrinsic value of the option on the exercise date. They in fact gained because shareholders can sell their own shares for higher values if they owned the shares on the date the employee options were first granted in lieu of wages.

My point is that the intrinsic value of an employee option that arises between the option's grant and exercise dates is not entirely an opportunity loss to shareholders equal to the intrinsic value on the exercise date. Shareholders who held shares between the grant and exercise dates gained to the extent that the intrinsic value arising from the marginal efforts of employees to increase the intrinsic value of their options.

What's not clear to me is why the corporation gets any tax break for dealing in its own stock or stock options. Employees, on the other hand, should have to pay a compensation tax, and it seems to me that they owe this tax on the date that they are entitled to sell the option (which may in fact be the exercise date but may also be in advance of the exercise date). Some might argue that an employee using a cash basis for tax accounting purposes does not owe the tax until cash is received, but the tax code requires that employees owe taxes on the date value is received irrespective of cash timing such as if employees are given inventory in lieu of wages.

There are of course fine points that must be worked out in the tax code. If each Apple employee receives a free iPad for personal use but is not allowed to resell that iPad for ten years when it is worth virtually zero, the employee should probably be taxed on the date the iPad is received rather than ten years from the grant date. That's because the employee is receiving the benefits of use before the iPad can be sold for cash. There is no benefit of use in a stock option, however, before the option can be turned into cash (ignoring its possible and questionable use as loan collateral).

Hence, I think an employee stock option is fundamentally different from inventory grants in terms of tax obligations. Employers should get tax deductions for inventory grants, and employees should be taxed for value received on the grant dates. Corporations should not get tax losses/gains for and dealings in their own shares or share options, but employees should be taxed for value received on the date they have the right to convert their stock option contracts into cash. If they do not sell on that date, the contracts become investments taxable on the basis of the difference between ultimate sales value and the value on the date for which they paid an initial compensation tax.

Bob Jensen


Wow:  A Must Read for Sure

"Cooking the Books Why do firms issue financial misstatements? Based on the Research of Jap Efendi, Anup Srivastava And Edward P. Swanson," Kellog Insight, February 2011 ---
http://insight.kellogg.northwestern.edu/index.php/Kellogg/article/cooking_the_books/#When:18:17:07Z

When the dot-com bubble of the late 1990s sent stock prices soaring, something else soared, too: CEOs’ perceptions of their net wealth. That theory alone may explain a large part of the psychology and behavior of why some corporate managers allowed their accounting books to get cooked.

On March 10, 2000, the dot-com bubble burst abruptly and as a result many firms had to issue accounting restatements well into the next decade. Let’s face it, a lot of people lost a lot of money, and not just the CEOs who watched large portions of their own stock holdings in their own companies vaporize. Let’s also not forget the chasm of broken trust that opened between the business community and the public.

So what happened? Did the CEOs transmogrify into greed-poisoned crooks? That answer may satisfy our human desire for a villain, but that is not exactly how things played out, says Anup Srivastava, an assistant professor of accounting information and management at the Kellogg School of Management.

While most firms were not guilty of accounting irregularities or criminal activity, a few were. Srivastava and Jap Efendi, an assistant professor at University of Texas at Arlington, and Edward P. Swanson, a professor at Texas A&M, dug into the problem of overvaluation of firms’ equity, and they developed several reasons why CEOs may have overseen the release of false or misleading financial statements. At the heart of the matter was a confluence of CEO compensation structuring with a little idea (holding large implications) about how very large incentives can cause normally law-abiding citizens to step outside the law’s bounds.

Taking Risks Srivastava explains that in 2005, Harvard professor emeritus and noted financial economist Michael C. Jensen wrote a paper titled “Agency costs of overvalued equity,” which was published in the journal Financial Management. “In this paper, Jensen argues that managers are normal human beings but when the stakes are very high, normal human beings begin making extremely risky decisions,” Srivastava says. “Our paper examining the overvaluation of a firm’s equity during the dot-com years is the only paper that has tested his theory.”

When Srivastava says a firm is overvalued, he is referring to extreme situations where the stock may be worth 100 to 1,000 percent of its fundamental value. When this happens, the firm’s fundamentals cannot justify the stock price and so managers begin to “do things.”

“They start taking extreme risks. They make acquisitions and play with their accounting numbers,” Srivastava explains. “This is very destructive to society. Decisions based on overvalued equity are not good for society because they lead to a loss of wealth.”

Srivastava says that an important trend in CEO compensation over the past two decades has been an increasing emphasis placed on company stock options. When this collides with market overvaluation, CEOs may find that their in-the-money stock options balloon into the stratosphere to nearly one hundred times the value of their salary.

“Let’s say their in-the-money stock options are worth a billion dollars now,” Srivastava says. “They may start to think, ‘I’m a billionaire.’” By confusing their overinflated stock options with their net wealth, these CEOs begin to make riskier and riskier decisions, perhaps to preserve their perceived wealth. It is a fragile zone to live within; a 10 percent decline in their company’s stock price could spell out a 50 percent decline in their net wealth.

“In this scenario, they will do anything and everything to keep the stock values high,” Srivastava says. But this motivation may also extend beyond their own personal gain; they may want to maintain the status quo by not liquidating their holdings as to avoid attention from the Securities and Exchange Commission or their investors regarding the overvaluation problem.

“What we highlight in our paper is the fact that when equity is overvalued, and overvaluation in equity results in large in-the-money options for managers, then managers have incentives to take very risky accounting decisions,” Srivastava says.

Show Me the Money The researchers used ninety-five sample firms—pinpointed from a Government Accountability Office (GAO) database of companies that restated a previously issued financial statement—and compared these to ninety-five control firms that had not issued restatements but were matched in terms of size, industry, and asset values. They then examined the firms that announced a restatement between January 1, 2001, and June 30, 2002, for accounting errors in prior years, extending back to April 1995. (Firms often announce a restatement one to two years after the year being restated, e.g., a restatement announced in January 2001 could be for the accounting year 1999 or 2000.) The team used press releases and annual reports to discover the exact year of the misstatement, a detail the GAO database lacks.

For example, say an Internet company called WidgetTechs tanked in the 2000 bust and announced a restatement of its accounts later. Srivastava and his team basically poked through records to find WidgetTechs’ historic stock prices and its compensation package. Then they dissected this data to look for trends that associated aspects of compensation to time points right before, during, and after accounting irregularities, or criminal activity, was said to have occurred.

By doing this, Srivastava and his colleagues found that the best predictors of accounting misstatements turned out to be in-the-money values of stock options held by CEOs. To illuminate the magnitude of in-the-money option holdings, they found the average holdings for CEOs at restating firms was approximately $50 million, which greatly exceeded the average of $9 million at matched firms that did not announce a restatement. Stated another way, the CEOs of restating firms held options with in-the-money value that was forty-six times their salary, compared with options six times the salary of CEOs in control firms.

The team then parsed the restating firms into two main categories based on accounting issue classifications assigned by the GAO—non-malfeasance and malfeasance—that describe the degree of seriousness of the firm’s accounting error. (A malfeasance category correlates to fraudulent behavior or an SEC-induced restatement, while a non-malfeasance category correlates to a non-criminal, less serious issue or irregularity.)

The researchers found that the in-the-money value of options for CEOs at restating firms with evidence of accounting malfeasance was even higher, averaging approximately $130 million (compared to an average of $50 million for all restating firms).

One of the study’s key insights centered on the degree to which options were in-the-money. The analysis detected no difference between the value or number of options issued by restatement and control firms to their CEOs. In other words, the larger in-the-money values of restatement firms were not due to the number of options held but the degree to which the firm’s stock options were in-the-money. Within both the restating firms and the control firms, the research team analyzed CEO compensation to look for predictors that a firm would issue a restatement. They tested the base salary, bonus, options grant, in-the-money stock options, restricted stock grants, and restricted stock holdings. The only statistically significant variable turned out to be in-the-money options.

Continued in article

Bob Jensen's recipes for cooking the books ---
http://www.trinity.edu/rjensen/Theory02.htm#Manipulation


Teaching Case from The Wall Street Journal Accounting Weekly Review on April 22, 2011

 
Strings Attached to Options Grant for GE's Immelt
by: Andrew Dowell and Joann S. Lublin
Apr 20, 2011
Click here to view the full article on WSJ.com
 

TOPICS: Corporate Governance, Executive Compensation, Stock Options

SUMMARY: GE granted two million stock options valued at $7.4 million to CEO Jeffrey Immelt one year ago in March 2010. The company now has stipulated that the options will only "...vest if the company successfully boosts its industrial businesses and delivers shareholder returns...that are as good or better than those of the Standard & Poor's 500-stock index...The move underscores [in part] shareholders' increasing clout regarding matters of executive compensation. GE's decision comes ahead of the company's annual meeting next week, when shareholders will cast a nonbinding vote on GE's pay practices."

CLASSROOM APPLICATION: The article is excellent for discussing corporate governance, the annual meeting of shareholders, the proxy process, the incentive value of stock option plans, and the accounting and valuation components of these plans.

QUESTIONS: 
1. (Introductory) What are executive stock options? What is the business purpose of awarding options?

2. (Introductory) What is a proxy statement? Access the filing of the proxy statement on the SEC web site at http://www.sec.gov/Archives/edgar/data/40545/000119312511065578/ddef14a.htm#tx122802_10 What matters will be decided at the annual GE shareholders' meeting? What information is contained in the proxy statement in relation to these matters?

3. (Advanced) The article states that "GE says" the options granted to Mr. Immelt were valued at $7.4 million in March 2010. How is this value determined? Where does "GE state" the value of these options?

4. (Advanced) Access the filing referred to in the article at http://www.sec.gov/Archives/edgar/data/40545/000119312511101003/ddefa14a.htm On what form was this filing made? On what date? Summarize the contents of the filing.

5. (Introductory) What is the Institutional Shareholder Services (ISS)? What was their initial recommendation to shareholders about the grant of options to Mr. Immelt?

6. (Advanced) Access the filing by GE on the SEC web site at http://www.sec.gov/Archives/edgar/data/40545/000119312511091124/ddefa14a.htm after the company's communication to shareholders that it disagreed with the ISS recommendation. Read the points made by GE, and particularly scroll down to the fourth item regard the option valuation model used by GE versus the one used by ISS. What are the concerns? How does the option pricing formula help to assess the compensation given to Jeffrey Immelt?
 

Reviewed By: Judy Beckman, University of Rhode Island

"Strings Attached to Options Grant for GE's Immelt," by: Andrew Dowell and Joann S. Lublin, The Wall Street Journal, April 20, 2011 ---
http://online.wsj.com/article/SB10001424052748703789104576272701168635450.html?mod=djem_jiewr_AC_domainid

Responding to shareholder criticism, General Electric Co. agreed to put new conditions on two million stock options granted to Chief Executive Jeff Immelt a year ago.

The options, which GE says were valued at $7.4 million when granted in March 2010, will now only vest if the company successfully boosts its industrial businesses and delivers shareholder returns, including stock appreciation and dividends, that are as good or better than those of the Standard & Poor's 500-stock index.

"Some shareholders have expressed the view that additional performance conditions should be applied to Mr. Immelt's 2010 stock option award," GE said in a filing with the Securities and Exchange Commission.

The move underscores the pressure on Mr. Immelt to get the company growing again, as well as shareholders' increasing clout regarding matters of executive compensation. GE's decision comes ahead of the company's annual meeting next week, when shareholders will cast a nonbinding vote on GE's pay practices.

The options grant was unusual for GE, which last granted Mr. Immelt options in 2002 and afterward shifted to equity awards based on measurable performance targets. The company said the 2010 award was intended to "increase the equity-based portion of his compensation" and to express confidence in the CEO.

Institutional Shareholder Services, which advises mutual funds and other shareholders about how to vote on corporate matters, criticized the grant for not being sufficiently pegged to GE's performance.

In light of the new conditions, ISS dropped its objections and recommended that shareholders vote to support GE's pay practices.

Under the new terms, 50% of the options will vest only if the company pulls in cumulative industrial cash flow from operating activities of at least $55 billion between the start of 2011 and the end of 2014. The other half will vest only if GE's total shareholder return is equal to or better than that of the S&P 500 over the same period.

Mr. Immelt is one of just 10 CEOs who got more than one million options last year—including two who received bigger grants than his, according to an analysis of the latest proxy statements by Hay Group for The Wall Street Journal. The consultancy looked at 320 CEOs of major U.S. corporations, of whom 232 received option awards in 2010.

Continued in article

Bob Jensen's threads on FAS 123R are at
http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm

 


The New York Times has proposed to turn us all into Seinfeld's Elaine Benes

The article below has a really weird introduction to say the least, especially for a venerable journal like the Harvard Business Review.

The article is really about the new New York Times way of charging readers, which is a very, very complicated scheme to say the least.

"Is Paul Krugman "Click-Worthy"?" by Joshua Gans, Harvard Business Review Blog, March 18. 2011 --- Click Here
http://blogs.hbr.org/cs/2011/03/is_paul_krugman_click-worth.html?referral=00563&cm_mmc=email-_-newsletter-_-daily_alert-_-alert_date&utm_source=newsletter_daily_alert&utm_medium=email&utm_campaign=alert_date

 

Last year, one of the most famous economists in the world, Avinash Dixit, released a paper, "An Option Value Model from Seinfeld," based on this episode (you can download it here). ---
http://www.princeton.edu/~dixitak/home/Elaine-Final-Web.pdf

 Bob Jensen's Threads on Real Options, Option Pricing Theory, and Arbitrage Pricing Theory ---
http://www.trinity.edu/rjensen/realopt.htm 

Bob Jensen's threads on option pricing theory are at
http://www.trinity.edu/rjensen/149wp/149wp.htm


"Do stock options improve employee performance?" PhysOrg, August 12, 2010 ---
http://www.physorg.com/news200843868.html

It has become an article of faith in Silicon Valley that stock options create incentives for employees to work harder and smarter. But does that assumption stand up? It depends on who is receiving the options, according to a new study co-authored by Nicole Bastian Johnson, assistant professor of accounting --- Nicole Bastian Johnson, assistant professor of accounting , UC Berkeley ---
http://www2.haas.berkeley.edu/Faculty/johnson_nicole.aspx

Stock options have rewarded many thousands of employees, particularly those working in the information technology industry, with income that far outstrips their normal salaries. It's become an article of faith in Silicon Valley that those rewards create incentives for employees to work harder and smarter, in turn rewarding the companies that lavish options on the workforce with better performance and greater shareholder value.

"Our findings provide evidence that options provide incentive effects at the executive level that are sufficiently large to be reflected in firm performance, but no evidence for similar incentive effects for non-executive employees," wrote Johnson and co-authors David Aboody of UCLA's Anderson School of Management and Ron Kasznik of Stanford's Graduate School of Business.

Their paper, "Employee Stock Options and Future Firm Performance: Evidence from Option Repricings," will be published in the Journal of Accounting and Economics later this year. Learning that granting options to a broad selection of employees may not be an effective tool is the paper's most important contribution to the literature, Johnson says.

Options and their effect on corporate performance have been frequently studied. However, nearly all of the research has focused on options for executive-level employees. Few researchers have looked at companies that granted options to rank-and-file employees, largely because obtaining data is so difficult, says Johnson.

Public companies generally disclose option grants on regularly scheduled proxy statements, but usually for only top-level managers. Digging through hundreds of corporate filings with the Securities and Exchange Commission to find who else may have received options is extremely time-consuming. But that's exactly what Johnson and her colleagues did.

The researchers identified 1,364 companies with employee stock options whose stock price declined by 30 percent or more annually in any of the years between 1990 and 1996. Of those companies, 300 repriced and formed a basis of comparison to a control group of the 1,064 that didn't.

The researchers theorized that when a company's stock price falls below the exercise price of an option, much of any incentive effect the options may have had disappears. Repricing those options should restore those incentives, the researchers assumed. A situation in which options have been repriced should be similar to that of a newly instituted option-grant program.

So the researchers first asked whether companies that repriced outperformed the companies that didn't, as measured by cash flow and operating income over one, three, and five years. Companies that repriced options did significantly outperform the control group, and the performance gap grew over time.

Johnson and her colleagues also found that companies that had repriced options for only executive-level employees significantly outperformed the companies that had not repriced at all. But firms that repriced options for only non-executive employees did not outperform the control group.

While Johnson is confident that the study's results are meaningful, there are, she says, a number of caveats.

The researchers chose to study performance before significant accounting changes were made to the treatment of options, particularly the rule instituted in 2005 requiring companies to expense the cost of options. However, while that rule may have prompted some firms to cut back on granting stock options, the researchers do not have any reason to assume it would have changed the effect that option grants have on employee behavior—the focus of their study.


Hi Ruth,

 

Denny Beresford and Jim Leisenring once faced a more seriously “pissed off audience” and were lucky to escape:
I often use this quotation as an example of where the FASB does not always cave in to big business
(Intel, Cisco, Microsoft, Apple, etc. are big, big businesses):

 

 

A Quote from FAS 123 History (1993)
Dennis R. Beresford and James J. Leisenring came to the Red Lion Inn on a hot August morning with a simple goal: to explain a change in an accounting rule. Before it was over they were lucky to have escaped the first lynching in San Jose in a half-century. Measuring out the rope were 300 seriously pissed off Silicon Valley CEOs and other senior execs who could see the ruin of their lives' work because some glorified bean counters in Washington had decided to count sacrifice flies as home runs.
Michael S. Malone, Upside Today, November 1, 1993 --- http://www.upside.com/texis/mvm/story?id=34712c0a45 
 


A Bit of Accounting History:  The Evolution of FAS 123R
"Lieberman’s Legacy on Accounting," by Floyd Norris, The New York Times, January 20, 2011 ---
http://norris.blogs.nytimes.com/2011/01/20/liebermans-legacy-on-accounting/

Gail Collins, who has known Joe Lieberman since he was a local politician in Connecticut, ends her column about his decision not to seek re-election with a threat to write a book entitled, “Everything Bad Is Joe Lieberman’s Fault.”

I assume she is kidding, but if she goes through with it she should definitely include a chapter on stock option accounting.  It was he who, in 1994, got the Senate to vote 88 to 9 in favor of a resolution opposing a rule requiring companies to treat the value of stock options they hand out as an expense.

He then threatened to push through legislation to basically abolish the Financial Accounting Standards Board, and the board caved.  It would be another decade before reasonable accounting came to the world of options, with the American board moving only after the International Accounting Standards Board had done so.

The senator crowed when the board caved, calling it “a great victory for American business and workers.”  To hear him tell it, forcing disclosure of reality would “diminish the ability of small companies to raise capital and attract employees.”

Had he not been there, some of the worst excesses of the technology stock bubble might have been avoided. Certainly shareholders would have had a better understanding of how the bosses were getting rich.  Somehow Silicon Valley survived after the accounting was changed.

"Floyd Norris on Joe Lieberman’s Views on Accounting," by David Albrecht, The Summa, January 21, 2011 ---
http://profalbrecht.wordpress.com/2011/01/21/floyd-norris-on-joe-liebermans-views-on-accounting/

January 21, 2011 by David Albrecht

Senator Joe Lieberman has announced his plans not to seek re-election.  This means that January 3, 2013 will be his last day to serve as the 112th Congress is replaced by the 113th.  Gail Collins, Op-Ed columnist for the New York Times is thrilled, announcing tongue-in-cheek plans for a new book, Everything Bad Is Joe Lieberman’s Fault.”

Piling on, respected New York Times business columnist Floyd Norris suggests that Collins include a chapter on Joe Lieberman’s opposition to an accounting rule on executive stock options. Norris says that not having a rule to expense executive stock options caused the stock market bubble of the late 1990s. Floyd, I love you, but you should check with me before you write your next piece on accounting.

Surely Lieberman was promoting his personal interests in fighting the rule, and had no altruistic purpose in mind such as improving the world of accounting. However, he was correct on this one issue.

Adding the value of executive stock options as an expense on the income statement was a bad idea in the 1990s when Lieberman fought it, it was still a bad idea in 2005 when the FASB adopted it, and it will continue to be a bad idea for as long as the rule is on the books.

Here’s why Norris and the FASB are wrong about expensing stock options. Traditionally, the income statement has been reserved for (1) the value received from selling products and services, and (2) the money spent (costs) to generate these revenues. An executive stock option causes no money to be spent by the company. It is merely a vehicle to increase (potentially) the wealth of the receiving executive by a grant of ownership from the company’s owners. The current owners take a hit, but that hit has nothing to do with the profit from company operations. No money is being spent by the company on the executives, and no money will ever be spent by the company on the executives.

The expensing rule is but one example of the the use of accounting rules to accomplish societal objectives. When executives are granted stock options, the current group of stockholders have been robbed by the company’s board of directors, with the receiving executives as willing co-conspirators. Crying foul, investors have looked for a way to curb this practice. Their solution is to add a charge to current earnings, thereby making it more difficult for executives to qualify for their annual bonus. Unfortunately, the only result accomplished is to diminish the importance of the income statement.

It would be so much more powerful to simply vote out the directors who voted in the executive stock option. If a few boards were voted out because of granting these options, the practice would dry up in a hurry, I assure you.

Mr. Norris, thanks for writing about accounting. This time, though, you got it wrong.

Debit and credit – - David Albrecht

January 22, 2011 reply from Bob Jensen

Hi David,

We been round and round about this before, and I just do not agree with your reasoning. Let me tell you a Fairy Tale I used to read to my children.

Years and years ago a penniless gnome named Rumpelstiltskin limped along a cobblestone road carrying his portable spinning machine on his humped back. He encountered a sign reading: "You're Entering the Land of Albrecht."

Inside the Land of Albrecht Rumpelstiltskin encountered a golfer named Walter Schuetze, and the two chatted under a Rosewood Tree.  Rumpelstiltskin bragged that if he had bale of straw he could spin it into a gold nugget. Walter Schuetze asked  Rumpelstiltskin to rest under the tree for a moment, raced to a nearby farm, and returned with a bale of straw.

Walter Schuetze then explained that he'd formed a new corporation in the Land of Albrecht with the following general journal entries:

Cash              $1
    Common stock      $1
-To record the formation of Schuetze Inc
.

          Straw inventory $1
                Cash                    $1
         -To record the purchase of a bale of straw

Walter Schuetze truthfully further explained that he had no more money. But he would give Rumpelstiltskin an employee stock option in this new corporation if Rumpelstiltskin would be an employee of the company and spin the straw inventory into a nugget of gold. Now this is a transaction for services rendered but in the Land of Albrecht such employee stock option transactions are not booked.

          No journal entry in the journal for the stock option granted to Rumpelstiltskin

Rumpelstiltskin labored on his spinning machine and did indeed transform the straw inventory into a nugget of gold. Walter Schuetze then took physical inventory under the accounting rules in the land of Albrecht and made the following entries:

        Retained earnings $1
                Straw inventory       $1
        -To record the disappearance of the bale of straw

Walter Schuetze then recorded the final journal entry as follows:

        Common stock    $1
                Retained earnings    $1
        -To record the liquidation of Schuetze Inc. in the Land of Albrecht

Walter Schuetze then bid Rumpelstiltskin good day and proceeded whistling with joy down the cobblestone road looking for a golf course.

Rumpelstiltskin followed making screeching noises and waving his stock option. Walter Schuetze looked back at the pitiful gnome and explained that in the Land of Albrecht a stock option in a defunct corporation is worthless. It was never even booked into the accounting journal.

In a rage Rumpelstiltskin picked up a cobblestone, hit Walter Schuetze in the head, dragged this former SEC Chief Accountant into a ditch, retrieved the nugget of gold from the golfer's golf bag, and proceeded on in the Land of Albrecht toward his ultimate destination where the accounting rules were much more fair --- the Land of the FASB.

Walter Schuetze awakened with a headache and no gold nugget. When he finally did find a golf course in the Land of the FASB his only option was to raise some lunch money by caddying for Denny Beresford.

Almost all lived happily ever after with the FASB's ruling on accounting for stock options under FAS 123R except for former FASB Board Member Walter Schuetze who fumed over FAS 123R for the rest of his lonely life in the Land of the FASB.

Long before I reached this thrilling ending to this Fairy Tale my children were always fast asleep.

Moral of the story:
Option value is the sum of intrinsic value plus time value.
Employees trade their services for the time value of options that should be recorded as the value at the time of vesting for services rendered.
Otherwise inventories will be seriously undervalued as they are in the Land of Albrecht.
If the corporation is disbanded the nugget of gold remaining cannot be confiscated without considering the value of the employee stock options that have not yet expired in the more equitable Land of the FASB.

Book --- Click Here
http://www.amazon.com/gp/product/0071703071?ie=UTF8&tag=worbet-20&linkCode=as2&camp=1789&creative=390957&creativeASIN=0071703071
Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, Third Edition [Hardcover]
Howard Schilit (Author), Jeremy Perler (Author)
Also available as an eBook

Bob Jensen's threads on creative accounting ---
http://www.trinity.edu/rjensen/Theory02.htm#Manipulation

 

 

Bob Jensen's threads on employee stock option accounting are at
http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm

 


A New Teaching Case on Executive Options Backdating

Options Backdating --- http://en.wikipedia.org/wiki/Options_backdating

From The Wall Street Journal Accounting Weekly Review on March 12, 2010

Options Trial to Take New Tack
by: Mark Maremont
Mar 09, 2010
Click here to view the full article on WSJ.com

TOPICS: Advanced Financial Accounting, Executive Compensation, Stock Options

SUMMARY: "The criminal options-backdating trial of the former chief executive of home builder KB Home, Bruce Karatz, is scheduled to start Tuesday [3/9/2010], in the latest test of the federal government's checkered attempt to crack down on a practice that enriched scores of executives around the U.S....The government alleges that Mr. Karantz reaped millions of dollars in 'undisclosed compensation' to which he wasn't entitled."

CLASSROOM APPLICATION: The article can be used in coverage of equity-based compensation methods in financial accounting classes.

QUESTIONS: 
1. (Introductory) As described in the article, what is the practice of backdating stock options?

2. (Introductory) Specifically refer to the chart showing the dates of options grant to KB Home's former CEO, Bruce Karatz, and describe how it evidences the issues in options backdating.

3. (Advanced) Describe the accounting for employee compensation through stock options. How can the government argue that Mr. Karatz received "undisclosed compensation" if the options actually were issued at a later date than indicated in the accounting records and the value of the company's stock had increased in the intervening time?

4. (Introductory) Refer to the first related article. Many firms opt to issue restricted stock as compensation to employees. What is restricted stock?

5. (Introductory) How do you think that the executive-compensation research firm Equilar, Inc., determined the values of restricted stock issued to executives and employees?

6. (Advanced) One reason companies issue restricted stock is "to replace employees' underwater stock options." What is an "underwater stock option"? How did the behaviors of backdating stock options help to avoid options going "underwater" and becoming worthless?

7. (Advanced) Refer to the second related article. How did research firm Equilar determine the value of options granted to Silicon Valley tech firms? Why did the company need to decide on one method to use in its analysis?

Reviewed By: Judy Beckman, University of Rhode Island

RELATED ARTICLES: 
Despite Downturn, Top Tech Firms Awarded Big Restricted-Stock Grants
by Pui-Wang Tam
Feb 25, 2010
Online Exclusive

Stock Options Still Popular with Tech Firms
by Pui-Wing Tam
Mar 04, 2010
Online Exclusive

"Options Trial to Take New Tack:  Prosecutors Focus on How Backdating Benefited Former KB Home Chief Executive," by Mark Maremont, The Wall Street Journal, March 9, 2010 ---
http://online.wsj.com/article/SB10001424052748703954904575109901879413726.html?mod=djem_jiewr_AC_domainid

The criminal options-backdating trial of the former chief executive of home builder KB Home is scheduled to start Tuesday, in the latest test of the federal government's checkered attempt to crack down on a practice that enriched scores of executives around the U.S.

Bruce Karatz, who resigned as CEO of Los Angeles-based KB Home in 2006, will be tried on 20 criminal counts in U.S. District Court in Los Angeles related to allegations that between 1999 and 2006 he backdated his own stock options and those of other executives. He had been one of the home-building industry's highest-paid executives. The government alleges he reaped millions of dollars in "undisclosed compensation" to which he wasn't entitled.

Mr. Karatz has pleaded not guilty and his lawyers have said in legal briefs he never thought he was committing a crime, calling the government's evidence "gossamer thin." In a statement, his lawyer John Keker said the accounting rules governing options-granting "made little sense," but "company after company applied those rules in good faith, in a way the government now says was wrong."

More than two dozen former executives of various companies have been criminally charged since 2006 in a federal crackdown on options backdating. But after a spate of early convictions and guilty pleas, officials have had setbacks in recent months.

A U.S. judge in Santa Ana, Calif., recently dismissed criminal charges against former and current officials of Broadcom Corp., finding prosecutorial misconduct and a lack of criminal intent. A U.S. judge in St. Louis last month halted a civil trial against a former official of Engineered Support Systems Inc., finding the government's case was weak.

Backdating involves retroactively setting the price of a stock option to a low point in the stock's value, allowing employees to reap higher profits if the stock is later sold.

The case against Mr. Karatz differs in key ways from the Broadcom case. Broadcom's co-founders never received any backdated options, but Mr. Karatz was the biggest recipient of KB Home's improperly priced grants. He received roughly half of the total annual options awarded to all KB corporate officers, according to prosecutors.

Filings show that at least four grants to Mr. Karatz were dated at yearly, quarterly or monthly low points in KB Home's stock.

Prosecutors also allege that Mr. Karatz tried to cover up the backdating, in part by lying to the company's top lawyer during a 2006 internal investigation. The allegation, if proven, could help show criminal intent, by suggesting that Mr. Karatz knew his conduct was wrong.

A key witness for prosecutors will be Gary A. Ray, KB Home's ex-head of human resources, who agreed to cooperate after pleading guilty to a conspiracy charge in 2008. According to documents filed with the court, Mr. Ray said he initially went along with the false story about the options granting process, but later informed Mr. Karatz he couldn't tell KB Home's outside lawyers "the same lies" he had given to the top internal lawyer.

Jensen Comment
The American Accounting Association in 2007 gave its Notable Contributions to Accounting Literature Award (and $5,000) to Iowa's finance professor Eric Lie --- http://aaahq.org/awards/awrd3win.htm

Erik Lie
"On the Timing of CEO Stock Option Awards"
Management Science (May, 2005)


Teaching Case on Executive Compensation and Stock Options

From The Wall Street Journal Accounting Weekly Review on March 4, 2011

J&J CEO's 2010 Bonus Cut by 45%
by: Peter Loftus
Feb 28, 2011
Click here to view the full article on WSJ.com
 

TOPICS: Compensation, Executive Compensation, Stock Options

SUMMARY: Johnson & Johnson's chief executive's pay has been reduced following a year of product recalls due to manufacturing problems. The company does not acknowledge that the pay reduction is related to this specific problem, but notes that the compensation review encompasses many company performance factors.

CLASSROOM APPLICATION: The article is useful to introduce compensation package issues and accounting for these plans.

QUESTIONS: 
1. (Introductory) From where did the reporter get the information in this article about bonus pay and other compensation awarded to the Johnson & Johnson (J&J) chief executive William Weldon?

2. (Introductory) Who evaluated William Weldon's performance in 2010? On what basis did they do so? Why was Mr. Weldon's overall compensation reduced in 2010 relative to 2009?

3. (Introductory) What items comprise Mr. Weldon's compensation package?

4. (Advanced) Access the Johnson & Johnson financial statements filed on Form 10-K with the SEC on and available at http://www.sec.gov/cgi-bin/viewer?action=view&cik=200406&accession_number=0000950123-11-018128&xbrl_type=v# Proceed to the Notes to Financial Statements, No. 17. Common Stock, Stock Option Plans, and Stock Compensation Plans. Summarize the information found in this footnote.

5. (Advanced) From where does the company obtain the shares of its common stock needed to be issued to executives and employees who exercise their stock options?

6. (Advanced) Over what range of stock prices may J&J option holders exercise their options? How does that compare to the company's current stock price? Over how long a time period may employees exercise these options?

7. (Advanced) What is restricted stock? How does J&J satisfy obligations to issue shares of stock to its executives and employees under these plans?
 

Reviewed By: Judy Beckman, University of Rhode Island

"J&J CEO's 2010 Bonus Cut by 45%," by: Peter Loftus, The Wall Street Journal, February 28, 2011 ---
http://online.wsj.com/article/SB10001424052748704150604576166313696650734.html?mod=djem_jiewr_AC_domainid

Johnson & Johnson slashed Chief Executive William Weldon's performance bonus by 45% for 2010, a year in which the health-care giant issued a series of product recalls due to manufacturing-quality lapses.

The recalls are continuing, with the company saying this past week that certain packages of the decongestant Sudafed were being recalled because of a misprint on product directions.

In an annual report filed with the Securities and Exchange Commission Friday, J&J said Mr. Weldon's performance bonus for 2010 was $1.98 million, down from $3.6 million for 2009. The bonus, which was approved by the compensation committee of J&J's board in January, is paid out in the form of 85% cash and 15% in J&J shares.

In addition, the New Brunswick, N.J., company granted fewer stock options, restricted share units and nonequity incentive compensation units to Mr. Weldon this year than last year. He was granted 560,691 stock options in January, with an exercise price of $62.20, versus 586,873 options last year with an exercise price of $62.62.

J&J did, however, boost Mr. Weldon's base salary for 2011 by 3% to $1.9 million, according to the SEC filing. The year-earlier figures were contained in last year's annual report.

J&J spokeswoman Carol Goodrich said the board's compensation committee evaluated Mr. Weldon and other senior executives against a set of financial and strategic objectives that will be disclosed in a proxy statement expected to be filed with the SEC in March. She said the objectives are based on a pay-for-performance philosophy, but declined to be more specific.

Ms. Goodrich declined to say whether the reduction in Mr. Weldon's performance bonus was related to the product recalls.

Mr. Weldon's total compensation was valued at $30.8 million for 2009, the last full year for which total compensation was reported. The figure included salary, bonus, changes in pension value and other items.

Continued in article

Bob Jensen's threads on outrageous executive compensation are at
http://www.trinity.edu/rjensen/FraudConclusion.htm#OutrageousCompensation

 


Update on IFRS and SPEs
October 12, 2009 message from Bob Jensen to the AECM

  • I previously provided a long quotation from the FT article by Yale’s Robert Shiller on the need for creative finance.
    "In defence of financial innovation," by Yale's Robert Shiller, Financial Times, September 27, 2009
    http://www.ft.com/cms/s/0/c4a74ba2-ab83-11de-9be4-00144feabdc0.html?nclick_check=1

    The FASB has done a part-way job in dealing with some of the creative financing paths to date, but the FASB has miles to go before it rests or gives up. The IASB is still asking “what’s creative finance.”

    At the moment the big international accounting firms are chomping at the bit to replace U.S. GAAP with IFRS and accounting educators in the U.S. are gearing up to teach IFRS as if U.S. GAAP already has one foot in the grave.

     

    The SEC might’ve jumped on the 2014 timetable promoted by former SEC Director Chris Cox, but the SEC is concealing its hand regarding when and if U.S. GAAP will be lowered into the grave. My understanding is that the major hang up is the absence of IFRS standards to deal with even the most basic and long-standing creative finance ploys such as SPEs (that date back to before the Enron scandal). To date international standards remain silent on SPEs even though the FASB has the controversial FIN 141R on SPEs, SPVs, VIEs, and synthetic leasing ---
    http://www.trinity.edu/rjensen/theory/00overview/speOverview.htm

     

    IFRS needs huge updates on the following types of contracting and financial engineering:

     

    Hence my bell weather of how badly the IASB wants to bury U.S. GAAP is how the IASB deals with SPEs and related creative financing vehicles. For this I requested my former student, great friend, and IASB insider Paul Pacter to keep me posted on SPEs in the IASB. It’s not like the IASB has been ignoring the problem, especially since the SEC is foot dragging on the failings to date of the IASB to deal with creative financing contracting in the U.S.

     

    Paul is a former project leader for both the FASB and IASB and still is very, very active in the development of international standards (he lead the recent SME project). He does this in spite of being located in Hong Kong with Deloitte. By the way, Paul has also been a major resource for setting accounting standards in China. Paul is also the founder and Webmaster if the absolutely fantastic IAS Plus --- http://www.iasplus.com/index.htm
    I would never leave home without it.

     

    Over his years and years of world travel, my great friend Paul Pacter must’ve taken 100,000 high quality photographs. Paul’s photo gallery is at http://www.whencanyou.com/index.htm

     

    After all this preamble let me get to the purpose of this message. The purpose is to forward a message from Paul Pacter regarding accounting for SPEs.

     

     

    The links to the two articles attached to Pauls message are can be found at the following URLs:

     

     

    Robert E. (Bob) Jensen
    Trinity University Accounting Professor (Emeritus)
    190 Sunset Hill Road
    Sugar Hill, NH 03586
    Tel. 603-823-8482
    www.trinity.edu/rjensen

    Reply From: Pacter, Paul (CN - Hong Kong) [mailto:paupacter@deloitte.com.hk
    Sent: Sunday, October 11, 2009 8:22 PM
    To: Jensen, Robert
    Subject: SPEs

     Bob,

    From Paul Pacter on October 12, 2009
    Bob
    You asked me to think of you re SPEs.  Attached is an excellent report on SPEs (plus related press release).  The three bullet points I highlighted below – alone – could be a good teaching tool.

    Paul

    12 October 2009: Regulators' report on special purpose entities

    The Joint Forum has released its Report on Special Purpose Entities. This paper serves two broad objectives. First, it provides background on the variety of special purpose entities (SPEs) found across the financial sectors, the motivations of market participants to make use of these structures, and risk management issues that arise from their use. Second, it suggests policy implications and issues for consideration by market participants and the supervisory community. Regarding accounting, here are three comments made in the report:

    The ability to achieve off-balance sheet accounting treatment is affected by the accounting regime to which the originating or sponsoring entity is subject. Generally speaking, off-balance sheet treatment is easier to achieve under US GAAP than under IFRS. However, the US FASB new accounting rules related to SPEs that are effective in 2010 will significantly reduce the ability of institutions to use SPEs to achieve off-balance sheet treatment. As a result, US accounting changes will significantly alter the motivations for originators in using SPEs. These accounting changes will also affect leverage and risk-based capital ratios, and could have an important effect on the management of regulatory capital adequacy requirements by firms.

    European financial firms generally have less ability to remove assets from their balance sheets by using SPEs. However, this is offset by the fact that risk-based capital requirements are not as closely tied to accounting in Europe. In contrast, while US firms currently can more easily remove assets from their balance sheets, the US implementation of Basel I required more capital for certain exposures than in Europe.

    Some examples (but not an exclusive list) of the ways SPEs can potentially confuse or obfuscate the financial position of a company are:

    • Return on equity and return on assets can be exaggerated if revenue flows are received from SPEs but the assets in those vehicles are not recognised on the balance sheet;
    • Sector exposure may be obscured, either deliberately or not, by recognising some SPEs on balance sheet and not others;
    • Leverage ratios may be obscured.

    An appendix to the report examines, in detail, the current accounting treatment of SPEs under IFRSs and under US GAAP. Click to download:

    The Joint Forum is a consortium of the Basel Committee on Banking Supervision, the International Organization of Securities Commissions, and the International Association of Insurance Supervisors that addresses issues common to the banking, securities, and insurance sectors, including the supervision of financial conglomerates.

     

    Jensen Comment:  Paul gave me permission to forward the above message.
    This message (including any attachments) contains confidential information intended for a specific individual and purpose, and is protected by law. If you are not the intended recipient, you should delete this message. Any disclosure, copying, or distribution of this message, or the taking of any action based on it, is strictly prohibited.

    ©2009 Deloitte Touche Tohmatsu in Hong Kong SAR, Deloitte Touche Tohmatsu in Macau SAR, and Deloitte Touche Tohmatsu Certified Public Accountants Ltd. in the Chinese Mainland. All rights reserved.

    Deloitte refers to one or more of Deloitte Touche Tohmatsu, a Swiss Verein, and its network of member firms, each of which is a legally separate and independent entity.  Please see www.deloitte.com/cn/en/about for a detailed description of the legal structure of Deloitte Touche Tohmatsu and its member firms.

     

  • Bob Jensen's threads on accounting theory ---
    http://www.trinity.edu/rjensen/theory01.htm

    What's Right and What's troublesome about synthetics, (SPEs), SPVs, and VIEs in accounting standards?
    http://www.trinity.edu/rjensen//theory/00overview/speOverview.htm

     


    I'm sorry," Reyes said. "There is much that I regret. If I could turn back the clock, I would."
     As pointed out in the Opinion Journal, January 18, 2008 Reyes' choice of words is truly ironic since he was convicted of options "backdating." When he committed the fraud he truly did turn the clock back. Now he would like to turn it back again since he got caught.

    From The Wall Street Journal Accounting Weekly Review, January 18, 2008

    Brocade Ex-CEO Gets 21 Months in Prison
    by Justin Scheck and Steve Stecklow
    The Wall Street Journal

    Jan 17, 2008
    Page: A3
    Click here to view the full article on WSJ.com ---
    http://online.wsj.com/article/SB120050817585095031.html?mod=djem_jiewr_ac
     

    TOPICS: Accounting, Financial Accounting, Financial Reporting, Stock Options

    SUMMARY: Gregory Reyes, the former chief executive of Brocade Communications Systems Inc. was the first to go on trial and be convicted over the improper dating of stock-option awards. The backdating scandal came to light from academic accounting research that was brought to the attention of the WSJ. Executives committing this fraudulent activity were awarded stock options that were backdated to a point at which the companies' stock prices were lower, often the lowest of the year or quarter. The related article describes the practice as "illegal if not accounted for properly." Mr. Reyes had faced a potential 20 year sentence, but that "...was reduced late last year when Judge Breyer ruled there was no quantifiable loss of money to the company."

    CLASSROOM APPLICATION: Accounting for stock options and related disclosures

    QUESTIONS: 
    1.) Summarize the accounting and disclosure requirements for stock options. Refer to authoritative accounting literature and include a description of dates associated with stock option grants sufficient to discuss the issues in the article.

    2.) What does it mean to "back date" a stock option award?

    3.) The related article describes the practice of backdating stock options as "illegal if not accounted for properly." What accounting would have been appropriate? You may refer to your answer to question 1 as necessary.

    4.) The potential sentence and fine to Mr. Reyes was reduced by the judge in the case because he "ruled there was no quantifiable loss of money to the company." What are the costs of stock option to the issuing company? To its shareholders? Support your answer.
     

    Reviewed By: Judy Beckman, University of Rhode Island
     

    RELATED ARTICLES: 
    Brocade Ex-CEO Seeks To Overturn Conviction
    by Justin Scheck
    Dec 13, 2007
    Page: A15
     

    Also see the definition at http://www.biz.uiowa.edu/faculty/elie/backdating.htm


    The SEC's Module on Stock Options Compensation and Options Backdating Scandals --- http://www.sec.gov/spotlight/optionsbackdating.htm


    "S.E.C. Fines Marvell $10 Million," The New York Times, May 9, 2008 --- Click Here

    The Marvell Technology Group, a maker of semiconductors, agreed on Thursday to pay a $10 million civil fine to settle regulators’ accusations of improper backdating of stock options.

    The Securities and Exchange Commission announced the settlement with the Silicon Valley company, which it said failed to publicly disclose the employee stock option awards as expenses and backdated the options to dates with lower stock prices. Marvell neither admitted nor denied wrongdoing but did agree to refrain from future violations of the securities laws.

    The backdating scheme allowed the company to overstate its profit by $362 million from fiscal years 2000 through 2006, the S.E.C. said in its civil lawsuit.

    Continued in article

    Bob Jensen's Fraud Updates --- http://www.trinity.edu/rjensen/FraudUpdates.htm  


    From The Wall Street Journal Accounting Weekly Review on September 7, 2012

    Facebook Plays Defense
    by: Geoffrey A. Fowler
    Sep 05, 2012
    Click here to view the full article on WSJ.com
     

    TOPICS: Executive Compensation, Individual Taxation, Stock Price Effects, Stockholders' Equity

    SUMMARY: "In a regulatory [Form 8-K] filing Tuesday, Facebook said Chief Executive Mark Zuckerberg won't sell any stock in the company for a year, and that two of its directors...have no plans to sell their personal holdings beyond the amount needed to cover their tax liabilities." The discussion in the article emphasizes the company's plans to maintain a relatively constant level of outstanding shares and also mentions tax treatment of individuals receiving the restricted stock.

    CLASSROOM APPLICATION: The article may be used in a tax class to cover the topic of restricted stock and in a financial accounting class covering authorized, issued, and outstanding shares. NOTE: INSTRUCTORS WILL WANT TO REMOVE THE FOLLOWING STATEMENTS AS THEY CONTAIN ANSWERS TO THE QUESTIONS ASKED IN THE REVIEW. Restricted stock is taxed similarly to non-qualified stock options except that employees are taxed on the full fair value of the stock at the vesting date, unless the employee makes an election under section 83(b) to accelerate the date to the grant date. As described in the article from review of an SEC Form 8-K filing, Facebook intends to maintain a similar level of outstanding shares after the vesting of the restricted stock as before the vesting date by repurchasing treasury shares.

    QUESTIONS: 
    1. (Introductory) What is restricted stock? What will happen in October in relation to Facebook's employees' restricted stock units?

    2. (Advanced) How are issuances of restricted stock units treated for tax purposes? In your answer, explain why the two directors mentioned in the article might sell shares because they face tax liabilities if they otherwise do not plan to sell these shares of stock.

    3. (Advanced) Define the terms authorized, issued, and outstanding shares of stock. How will the issuance of the restricted stock affect each of these categories of stock?

    4. (Introductory) According to the article, what will Facebook do to offset the impact of releases of restricted stock previously granted to executives and employees? Again, explain the impact of this action on the three types of stock identified above.

    5. (Advanced) Why is Facebook's action important to shareholders who bought the stock upon its initial public offering?
     

    Reviewed By: Judy Beckman, University of Rhode Island

     

    "Facebook Plays Defense," by Geoffrey A. Fowler, The Wall Street Journal, September 5, 2012 ---
    http://professional.wsj.com/article/SB10000872396390443759504577631854230025164.html?mod=djem_jiewr_AC_domainid&mg=reno-wsj

    Facebook Inc. FB +2.00% took steps Tuesday to reassure investors and employees worried about its plummeting stock price, as the social network's shares hit new lows.

    In a regulatory filing Tuesday, Facebook said Chief Executive Mark Zuckerberg won't sell any stock in the company for a year, and that two of its directors—Marc Andreessen and Donald Graham—have no plans to sell their personal holdings beyond the amount needed to cover their tax liabilities.

    Facebook also detailed how it will essentially buy back 101 million shares when it issues previously restricted stock units to its staff in October. At recent prices, it would spend roughly $1.9 billion to keep those shares off the market.

    Together, the steps function like a kind of defensive wall around the Facebook share price. They effectively reduce the amount of Facebook stock in the public market and spread out the amount of shares that could flood the market in November after a lockup period on the stock expires.

    Facebook spokesman Larry Yu said the details in the filing were approved by the company's compensation committee on Aug. 30. "We wanted to get the filing out as soon as we could after that meeting as a measure of clarity and transparency," he said.

    Mr. Yu declined to comment on the impact that the moves might have on investors.

    Facebook's stock has been in a tailspin since the Menlo Park, Calif., company's initial public offering in May. After making their market debut at $38 a share amid much hype that month, they have plunged more than 50% over concerns about how much the company is really worth.

    On Tuesday, Facebook's shares dropped to a fresh low of $17.73 in 4 p.m. trading after analysts at the two biggest underwriters for the company's IPO—Morgan Stanley MS +3.51% and J.P. Morgan Chase JPM +4.08% & Co.—cut their price targets on the stock.

    In after-hours trading following the regulatory filing, Facebook's shares ticked up 1.7% to $18.03.

    Facebook's stock has continued to suffer as share lockups began expiring last month, releasing 271 million shares—or nearly 13% of those outstanding—on the market. More lockup expirations in October, November and December will allow insiders and others to sell more than 1.4 billion shares.

    Enlarge Image image image Julie Jacobson/Associated Press

    Facebook said Mr. Zuckerberg won't sell any shares in the social network for a year. Mr. Zuckerberg, above, in May.

    Last month, director and early investor Peter Thiel sold the majority of his Facebook holdings—some 20.1 million shares—after restrictions on insider selling lifted.

    Facebook has publicly said little about its stock slide but internally is reassuring employees about their shares. In a companywide meeting last month, Mr. Zuckerberg told them it may be "painful" to watch the stock plunge, but that investments Facebook has made will soon bear fruit.

    In its filing, Facebook said Mr. Zuckerberg "has no intention to conduct any sale transactions in our securities for at least 12 months." Mr. Zuckerberg sold Facebook stock in the IPO to cover his tax liabilities, and now holds about 444 million shares of Class B common stock and an option exercisable for an additional 60 million Class B shares.

    A Facebook spokesman declined to make Mr. Zuckerberg available to comment.

    A spokeswoman declined to make Mr. Andreessen available for comment. Mr. Graham declined to comment.

    Facebook also said it plans to withhold 45% of employees' restricted stock units to cover their tax liabilities, paying the obligations, worth about $1.9 billion, in cash and from existing credit facilities. In doing so, it would remove 101 million shares from the market for accounting purposes, about 4% of the shares outstanding. Facebook also said the lockup date for some employees' stock would be Oct. 29, after previously suggesting it might fall on Nov. 14.

    Continued in article

    Bob Jensen's threads on employee stock option accounting ---
    http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm

    Bob Jensen's threads on accounting theory ---
    http://www.trinity.edu/rjensen/Theory01.htm

     


    In 2004 the FASB issued a revision called FAS 123R to the employee stock option standard that caused a huge stir because for the first time employee stock options had to be expensed when they vested rather than when employees exercised the options.
    FAS 123R --- Click Here
    Any future revisions will be in the FASB Codification database.

    This is one of the few standards where industry mounted a serious lobbying effort to have Congress and/or the SEC override the requirement to expense employee stock options when vested. In particular, huge technology firms like Cisco and Intel mounted an expensive lobbying effort. I can only speculate, but I think the lobbying effort might've succeeded had it not been for the timing of media coverage of outrageous and egregious executive compensation scandals ---
    http://www.trinity.edu/rjensen/FraudConclusion.htm#OutrageousCompensation
    It became politically correct in Congress to resist any effort to make executive compensation in corporations less transparent.

    Even though the original industry effort failed to override the FAS 123R requirement to book employee stock options as expenses, pressures continued long after FAS 123R went into effect in 2004. Janet Tavakoli summarizes an effort launched by bit names in academia, government, and industry.

    Warren Buffett's wisdom is often at odds with "famous names" and the nonsense taught by economists in graduate business schools. In August 2006, veture capitalist Kip Hagopian published a commentary in California Management Review, the scholarly journal of the University of California-Berkley Haas School of Business.He stated that expensing employee stock options was improper accou8nting and argued stock prices reflect employee stock options liabilities, implying that shareholders know how to efficiently value those stock options. He got 29 "famous names" to undersign his article. These included Milton Friedman (who would pass away in November) and Harry Markowitz, both former University of Chicago professors and winners of the Nobel Prize in Economics; George P. Schultz and Paul O'Neill, both former U.S. Treasury Secretaries; and Arther Laffer, Holman W. Jenkins Jr., a member of the Wall Street Journal editorial board, and supported this notion in a separate commentary.

    Even iff it were true that shareholders are well equipped to independently value stock options --- and it is not --- the proper place to account for costs is in the accounting statement. Shareholders shouldn't have to make a separate correction for material information that has been omitted from financial statements. The "famous names" should have lobbied for more transparency, or better yet, the abolishment of stock options as a compensation scheme. Instead, these Princes of Darkness advocated opacity.
    Janet Tavakoli, Dear Mr. Buffet (Wiley, 2009, Page 36).

    Jensen Comment
    With all due respects to Janet FAS 123, before FAS 123R did require companies to disclose the values of employee stock options and gave an option to expense that value on the date of vesting (only one out of the Fortune 500 companies expensed this value). This made it easier for financial statement users to adjust earnings for options expense, but it did make it more difficult for users and analysts. FAS 123R requires that such values be expensed.

    September 11, 2009 reply from Patricia Walters [patricia@DISCLOSUREANALYTICS.COM]

    Bob:

    The IASB issued IFRS 2 Share-based Payments almost a year earlier than 123R. So there might have been additional pressure for the FASB not to be seen as more lenient on this issue.  If I remember correctly, the Canadian standard was also issued before the US standard.

    Companies used the traditional arguments against expensing stock comp including:  competitive disadvantage, too costly and it's already in the notes.

    In one of the more interesting presentations by a preparer representative that I attended, the presenter argued the following:
    (1) Information was in footnotes.
    (2) Analysts and other users were relying on this information and already making adjustments to the reported numbers.
    (3) BUT: Information was not reliable!
    (4) Therefore, companies should be required to move information from notes to financial statements.

    Even after questioning him to be sure he really meant the information provided in the notes wasn't reliable, he still maintained that was the case, despite admitting people used that information.

    My favorite preparer argument, though, has always been what I refer to as the "end of civilization as we know it" argument.  For stock options, this took the form of the end of entrepreneurship in the US if companies had to expense this compensation (because, of course, they wouldn't want to use options for compensation if they had to be expensed).

    I believe the prediction of the death of stock options was premature.

    Regards
    Pat


    There is considerable theoretical and practical objection to valuing employee stock options on the date of vesting. Most accounting literature suggests using the Black-Scholes model for valuing options. William Brighernti has a practical solution for valuation of stock options using the Black-Scholes model --- http://www.cpa-connecticut.com/sfas123r.html
    http://www.cpa-connecticut.com/IPIC.html

    The problem in theory and practice is that the Black-Scholes model that is popular in financial markets for purchased options is not especially well suited for employee stock options where employees tend to have greater fears that option values will tank before expiration dates. It's a little like having to put your salary in suspension and then losing it before you get it back. As a result the lattice model described below may be more approprate.

     

    "How to “Excel” at Options Valuation," by Charles P. Baril, Luis Betancourt, and John W. Briggs, Journal of Accountancy, December 2005 --- http://www.aicpa.org/pubs/jofa/dec2005/baril.htm
    This is one of the best articles for accounting educators on issues of option valuation!

    Research shows that employees value options at a small fraction of their Black-Scholes value, because of the possibility that they will expire underwater. --- http://www.cfo.com/article.cfm/3014835

    "Toting Up Stock Options," by Frederick Rose, Stanford Business, November 2004, pp. 21 --- http://www.gsb.stanford.edu/news/bmag/sbsm0411/feature_stockoptions.shtml 

    How to value stock options in divorce proceedings --- http://www.optionanimation.com/MarlowHowToValueStockOptionsInDivorce.htm

    How the courts value stock options --- http://www.divorcesource.com/research/edj/employee/96oct109.shtml

    Search for the term options at http://www.financeprofessor.com/summaries/shortsummaries/FinanceProfessor_Corporate_Summaries.html

    "Guidance on fair value measurements under FAS 123(R)," IAS Plus, May 8, 2006 ---
    http://www.iasplus.com/index.htm

    Deloitte & Touche (USA) has updated its book of guidance on FASB Statement No. 123(R) Share-Based Payment: A Roadmap to Applying the Fair Value Guidance to Share-Based Payment Awards (PDF 2220k). This second edition reflects all authoritative guidance on FAS 123(R) issued as of 28 April 2006. It includes over 60 new questions and answers, particularly in the areas of earnings per share, income tax accounting, and liability classification. Our interpretations incorporate the views in SEC Staff Accounting Bulletin Topic 14 "Share-Based Payment" (SAB 107), as well as subsequent clarifications of EITF Topic No. D-98 "Classification and Measurement of Redeemable Securities" (dealing with mezzanine equity treatment). The publication contains other resource materials, including a GAAP accounting and disclosure checklist. Note that while FAS 123 is similar to IFRS 2 Share-based Payment, there are some measurement differences that are Described Here.

    Bob Jensen's threads on employee stock options are at http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm

    Bob Jensen's threads on fair value accounting are at http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue

    Bob Jensen's threads on valuation are at http://www.trinity.edu/rjensen/roi.htm

     


    April 5, 2005 message from Dennis Beresford [dberesfo@TERRY.UGA.EDU]

    The SEC recently released an interesting memo from its Office of Economic Analysis to the Chief Accountant on economic valuation of stock options. It is available at: http://www.sec.gov/interps/account/secoeamemo032905.pdf 

    The memo concludes that valuing employee stock options under new FASB Statement 123R is "not unusual" and is quite similar to valuations done in other areas of accounting and finance. This seems to deflate the arguments of some within the business community who continue to assert that employee stock options are too hard to value. The memo footnotes several academic studies from both accounting and finance scholars in supporting its findings.

    Denny Beresford

    Bob Jensen's threads on employee stock options are at http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm
    Bob Jensen's threads on valuation are at http://www.trinity.edu/rjensen/roi.htm

     

    Concept of Real Options --- http://www.trinity.edu/rjensen/realopt.htm


    Fodder for Accounting and Finance Agency Theorists to Digest

    Principle-Agent Theory --- http://en.wikipedia.org/wiki/Agency_Theory

    In political science and economics, the principal-agent problem or agency dilemma treats the difficulties that arise under conditions of incomplete and asymmetric information when a principal hires an agent. Various mechanisms may be used to try to align the interests of the agent with those of the principal, such as piece rates/commissions, profit sharing, efficiency wages, performance measurement (including financial statements), the agent posting a bond, or fear of firing. The principal-agent problem is found in most employer/employee relationships, for example, when stockholders hire top executives of corporations. Numerous studies in political science have noted the problems inherent in the delegation of legislative authority to bureaucratic agencies. Especially since bureaucrats often have expertise that legislators and executives lack, laws and executive directives are open to bureaucratic interpretation, creating opportunities and incentives for the bureaucrat-as-agent to deviate from the preferences of the constitutional branches of government. Variance in the intensity of legislative oversight also serves to increase principal-agent problems in implementing legislative preferences.

    Four principles of contract design

    ·         3.1 Informativeness Principle

    ·         3.2 Incentive-Intensity Principle

    ·         3.3 Monitoring Intensity Principle

    ·         3.4 Equal Compensation Principle

    ·         3.5 A linear model

    ·         3.6 Nonlinearities

    "Compensation Under Competition," by Richard Posner, The Becker-Posner Blog, April 7, 2008 --- http://www.becker-posner-blog.com/

    There is a long-standing concern that corporate executives are more risk averse than a corporation's shareholders, because the latter can eliminate firm-specific risk by holding a diversified portfolio, while the former cannot, because they have firm-specific human capital that they will lose if the firm tanks. The solution to this problem was thought to consist in making stock options a large part of the executive's compensation, so that his incentives would be closely aligned with those of the shareholders. True, because he would bear more risk, he would have to be paid more in total compensation than if he did not receive a large part of his compensation in the form of stock options. But the cost to the corporation of the additional pay would presumably be offset by the gain to the shareholders from the executives' enhanced incentives to maximize shareholder wealth.

    But we are beginning to realize that the grant of stock options may make corporate executives take more risks than the shareholders desire [Jensen insert:  To say nothing of cheating on earnings reports]. Suppose that instead of being compensated for bearing risk just by being paid a higher salary or given even more stock options, the executive is guaranteed generous retirement and severance benefits that are unaffected by the price of the corporation’s stock. Now he has a hedge against risk, and can take more risks in operating the corporation because his personal downside risk has been truncated. Perhaps this was a factor in the recent stock market bubbles--the one that burst in 2000 with the crash of the high-tech stocks and the one that burst this year as a result of the collapse of the subprime mortgage market and the resulting credit crunch. A bubble is both a repellent and a lure. It is a lure because during the bubble values are rising steeply, so an investor who exits before the bubble has peaked may be leaving a good deal of money on the table. He will be especially loath to do that if he is hedged against the consequences of the bubble's eventual bursting.

    Boards of directors could devise compensation schemes that limited the attractiveness of risky undertakings, but they have little incentive to do so. The boards tend to be dominated by CEOs and other high corporate executives of other firms, who have an interest in keeping executive compensation high and who are abetted by compensation consultants who naturally recommend generous compensation packages to directors who are recipients of generous compensation and therefore believe that the CEOs of the companies on whose boards they sit should be paid top dollar.

    It is not clear what the free-market antidote to this tendency to ratchet up executive compensation is. The compensation of the CEO and other high officials of a large corporation is usually only a small part of the corporation's costs, so shaving such compensation is unlikely to be a powerful competitive weapon. But more important, what rival corporation would have the governance structure that would enable such shaving to be accomplished by overcoming the obstacles that I have discussed? The private-equity firm is a partial answer, because it has only a few shareholders and so need not delegate compensation to a board of directors that has other interests besides the welfare of the shareholders at heart. The reason it is only a partial answer is that there are too few owners of capital who want or have the ability or experience to participate as actively in management as the private-equity entrepreneurs and there are too many efficiently large corporations for all of them to have the good fortune of being owned by a handful of entrepreneurial investors. There is a vast pool of passive equity capital that can be put to work only in companies that are organized in the traditional board-governed corporate form.

    Here is another though related example of a stubborn efficiency-in-compensation problem, also in a highly competitive sector of the economy: law-firm billing practices. Major law firms, with few exceptions, base their bills to their clients on the number of hours that the firm's lawyers work on the client's case or other project. In other words, they bill on the basis of inputs rather than outputs. This is rational when output is difficult to evaluate, as is often the case with a law firm's output because of the uncertainty of litigation (in nonlitigation practice, because of legal and factual uncertainties). The fact that a firm loses a case doesn't mean that it did a bad job; both the winner's firm and the loser's firm may have done equally good jobs--the lawyers don't control the outcome. A law firm can give the client a pretty good idea of the quality of the lawyers it assigns to the client's case, because there are observable proxies for a lawyer's unobservable quality, proxies such as his educational and employment history. What the client cannot readily judge is whether the law firm put in excessive hours on the case, and the result, according to persistent and cumulatively persuasive anecdotage, is a tendency for law firms to invest hours in a case beyond the point at which the marginal value of the additional hour is just equal to the marginal cost to the client. Young lawyers often feel that they are being assigned work to do that has little value to the client but that will increase the firm's income because the firm bills its lawyers' time at a considerably higher rate than the cost of that time to the firm. The very high turnover at many law firms is attributed in part to dissatisfaction of young lawyers with the amount of busywork that they are assigned, work that bores them and does not contribute to the development of their professional skills, yet may be very time-consuming.

    The problem is compounded by the distorted incentives of corporate general counsels. A general counsel wants to show his boss, the corporate CEO, that he monitors expenses carefully, and, since he knows that he is likely to lose at least some of his cases, he also wants to be able to avoid if possible being blamed by his boss for the loss. Hourly billing serves both of these ends. The law firm and the general counsel play a little game, in which the law firm prices its hours on the assumption that it will not be able to collect its billing rates on all of them, and the general counsel reduces the number of hours that he is willing to pay for. He can then show his CEO that he squeezed the water out of the law firm's bills. At the same time, by paying a prominent law firm by the hour, he can assure his CEO, in the event a case is lost, that he had told the firm to do as much work as was needed to maximize the likelihood of a favorable outcome, rather than paying a fixed rate agreed to at the outset that might have induced the law firm to skimp on the amount of work it put into the case.

    One can imagine a law firm's adopting a different method of pricing, in which it would charge at the outset a fixed fee, subject to adjustments up or down at the end of the case based on outcome, amount of work, or some other performance measure or combination of such measures. The conventional law firm billing system is a form of cost-plus pricing, which is considered wasteful. But litigation is risky, and cost-plus pricing diminishes risk by eliminating a contractor's incentive to cut corners. If the disutility of risk to a general counsel is great, he will prefer to "overpay" law firms rather than trying to explain to the CEO that the novel compensation deal that he worked out with the law firm that lost the case was not a factor in the loss; that he had not been penny wise and pound foolish.

    Although the compensation practices that I have described seem inefficient, it does not follow that corrective measures would be appropriate. They would be costly and the net benefits might well be negative. It is efficient to live with a good deal of inefficiency. Stated otherwise, the fact that competitive markets contain large pockets of inefficiency is not in itself inefficient. For example, while cartel pricing is inefficient, if the cost of preventing cartelization exceeded the benefits one wouldn't want to prevent it. Yet cartel pricing would still be inefficient in the sense of misallocating resources, relative to the allocation under competition. We must live with a good deal of inefficiency, but it is still inefficiency.

    Continued in article

    "Compensation Under Competition," by Nobel Laureate Gary Becker, The Becker-Posner Blog, April 7, 2008 --- http://www.becker-posner-blog.com/

    Executive compensation has been criticized both for being too generous, and for encouraging excessive risk-taking relative to the desires of stockholders. Yet while there are links between the level of pay and the amount of risk chosen, these are mainly distinct issues. Executives may be paid little, but the pay can be structured to have a much better payoff when profits are high than when profits are low. In this case, the average level of pay over both good and bad times would not be particularly generous, but its structure would tend to encourage risk-taking behavior. On the other hand, a CEO's pay might be excessively high on average, but not appreciable better when his company does well than when it does badly. He would be overpaid, but he would not have a financial incentive to take much risks.

    Does the pay structure in American corporations, with the growing emphasis during the past several decades on stock options, bonuses, and severance and retirement pay, encourage excessive risk-taking, where "excessive" is defined relative to the desires of stockholders? It may look that way now with the sizable number of major financial companies that have taken huge write downs in their mortgage-backed and other assets, while top executives of some of these companies have only had modest declines in their pay (although others, such as the head of Bears Sterns, have taken huge hits). However, these financial difficulties do not necessarily imply that heads of most financial companies knowingly engaged in more speculative activities than desired by stockholders because of the incentives CEOs had. A more compelling explanation is that heads of companies have undervalued the risks involved in holding derivatives and other exotic securities, particularly securities that were rather new and not well understood. Let me stress, however, that I am not trying to excuse the many CEOs in the financial sector and in other sectors who got off much too easily for terrible investment decisions.

    Bubbles are prolonged periods of excessive optimism where the true longer-term risk to holding particular assets is generally underestimated. The housing boom of the past few years now appears to have been a serious bubble where pervasive optimism about housing price movements raised the rate of increase in housing prices far beyond sustainable levels. Sophisticated lenders as well as low-income borrowers underestimated the risks involved in the residential housing market, as they appeared to have assumed that housing prices would continue to rise for a number of years in excess of ten percent per year.

    Evidence suggesting that the risk taken by companies during the recent boom was not mainly due to a principal-agent problem between executives and stockholders is that the major private equity firms also experienced serious loses on their investments, especially on their housing investments. Private equity companies have much less of a principal-agent problem than do Citicorp, Bears Sterns and other publicly traded companies because private equity companies have a concentrated ownership. Also borrowers in the residential housing market have basically no principal-agent problems since they buy for themselves; yet many of them too took on excessive risk because of undo optimism about the housing market.

    The private equity example provides a more general way to test whether CEOs take greater risks than their stockholders desire. One can analyze the relation between the degree of concentration of stock ownership in different companies and various measures of risk, such as their year-to-year variance earnings, adjusted for industry and other relevant determinants of this variance. The excessive risk argument would suggest that the more concentrated the ownership, the smaller would be the actual exposure to earnings and asset risk.

    Another test of the excessive risk argument is whether the trend toward greater compensation in the form of stock options and other performance contingent compensation increased the risk taking of companies. Some have attributed much of the dot-com bubble to increased performance based compensation. However, most dot-com companies that went under were quite small and rather closely held by venture capitalists and similar investors. Hence these companies did not have a sharp conflict between stockholders and managers. Moreover, during the dot-com bubble, assets of minor Internet companies were raised in market value to more than 100 times earnings, even when they had no sales, let alone earnings. Such huge earnings-profits ratios suggest excessive risk taking by stockholders more than by managers.

    Economic theory does imply that the increasing trend toward performance-based compensation would increase the degree of risk-taking by top executives. It is much less clear whether this effect is large- doubts are expressed by Canice Prendergast in his study "The Tenuous Trade-Off Between Risk And Incentives", Journal of Political Economy, 2002, (Oct), 1071-1102. It is also unclear if CEOs have been induced to take more risks than the level of risk desired by stockholders. Furthermore, and most important, there is no persuasive evidence that the structure of CEO compensation played an important roll in either the dot-com or housing bubbles.

    Bob Jensen's threads on outrageous executive compensation and schemes that reward failure are at http://www.trinity.edu/rjensen/FraudConclusion.htm#OutrageousCompensation


    SEC reaches settlement with Monster's McKelvey for stock options backdating
     McKelvey caused Monster to misrepresent in its periodic filings and proxy statements filed with the Commission that all stock options were granted at the fair market value of the stock on the date of the award, when that was not the case. McKelvey also caused Monster to file materially misstated financial statements with the Commission in its Forms 10-K and 10-Q that did not recognize compensation expense for the company's stock option grants, as required by generally accepted accounting principles. As a result, Monster overstated its aggregate pretax operating income by approximately $339.5 million, for fiscal years 1997 through 2005. Although McKelvey did not receive backdated options, he benefited from the scheme by granting backdated options to four individuals that he personally employed, including three pilots and a mechanic. Under the settlement, McKelvey will be permanently enjoined from violating Section 17(a) of the Securities Act of 1933, and Sections 10(b), 13(b)(5) and 14(a) of the Securities Exchange Act of 1934, and Rules 10b-5, 13a-14, 13b2-1, 13b2-2 and 14a-9, and from aiding and abetting violations of Sections 13(a) and 13(b)(2)(A) of the Exchange Act and Rules 12b-20, 13a-1, 13a-11, and 13a-13. Additionally, McKelvey will pay $275,989.72 in disgorgement and prejudgment interest, and will be barred from serving as an officer or director of a public company. The settlement does not include a civil penalty due to overriding personal circumstances related to McKelvey. McKelvey agreed to the settlement without admitting or denying the allegations in the complaint.
     AccountingWeb, January 29, 2008 --- http://www.accountingweb.com/cgi-bin/item.cgi?id=104543


    More than 180 stock options backdating scandals have been investigated.
    Back dated options awards are equivalent to betting on yesterday's football games.

    "$117.5 Million Settlement Reported in Options Case," The New York Times, October 15, 2007 ---
    http://www.nytimes.com/reuters/technology/reuters-options.html?_r=1&oref=slogin

    The software maker Mercury Interactive has agreed to pay $117.5 million to settle an investor lawsuit over the company’s stock options award practices, a lawyer for the plaintiffs said today.

    The settlement with Mercury, now owned by Hewlett-Packard, is believed to be the biggest in any stock options backdating case to date, said Joel Bernstein, an attorney at the firm of Labaton Sucharow LLP, who represents investors in the lawsuit.

    Many investor lawsuits have resulted from the options scandal in corporate America, in which more than 180 companies have been investigated by authorities or have conducted internal inquiries into whether they manipulated grants to make them more valuable for top executives.

    In one legal settlement last month, Rambus agreed to pay $18 million to resolve an investor lawsuit related to its accounting for option grants.

    The Mercury settlement, which was reached in principle among the parties but is still subject to court approval, would resolve a lawsuit filed in August 2005.

    H.P. said in a statement that it had agreed to a settlement but did not provide details.

    Continued in article.


    A Short History of Employee Stock Options
    "Bosses' Pay: How Stock Options Became Part of the Problem Once Seen as a Reform, They Grew Into Font of Riches And System to Be Gamed Reload,” by Mark Maremont and Charles Forelle, The Wall Street Journal, December 27, 2006; Page A1 --- http://online.wsj.com/public/article/SB116718927302760228-N9OV_AeDh_nT31VqRKS1wZeGN3w_20070223.html?mod=blogs

     Eugene Isenberg is the little-known chief executive of a modest-sized oil-services company in Houston. But he stands out in one way: He is among the highest-paid corporate executives in history. In the past 19 years, he has pocketed more than $450 million.

    The key to this wealth: stock options, in abundance. His employer, Nabors Industries Ltd., has lavished more than 25 million options on him over the years.

    They became lucrative partly because of Nabors's generally rising stock price, but also because of some controversial moves that gave the options more punch. When Nabors's stock fell below the price at which the options could be exercised, temporarily making them worthless, Nabors let him trade in some of his options for new ones with lower exercise prices. And when Mr. Isenberg cashed some options in, Nabors "reloaded" him, replacing those he'd exercised with the same number of new ones.

    Stock options were hailed two decades ago as a remedy for runaway executive pay. Academics, politicians and investors, tired of seeing CEOs pocket big money for a so-so job, pushed to have stock options become a primary method of compensating executives. Options -- granting the right to buy stock tomorrow at today's price -- would pay off only if the company's stock went up. To advocates they were the ideal carrot, an incentive for good work that aligned executives' interests with those of shareholders.

    That happened -- sometimes. But at many companies, options morphed into the biggest executive bonanza yet, pouring out cash like a stuck ATM, and sorely disappointing those who thought options would moderate executive pay.

    Instead of replacing big bonuses, options became an additional form of pay slathered on top of already-generous packages. Employers doled out options in ever-growing numbers, in part because, until recently, accounting rules meant companies didn't have to treat this largess to executives as an expense. And like Nabors, some used repricing, reloading and other tactics that made it even easier for executives to score huge hauls.

    • The Biggest Paydays: See a chart of executives who have profited most from stock options, from 1992 to 2005.

    • Plus, complete coverageThis year, options practices exploded in one of the biggest corporate-fraud scandals in decades. Some companies and executives stole from shareholders, by pretending that options had been issued earlier than they really were, at more favorable prices. At least 130 U.S. corporations are under investigation for possible backdating of option grants. Some have admitted to it. More than 60 executives and directors of public companies have lost their jobs so far, 17 of them chief executive officers. After probable backdating was exposed at giant insurer UnitedHealth Group Inc., the CEO had to resign and give up about $200 million of stock-options value. The company said it will have to restate past earnings by as much as $1.7 billion.

    Nabors's Mr. Isenberg offers an example of the huge wealth CEOs have gained through stock options. Now, some of his option grants appear to raise questions about how they were dated. A number came on days when the stock hit its lowest close for the month or the quarter. At other companies, a series of low-price grants has been a pattern that has suggested possible dating problems. At the least, the favorable grant dates added to Mr. Isenberg's mammoth options gains.

    A spokesman for Nabors said its legal department did an internal review and found "no irregularities in its grant practices." Nabors showed internal documents to The Wall Street Journal that the company said provide evidence the grants were properly dated. Some of the documents bolster that assertion. The spokesman, citing Mr. Isenberg's record in lifting Nabors from a company in bankruptcy court to one with a market value of more than $9 billion today, also said that "Nabors strongly believes that Mr. Isenberg is appropriately compensated."

    The backdating scandal at scores of companies shows one way stock options, once seen as an executive-pay reform, have often been distorted by corporate officials and their consultants. Nell Minow, a longtime corporate-governance advocate, calls backdating "just another in an endless and unstoppable series of mechanisms to subvert the purpose of stock options." A vocal proponent of options in the early 1990s, Ms. Minow now regrets that stance. "Options became completely disconnected from shareholder interests," she says. "I grossly underestimated the capacity of corporate boards and corporate managers to circumvent the principles we established."

    From 1992 to 2001, the average value of option grants to CEOs of S&P 500 companies soared nearly tenfold, according to data compiled by Kevin J. Murphy of the University of Southern California. The result was that options, which in 1992 made up less than a quarter of the average CEO's pay, by 2001 provided more than half of pay packages -- packages that were much larger. Companies have started doling out fewer options in the past few years, but grants remain far more generous than a decade ago.

    In 1985, Miami financier Victor Posner pulled down $12.7 million, putting him atop lists of best-paid CEOs that year. Last year, 393 executives earned more than that, thanks largely to gains from exercising options, according to Standard & Poor's ExecuComp, which tracks executive pay at about 1,800 public companies. The top 2005 earner was Barry Diller of IAC/InterActiveCorp., with $295 million, nearly all from options.

    Defenders of options, who remain numerous, say options shouldn't be judged by a few giant packages. Many companies have given out options judiciously, say defenders, some of whom attribute rising executive pay to tight competition for top managers. Others say stock options have helped to foster innovation, by giving young but cash-poor companies a currency with which to attract talent.

    Some supporters of options even give them partial credit for the long bull market that began in 1982, figuring that options help focus top executives on the key issue for shareholders: the stock price. Frederic W. Cook, a New York compensation consultant, calls the stock option "the most perfect equity derivative that's ever been invented: It's simple, elegant, easily understood, and it gives you a little piece of the action."

    Popular Demand

    Stock options usually give recipients a 10-year window to buy the company's stock at the price when the options are granted. If someone gets options when the stock trades at $50 and it goes to $75, the holder can cash out at the $50 "exercise price" -- also called a "strike price" -- and nail a $25 profit on each option. Options usually don't "vest," or become exercisable, for at least a year after they're granted.

    Stock options appeared at least as early as the 1920s, says Carola Frydman, an assistant professor of finance at Massachusetts Institute of Technology who has studied the history of executive pay. The modern era began in 1950, when Congress, reversing a court ruling, gave options substantial tax advantages over ordinary income. By the middle of that decade, they accounted for nearly a third of CEO compensation at large industrial companies.

    "In the 1950s, they called it the period of stock-option opulence," says Ms. Frydman. "They didn't know what was coming."

    After losing popularity during the weak stock market of the 1970s, options surged back into favor in the late 1980s. One reason was public fury over mammoth executive paydays for bosses with just average performance. In an influential 1990 Harvard Business Review article, Mr. Murphy and Michael C. Jensen said the problem was executives were paid like "bureaucrats" instead of entrepreneurs. They called for giving "big rewards for superior performance and big penalties for poor performance."

    "We were suggesting people shift from salaries to stock options to put more pay at risk," Mr. Murphy says today. But "that's not what companies ended up doing. They layered on massive amounts of options on top of the rest."

    The bandwagon got two big boosts from an unlikely source: Congress.

    First, it passed a law, pushed by President Clinton, seeking to rein in executive pay by limiting the tax break for it. The 1993 law said companies couldn't deduct yearly compensation of more than $1 million for any one of their top five officers.

    But it exempted certain kinds of pay linked to performance, which included stock options. Companies rushed to restructure pay plans to grant more options. In 1994, the first year the law was in effect, the value of option grants to CEOs at S&P 500 firms leapt by 45% on average, according to Mr. Murphy, and nearly doubled again over the next two years.

    The 1993 law "deserves pride of place in the Museum of Unintended Consequences," said Christopher Cox, chairman of the Securities and Exchange Commission, this fall.

    Then in 1994, Congress helped beat back a proposed rule requiring companies to treat a stock-option grant as an expense and deduct it from profits. The plan, backed by the SEC and accounting rule makers, sparked intense corporate opposition. Congress stepped in to fight it, and after a long battle, the accounting rule makers caved. They issued a watered-down rule saying all that companies had to do was disclose in a footnote what options would have done to their profits, had the proposal passed.

    Meanwhile, Congress left alone an older law that gave companies a tax deduction whenever stock options were exercised. Under that rule, which applied to the most common type of option given to executives, the employer can deduct a dollar from its income for tax purposes for every dollar of option gains pocketed by employees.

    With rules like these, "what wasn't there to like about a stock option?" says Paula Todd, a compensation expert at consulting firm Towers Perrin. "You could grant them in unlimited amounts, with no expense, and claim a tax deduction. [Companies] would pay their dry cleaners if they could with stock options."

    Better Than Average

    Soon, other forces spurred companies to give executives ever more stock options. One was the "Lake Wobegon effect," named for the mythical Minnesota town in radio host Garrison Keillor's world where all the children are above average. Many boards believed their chiefs should be paid at least as much as the average in their industry, and often more. That attitude had the effect of pushing this average up, year after year.

    Another force largely escaped notice because it seemed benign. This was a tendency by companies to grant top executives the same number of options each year, or more, even if the stock price had risen. During a bull market, doing so kept raising the value of pay packages.

    Consider an executive who is granted a million options when the stock is at $20. If it's 50% higher a year later, the executive can reap a $10 profit per option, or $10 million.

    But now the stock is at $30. If the executive again gets a million options, and the stock again rises 50%, the executive's profit is $15 million, not $10 million. In order to give this executive an option grant of merely the same value in year two as in year one, the year-two grant would have to contain far fewer options.

    Directors had a hard time telling a CEO they were cutting the number of options because the stock had risen. Ms. Todd says the CEO's reaction would be, "I worked to get the stock price up, and my next grant is smaller and has a higher strike price?'"

    Exxon awarded CEO Lee Raymond a similar number of options yearly from 1993 through 1999 -- 800,000 to 900,000, adjusted for later stock splits. Over that period, the stock rose sharply. The rise meant the value of the 1999 grant was $8.5 million, or six times that of the 1993 grant, by ExecuComp's tally. The calculation used a standard formula for valuing options known as "Black-Scholes," which sets a value for a grant at the time it's given by estimating how much gain it will someday bring the recipient.

    An Exxon Mobil Corp. spokesman said the grants were made by a panel of outside directors and based partly on the size of grants to top executives elsewhere. After 2001, Exxon replaced options grants with restricted stock, a different form of compensation that the board said was "more effective in aligning executives' interests with those of shareholders." Mr. Raymond retired a year ago.

    At times, the value of options companies doled out has been equal to a large share of their profits. Retailer Abercrombie & Fitch Co. gave CEO Michael Jeffries 4.66 million options in 1999, a grant ExecuComp valued at $120 million. The firm's 1999 net income was $150 million.

    Abercrombie didn't actually have to shell out $120 million when it gave the options to Mr. Jeffries, of course. But it incurred an obligation to issue 4.66 million shares someday at the 1999 price. And this obligation didn't have to be reflected as an expense on the company's income statement.

    A spokesman for Abercrombie said the grant had a "delayed vesting" feature "intended to incentivize Mike Jeffries to remain with the company...and to continue to generate exceptional financial results." Under him, the stock has risen more than 750% since it began trading in 1996. Mr. Jeffries is eligible to exercise the big 1999 grant now, and if he did so would reap about a $120 million profit.

    The options-issuing frenzy reached a peak in 1999 and 2000. Dot-com companies, some with little other way to pay employees, handed out options like confetti. Thousands of people made fortunes on stratospheric rises in the stocks of tech firms, some of which didn't exist a couple of years later. Meanwhile, some "old economy" companies, trying not to lose top people to Silicon Valley, cranked up their own options generators.

    In mid-2002, Alan Greenspan testified to Congress about what was then a tech and telecom bust, and about a wave of corporate scandals at firms like Enron, WorldCom and Tyco International. The Federal Reserve's then-chairman spoke of an "infectious greed" that seemed to grip some in business, for which he partly blamed "poorly structured" stock options. Giant grants "perversely created incentives to artificially inflate reported earnings in order to keep stock prices high and rising," he said. "The incentives they created overcame the good judgment of too many corporate managers."

    Moving the Goal Post

    When stock prices failed to rise, some companies changed the rules. If the share price fell well below stock options' exercise price, they simply lowered that price. Companies defended the move by saying options far "under water" or "out of the money" no longer served as incentives to executives to perform well.

    Critics of repricing say it subverts the fundamental options purpose of aligning managers' and shareholders' interests. Since shareholders can't get a refund on a stock they bought that has fallen, the critics say, why should executives be able to do something similar?

    Repricings "basically ensure that the manager gets paid no matter what. It takes a lot of risk out of the whole thing," says David Yermack, a New York University professor who studies executive pay.

    About 11% of companies repriced options at least once between 1992 and 1997, according to research by Chandra Subramaniam, an associate professor of accounting at the University of Texas at Arlington. Borland Software Corp. did it eight times in the decade ended in 1998. System Software Associates Inc. repriced the same options five times in 1996 and 1997 as its stock kept plunging, Mr. Subramaniam says. In a paper published in 2004, he and his co-authors calculated that repricings padded executives' pay by an average of nearly $500,000 each.

    In 1998, a change in accounting rules crimped repricing somewhat. Companies now had to take a hefty charge against earnings if they put new exercise prices on existing options. But there was a loophole. If they canceled the old options, waited six months and issued new ones at a lower price, there was no penalty.

    Continued in article


    A Double Standard:  Companies are still playing games with executive stock option expense reporting
    Sen. Carl Levin, D.-Mich., introduced legislation Friday to bar companies from reporting tax deductions for stock option expenses to the Internal Revenue Service that far exceed what they disclose to shareholders as expenses. A Senate investigation this summer found that U.S. public companies between December 2004 and June 2005 legally avoided billions of dollars in taxes by claiming $43 billion more in tax deductions for options awards than the compensation for options recorded on their books. His bill would require the corporate tax deduction for stock option compensation equal stock option expenses reported to the Securities and Exchange Commission.
    "Senator Aims to Cut Option Deductions," SmartPros, October 1, 2007 --- http://accounting.smartpros.com/x59266.xml


    Reprice, Backdate," by Mark Maremont and Charles Forelle, The Wall Street Journal, December 27, 2006; Page A1 --- http://online.wsj.com/article/SB116718927302760228.html

    "Toll of the stock options scandal heavy in 2006:  More prosecutions are expected to be brought next year," by Marcy Gordon, SeattlePi, December 27, 2006 --- http://seattlepi.nwsource.com/business/297346_stockoptions27.html

    Eighteen chief executives swept out. More than 100 public companies under federal investigation and more than $5 billion in profits erased by restatements. Indictments so far: five former top executives at two companies, Brocade Communications Systems Inc. and Comverse Technology Inc. The toll of the stock options timing affair -- corporate America's scandal of the year -- has been heavy. Federal officials say more prosecutions will be brought in 2007 over manipulation of the timing of stock option grants to enrich top company executives.

    The toll of the stock options timing affair -- corporate America's scandal of the year -- has been heavy. Federal officials say more prosecutions will be brought in 2007 over manipulation of the timing of stock option grants to enrich top company executives.

    Nearly every business day, more companies report federal or internal investigations. New lawsuits by shareholders are filed. More businesses disclose that because past option grants may have distorted their financial results, they may have to restate earnings.

    Next year could well bring more restatements, and companies' stock could be stripped from public trading because reviews of options grants made them late in filing their quarterly financial reports.

    The Justice Department will "continue to be engaged for perhaps years to come, as we work these cases out," U.S. Attorney Kevin Ryan, who heads a task force in Northern California pursuing options timing cases, said recently at a gathering of attorneys. "The final chapter hasn't been written yet."

    Many of the companies ensnared in the scandal are in Silicon Valley's high-tech industry, where stock options for employees created legions of millionaires in the dot-com era.

    The prized perks allow executives and employees to buy shares of their company's stock in the future at a set price. If the stock rises before the options are exercised, the employee can buy the stock at the predetermined, lower price, then sell it at the higher, current price -- and pocket the difference.

    Among the wide swath of companies caught up in internal or government investigations: Apple Computer Inc., Barnes & Noble Inc., Caremark Rx Inc., Issaquah-based Costco Wholesale Corp., Seattle-based F5 Networks, Gap Inc., The Home Depot Inc., McAfee Inc., Monster Worldwide Inc., Restoration Hardware Inc., Staples Inc. and UnitedHealth Group Inc.

    Some prominent executives at blue-chip companies have lost their jobs in the affair, including former UnitedHealth CEO William McGuire, who engineered the company's ascent from a regional health insurer into the nation's second-largest.

    Continued in article


    While it won't sue Apple for Nancy Heinen's alleged backdating of options, the SEC does want to talk to CEO Steve Jobs, most likely about the timing of events
    Though Apple (AAPL) was given a clean bill of health by regulators over its involvement in the backdating of stock options, the investigation of a former executive continues to dog Chief Executive Steve Jobs. Securities & Exchange Commission lawyers suing former Apple General Counsel Nancy Heinen over her alleged role in the matter have issued subpoenas to Jobs. The SEC has said it won't sue Apple over the backdating of grants, praising the company for its cooperation with the investigation. Attorneys say the company and current executives are unlikely to face criminal charges from the Justice Dept. or civil charges from the SEC.
    Arik Hesseldahl, "SEC Subpoenas Jobs On Backdating," Business Week, September 20, 2007 --- http://www.businessweek.com/technology/content/sep2007/tc20070920_913875.htm?link_position=link2


    Question
    What is a "Black Swan" in portfolio theory?
    Hint: Our strategies for managing risk, for instance--including Modern Portfolio Theory and the Black-Scholes formula for pricing options--are likely to fail at the worst possible time.

    "Shattering the Bell Curve:  The power law rules," by David A. Shaywitz, The Wall Street Journal, April 24, 2007 --- http://www.opinionjournal.com/la/?id=110009979 

    Excerpt
    The attractiveness of the bell curve resides in its democratic distribution and its mathematical accessibility. Collect enough data and the pattern reveals itself, allowing both robust predictions of future data points (such as the height of the next five people to enter the room) and accurate estimations of the size and frequency of extreme values (anticipating the occasional giant or dwarf.

    The power-law distribution, by contrast, would seem to have little to recommend it. Not only does it disproportionately reward the few, but it also turns out to be notoriously difficult to derive with precision. The most important events may occur so rarely that existing data points can never truly assure us that the future won't look very different from the present. We can be fairly certain that we will never meet anyone 14-feet tall, but it is entirely possible that, over time, we will hear of a man twice as rich as Bill Gates or witness a market crash twice as devastating as that of October 1987.

    The problem, insists Mr. Taleb, is that most of the time we are in the land of the power law and don't know it. Our strategies for managing risk, for instance--including Modern Portfolio Theory and the Black-Scholes formula for pricing options--are likely to fail at the worst possible time, Mr. Taleb argues, because they are generally (and mistakenly) based on bell-curve assumptions. He gleefully cites the example of Long Term Capital Management (LTCM), an early hedge fund that blew up after its Nobel laureate founders "allowed themselves to take a monstrous amount of risk" because "their models ruled out the possibility of large deviations."

    Mr. Taleb is fascinated by the rare but pivotal events that characterize life in the power-law world. He calls them Black Swans, after the philosopher Karl Popper's observation that only a single black swan is required to falsify the theory that "all swans are white" even when there are thousands of white swans in evidence. Provocatively, Mr. Taleb defines Black Swans as events (such as the rise of the Internet or the fall of LTCM) that are not only rare and consequential but also predictable only in retrospect. We never see them coming, but we have no trouble concocting post hoc explanations for why they should have been obvious. Surely, Mr. Taleb taunts, we won't get fooled again. But of course we will. Writing in a style that owes as much to Stephen Colbert as it does to Michel de Montaigne, Mr. Taleb divides the world into those who "get it" and everyone else, a world partitioned into heroes (Popper, Hayek, Yogi Berra), those on notice (Harold Bloom, necktie wearers, personal-finance advisers) and entities that are dead to him (the bell curve, newspapers, the Nobel Prize in Economics).

    A humanist at heart, Mr. Taleb ponders not only the effect of Black Swans but also the reason we have so much trouble acknowledging their existence. And this is where he hits his stride. We eagerly romp with him through the follies of confirmation bias (our tendency to reaffirm our beliefs rather than contradict them), narrative fallacy (our weakness for compelling stories), silent evidence (our failure to account for what we don't see), ludic fallacy (our willingness to oversimplify and take games or models too seriously), and epistemic arrogance (our habit of overestimating our knowledge and underestimating our ignorance).

    For anyone who has been compelled to give a long-term vision or read a marketing forecast for the next decade, Mr. Taleb's chapter excoriating "The Scandal of Prediction" will ring painfully true. "What is surprising is not the magnitude of our forecast errors," observes Mr. Taleb, "but our absence of awareness of it." We tend to fail--miserably--at predicting the future, but such failure is little noted nor long remembered. It seems to be of remarkably little professional consequence.

    I suspect that part of the explanation for this inconsistency may be found in a study of stock analysts that Mr. Taleb cites. Their predictions, while badly inaccurate, were not random but rather highly correlated with each other. The lesson, evidently, is that it's better to be wrong than alone.

    If we accept Mr. Taleb's premise about power-law ascendancy, we are left with a troubling question: How do you function in a world where accurate prediction is rarely possible, where history isn't a reliable guide to the future and where the most important events cannot be anticipated?

    Mr. Taleb presents a range of answers--be prepared for various outcomes, he says, and don't rush for buses--but it's clear that he remains slightly vexed by the world he describes so vividly. Then again, beatific serenity may not be the goal here. As Mr. Taleb warns, certitude is likely to be found only in a fool's (bell-curve) paradise, where we choose the comfort of the "precisely wrong" over the challenge of the "broadly correct." Beneath Mr. Taleb's blustery rhetoric lives a surprisingly humble soul who has chosen to follow a demanding and somewhat lonely path.

    I wonder how many of us will have the courage to join him. Very few, I predict--unless, of course, something unexpected happens.

    Dr. Shaywitz is a physician-scientist in New Jersey. You can buy "The Black Swan" from most online bookstores, including the OpinionJournal bookstore.


     

    Yet Again the SEC Amends Executive Compensation Disclosure (particularly regarding stock options)
    The US Securities and Exchange Commission has amended its executive and director compensation disclosure rules to more closely conform the reporting of stock and option awards to FASB Statement No. 123 (revised 2004) Share-Based Payment. FAS 123R is similar to IFRS 2 Share-based Payment. The amendment modifies rules that were adopted in July 2006.
    SEC Press Release 2006 219 --- http://www.iasplus.com/usa/0612seccomp.pdf


    Bob Jensen's threads on outrageous executive compensation are at http://www.trinity.edu/rjensen/FraudConclusion.htm#OutrageousCompensation


    Home Depot may see fallout over options backdating
     Home Depot Inc.'s admission this week that some stock option grants were backdated could spur lawsuits, result in fines and have tax implications, analysts and other experts said. The disclosure of 19 years of backdating tops off a difficult year for the world's No. 1 home improvement retailer as it continues to be dogged by criticism about executive pay, a disappointing stock performance and the fallout from the slower U.S. housing market.
     "Home Depot may see fallout over options backdating," Reuters, December 8, 2006 --- Click Here
     Jensen Comment
     Those that blame back dating on changes in tax laws and/or newer options expense requirements under FAS 123(R) should note the 19 years of backdating by Home Depot.


    "How Backdating Helped Executives Cut Their Taxes:  Evidence Suggests Recipients Of Some Stock-Option Grants Manipulated Exercise Dates," by Mark Maremont and Charles Forelle, The Wall Street Journal, December 12, 2006; Page A1 --- http://online.wsj.com/article/SB116589240479347248.html?mod=todays_us_page_one

    New evidence suggests that corporate executives may have found another way to manipulate their stock options, this time to cheat on their income taxes.

    In a paper that began circulating in recent days, a Securities and Exchange Commission economist concludes there is strong statistical evidence that executives manipulated the exercise dates of their options as part of a tax dodge. And a review of corporate filings turns up some companies with startling options-exercise patterns.

    The new information could open another front in the options-backdating scandal. Backdating already has sparked the broadest corporate-fraud probe in decades, with more than 130 companies under investigation by federal authorities. So far, attention has focused on the practice of retroactively selecting favorable dates to grant options. The new wrinkle involves rigging the dates on which options are exercised, sometimes years after they're granted.

    The tax dodge related to options, however, almost certainly involves fewer executives than are caught up in the furor over the backdating of grants. (See related article.)

    The reason it can be tempting to backdate the exercise of options lies in the way the Internal Revenue Service treats different types of income for tax purposes. Options, a common part of executive pay packages, give the recipient the right to buy a company's stock at a fixed price in the future. That price, known as the strike price, is usually the stock's market price on the day the options were granted.

    About three-quarters of the time, executives immediately sell the shares they buy when they exercise options. Under IRS rules that typically apply, those executives must pay ordinary income tax, as well as payroll taxes, on the difference between the stock's value on the date the option was exercised and the option's strike price. The highest federal marginal income tax rate is 35%.

    But for a variety of reasons, including corporate rules that require top managers to own a certain amount of stock, some executives don't sell immediately. Those who hold the shares for at least a year pay a much lower capital-gains tax -- currently 15% -- on any profit between the time they exercise and when they eventually dispose of the shares. That lower rate gives the executive an incentive to exercise the options at a relative low point for the stock: The move reduces the amount of money that would be owed at the ordinary income tax rate, and shifts the difference so it is potentially taxed at the much-lower capital gains rate.

    Consider an executive who holds options on 100,000 shares with a strike price of $10. If he exercises and sells when the price is $20, he realizes $1 million in income and must pay $350,000 in income taxes.

    If he instead can claim an exercise price of $16, he lowers his income tax to $210,000. If he then sells a year later and the stock is at the same price of $20, he pays $60,000 in capital-gains levies, for a total tax bite of $270,000. In other words, he has the same $1 million gain but saves $80,000 in taxes. The problem arises if the executive misrepresents when the exercise occurred to claim a lower exercise price.

    Determining which executives or companies might be involved is difficult, and it's impossible to know what information they may have included in their tax returns. But some executives have exhibited unusual timing in their options exercises.

    At Maxim Integrated Products Inc., a Sunnyvale, Calif., chip maker, chief executive John F. Gifford exercised options and held shares seven times between 1997 and 2002, according to regulatory filings and insider-trading data from Thomson Financial. In all but one case, Mr. Gifford's reported exercise date was the very day the stock reached its lowest closing price of the month. After the Sarbanes-Oxley corporate-reform law took effect in 2002, drastically reducing the opportunity to backdate by tightening reporting requirements, his fortunate timing vanished.

    Maxim is facing investigations by the SEC and federal prosecutors in California over its option-granting practices. A special committee of directors is also probing the matter.

    Chuck Rigg, a Maxim vice president, said the company is "looking into" questions about Mr. Gifford's options exercises, but said initial data don't indicate any problems. Mr. Rigg added that the company used an outside broker to handle options exercises. "There's not a way you can backdate that," he said. Mr. Gifford didn't respond to requests for comment.

    Continued in article


    "Options backdating might never have happened if reasonable options accounting had been required years ago," by Floyd Norris, The New York Times, October 13, 2006 --- http://norris.blogs.nytimes.com/?ref=business


    The FASB has published FASB Statement No. 123 (revised 2004), Share-Based Payment. Statement 123(R) will provide investors and other users of financial statements with more complete and neutral financial information by requiring that the compensation cost relating to share-based payment transactions be recognized in financial statements. That cost will be measured based on the fair value of the equity or liability instruments issued.

    This and other FASB standards can be downloaded free from http://www.fasb.org/st/index.shtml


    Question
    How is “spring-loading” is “bound up in the notion of insider trading” by executives?
    You can't beat corporate executives bent on inventing ways to cheat investors in executive compensation tricks invented by corporate accountants and investors.

    "Accounting Rules Allow “Spring-loading,” “Bullet-dodging” Option Grants," AccountingWeb, October 6, 2006 --- http://www.accountingweb.com/cgi-bin/item.cgi?id=102652

    The government will not have any accounting basis for enforcement actions against companies for “spring-loading” or “bullet-dodging” stock option grants, according to Scott Taub, deputy chief accountant for the U.S. Securities and Exchange Commission (SEC ). Taub spoke at a Financial Accounting Standards Board (FASB) advisory council meeting in New York on Tuesday, Reuters reports.

    Christopher Cox, SEC Commissioner, said last month that the practice of “spring-loading” is “bound up in the notion of insider trading,” according to CFO.com, suggesting that companies might still face legal action, but said that the SEC focused on insider trading in cases where it has occurred and can be proved.

    “Spring-loading” occurs when a company purposely schedules an option grant ahead of the announcement of good news that will boost the stock price. “Bullet–dodging” involves setting the grant date just after a negative announcement that will be followed by a rebound in the stock price.

    Taub told Reuters that the SEC was not trying to endorse the practice, and added “the accounting for those kinds of options is clear. We felt our hands were tied.”

    “There are people in our building who have varying feelings about whether spring-loading is good or bad. Accounting-wise we felt stuck.”

    “This is accounting literature written in the 70’s that clearly did not hold up well. We don’t get to enforce the accounting standards we wish existed, we have to enforce the accounting standards that do exist,” Taub went on to say, according to Reuters.

    Cox made his comments on “spring-loading” and “bullet dodging” at a Senate Finance Committee hearing in September. Cox had said in July that “backdating is more easily determined than spring-loading, because of the nature of the evidence,” the LA Times reports.

    SEC Commissioner Paul Atkins has argued that there is nothing wrong with spring-loading. Boards award options based on business judgments, Atkins said, according to the Wall Street Journal. “An insider-trading theory falls flat in this context, where there is no counterparty who could be harmed by an options grant. The counterparty here is the corporation and thus the shareholders.”

    In the case of Analog Devices Inc., a Norwood, Mass., technology company, the SEC questioned the propriety of stock option grants made by the company because it did not adequately disclose that it priced stock options before the release of good financial results, the Journal says. Analog Devices is also being investigated for backdating stock options.

    In another case, the SEC is looking at grants made to executives of Cybertronics Inc., a Houston medical-device maker that made grants to several executives on the day a Food and Drug Administrations advisory panel recommended approval of a Cybertronics device. Trading in the stock was halted that day and the grants used the exercise price of the previous day.

    It is not clear what the tax implications are for spring-loading, says S. James DiBrnardo, a partner at Morgan Lewis & Bockius LLP, the Journal says. DiBernardo says the Internal Revenue Service (IRS) might argue that spring-loaded options are also discount options like backdated options. But he says that the IRS would have a much more difficult time proving their case, because they would have to prove the “true” market value on the date the spring-loaded options were granted.


    Barf Alert:  Expensing Employee Stock Options is Improper Accounting

    Hey Denny!
    Options accounting expense deferral will just no go away because CEOs caught with their hands in the till (backdating of options) are harder to fight than City Hall. The good news is that we've heard all the arguments for decades and will not have to devote journal space and FASB research time since there are hundreds of leftover studies.

    "Accounting, Economic Experts Call Expensing Stock Options Improper Accounting," AccountingWeb, August 18, 2006 --- http://www.accountingweb.com/cgi-bin/item.cgi?id=102475
     

    A University of California (UC), Berkley management journal became the focus in reopening the debate on stock option expensing 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.

    “Mandating the expensing of employee stock options is one of the most radical changes in accounting rules 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.”

    Thirty of the nation’s leading experts in accounting, economics, business and finance signed the paper, entitled Expensing Employee Stock Options is Improper Accounting, 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 chief executive officers (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 the UC Berkley’s Haas School of Business, who noted that the paper represents his personal views, not those of the university or the business school.

    “The SEC rule poses an obstacle to proper accounting,” Campbell agrees. “Allowing for a more 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.”

    Key findings from Expensing Employee Stock Options is Improper Accounting include:

    * 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 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, 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.”

    When Top Scholars Write Outside Their Realm of Expertise to Favor Executives at the Expense of Investors
     
    To close, the appeal to authority is enticing because it gives the aura that those with brilliant minds adopt a particular point of view. While powerful rhetorically, this approach constitutes a logical error because authorities sometimes make mistakes, such appeals to authority do not address the subject under debate, and the opposing side can solicit its own bevy of experts. Worse, this strategy backfires when the list of experts do not really possess the requisite knowledge base in the field of battle. With such ignorant experts, the glamour of Hagopian's paper disappears. I could stop my critique at this point, but opponents of the expensing of employee stock options would continue their nonsense. Therefore, I shall resume the critique in the next column by reviewing the arguments by FASB and by Bodie, Kaplan, and Merton.
    J. Edward Ketz,  "Accounting for Stock Options: Reasoning by Authority:  Part 1,"  SmartPros, November 2006 --- http://accounting.smartpros.com/x55203.xml 
     Jensen Comment
     Bravo Ed!


    Why are CEOs making such a fuss over the accounting for stock options? It has nothing to do with their concern about accounting theory, argues J. Edward Ketz. "If they cared about accounting theory, CEOs would be more supportive of the FASB, the SEC, and the IASB in developing and improving accounting practice. They don't want improvements in accounting, else somebody might actually know what they are up to.
    J. Edward Ketz, "The Accounting Cycle Accounting for Stock Options (Part Three): Why CEOs Fight Stock Option Accounting," SmartPros, November 2006 --- http://accounting.smartpros.com/x55207.xml

    Kip Hagopian wrote a recent article in California Management Review in which he claimed that "Expensing Employee Stock Options is Improper Accounting." I explained in my first column that his appeal to authority was misplaced, an error in logic. My second column clarified why expensing employee stock options is indeed proper and that Hagopian's assertions are invalid. In this essay, I shall endeavor to discuss why CEOs are making such a fuss over the accounting for stock options.

    Let's state the obvious fact: that CEOs are creating this hubbub over how to account for stock options has nothing to do with their concern about accounting theory. They don't care a wooden nickel about such matters. If they cared about accounting theory, CEOs would be more supportive of the Financial Accounting Standards Board (FASB), the Securities and Exchange Commission (SEC), and the International Accounting Standards Board (IASB) in developing and improving accounting practice. They don't want improvements in accounting, else somebody might actually know what they are up to.

    If CEOs cared about investors, they would quit employing aggressive accounting techniques and they would quit biasing their estimates (whether of interest rates, asset lives, or fair values) to obtain their desired results. As they continue to utilize aggressive, almost fraudulent accounting, we can infer that they are looking out after themselves rather than anybody in the investment community.

    If CEOs were worried about the state of accounting in the U.S., then we would expect them to learn the vocabulary, the concepts, and the principles of accounting to engage in meaningful debate. Mr. Hagopian and the set of signatories have not bothered themselves with the trifles of accounting, as seen in their invention of "gain-sharing instruments," their lack of appreciation for accrual accounting, and the misapplication of the entity concept.

    If CEOs were really apprehensive about today's accounting, then we would expect them to get involved in the many less-than-stellar accounting rules and argue for a tightening and an improvement in them. Pension accounting and lease accounting and the accounting for business combinations, to name a few, are deficient FASB standards and in need of great work. Instead, CEOs get involved primarily to prevent FASB from doing too much damage to them.

    So why does Kip Hagopian and so many CEOs still carp about the accounting for stock options? I posit it is because, first, they do not want the general public to understand the ever increasing gap between the wages of the average American worker and the average corporate CEO and, second, they do not want investors and creditors to realize the nexus between treasury stock repurchases and their personal bank accounts.

    The average CEO in 2004 earned $11.8 million, while the average worker made only $27,460. The ratio of CEO-to-worker pay was 42 in 1980, 107 in 1990, and hit an all-time high of 525 in 2001. Even now the ratio is 431. The explosive growth in CEO compensation comes about primarily with stock and stock options.

    Maybe as CNN's Lou Dobbs continues his criticism of exporting American jobs overseas to cheaper venues, he could advocate that we start outsourcing CEOs for cheaper ones. Or maybe he should just insist on receiving some value for the compensation. Broadcom's managers have received $5 billion from stock options while the business entity has lost $6 billion in operating profits. What have these executives done to deserve $5 billion in stock options?

    I shall leave it to others to debate the issue of when CEO pay becomes excessive. At this time, I merely think people ought to have the facts so the debate will be meaningful. And saying that stock options are costless is, well, witless.

    The second point is that we need to understand better the nexus between stock repurchases and CEO's personal bank accounts. Stock options line their bank accounts of managers with tons of money, but needing some emphasis is the fact that stock options are quite similar to the government's printing more money. When the government prints more money, the effect is inflation; for instance, it takes more money to buy the same goods. In like manner, when corporations print more stock certificates, the effect is also dilutive; for instance, an investor's shares in the company provides over time a claim to fewer and fewer of the net assets of the entity.

    Corporate managers comprehend this inflationary aspect of stock options quite well, so they nearly always couple an aggressive stock option plan with a strategy to buy back shares with some hogwash like they want to put some cash in the hands of stockholders. If CEOs really wanted to do that, they could declare a dividend instead of playing this song-and-dance.

    Cisco Systems has enriched its executives with $24 billion of stock options; it has counterbalanced the dilutive effect by repurchasing $19 billion of its own stock. Broadcom, Dell, and many other hi-tech companies have acted likewise.

    Indeed, it is the nexus of the stock options and the stock repurchases that explains why stock options ought to be expensed. Managers find it critical to repurchase enough shares of stock to offset the inflationary ripples that stock options create. Simultaneously, the cash that the business enterprise disburses to replenish the lost shares represents the assets conveyed to compensate the management team.

    While Kip Hagopian is entitled to his opinion, the standard setters at FASB, SEC, and IASB should not give it much weight. It is tainted with the greed of Lay and Kozlowski. It is mere rhetoric to justify incredibly exorbitant salaries.

    J. EDWARD KETZ is accounting professor at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals. He also has edited Accounting Ethics, a four-volume set that explores ethical thought in accounting since the Great Depression and across several countries.


    From The Wall Street Journal Accounting Weekly Review on November 10, 2006

    TITLE: UnitedHealth Expects Probe to Result in 'Greater' Charges
    REPORTER: Steve Stecklow and Vanessa Fuhrmans
    DATE: Nov 09, 2006
    PAGE: B1
    LINK: http://online.wsj.com/article/SB116299996219517252.html?mod=djem_jiewr_ac 
    TOPICS: Accounting, Accounting Changes and Error Corrections, Sarbanes-Oxley Act, Securities and Exchange Commission, Stock Options

    SUMMARY: "UnitedHealth Group Inc. said it would have to take charges related to its backdated stock options that will be 'significantly greater' than its previous estimates and expects the charges to impact more than 10 years of previously reported earnings."

    QUESTIONS:
    1.) Describe the options backdating scandal that has developed since March, 2006. If you are unfamiliar with the issue, you may click on the link for "Perfect Payday: Complete coverage" on the left hand side of the on-line article.

    2.) For how long has options backdating been going on at UnitedHealth? Have the accounting requirements remained the same throughout that period of time? Summarize the required accounting and other financial reporting practices for executive and employee stock options over the last 10 years.

    3.) Suppose that, once UnitedHealth finishes its review, the restatement of earnings nearly doubles to $500 million and that the restatement applies equally to each of the preceding 10 years. What accounting entry must be made to correct this $500 million error? What will be the ultimate impact on each year's earnings and on stockholders' equity at the end of each year? How will this correction be disclosed? In your answer, cite the accounting standards which require the treatment you present.

    4.) Click on "Read the full text" of UnitedHealth's Nov. 8 filing with the SEC on the right-hand side of the on-line article. What Form number did UnitedHealth file? Summarize the implications of the depth of the options backdating problem found at this company.

    5.) Refer to the related article. What role does the Public Accounting Oversight Board fill in assisting accountants to audit companies' accounting for stock options?

    Reviewed By: Judy Beckman, University of Rhode Island

    --- RELATED ARTICLES ---
    TITLE: Guidelines Set for How to Audit Stock Options
    REPORTER: Siobhan Hughes
    PAGE: A10 ISSUE: Oct 18, 2006
    LINK: http://online.wsj.com/article/SB116114078518696161.html?mod=djem_jiewr_ac

    Bob Jensen's fraud updates are at http://www.trinity.edu/rjensen/FraudUpdates.htm


    "FASB Appears In a New Light On Stock Options:  Some Companies That Opposed Expensing Rule Are Caught Up In U.S. Probe on 'Backdating'," by David Reilly, The Wall Street Journal, August 14, 2006; Page C1 --- http://online.wsj.com/article/SB115552025107534780.html?mod=todays_us_money_and_investing

    When the nation's accounting-rule makers proposed in 2004 that companies treat employee stock options as an expense that cuts into profit, corporate executives all but stormed the Financial Accounting Standards Board's headquarters in Norwalk, Conn.

    In letters and public statements, business leaders declared that such an accounting rule would damage their bottom lines, compromise their ability to attract talented employees and make them less competitive against foreign rivals that didn't face similar requirements. Their protests failed to sway FASB; the new rule went into effect this year.

    Now, some of the same companies that opposed it are among those caught up in a widening probe by federal authorities of companies that allegedly "backdated" employee stock options, a practice in which executives retroactively pick an options-grant date at which the company's share price was at a low, meaning they potentially can lock in a greater profit. This could violate securities laws and lead to misstated financial results and tax problems. This turn of events casts the companies' arguments against expensing stock options in a different light and offers what some accounting-industry observers say is a vindication for FASB.

    It isn't clear that a rule requiring the expensing of options would have prevented the abuses now believed to have taken place from the early 1990s until recent years. But expensing "would have served as a deterrent," because the related cost would have affected profit rather than being shown in a footnote, says Rebecca Todd McEnally, director of the capital-markets policy group at the CFA Institute, a financial-markets organization. "Auditors would have had to pay considerably more attention to [options grants] than they apparently did."

    Some of the companies opposing an expensing rule argued in 2004 that options didn't actually "cost" companies anything and that investors had all the information they needed regarding this type of compensation. One executive at that time even insisted to FASB there was no way for her company to issue options in a way that would provide potentially greater gains for executives; the company, KLA-Tencor Corp., has since acknowledged that probably did happen.

    Other companies complained to FASB that its proposal would give investors a distorted view of a company's finances. Patrick Erlandson, chief financial officer at UnitedHealth Group Inc., wrote in a June 2004 letter that "expensing stock options does not provide financial statement readers with the most appropriate reflection of the economic impact of stock-options grants on an entity's financial statements."

    UnitedHealth this spring disclosed that its options-grant practices are the subject of an "informal" SEC inquiry and that the Internal Revenue Service has requested documents regarding the options. Federal prosecutors also are probing the Minnetonka, Minn., company, which has warned it may have to restate prior year's results. A company spokesman declined to comment on the letter.

    Those favoring expensing of stock options "seem to do so for the wrong reasons," the then-top-three executives at Macrovision Corp., including Chairman John Ryan, wrote FASB in 2004. "They tend to focus on corporate greed," the letter said, referring to scandals such as the implosion of Enron. "Stock options in themselves do not make people corrupt," the letter added.

    In June, Macrovision, based in Santa Clara, Calif., disclosed that the Securities and Exchange Commission had requested information about the company's options practices since 1997; later that month the company said it was subpoenaed by federal prosecutors.

    "It's irrelevant what the thought process was three years ago," says James Budge, Macrovision's current chief financial officer, who wasn't in that position in 2004 and didn't sign the company's letter to FASB. "There is a rule there today and we live by it." But he adds that he doesn't think the expensing rule solves any of the problems related to backdating.

    Stock options give employees the right to buy stock at a preset, or exercise, price at a future date -- typically the same as the company's closing price on the date the option is granted. Backdating the grant date to coincide with a recent low point in a company's share price essentially builds in an instant paper gain on the options.

    FASB tried to put options expensing in place in the mid-1990s but got pushed back by companies and Congress. Then came Enron, and FASB tried again, and succeeded. Since the beginning of this year, all public companies have had to record a cost for issuing options on their income statements.

    Some executives argued in 2004 that expensing could lead to abuses. The difficulty in assessing values needed to expense options would result in an "opportunity for creativity for those who might push the envelope," Nathan Sarkisian, chief financial officer at Altera Corp., wrote in a June 25, 2004, letter.

    In May, Altera said the SEC and federal prosecutors were looking into its options-granting practices. The San Jose, Calif., company has since said there were problems with options granted between 1996 and 2000 and that it expects to restate nine years of financial results. A spokeswoman declined to comment.

    In another letter to FASB, the KLA executive questioned the motives of those pushing an options-expensing rule. Maureen Lamb, then a vice president, finance, wrote that while there were flaws in the accounting rules for stock-based compensation, "the politically charged belief that the blame lies with executives unwilling to give up their ill-begotten compensation is backward and unproductive."

    Ms. Lamb, who is no longer with the company, added that "KLA-Tencor does not currently have the ability to issue any equity-based compensation other than at-the-money stock options." At the time, only options with exercise prices below the current trading price -- "in-the-money" options -- had to be expensed. So-called at-the-money options have an exercise price equal to the grant day's trading price; they didn't have to be expensed back then, but under the new rule they do.

    This June, a committee of KLA's board reached a preliminary conclusion that the price dates for certain grants likely differed from recorded grant dates. In other words, the options likely weren't "at-the-money" and should have been expensed. Federal regulators and prosecutors have requested information from the company.

    KLA officials didn't return calls seeking comment. Ms. Lamb, now chief financial officer of Photon Dynamics Inc., a San Jose technology company, also didn't return calls seeking comment.


    It appears that thousands of CEOs were allowed by their boards to bet on yesterday's horse race
    In theory, directors are supposed to help keep wayward practices like options backdating in check at most companies, but at Mercury it was the directors themselves — who received a final seal of approval from the company’s compensation committee — who kept the backdating ball rolling. Now, as federal investigations of possible regulatory and accounting violations related to options backdating have expanded to include more than 80 companies. Mercury’s pay practices — and the actions of the three outside directors on its compensation and audit committees — have come under scrutiny. In late June, the Securities and Exchange Commission advised the three men that it was considering filing a civil complaint against them in connection with dozens of manipulated options grants.
    Eric Dash, "Who Signed Off on Those Options?" The New York Times, August 27, 2006 --- http://www.nytimes.com/2006/08/27/business/yourmoney/27mercury.html


    Timely Filing of 10-K Reports is not "Optional"
     
    Corinthian Colleges, Inc. announced Thursday that the staff of the Nasdaq stock exchange has threatened the company with de-listing for its failure to submit its 2006 annual financial statements to the Securities and Exchange Commission on time. Corinthian said it has appealed the staff’s recommendation and sought a hearing to challenge the ruling, noting that the company had previously told the SEC that it would be filing its Form 10-K late while it conducts an outside review of its awarding of historic stock option grants. The company is one of several for-profit higher education companies facing scrutiny from federal regulators for their procedures and practices in awarding stock options.
     Inside Higher Ed, October 5, 2006


    Teaching Case on Employee Compensation

    From The Wall Street Journal Accounting Weekly Review on April 16, 2010

    For Entrepreneurs, Sharing Isn't Always Fun
    by: Sarah E. Needleman
    Apr 13, 2010
    Click here to view the full article on WSJ.com

    TOPICS: Compensation, Dilution, Equity, Stock Options, Stock Valuation

    SUMMARY: The article discusses small businesses' use of equity "as a substitute for a portion of salary when trying to attract top talent" either in the form of a portion of the company's overall financial value or in stock options that become valuable if the company goes public. In essence, when employees accept equity in lieu of salary, small business owners are diluting potential reward, notes Michael Keeling, president of ESOP Association, "a Washington trade group representing businesses with employee stock ownership plans." Another issue arising in relation to small businesses in particular is that "companies sometimes outgrow the competence of the individuals they hire," in the words of Chris Carey, a small-business adviser in Brooklyn, NY, and so owners considering using equity-based compensation "

    CLASSROOM APPLICATION: The article can be used to discuss the use of stock option plans by small businesses in addition to the typical view of larger firms' use of these plans and the recent focus on the backdating scandal in executive stock option plans. Though the article doesn't address accounting issues per se, points about compensation value stemming from equity-based compensation and the definition of dilutive effects on owners' shares in firm value are useful for understanding the economic substance behind accounting for equity-based compensation.

    QUESTIONS: 
    1. (Introductory) Define the term equity-based compensation.

    2. (Introductory) What two forms of equity-based compensation used by small businesses, particularly at the start-up phase of business, are described in this article?

    3. (Introductory) What is dilution? How does offering a share of stockholders' equity or a stock option plan to an employee dilute an owner's interest in a business currently? In the future?

    4. (Advanced) Consider the accounting for stock option plans offered by ForceLogix to its employees in 2008 and 2009 as described in the article. How do you think the granting of these stock options was accounted for?

    5. (Advanced) Access the ForceLogix (formerly Courtland Capital Corp.) Financial Statements for the year ended August 31, 2009, available online at http://www.sedar.com/DisplayCompanyDocuments.do?lang=EN&issuerNo=00026340 or by searching for them through the company's web site link to investor information. Read Note 2, Summary of Significant Accounting Policies (particularly the paragraph on stock-based compensation) and Note 6, Share Capital. Does this description confirm your answer to the question above? Explain, including a comment on the method used to value the options.

    6. (Advanced) Have the stock options described in the article been exercised? Cite your source for this information.

    7. (Introductory) Have the stock options described in the article been exercised? Cite your source for this information.

    8. (Advanced) Refer again to the ForceLogix financial statements Note 2, this time the paragraph on Loss per share. What can you infer about the current market value of the company's stock from the fact that no diluted earnings (loss) per share is shown in these financial statements and the statement in this note that the impact of potentially dilutive securities would be anti-dilutive.

    Reviewed By: Judy Beckman, University of Rhode Island

    "For Entrepreneurs, Sharing Isn't Always Fun," by: Sarah E. Needleman, The Wall Street Journal, April 13, 2010 ---
    http://online.wsj.com/article/SB10001424052702303828304575180073125261114.html?mod=djem_jiewr_AC_domainid

    Business owners with limited payroll budgets may be tempted to use equity as a substitute for a portion of salary when trying to attract top talent—but this means possibly parting with a piece of their business's future success.

    Mary and Matt Paul say they're grateful that their employees turned down an offer of equity in lieu of more pay when they launched their transportation-services firm, Crown Cars & Limousines Inc., more than 15 years ago.

    "They didn't trust that the company was going to be successful," says Ms. Paul of the recruits. "I'm happy it worked out that way because now I couldn't imagine sharing my profits." She says the company earned roughly $4 million in 2009.

    Businesses have long used part-ownership in place of—or in addition to—bigger salaries. Some offer a piece of their firm's overall financial value as equity. Others dispense it in the form of stock options that only become valuable if their company goes public.

    The latter may be a tougher sell these days since few companies have gone public in recent years: There were just 63 U.S. initial-public offerings last year and 43 in 2008, compared with 272 in 2007 and 221 in 2006, according to Renaissance Capital LLC, an independent research firm in Greenwich, Conn.

    For a small business, where profits often aren't too big to begin with, this can mean dividing the pot even further. "In essence you are diluting your potential reward," says Michael Keeling, president of ESOP Association, a Washington trade group representing businesses with employee-stock-ownership plans.

    Chris Carey, a small-business adviser in Brooklyn, N.Y., says owners thinking about offering new recruits equity-based pay should consider what would happen if they later decide that those workers aren't worth retaining.

    "Companies sometimes outgrow the competence of the individuals they hire," says Mr. Carey. Other recruiting incentives, such as performance-based bonuses, may be more palatable for owners fearful of landing in that kind of situation, he says.

    On the flip side, sharing a smaller percentage of something successful can be "better than 100% of your business closing down," says ESOP's Mr. Keeling.

    View Full Image

    Studio West Photography

    Employees at ForceLogix Offering equity can be an especially useful tool in a downturn. Business owners should be able to more easily offset a below-market salary with equity-based pay when unemployment is high, theorizes Andrew Zacharakis, professor of entrepreneurship at Babson College in Wellesley, Mass. "A lot of people are trying to get something on their résumé, even though it may not pay as much as what they earn in a good economic climate," he says.

    Equity can also sweeten a job offer for candidates who are always in high demand because they possess unique skills or knowledge. Bret Farrar proposed giving a financial stake in his small consulting firm to two prospective recruits last year in lieu of bigger salaries.

    He says both candidates accepted the positions over other, higher-paying opportunities. "We wanted to attract better people and keep them for the long haul," says Mr. Farrar, founder of Sendero Business Services LP in Dallas.

    Even in prosperous times, equity can be an effective recruiting tool for small firms, says David Wise, a senior consultant for Hay Group Inc., a management-consulting firm based in Philadelphia.

    "There's a limited pool of equity available, and larger companies with more employees have to be that much more selective in allocating it," says Mr. Wise. "For a smaller company, providing an equity stake is one way to compete for talent with the big boys."

    When Patrick Stakenas co-founded ForceLogix Technologies Inc. in Chicago in 2005, he says he and his business partner, Steve Potts, couldn't afford to pay recruits salaries on par with market rates. So they offered equity in their sales-technology firm to compensate for the difference.

    "We looked for people who understood they'd have the opportunity to make a lot of money down the road," says Mr. Stakenas.

    Over the next few years, ForceLogix employees also received pay raises mostly in the form of equity. "A couple of times in 2008 and 2009 cash was very tight, so tight that we weren't going to potentially make payroll," says Mr. Stakenas. "We promised employees that if they stay, there will be more equity for them, and all of them stayed."

    This past December, ForceLogix went public on the Toronto stock exchange at 10 cents a share, making its 10 employees' stock options finally worth something. The price has been fluctuating between eight and 11 cents ever since.

    "They can sit on it or sell it," says Mr. Stakenas, who declines to offer specifics on how much equity his staff has in his firm. "All of them are holding onto it because they want to see the company go further."

    Bob Jensen's threads on employee stock options and equity sharing are at
    http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm

     

     


    Executive Compensation Fraud at Apple Corporation:
     Apple's mea culpa on backdating last week was eloquently incomplete
     
    Apple's mea culpa on backdating last week was eloquently incomplete, and all the more intriguing because the gaps seemed almost Socratically mapped to invite the media to fill the holes by asking obvious questions. The big joke here is that the logic of the witch hunt will stop the media from asking the obvious questions, not least because CEO Steve Jobs is a hero to much of the press and there's little appetite for bringing him down. Don't misunderstand. We believe it would be a gross injustice if he were defenestrated over backdating, just as we have serious doubts about the prosecutions launched against other backdating CEOS. And Apple's likely purpose in issuing its statement, naturally, was not lexical comprehensiveness but saving Mr. Jobs's job.
     Holman W. Jenkins, Jr., "A Typical Backdating Miscreant, The Wall Street Journal, October 11, 2006; Page A15 --- http://online.wsj.com/article/SB116052823194588801.html?mod=opinion&ojcontent=otep

    "Apple C.E.O. Apologizes for Stock Practices," The New York Times, October 5, 2006 --- Click Here

    Now that an internal investigation over Apple Computer Inc.'s stock-option practices has helped abate investor worries over Steve Jobs' role as CEO, a key lingering concern will be the impact of pending earnings restatements.

    Apple said Wednesday its three-month investigation did not uncover any misconduct of any current employees but did raise ''serious concerns'' over the accounting actions of two unnamed former officers.

    The iPod and Macintosh maker also said its former chief financial officer, Fred Anderson, had resigned from the company's board of directors.

    Jobs -- his position intact -- apologized.

    The probe found that Jobs knew that some option grants had been given favorable dates in ''a few instances,'' but he did not benefit from them and was not aware of the accounting implications, the company said.

    ''I apologize to Apple's shareholders and employees for these problems, which happened on my watch,'' Jobs said in a statement. ''We will now work to resolve the remaining issues as quickly as possible and to put the proper remedial measures in place to ensure that this never happens again.''

    Apple said it will likely have to restate some earnings due to revised tax and stock option-related charges. Auditors are still reviewing the situation, and Apple said it has not yet determined the extent of the financial impact.

    The looming restatements could dramatically reduce some of the windfall generated during the company's recent run of record profit, analysts said.

    Shares of Apple shed 10 cents to $75.28 in midday trading Thursday on the Nasdaq Stock Market. The stock has traded between $47.87 and $86.40 over the past year.

    Apple has reported profit totaling $3.1 billion during the past four years. If the restatements are severe, it could dent Apple's stock, said IDC analyst Richard Shim.

    ''The restatements have the potential to bite them again depending on how large they end up being,'' Shim said. ''That said, the company is certainly firing on all cylinders so investors may be willing to forgive them, but it's something that will linger in the backs of their minds.''

    Piper Jaffray analyst Gene Munster said he and other investors are breathing a sigh of relief that Jobs kept his job throughout the scandal.

    ''The risk was that if something bizarre happened and Steve Jobs got fired over it,'' Munster said from his office in Minneapolis. ''That could have significantly impacted the company in a negative way. Steve Jobs is Apple. Ultimately, the scope of the backdating was bigger than we thought, but the impact turned out to be less severe.''

    Apple is one of the most prominent among more than 100 companies caught in the nationwide stock options mishandling scandal. Cupertino-based Apple initiated its own stock-options investigation in June after problems at other companies began to unravel.

    In many instances, the problem has centered on the ''backdating'' of stock options -- a practice in which insiders could make the rewards more lucrative by retroactively pinning the option's exercise price to a low point in the stock's value.

    Apple said its probe found irregularities in the recording of stock option grants made on 15 dates between 1997 and 2002, with the last one involving a January 2002 grant, the company said. The grants had dates that preceded the approval of those grants.

    Apple spokesman Steve Dowling said the 15 grants represented 6 percent of the total issued during that period. He said he did not have further details regarding the specific grants or whether they were awarded to officers or employees.

    The company did not identify the two former officers whose accounting, recording and reporting of option grants raised ''serious concerns'' during the probe.

    Apple said Anderson, who served as the company's chief financial officer from 1996 until 2004, resigned from the board, citing he did so in ''Apple's best interest.''

    Dowling said the company will provide more details about the probe to the Securities and Exchange Commission.

    The company's special committee conducting the investigation examined more than 650,000 e-mails and documents, and interviewed more than 40 current and former employees, directors and advisers.

    "Apple Says Jobs Knew of Options," by Laurie J. Flynn, The New York Times, October 5, 2006 --- Click Here

    The external auditor for Apple Corporation is KPMG --- http://www.trinity.edu/rjensen/Fraud001.htm#KPMG


    The Enron stuff is very sexy, but that type of fraud was not pervasive.
    Backdatings of executive stock option frauds are another matter.

    From Jim Mahar's blog on September 22, 2006 --- http://financeprofessorblog.blogspot.com/

    The sleuth who exposed (stock option) backdating scandal

    I allways like to see finance professors in the news!

    Philadelphia Inquirer | 09/21/2006 | Sleuth who exposed backdating scandal:

    A few "look-ins":
     

    "From his second-floor office at Iowa's Tippie College of Business, [Erik] Lie spent months analyzing data to demonstrate how companies were illegally and retroactively timing, or backdating, stock option grants to fatten bonuses paid to top executives.

     

    "He's uncovered a scandal that has just mushroomed," said Adam C. Pritchard, a former attorney at the Securities and Exchange Commission and now a law professor at the University of Michigan.

    and later in the article:
     

    "'The Enron stuff is very sexy, but that type of fraud was not pervasive,' said Andrew Metrick, a professor of finance and corporate governance at the Wharton School in Philadelphia. 'This is widespread, pervasive. I think when this is all said and done, the total amount of dollars that we'll find have been stolen from the corporate till is larger here than any other case we've seen.'"


    Suspected Fraud:  Attorneys, Auditors, Others Getting Attention In Options Timing Affair
     "It's hard to believe ... that the executives did this all by themselves," Sen. Charles Grassley, R-Iowa, said at a hearing Wednesday. "And to be honest, the idea that all executives at different companies came up with this idea at the same time stretches the imagination." Grassley said he planned to write to "several major corporations" that have engaged in backdating of stock options, asking them to provide the minutes of board meetings in which directors discussed the matter as well as documents from attorneys, accountants and consultants who assisted. In backdating, options are issued retroactively to coincide with low points in a company's share price, a practice that can fatten profits for options recipients when they sell their shares at higher market prices. Backdating options can be legal as long as the practice is disclosed to investors and properly approved by the company's board. In some cases, however, the practice can run afoul of federal accounting and tax laws. "We need to understand and bring enforcement action against all the actors who were involved with this abusive scandal," Grassley declared.
     "Attorneys, Auditors, Others Getting Attention In Options Timing Affair," SmartPros, September 11, 2006 --- http://accounting.smartpros.com/x54672.xml

    From The Wall Street Journal Accounting Weekly Review on September 22, 2006

    TITLE: SEC Accountant Issues Guidelines on Stock Options
    REPORTER: David Reilly
    DATE: Sep 20, 2006
    PAGE: C3
    LINK: http://online.wsj.com/article/SB115871130408368314.html?mod=djem_jiewr_ac 
    TOPICS: Accounting, Fair Value Accounting, Securities and Exchange Commission, Standard Setting, Stock Options

    SUMMARY: "The Securities and Exchange Commission's chief accountant issued guidance on how companies should account for employee stock options in light of regulators' probes into "backdating" of this type of compensation." Specific guidance issued in a letter by Chief Accountant Conrad Hewitt is developed from the SEC's observations from reviews of cases investigated during the options backdating scandal.

    QUESTIONS:
    1.) Through what mechanism is the Securities and Exchange Commission (SEC) issuing this new guidance on accounting for stock options? How does this guidance differ from that provided in statements of financial accounting standards issued by the Financial Accounting Standards Board (FASB)?

    2.) Summarize the requirements currently in place to account for employee stock options. What accounting standard establishes these requirements?

    3.) Refer to the related article. What were the political pressures that were put to bear on the FASB when it implemented changes in accounting for stock options?

    4.) Define the terms "in the money", "at the money", and "out of the money" stock options.

    5.) How do current accounting requirements differ from those that were in effect prior to issuance of this most recent standard? Relate this description to your definitions provided in answer to question 4

    6.) Describe the issue of options backdating. Again, relate this answer to the definitions provided in answer to question 4.

    7.) Based on comments in the main article, how has elevating the accounting for stock options to the face of the financial statements, rather than merely requiring disclosures of the fair values of stock options granted to employees, likely impacted the audit process over these activities?

    Reviewed By: Judy Beckman, University of Rhode Island

    --- RELATED ARTICLES ---
    TITLE: FASB Appears in a New Light on Stock Options
    REPORTER: David Reilly
    PAGE:
    C1 ISSUE: Aug 14, 2006
    LINK: http://online.wsj.com/article/SB115552025107534780.html?mod=djem_jiewr_ac

    "SEC Accountant Issues Guidelines On Stock Options," by David Reilly, The Wall Street Journal, September 20, 2006; Page C3 --- Click Here

    The Securities and Exchange Commission's chief accountant issued guidance on how companies should account for employee stock options in light of regulators' probes into "backdating" of this type of compensation.

    But chief accountant Conrad Hewitt made clear that in considering problems related to options accounting the commission would distinguish between honest mistakes, such as paperwork errors, and those that showed a company was trying to game accounting rules. Mr. Hewitt's tone echoed previous comments made by SEC Chairman Christopher Cox that indicated the commission would look closely at a company's intent when investigating possible backdating practices.

    Stock options give employees the right to purchase stock at a preset price, known as the strike or exercise price, at a future date. Under accounting rules in place until the start of this year, companies didn't have to recognize any expense related to options grants if the exercise price was equal to the company's share price on the date the options were granted.

    However, many companies retroactively picked a grant date to correspond with a low-point for their stock, in effect setting a lower bar for executives.

    Under accounting rules in place at the time, such grants could have required companies to book an expense because the exercise price picked wasn't actually the same as the company's share price on the real grant date. Starting this year, companies have had to take an expense for all options grants.

    Mr. Hewitt's letter laid out examples where questions have arisen over whether a company should have taken an expense for options under the old accounting rules. In cases where companies picked an exercise price over a 30-day period, for example, they generally should have recorded an expense for the options, the letter said. However, so-called springloading of options, where companies grant options ahead of good news, doesn't result in an accounting issue, the letter said.

    The SEC guidance to companies follows an alert to auditors on backdating issues in July from the Public Company Accounting Oversight Board. More than 100 companies are under investigation in relation to backdating, according to recent congressional testimony from Mr. Cox. The agency has brought civil charges against executives from two companies in tandem with criminal charges by prosecutors.

    Mr. Hewitt stressed that the guidance related only to accounting issues, not legal matters arising from backdating issues.

     

    Bob Jensen's threads on executive options compensation scandals are at http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm

    Bob Jensen's threads on outrageous executive compensation are at http://www.trinity.edu/rjensen/FraudConclusion.htm#OutrageousCompensation


    Executives Are Betting On Yesterday's Horse Races

    As an aside, once again this shows that finance and accounting go hand in hand as Collins, Gong, and Li are accounting professors!

    From Jim Mahar's blog on May 23, 2006 --- http://financeprofessorblog.blogspot.com/

    Do managers backdate options?

    Do managers backdate options? It sure seems that way.

    From
    Reuters:
     

    A U.S. government probe into stock option grants for executives widened on Tuesday with more technology companies being called on to explain the way these grants are awarded.

    The investigation focuses on whether companies are giving executives backdated options after a run-up in the stock. Backdated securities are priced at a value before a rally, which boosts their returns.

    From NPR:

    The Securities and Exchange Commission (SEC) is reportedly examining the timing of stock option awards by corporations." (BTW this is included to you can listen to it--has several professors speaking on it.)

    From the LA Times:
     

    ""The stock-option game is supposed to confer the potential for profit, but also some risk," said John Freeman, a professor of business ethics at the University of South Carolina Law School who was a special counsel to the SEC during the 1970s. "When in essence the executives are betting on yesterday's horse races, knowing the outcome, there's no risk whatever.""

    What does past academic research have to say on this? Most of the evidence suggests that backdating probably does occur.

    For years there have been papers showing that managers tend to announce bad news prior to option grants and even time the grants prior to price run ups (see Yermack 1997) it has only been more recently that researchers have noticed that the price appreciation was not merely due to firm specific factors (which managers may be able to control and time) but also market wide factors (i.e. the stock market goes up after option grants).

    Last year a paper by Narayanan and Seyhun suggested that this may be the result of backdating the option grants. More recently two papers by Collins, Gong, and Li (a) and (b) find further evidence that backdating is (or at least was) happening and that unscheduled grant dates (where this can occur) tend to be found more commonly at firms whose management has relatively more control over their board of directors.
    Stay tuned!!

    * A quick comment to any manager who may have done this: Why bother? Why risk it all cheating for a few extra dollars? (Indeed it reminds me of the Adelphia case where the firm outsourced snow plowing to a Rigas owned firm. It just doesn't seem worth it.)

    *As an aside, once again this shows that finance and accounting go hand in hand as Collins, Gong, and Li are accounting professors!



    "PCAOB Issues Alert to Auditors on Backdating," SmartPros, July 31, 2006 --- http://accounting.smartpros.com/x54136.xml

    The oversight board's first-ever "audit practice alert," released on Friday, warns auditors to "be alert to the risk that the issuer may not have properly accounted for stock options, and as a result, may have materially misstated its financial statements."

    The nine-page practice alert, Matters Relating to Timing and Accounting for Options Grants (PDF), was prompted by recent reports and disclosures about issuer practices related to the granting of stock options, including the "backdating" of such grants.

    In a statement Friday, the board said these reports and disclosures indicate that some issuers' actual practices in granting options might not have been consistent with the manner in which these transactions were initially recorded and disclosed. Some issuers have announced restatements of previously issued financial statements as a result of these practices. In addition, some of these practices could result in legal and other contingencies that may require recognition of additional expense or disclosure in financial statements.

    The alert advises auditors that these practices may have implications for audits of financial statements or of internal control over financial reporting and discusses factors that may be relevant in assessing the risks related to these matters. The alert reminds auditors to "be mindful" of applicable financial accounting standards, including SFAS No. 123 (Accounting for Stock-Based Compensation).

    PCAOB audit practice alerts are issued by the board's staff to "highlight new, emerging, or otherwise noteworthy circumstances that may affect how auditors conduct audits under the existing requirements of PCAOB standards and relevant laws." They will be posted on the board's Web site, www.pcaobus.org, as well as transmitted to registered public accounting firms via email when possible.

     


     

    From the Wharton School of Business at the University of Pennsylvania
    "How New Accounting Rules Are Changing the Way CEOs Get Paid (Audio Available)," Knowledge@Wharton, May 3, 2006 --- http://knowledge.wharton.upenn.edu/index.cfm?fa=viewArticle&id=1465

    When a well-known compensation consulting firm predicted in early April that new accounting rules wouldn't have any impact on the use of options as compensation for corporate executives, Wharton accounting professor Mary Ellen Carter was ready to disagree. "That's just not true," she says. "Options will be cut and directors will be switching to restricted stock for executive compensation."

    Carter's response is the result of her research into the role of accounting in the design of CEO equity compensation, specifically as it relates to the use of options and restricted stock. Her study coincides with a ruling, implemented this year by the Financial Accounting Standards Board (FASB), requiring all firms to expense the value of employee stock options. Specifically, Carter looks at the accounting practices of 1,500 firms from 1995 to 2001, before many large companies began expensing stock options but during the years when the FASB began pushing the reform. Carter corroborates the findings of her study by examining changes in CEO compensation within firms that voluntarily began to expense options in 2002 and 2003.

    In a new paper on this topic entitled, "The Role of Accounting in the Design of CEO Equity Compensation," Carter concludes that CEO compensation will change now that companies are required to subtract the expense of stock options from their earnings, just as they are required to account for salaries and other costs. And Carter predicts that as a result, firms will switch from options to restricted stock as a preferred compensation option.

    "By eliminating the financial reporting benefits of stock options, firms expensing stock options no longer have an ability to avoid recording expenses with any form of equity compensation," writes Carter, who authored the study with Luann J. Lynch, a professor at the Darden Graduate School of Business Administration, and Wharton accounting professor Irem Tuna.

    "We found that companies prior to the rule changes granted more options because of favorable financial reporting. Results suggest that favorable accounting treatment for stock options led to a higher use of options and lower use of restricted stock than would have been the case absent accounting considerations. Our findings confirm the role of accounting in equity compensation design."

    Leveling the Playing Field

    The timing of Carter's report could hardly be better.

    This past year, a revised FASB rule took effect that requires companies to expense the value of stock options given to employees. Most public companies are required to expense options for fiscal years beginning after June 15, 2005. Since most companies operate on a calendar basis, this means expensing options by March 31, 2006. Known as SFAS 123(R), the new accounting standard was developed by the FASB to create a more level playing field when it came to management incentive compensation and its impact on a company's bottom line. Before SFAS 123(R), companies that gave out stock options did not have to report the "fair value of the option" -- i.e., did not have to claim the options as an expense, which in turn would result in a reduction in net income at the end of the fiscal year. However, companies that relied on cash bonuses or restricted stock for equity compensation have always had to report or "expense" the value amount, an accounting requirement that reduced corporate net income at year's end.

    The FASB first proposed changing the accounting standard in 1991. At the time, the move was strenuously opposed, particularly by many hi-tech firms and start-up businesses that relied heavily on stock options as an incentive to recruit and motivate employees to work for companies that reported little or no income. As nearly everyone knows, stock options are perks given to employees that allow them to buy company stock in the future at a set price. If the stock rises before the options are exercised, the employee can buy the stock at the lower predetermined price, and then sell it at the higher price and quickly realize the difference.

    During the dot-com boom, the use of stock options skyrocketed. According to the National Center for Employee Ownership, up to 10 million employees held stock options by 2002. "Stock options were always seen as an incentive, a way of tying employee or executive action and company performance to compensation," says Carter. "In other words, 'You will get something if you get the stock price to go up.' It was a way of aligning employees' and executives' interests with those of the shareholders."

    But from the beginning, companies balked at putting a numerical value on options and expensing them, arguing that doing so would result in a negative impact on their stock price. After intense lobbying, the FASB backed off the proposal in the early 1990s, but issued a compromise, known then as SFAS 123: Companies had to disclose the use of stock options and their fair value in the footnotes of their financial reports or proxy statements.

    Nearly 10 years later -- in the wake of the volatile post-Enron era, when improper and unethical accounting practices were widely exposed in one corporate scandal after another -- the FASB returned to the concept of expensing stock options. At the time, corporate institutions like Global Crossing and WorldCom, in addition to Enron, had became synonymous with corporate greed, and anyone who followed their downfalls quickly understood how company executives who held substantial stock options were motivated to artificially inflate stock prices for their own financial gain.

    In an effort to distance themselves from companies that routinely "cooked the books," many corporations wanted to showcase their ethical financial practices. So they began to voluntarily expense options in their proxy statements, a step above and beyond the footnote citation already required by the FASB. In 2002, General Electric, Bank One Corp., Coca-Cola, The Washington Post Co., Procter & Gamble and General Motors announced that they would expense options, along with Amazon.com and Computer Associates. Some companies -- like Papa John's International, USA Interactive and Microsoft -- announced that they were doing away with options altogether.

    Continued in article


    July 5, 2006 message from Dennis Beresford [dberesfo@TERRY.UGA.EDU]

    Today's Wall Street Journal reports that Mercury Interactive is the first company to actually restate its financial statements and describe in detail how it had improperly accounting for stock options. A revised 10-K for 2004 is now available at the company's web site
    http://www.mercury.com/us/website/pdf-viewer/?url=/us/pdf/company/10ka-final-2004.pdf
    make for fascinating reading.

    Denny Beresford

    Note the University of Phoenix issue over possible backdating of options

    "CNET to Restate Results Over Stock-Option Grants," by John Hechinger,  The Wall Street Journal, July 11, 2006; Page A3 --- http://online.wsj.com/article/SB115253695093802258.html?mod=todays_us_page_one

    CNET Networks Inc. said it expects restatements that will lower its reported earnings for at least three years, bringing to nearly a dozen the number of companies that have acknowledged errant stock-options accounting.

    The San Francisco Web site operator and more than 50 other companies are under scrutiny by federal authorities because they granted stock options to executives at unusually low prices, often before sharp jumps in the companies' share prices.

    . . .

    Also, Apollo Group Inc., the big for-profit education company that operates the University of Phoenix, disclosed it will be unable to file its 10-Q quarterly SEC filing on time because of its directors' review of stock-option practices. At the same time, Apollo revealed that the SEC notified the Phoenix-based company that it was conducting an informal investigation of its stock-option granting practices. Apollo, which said it was cooperating with the SEC, already disclosed that it had received a subpoena from the U.S. attorney for the Southern District of New York related to the matter. Apollo shares rose 20 cents, or 0.4%, to $50.12 on Nasdaq.

    Terri Bishop, an Apollo spokeswoman, said the company believes "there has been no backdating and that we have complied with all applicable laws."

    In addition, Take-Two Interactive Software Inc., the New York maker of gaming software, said it has received a notice from the SEC of an "informal non-public investigation" into stock-option grants "from January 1997 to the present." The company already had said a special committee of independent directors was investigating such matters. Take-Two said it is cooperating with the SEC and declined further comment. The company's shares fell 76 cents, or 7.5%, to $9.34, also on Nasdaq.

    From The Wall Street Journal Accounting Weekly Review on June 30, 2006

    TITLE: Timely Question: How to Undo Unfair Options?
    REPORTER: Kara Scannell
    DATE: Jun 27, 2006
    PAGE: C1 LINK: http://online.wsj.com/article/SB115137241897491448.html 
    TOPICS: Accounting, Auditing, Financial Accounting, Internal Controls, Stock Options

    SUMMARY: "Boards of directors at companies with executives who may have benefited from backdated stock-option grants face thorny questions about whether they should void the options or try to get back money from options already cashed in.

    QUESTIONS:
    1.) Summarize the issue with backdating stock options granted to executives.

    2.) Why are some executives not being terminated upon discovery of of the stock option backdating practices? Are some executives being terminated?

    3.) What internal control procedures should be in place regarding issuance of stock options to executives?

    4.) How does the problem with backdating indicate that internal control breakdowns occurred at companies in which stock option backdating has been discovered?

    5.) Do you think that there are companies with problems of options backdating in which there was no breakdown of internal control? Support your answer.

    6.) How was the problem of backdating stock options uncovered? Did this discovery occur through an annual audit of financial statements, through an internal audit procedure, or through some other means? Explain.

    7.) Explain how it is possible that an annual financial statement audit did not detect these problems with stock options backdating in at least some cases now being uncovered.

    Reviewed By: Judy Beckman, University of Rhode Island

    --- RELATED ARTICLES ---
    TITLE: Why '90s Audits Failed to Flag Suspect Options
    REPORTER: George Anders
    PAGE: B1
    ISSUE: Jun 22, 2006
    LINK: http://online.wsj.com/article/SB115093901436887061.html

     


    Is any CEO really entitled to over $6  billion in gains on employee stock options?

    "Calpers Puts Pressure on Board of UnitedHealth: Holder Demands a Meeting Over Option-Grant Timing; A Threat to Withhold Votes," by Vanessa Fuhrmans, The Wall Street Journal, April 26, 2006; Page A3 --- http://online.wsj.com/article/SB114599506269535599.html?mod=todays_us_page_one

    The California Public Employees' Retirement System is demanding a conference call with the compensation committee of the board of UnitedHealth Group Inc. over its disclosure practices, and is threatening to withhold votes for board directors seeking re-election.

    In a letter sent to James A. Johnson, chairman of the UnitedHealth board's compensation committee, Calpers board President Rob Feckner demanded a conference call ahead of Tuesday's UnitedHealth shareholders meeting to discuss what he called "serious threats to the credibility, governance and performance of UnitedHealth." Specifically, the letter criticized the company's failure to explain how it determined stock option grant dates for Chief Executive William McGuire and a handful of other executives in past years, and its "inconsistent" disclosure of its option-granting program.

    The move by Calpers increases the scrutiny of the process by which Dr. McGuire received some of the $1.6 billion in unrealized gains he holds in company stock options. Calpers holds 6.55 million shares, or 0.5%, of UnitedHealth's outstanding stock. The pension fund, known for its strong stances on corporate governance, could spur other investors to join in its criticism. The move also increases pressure on UnitedHealth's board to more fully explain its past option-award practices soon, even though its board only launched a probe into them earlier this month.

    Continued in article


    "The thing I think that is more problematic is there have been some allegations that auditors knew about this and counseled their clients to do it," said Joseph Carcello, director of research for the corporate-governance center at the University of Tennessee. "If that turns out to be true, they will have problems."


    The SEC is not yet done with Apple: Where were the auditors?

    "Apple's Former CFO Settles Options Case:  Finance Official Ties CEO Jobs To Stock Backdating Plan," by Carrie Johnson, The Washington Post, April 25, 2007; Page D01 --- Click Here

    A former chief financial officer of Apple reached a settlement with the Securities and Exchange Commission yesterday over the backdating of stock options and said company founder Steve Jobs had reassured him that the questionable options had been approved by the company board.

    Fred D. Anderson, who left Apple last year after a board investigation implicated him in improper backdating, agreed yesterday to pay $3.5 million to settle civil charges.

    Chief executive Steve Jobs has not been charged in the probe. (Alastair Grant - AP)

    Complaint: S.E.C. v. Heinen, Anderson

    Separately, SEC enforcers charged Nancy R. Heinen, former general counsel for Apple, with violating anti-fraud laws and misleading auditors at KPMG by signing phony minutes for a board meeting that government lawyers say never occurred.

    Heinen, through her lawyer, Miles F. Ehrlich, vowed to fight the charges. Ehrlich said Heinen's actions were authorized by the board, "consistent with the interests of the shareholders and consistent with the rules as she understood them."

    Anderson issued an unusual statement defending his reputation and tying Jobs to the scandal in the strongest terms to date. He said he warned Jobs in late January 2001 that tinkering with the dates on which six top officials were awarded 4.8 million stock options could have accounting and legal disclosure implications. Jobs, Anderson said, told him not to worry because the board of directors had approved the maneuver. Regulators said the action allowed Apple to avoid $19 million in expenses. Late last year, Apple said that Jobs helped pick some favorable dates but that he "did not appreciate the accounting implications."

    Explaining Anderson's motive for issuing the statement, his lawyer Jerome Roth said: "We thought it was important that the world understand what we believe occurred here."

    Roth said his client, a prominent Silicon Valley figure and a managing director at the venture capital firm Elevation Partners, will not be barred from serving as a public-company officer or board member under the settlement, in which Anderson did not admit wrongdoing. Roth declined to characterize the current relationship between Anderson and Jobs.

    The SEC charges are the first in the months-long Apple investigation. Jobs was interviewed by the SEC and federal prosecutors in San Francisco, but no charges have been filed against him.

    Steve Dowling, a spokesman for Apple, declined to comment on Jobs's conversations with Anderson. Dowling emphasized that the SEC did not "file any action against Apple or any of its current employees."

    Government authorities praised Apple for coming forward with the backdating problems last year and for sharing information with investigators. Apple has not publicly released its investigation report.

    Continued in article

    "SEC charges former Apple executive in options case:  The SEC accuses Apple's former general counsel of fraudulently backdating stock options," by Ben Ames, The Washington Post, April 24, 2007 --- Click Here

    The SEC said it did not plan to pursue any further action against Apple itself, which cooperated with the government's probe, but it stopped short of saying its investigation was closed. Commission officials declined to comment on whether possible charges could still be filed against Jobs or other current officers.
    "Options troubles at Apple remain despite SEC case against 2 former officers," Associated Press, MIT's Technology Review, April 25, 2007 --- http://www.technologyreview.com/Wire/18587/

    Bob Jensen's fraud updates are at http://www.trinity.edu/rjensen/FraudUpdates.htm

    Bob Jensen's threads on employee stock option accounting under FAS 123 are at
    http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm

    Bob Jensen's threads on KPMG's woes are at http://www.trinity.edu/rjensen/Fraud001.htm#KPMG


    "Backdating Woes Beg the Question Of Auditors' Role," by David Reilly, The Wall Street Journal, June 23, 2006; Page C1 --- http://online.wsj.com/article/SB115102871998288378.html?mod=todays_us_money_and_investing

    Where were the auditors?

    That question, frequently heard during financial scandals earlier this decade, is being asked again as an increasing number of companies are being probed about the practice of backdating employee stock options, which in some cases allowed executives to profit by retroactively locking in low purchase prices for stock.

    For the accounting industry, the question raises the possibility that the big audit firms didn't live up to their watchdog role, and presents the Public Company Accounting Oversight Board, the regulator created in response to the past scandals, its first big test.

    "Whenever the audit firms get caught in a situation like this, their response is, 'It wasn't in the scope of our work to find out that these things are going on,' " said Damon Silvers, associate general counsel at the AFL-CIO and a member of PCAOB's advisory group. "But that logic leads an investor to say, 'What are we hiring them for?' "

    Others, including accounting professionals, aren't so certain bookkeepers are part of the problem. "We're still trying to figure out what the auditors needed to be doing about this," said Ann Yerger, executive director of the Council of Institutional Investors, a trade group. "We're hearing lots of things about breakdowns all through the professional-advisor chains. But we can't expect audit firms to look at everything."

    One pressing issue: Should an auditor have had reason to doubt the veracity of legal documents showing the grant date of an option? If not, it is tough for many observers to see how auditors could be held responsible for not spotting false grant dates.

    "I don't blame the auditors for this," said Nell Minow, editor of The Corporate Library, a governance research company. "My question is, 'Where were the compensation committees?' "

    To sort out the issue, the PCAOB advisory group -- comprising investor advocates, accounting experts and members of firms -- last week suggested the agency provide guidance to accounting firms on backdating of stock options. A spokeswoman for the board said, "We are looking to see what action they may be able to take."

    To date, more than 40 companies have been put under the microscope by authorities over the timing of options issued to top executives. Federal authorities are investigating whether companies that retroactively applied the grant date of options violated securities laws, failed to properly disclose compensation and in some cases improperly stated financial results. A number of companies have said they will restate financial statements because compensation costs related to backdated options in questions weren't properly booked.

    All of the Big Four accounting firms -- PricewaterhouseCoopers LLP, Deloitte & Touche LLP, KPMG LLP and Ernst & Young LLP -- have had clients implicated. None of these top accounting firms apparently spotted anything wrong at the companies involved. One firm, Deloitte & Touche, has been directly accused of wrongdoing in relation to options backdating. A former client, Micrel Inc., has sued the firm in state court in California for its alleged blessing of a variation of backdating. Deloitte is fighting that suit.

    The big accounting firms haven't said whether they believe there was a problem on their end. Speaking at the PCAOB advisory group's recent meeting, Vincent P. Colman, U.S. national office professional practice leader at PricewaterhouseCoopers, said his firm was taking the issue "seriously," but more time is needed "to work this through" both "forensically" and to insure this is "not going to happen going forward."

     

    Robert J. Kueppers, deputy chief executive at Deloitte, said in an interview: "It is one of the most challenging things, to sort out the difference in these [backdating] practices. At the end of the day, auditors are principally concerned that investors are getting financial statements that are not materially misstated, but we also have responsibilities in the event that there are potential illegal acts."

    While the Securities and Exchange Commission has contacted the Big Four accounting firms about backdating at some companies, the inquiries have been of a fact-finding nature and are related to specific clients rather than firmwide auditing practices, according to people familiar with the matter. Class-action lawsuits filed against companies and directors involved in the scandal haven't yet targeted auditors.

    Backdating of options appears to have largely stopped after the passage of the Sarbanes-Oxley corporate-reform law in 2002, which requires companies to disclose stock-option grants within two days of their occurrence.

    Backdating practices from earlier years took a variety of forms and raised different potential issues for auditors. At UnitedHealth Group Inc., for example, executives repeatedly received grants at low points ahead of sharp run-ups in the company's stock. The insurer has said it may need to restate three years of financial results. Other companies, such as Microsoft Corp., used a monthly low share price as an exercise price for options and as a result may have failed to properly book an expense for them.

    At the PCAOB advisory group meeting, Scott Taub, acting chief accountant at the Securities and Exchange Commission, said there is a "danger that we end up lumping together various issues that relate to a grant date of stock options." Backdating options so an executive can get a bigger paycheck is "an intentional lie," he said. In other instances where there might be, for example, a difference of a day or two in the date when a board approved a grant, there might not have been an intent to backdate, he added.

    "The thing I think that is more problematic is there have been some allegations that auditors knew about this and counseled their clients to do it," said Joseph Carcello, director of research for the corporate-governance center at the University of Tennessee. "If that turns out to be true, they will have problems."

    Question
    What auditing firms are associated with worst options accounting abuses?

    "Study Finds Backdating of Options Widespread," by Stephanie Saul, The New York Times, July 17, 2006 --- http://www.nytimes.com/2006/07/17/business/17options.html

    More than 2,000 companies appear to have used backdated stock options to sweeten their top executives’ pay packages, according to a new study that suggests the practice is far more widespread than previously disclosed.

    The new statistical analysis, which comes amid a broadening federal inquiry of the practice of timing options to the stock market, estimates that 29.2 percent of companies have used backdated options and 13.6 percent of options granted to top executives from 1996 to 2005 were backdated or otherwise manipulated.

    So far, more than 60 companies have disclosed that they are the targets of government investigations, are the subject of investor lawsuits or have conducted internal audits involving the practice, in which options are backdated to days when the company’s shares trade at low prices. They include Apple Computer, CNet and Juniper Networks.

    Last week, the United States attorney in San Francisco announced a task force to investigate the backdating of options, which appears to have been particularly popular in Silicon Valley during the 1990’s dot-com boom. The study found that the abuse was more prevalent in high-technology firms, where an estimated 32 percent of unscheduled grants were backdated; at other firms, an estimated 20 percent were backdated.

    An author of the study said the analysis suggested that the disclosures so far about backdated stock options may be just the tip of the iceberg.

    “It is pretty scary, and it’s quite surprising to see,” said Erik Lie, an associate professor of finance at the Tippie College of Business at the University of Iowa.

    Professor Lie said the findings were so surprising that he asked several colleagues to check his numbers. Together, they concluded that the numbers probably erred on the low side.

    The study by Professor Lie and Randall A. Heron, of the Kelley School of Business at Indiana University, was posted Saturday to a University of Iowa Web site. Using information from the Thomson Financial Insider Filing database of insider transactions reported to the Securities and Exchange Commission, the two men examined 39,888 stock option grants to top executives at 7,774 companies dated from Jan. 1, 1996 to Dec. 1, 2005.

    The findings were based on an analysis of whether share values increased or declined after option grant dates. “Half should be negative and half should be positive,” said Professor Lie. “That’s the underlying logic.”

    But the analysis revealed that the distribution was shifted upward.

    “This is not random chance. It’s something that’s manipulated, clearly,” said Professor Lie.

    Of the companies examined, 29.2 percent, or 2,270, had at some point during the period manipulated stock option grants, the study estimated.

    “Over all, our results suggest that backdated or otherwise manipulated grants are spread across a remarkable number of firms, although these firms did not manipulate all their grants,” the authors said.

    The study concluded that before Aug. 29, 2002, 23 percent of unscheduled grants — as distinguished from grants that companies routinely schedule annually — were backdated. Unscheduled grants are easier to backdate.

    On that day, the S.E.C. tightened reporting requirements to require that executives report stock option grants they receive within two business days. After that, the backdating figure declined to 10 percent of unscheduled grants, the paper said.

    Professor Lie said that a number of companies simply ignored the new reporting rule. “You still see problems. The rule is not enforced,” he said.

    Professor Lie, who first alerted S.E.C. investigators to problems with backdating after an analysis that he conducted in 2004, said there was some positive news in his new research.

    “It has been suggested that some accounting firms have been pushing this practice more than others,” he said. “There’s actually very little evidence of that, which to me is very comforting.”

    The study found that smaller auditors rather than larger ones were associated with a larger proportion of late filings and unscheduled grants, which most likely lead to more backdating and manipulative practices.

    It also singled out two firms — PricewaterhouseCoopers and KPMG — as being associated with a lower percentage of manipulation.

     

    Bob Jensen's threads on why "Incompetent and Corrupt Audits are Routine" are at http://www.trinity.edu/rjensen/FraudConclusion.htm#IncompetentAudits


    Which brings us to Congress, the villain of this tale that the rest of the press corps wants to ignore. Executive greed is an easier story to sell, we suppose. But the same Members of Congress who most deplore big CEO paydays are the same ones who created the incentive for companies to overuse options as compensation.

    "Backdate Backlash," The Wall Street Journal, May 27, 2006; Page A6 --- Click Here

    These columns have never joined the media pack deploring executive pay, since wages are best determined by directors and shareholders. But that doesn't mean every pay practice is kosher, especially if it's done on the sly. That's where the recent news over the "backdating" of stock options is cause for some concern -- and for more aggressive director supervision.

    CEO pay has been going up, in part because the market is putting a premium on the skills necessary to navigate today's legal and competitive minefields. Some of the increases also flow from the greater use of stock options, which came into their own in the 1990s thanks in part to Congress (more on that below). Options are supposed to align the interests of management with those of shareholders, but they can also be abused.

    This appears to be the case with "backdating," which is the practice of moving the strike date for option grants to ensure lower exercise prices and thus a bigger payday. Companies grant options according to shareholder-approved plans, most of which require a grant to carry the stock price on the day it was awarded. If it turns out the grant carries a different day's price, those who do the "backdating" could be guilty of false disclosure and securities fraud.

    The number of companies doing this isn't clear, though the SEC is investigating at least 20 and prosecutors have launched criminal probes into a half-dozen. In the least savory instances, executives may have been trying to pull a fast one by altering option dates without the approval of directors. Vitesse Semiconductor Corp. recently fired three top managers, including its CEO, because of what it called "issues related to the integrity of documents relating to Vitesse's stock option grant process." Never a good sign.

    But some boards may also have been asleep at the option switch. Affiliated Computer Services recently announced it will take a charge against earnings of as much as $40 million due to accounting problems related to option grants. Why? Well, ACS explained that its board compensation committee has typically approved grants over the phone -- making them effective that day -- with official written consent coming later. ACS says it believes this practice was "permitted" under law, but shareholders might ask why they are now getting stuck with the $40 million surprise tab.

    Then there's UnitedHealth Group CEO William McGuire, who is being pilloried for his $1.8 billion in unrealized option gains. The health insurer has said it may have to restate three years of results due to a "significant deficiency" in how it administered option grants, which would suggest backdating.

    But what especially caught investor eyes was the news that the company's board had allowed Mr. McGuire to choose his own grant dates. Directors may well have meant this as an added perk for a CEO whose tenure has seen a 50-fold rise in UnitedHealth's share price. Yet the practice still looks like an abdication by the board, which represents shareholders and is supposed to guard against needless equity dilution.

    Some companies have insisted that their boards consciously pegged option grants to coincide with relatively low stock prices. But this would seem to contradict the alleged purpose of options, which is to give management an incentive to raise the stock price and thus the return to shareholders. Granting options at a very low price amounts to additional guaranteed compensation, and ought to be labeled as such.

    Especially since shareholders will end up paying for this executive privilege. UnitedHealth has lost more than $17 billion of its market value since the backdating story broke. Several companies are restating results, facing enormous back taxes and are already grappling with the usual opportunistic lawsuits. * * *

    Which brings us to Congress, the villain of this tale that the rest of the press corps wants to ignore. Executive greed is an easier story to sell, we suppose. But the same Members of Congress who most deplore big CEO paydays are the same ones who created the incentive for companies to overuse options as compensation.

    In 1993, amid another wave of envy over CEO pay, Congress capped the tax deductibility of salaries at $1 million. To no one's surprise except apparently the Members who passed this law, most CEO salaries have since had a way of staying just below $1 million year after year. But because companies still need to compete for and retain top talent, they have found other forms of compensation -- notably stock options.

    And one of the problems with options is that they give executives every incentive to capitalize all company profits back into the stock price -- thus contributing to their own pay -- rather than paying out dividends to shareholders. As SEC Chairman Chris Cox has noted, the 1993 law deserves "pride of place in the museum of unintended consequences."

    In a better world -- one in which Congress kept its nose out of wage decisions -- corporate directors could pay the salaries they wanted and wouldn't rely so much on options to motivate executives. This, in turn, would reduce the incentive for companies to stoop to such dubious pay practices as option backdating. But as long-time observers of Washington, we can say with certainty that backdating will cease as a corporate practice long before Congress admits its mistake.


    Question
    What are the accounting and tax implications of backdating employee stock options?

    The stock-options backdating scandal continued to intensify, with the announcement by a Silicon Valley chip maker that its chairman and its chief financial officer had abruptly resigned. That brought to eight the number of officials at various companies to leave their posts amid scrutiny of how companies grant stock options.
    "Backdating Probe Widens as 2 Quit Silicon Valley Firm:  Power Integrations Officials Leave Amid Options Scandal; 10 Companies Involved So Far," by Charles Forelle and James Bandler, The Wall Street Journal, May 6, 2006; Page A1 --- http://online.wsj.com/article/SB114684512600744974.html?mod=todays_us_nonsub_page_one

    More on Accounting Fraud Via Backdating Options

    "ACS Says Some Options Carried Dates That Preceded Approvals," by Charles Forelle and James Bandler, The Wall Street Journal, May 11, 2006; Page A2 ---
    http://online.wsj.com/article/SB114731443041049838.html?mod=todays_us_page_one

    Affiliated Computer Services Inc. acknowledged that it issued executive stock options that carried "effective dates" preceding the written approval of the grants, saying it plans a charge of as much as $40 million to rectify its accounting related to the grants.

    The announcement followed a preliminary internal probe at ACS, a Dallas technology outsourcer that is also under scrutiny by the Securities and Exchange Commission for its options practices. Between 1995 and 2002, the company granted stock options to Jeffrey Rich, its chief executive for part of that time, that were routinely dated just before sharp run-ups in the company's share price, and often at the nadir of big dips.

    Mr. Rich left the company last year. A rising share price helped him reap more than $60 million from options during his tenure at the company. The timing of his grants helped, too. If his six grants had come at the stock's average closing price during the year they were dated, he'd have made about 15% less.

    Continued in article

    Is any CEO really entitled to over $ 6  billion in gains on employee stock options?
    "Calpers Puts Pressure on Board of UnitedHealth: Holder Demands a Meeting Over Option-Grant Timing; A Threat to Withhold Votes," by Vanessa Fuhrmans, The Wall Street Journal, April 26, 2006; Page A3 --- http://online.wsj.com/article/SB114599506269535599.html?mod=todays_us_page_one

    The California Public Employees' Retirement System is demanding a conference call with the compensation committee of the board of UnitedHealth Group Inc. over its disclosure practices, and is threatening to withhold votes for board directors seeking re-election.

    In a letter sent to James A. Johnson, chairman of the UnitedHealth board's compensation committee, Calpers board President Rob Feckner demanded a conference call ahead of Tuesday's UnitedHealth shareholders meeting to discuss what he called "serious threats to the credibility, governance and performance of UnitedHealth." Specifically, the letter criticized the company's failure to explain how it determined stock option grant dates for Chief Executive William McGuire and a handful of other executives in past years, and its "inconsistent" disclosure of its option-granting program.

    The move by Calpers increases the scrutiny of the process by which Dr. McGuire received some of the $1.6 billion in unrealized gains he holds in company stock options. Calpers holds 6.55 million shares, or 0.5%, of UnitedHealth's outstanding stock. The pension fund, known for its strong stances on corporate governance, could spur other investors to join in its criticism. The move also increases pressure on UnitedHealth's board to more fully explain its past option-award practices soon, even though its board only launched a probe into them earlier this month.

    Continued in article

    After the Horse is Out of the Barn:  UnitedHealth Halts Executive Options
    The UnitedHealth Group, under fire for the timing of lucrative options grants to executives, said Monday that it had discontinued equity-based awards to its two most senior managers and that it would cease other perks like paying for personal use of corporate aircraft. UnitedHealth’s board said it had discontinued equity-based awards for the chief executive, William W. McGuire, who has some $1.6 billion in unrealized gains from earlier options grants, and for the president and chief operating officer, Stephen J. Helmsley.
    "UnitedHealth Halts Executive Options," The New York Times, May 2, 2006 --- http://www.nytimes.com/2006/05/02/business/02unitedhealth.web.html

    From The Wall Street Journal Accounting Weekly Review on May 19, 2006

    TITLE: UnitedHealth Cites 'Deficiency' in Options Grants
    REPORTER: James Bandler and Charles Forelle
    DATE: May 12, 2006
    PAGE: A1
    LINK: http://online.wsj.com/article/SB114734563729450037.html 
    TOPICS: Financial Accounting, Income Taxes, Materiality, Securities and Exchange Commission, Stock Options, Taxation, Accounting Changes and Error Corrections, Audit Quality, Auditing

    SUMMARY: UnitedHealth Group Inc. disclosed on May 11 that "...a 'significant deficiency' in how it administered [stock option] grants could force it to restate results ...[and cut] net income by as much as $286 million over that period." The company also disclosed that the SEC is "conducting an informal inquiry into its options-granting practices"...UnitedHealth...said its internal review had indicated it had uncovered 'significant deficiency' in the way it administered, accounted for and disclosed past option grants and that it may be required to take certain accounting adjustments for 'stock-based compensation expense.' It said that could reduce operating earnings by up to $393 million in the past three years, adding that the company's management believes that any adjustments would not be 'material'."

    QUESTIONS:
    1.) Summarize the issue regarding accounting for stock options that was uncovered in a March 18, 2006, Wall Street Journal article and that has subsequently been the subject of SEC scrutiny.

    2.) The summary description for this review quotes a paragraph in the article describing the financial statement effects of potential adjustments the deficiencies in UnitedHealth's option granting practices. The paragraph begins "In its filing, UnitedHealth, which reported $3.3 billion in net income last year..." Identify all of the terms in that paragraph with specific meaning for accounting and/or auditing purposes. Define each of those terms, explain why it has specific meaning in its use in accounting or auditing, and, if it is a relevant point, explain why understanding that meaning helps to analyze the impact of these options issues on UnitedHealth.

    3.) Refer again to the paragraph described in question 1. The concluding sentence states that the company management believes that adjustments resulting from their review of options granting practices will not be material. Contrast this point to the comments by Professor James Cox of Duke University that "this isn't just a little material...for this kind of issue." Construct arguments to support one of these positions, being sure to refute arguments potentially in favor of your opposing side. In your answers to this and the preceding question, be sure to address the two components of materiality in an audit engagement.

    4.) Refer to the list of companies in the table entitled "Key Companies in Options Probes." In what industry do most of these companies operate? Why is there industry concentration amongst this sample of firms?

    5.) What are the potential issues facing UnitedHealth's auditors, Deloitte and Touche, regarding these matters? What basic audit steps do you think should be carried out in relation to any company's accounting for stock options?

    6.) Do you think the situation with UnitedHealth necessarily indicates an audit failure on the part of Deloitte and Touche? In your answer, define the terms "audit risk", "business risk" in relation to audits, and "audit quality."

    7.) Summarize the tax implications described in the article regarding these matters. How might adjustments to the tax accounting for these stock options exacerbate or reduce the impact of the adjustments to the accounting for stock based compensation expense?

    Reviewed By: Judy Beckman, University of Rhode Island

    --- RELATED ARTICLES ---
    TITLE: The Perfect Payday
    REPORTER: Charles Forelle and James Bandler
    PAGE: A1
    ISSUE: Mar 18, 2006
    LINK: http://online.wsj.com/article/SB114265075068802118.html 

    TITLE: How the Journal Analyzed Stock-Option Grants
    REPORTER: Charles Forelle
    PAGE: A5
    ISSUE: Mar 18, 2006
    LINK: http://online.wsj.com/article/SB114265125895502125.html


    From The Wall Street Journal Accounting Weekly Review on May 5, 2006

    TITLE: As Options Cloud Looms, Companies May Get Tax Bill
    REPORTER: Charles Forelle and James Bandler
    DATE: Apr 28, 2006
    PAGE: C1
    LINK: http://online.wsj.com/article/SB114619341731038487.html 
    TOPICS: Accounting, Financial Accounting, Securities and Exchange Commission, Stock Options, Taxation

    SUMMARY: Tax implications of the developing issues in stock options, covered also in a recent Weekly Review, are discussed.

    QUESTIONS:
    1.) What is the recently-developing concern with dating of executive stock options? In your answer, comment on the Securities and Exchange Commission investigation into the issue. You may refer to the related article for your answer.

    2.) Define the terms "compensatory stock options"; "incentive stock options";"option grant date"; and "option exercise price".

    3.) Summarize the tax implications to both executives receiving stock options and to companies issuing stock options if option grant dates are changed to a point when the stock price is higher than on the originally reported date, but the exercise price is not changed.

    4.) The author quotes Mr. Brian Foley as saying that one company under SEC and IRS scrutiny for this issue, UnitedHealth, would have a "serious and incurable problem" if options were "backdated" and they have been exercised. What could be the difference between options that were exercised and options that have not been?

    5.) What are the financial reporting implications of the problems highlighted in this article? How do the tax issues exacerbate the financial reporting problems?

    Reviewed By: Judy Beckman, University of Rhode Island

    --- RELATED ARTICLES ---
    TITLE: The Perfect Payday
    REPORTER: Charles Forelle and James Bandler
    PAGE: A1 ISSUE: Mar 18, 2006
    LINK: http://online.wsj.com/article/SB114265075068802118.html

    "As Options Cloud Looms, Companies May Get Tax Bill," by Charles Forelle and James Bandler, April 28, 2006; Page C1 --- http://online.wsj.com/article/SB114619341731038487.html

    Companies that backdated stock-option grants to top executives could face a costly reckoning with the Internal Revenue Service, with some potentially owing large sums in back taxes, legal experts say.

    The tax problems, which could affect the personal tax filings of hundreds of individual employees, are the latest wrinkle in widening inquiries into stock-option awards.

    A half-dozen companies, including insurance titan UnitedHealth Group Inc., have said their boards, or the Securities and Exchange Commission, are examining their past option grants amid concerns that some may have been backdated to take advantage of lower exercise prices. Backdating could have resulted in millions of dollars in extra compensation for insiders, at the expense of shareholders. Most of the probes are preliminary, and so far the SEC hasn't charged anyone.

    If the investigations turn up backdated grants, the companies face a host of issues, including the prospect of earnings restatements and delistings. Such options offer the right to buy a stock at a fixed, or exercise, price, allowing the holder to profit by later selling the underlying shares at a higher price than the exercise price.

    One company that has acknowledged "misdating" options, Mercury Interactive Corp., a Mountain View, Calif., software company, has had its stock delisted by the Nasdaq Stock Market and has said it will have to restate financial results. Vitesse Semiconductor Corp. last week suspended its chief executive and two other top officials, saying the move was related to the "integrity of documents" in its stock-option program. Late Wednesday, Vitesse said its board had discovered additional accounting issues and had hired a turnaround firm.

    Granting an option at a price below the current market value, while not illegal in itself, could result in problems of wrongful disclosure under securities laws. Companies' shareholder-approved option plans and SEC filings often say options will carry the stock price of the day the company awards them or the day before.

    Favorable tax treatment was one reason that options gained popularity in the 1990s as a way to compensate employees, particularly executives. When an option is exercised, the company typically can take any gain pocketed by the employee as a deduction on its tax return, because the IRS views the option profit as akin to extra compensation paid to the employee. The employee reports the gain on his or her personal tax return.

    Tax experts say that options backdated to a day with a lower market price don't qualify for a deduction -- although the disqualification only affects options exercised by the chief executive or any of the next four most highly compensated executives. And $1 million of each of the executives' total compensation always can be deducted. As a result, they say, companies with backdated options could face the prospect of shelling out cash to revise prior years' tax returns -- and could be ineligible for the deductions they planned to take in the future on executive option gains.

    A Wall Street Journal analysis, published in March, described a pattern of unusual stock-option grants to a handful of chief executives, including William McGuire, UnitedHealth's chief executive. Twelve grants to Mr. McGuire between 1994 and 2002 were each dated in advance of a substantial run-up in the company's share price, and three of them fell on yearly lows. Last week, Mr. McGuire told investors on a conference call that, "to my knowledge, every member of management in this company believes that at the time we collectively followed appropriate practices."

    The potential tax issues could be big, particularly for companies whose stocks have greatly increased since the grants. UnitedHealth, Minnetonka, Minn., reported $346 million in realized option gains among its five best-paid executives from 2003 to 2005. At the end of last year, it said its five best-paid executives had another $2.4 billion in unrealized, exercisable options gains. UnitedHealth's stock has soared since the 1990s, when many of the options were granted. A board committee investigating options granting at the company hasn't completed its work, and it isn't known whether any option grants were backdated at all.

    "If they had a backdating problem, and that's a big if, the tax consequences could certainly be ugly," says Brian Foley, a compensation consultant and tax lawyer in White Plains, N.Y. With respect to the already-exercised options, he added, "they would have an obvious and serious and incurable problem."

    UnitedHealth had a corporate-tax rate ranging between 34.9% and 35.7% in the past three years. Although the company's actual payments likely were lower, that suggests the tax savings to UnitedHealth from exercised executive options could have been as much as $120 million from 2003 to 2005. As of end of 2005, the value of the future tax savings was as much as $800 million.

    "That's a huge number," says Robert Willens, a tax and accounting expert at Lehman Brothers Holdings Inc.

    UnitedHealth has reported substantial tax benefits from deducting its employees' stock option gains. Until recently, the company said in its proxy statements that it believed its executive option grants qualify for the tax deduction. Starting in a proxy filed in April 2005, it said some options might not qualify, but that the amounts involved were immaterial. Ruth Pachman, an outside spokeswoman for UnitedHealth, said in a statement that the company "continues to believe" that its proxy statements were accurate and remain accurate. She said the company "declined to speculate about hypothetical scenarios."

    Executives at other companies reporting options investigations, including Vitesse and Affiliated Computer Services Inc., reported substantial options gains to top executives. ACS, which reported about $44 million in realized options gains by its top five executives in the most recent three fiscal years, didn't return calls. Vitesse officials didn't return several messages seeking comment.

    S. James DiBernardo, a partner at Morgan, Lewis & Bockius LLP who specializes in tax issues, says there is no easy way to make grants comply with the terms of the tax code retroactively. A company could reprice the options, he says, but it would have to reprice them at the current share value, effectively erasing all of an executive's past gains. Another route is for the top executives to wait until after retirement to exercise the options -- when they are no longer executive officers.

    Ethan Yale, an associate professor at Georgetown University Law Center who was retained by UnitedHealth to look into this matter, agreed that the issue could pose tax problems. He said this is largely uncharted territory and ambiguities in tax rules might allow a company to get back in compliance retroactively by repricing the options to the actual grant-date prices.

    Continued in article


    "Guidance on fair value measurements under FAS 123(R)," IAS Plus, May 8, 2006 ---
    http://www.iasplus.com/index.htm

    Deloitte & Touche (USA) has updated its book of guidance on FASB Statement No. 123(R) Share-Based Payment: A Roadmap to Applying the Fair Value Guidance to Share-Based Payment Awards (PDF 2220k). This second edition reflects all authoritative guidance on FAS 123(R) issued as of 28 April 2006. It includes over 60 new questions and answers, particularly in the areas of earnings per share, income tax accounting, and liability classification. Our interpretations incorporate the views in SEC Staff Accounting Bulletin Topic 14 "Share-Based Payment" (SAB 107), as well as subsequent clarifications of EITF Topic No. D-98 "Classification and Measurement of Redeemable Securities" (dealing with mezzanine equity treatment). The publication contains other resource materials, including a GAAP accounting and disclosure checklist. Note that while FAS 123 is similar to IFRS 2 Share-based Payment, there are some measurement differences that are Described Here.

    Bob Jensen's threads on employee stock options are at http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm

    Bob Jensen's threads on fair value accounting are at http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue

    Bob Jensen's threads on valuation are at http://www.trinity.edu/rjensen/roi.htm


     


    From The Wall Street Journal Accounting Weekly Review on April 21, 2006

    TITLE: Comverse to Restate Results After Options Audit
    REPORTER: James Bandler and Charles Forelle
    DATE: Apr 18, 2006
    PAGE: A3
    LINK: http://online.wsj.com/article/SB114527632069427484.html 
    TOPICS: Accounting, Executive compensation, Financial Accounting, Stock Options

    SUMMARY: "Comverse Technology Inc. said that after a preliminary review of its stock-option practices, it expects to restate more than five years of financial results because the grant dates used in its accounting 'differed' from the actual grant date...Comverse also said it could face delisting from the Nasdaq Stock Market because it will be unable to file its annual report for the latest fiscal year on time." The related articles describe the WSJ analysis of stock option grants to identify unusual patterns in stock option grant dates that led to the SEC investigation of several companies regarding this issue.

    QUESTIONS:
    1.) Summarize accounting for employee stock options. In your answer, define the terms "grant date" and "measurement date" and identify their importance to the accounting process.

    2.) Summarize the analysis undertaken by the Wall Street Journal to investigate the timing of stock option grants. What was the objective of the analysis? What conclusions were drawn?

    3.) Again refer to the analysis undertaken by the Wall Street Journal to investigate the timing of stock option grants. How did the analysis support the conclusions drawn? Are there any possible weaknesses in the support for the conclusions drawn from the analysis?

    4.) What data used for the analysis of stock options were taken from the companies' financial statements? Where in the financial statements can these data be found? Be specific.

    5.) How will restatements affect prior earnings reported by companies who uncover issues with option grant dates? Specifically describe the accounting and reporting requirements for problems such as those uncovered by Comverse.

    6.) Under what circumstances will Comverse's cash flows be affected by changes related to the timing of stock option grant dates? Explain how this answer differs from your answer regarding earnings effects.

    Reviewed By: Judy Beckman, University of Rhode Island

    --- RELATED ARTICLES ---
    TITLE: The Perfect Payday
    REPORTER: Charles Forelle and James Bandler
    PAGE: A1
    ISSUE: Mar 18, 2006
    LINK: http://online.wsj.com/article/SB114265075068802118.html 

    TITLE: How the Journal Analyzed Stock-Option Grants
    REPORTER: Charles Forelle
    PAGE: A5
    ISSUE: Mar 18, 2006
    LINK: http://online.wsj.com/article/SB114265125895502125.html


    From The Wall Street Journal Accounting Weekly Review on January 27, 2006

    TITLE: Google Stock-Sharing Plan may Bite Investors
    REPORTER: Gregory Zuckerman
    DATE: Jan 19, 2006
    PAGE: C1
    LINK: http://online.wsj.com/article/SB113763917137950549.html 
    TOPICS: Accounting, Advanced Financial Accounting, Financial Accounting, Financial Statement Analysis, Stock Options

    SUMMARY: Google has awarded an increasing number of 'performance-based stock units' (restricted shares and options) as its business grows. The article analyzes the impact of these issuances on future earnings. Questions focus on understanding the accounting for stock options, the use of that information for analysis presented in the article, and the FASB's concept statements on objectives of financial reporting and qualitative characteristics of financial information (particularly, predictive value).

    QUESTIONS:

    1.) The author describes the issuances of employee stock options and restricted stock by Google. Based on the information presented in the article, summarize the accounting entries Google made .

    2.) From where does the author obtain the information to forecast the expected impact of these stock and option issuances on Google's future earnings? To answer this question, access Google's most recent 10-Q filing (for the 3 quarters ended 9/30/2005 and filed on 11/14/2005, available on the SEC's web site at http://www.sec.gov/Archives/edgar/data/1288776/000119312505225524/d10q.htm  Specifically state where information that is presented in the article can be found.

    3.) Robert Willens, a Lehman Brothers analyst, notes that compensation expenses for stock options and restricted stock could impact earnings negatively "unless the employees who are incentivized generate more than enough revenue to cover the cost." Explain this analyst's statement.

    4.) The use of information from financial statements in the way that is done for this article exemplifies the concept of the predictive value of financial information identified in the Financial Accounting Standard's Board's Concept Statements. Explain how this is so, including a definition of "predictive value" as the phrase is used in the concept statements.

    5.) Identify an objective of financial reporting in the FASB's Concept Statement No. 1 that is exemplified by this article; support your choice with an explanation.

    Reviewed By: Judy Beckman, University of Rhode Island


    With the aid of a researcher from the University of Iowa, the WSJ
    uncovers evidence of backdating of employee stock options

    "How the Journal Analyzed Stock-Option Grants," by Charles Forelle, The Wall Street Journal, March 18, 2006; Page A5 --- http://online.wsj.com/article/SB114265125895502125.html?mod=todays_us_page_one

    The Wall Street Journal asked Erik Lie, an associate professor of finance at the University of Iowa who has studied backdating, to generate a list of companies that made stock-option grants that were followed by large gains in the stock price.

    The Journal examined a number of the companies, looking at all of their option grants to their top executive from roughly 1995 through mid-2002. Securities-law changes in 2002 curtailed the potential for backdating a grant. Executives typically receive option grants annually.

    Mr. Lie and other academics say a pattern of sharp stock appreciation after grant dates is an indication of backdating; by chance alone, grants ought to be followed by a mixed bag of stock performance -- some rises, some declines.

    To quantify how unusual a particular pattern of grants is, the Journal calculated how much each company's stock rose in the 20 trading days following each grant date. The analysis then ranked that appreciation against the stock performance in the 20 days following all other trading days of the year. It ranked all 252 or so trading days in a given year according to how much the stock rose or fell following them.

    For instance, Affiliated Computer Services Inc. reported an option grant to its then-president, Jeffrey Rich, dated Oct. 8, 1998. In the succeeding 20 trading days -- equal to roughly a month -- ACS stock rose 60.2%. That huge gain was the best 20-trading-day performance all year for ACS. So the Journal ranked Oct. 8 No. 1 for ACS for 1998.

    It is very unlikely that several grants spread over a number of years would all fall on high-ranked days.

    But all six of Mr. Rich's did. Another of his option grants also fell on the No. 1-ranked day of a year, March 9, 1995. Two grants fell on the second-ranked day, those in 1996 and 1997. In 20 02, his options grant was on the third-ranked day of the year, and in 2000, his grant came on the fourth-ranked day.

    If a year has 252 trading days, the probability of a single options grant coming on the top-ranked day of that year would be one in 252. The chance of it coming on a day ranked No. 8 or better would be eight in 252.

    The analysis then used the probability of each grant to figure how likely it is that an executive's overall multiyear grant pattern, or one more extreme than the actual pattern, occurred merely by chance. The more high-ranked days in the pattern, the longer the odds and the more likely it is that some factor other than chance influenced those dates. Two companies said they did use something other than chance -- they made grants on days when they thought the stock was temporarily low. This could explain results that differ somewhat from chance, but it wouldn't account for the extreme patterns of consistent post-grant rises.

    John Emerson, an assistant professor of statistics at Yale, reviewed the methodology and developed a computer program to calculate the probabilities for all of the executives' grants except those to UnitedHealth CEO William McGuire. Because the number of his grants and complexity of his pattern made a computational method infeasible, the Journal used an estimate for his probability that Mr. Emerson said is conservative. Mr. Emerson said the figures for all six executives surpass a standard threshold statisticians use to assess the significance of a result.

    For Mr. Rich's grants, the Journal's methodology puts the overall odds of a chance occurrence at about one in 300 billion -- less likely than flipping a coin 38 times and having it come up "heads" every time.

    Exceedingly long odds also turned up in the Journal's analysis of grant-date patterns at several other companies. "It's very, very, very unlikely that they could have produced such patterns just by choosing random dates," said Mr. Lie.

    David Yermack, an associate professor of finance at New York University, reviewed the Journal's methodology and said it was a reasonable way to identify suspicious patterns of grants. But Mr. Yermack also said the odds shouldn't be thought of as precise figures, largely because they depend on assumptions in the method used to determine which grant dates are more favorable than others.

    Because nobody actually authorizing the grant on a given day could have known how the stock would do in the future, the Journal's analysis used post-grant price surges as an indication of possible backdating. Academics theorize that the most effective way to consistently capture low-price days for option grants is to wait until after a stock has risen, then backdate a grant to a day prior to that rise.

    The decision to look at 20 trading days after each grant was arbitrary. But Messrs. Yermack and Lie said it was a reasonable yardstick to detect possible backdating. Using a longer period, such as a year, wouldn't be a good way to spot backdating of a few days or weeks because the longer-term trading would overwhelm any backdating effect.

    The 20-day price rises don't present an immediate opportunity to profit, since options can't usually be exercised until held a year or more. But when the options do become exercisable, they'll be more valuable if they were priced when the stock was low.


    Question
    Why do standard setters pretend that accounting standards are "neutral?"
    Who said that financial analysts "saw through" stock option compensation whether or not options were booked?

    From The Wall Street Journal Accounting Weekly Review on February 17, 2006

    TITLE: Hold on Tight: Cuts in Profit Estimates Loom
    REPORTER: Gregory Zuckerman
    DATE: Feb 14, 2006
    PAGE: C1
    LINK: http://online.wsj.com/article/SB113988486291673150.html 
    TOPICS: Accounting, Advanced Financial Accounting, Earnings Forecasts, Earnings per share, Financial Accounting, Stock Options, Stock Price Effects

    SUMMARY: Goldman Sachs analysts are warning investors to stay away from 30 companies expected to face revisions in EPS estimates of 30% or more over the next 90 days due to the change in accounting requirements to expense employee stock options. The article also covers the viewpoint that investors should not expect substantial share price revisions due to this issue because it is a noncash charge that reflects no change in underlying economic contracting.

    QUESTIONS:
    1.) Describe the change in accounting requirements that lead to the concerns expressed by Goldman Sachs analysts. Why is this accounting change described as a "non-cash charge" against earnings? What standard requires this accounting treatment?

    2.) When was this change in accounting implemented? Why do the analysts expect to see the effect of this change in earnings estimates over the next 90 days?

    3.) How is the change in earnings expected to affect stock prices? Specifically describe the relationship between earnings and stock prices and address any examples given in the article about that relationship.

    4.) What are the arguments against any significant adjustment to stock prices from this earnings change? In your answer, specifically address three issues: disclosure requirements in effect in FAS 123 prior to revision to FAS 123 (R); the notion of a non-cash charge against earnings as discussed in answer to question 1; and the concept of "pro-forma earnings" which you should define.

    5.) What is the importance of the finding by Credit Suisse that "the amount of money reaped by employees cashing in their options between 1999 and 2004 was very close to the fair value placed on those options..."? How do you think Credit Suisse analyzed this issue? Specifically explain whether you would find the information that Credit Suisse likely used to undertake this analysis.

    Reviewed By: Judy Beckman, University of Rhode Island


    E&Y REPORT ON SHARE-BASED PAYMENT – FASB STATEMENT NO. 123 --- Accounting Education News, January 12, 2006 --- http://accountingeducation.com/index.cfm?page=newsdetails&id=142123

    On December 16, 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123 (revised 2004), Share-Based Payment, which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation. Statement 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees and its interpretations, and amends FASB Statement No. 95, Statement of Cash Flows.

    While the Statement builds on many of the concepts in Statement 123, there are significant differences between the requirements of Statement 123(R) and Statement 123. Further, because of the short time between issuance of the Statement and its required implementation (annual periods beginning after June 15, 2005 for most public companies), it is critical that issuers of options and other share-based payments to employees quickly gain a thorough understanding of those requirements and be prepared to implement them within an effective internal control framework. Because of the length and complexity of Statement 123(R), efforts to understand and implement the Statement should have already begun.

    Ernst & Young have designed a publication as a resource to help you become familiar with Statement 123(R) and assess the impact that Statement 123(R) will have on your company’s financial statements. Chapter 1 provides a high-level overview of Statement 123(R) and describes considerations for compensation plan design and implementation of the new Statement. The implementation discussion includes a description of certain requirements of Statement 123(R) that are catching many preparers by surprise. The remainder of this publication describes the requirements of Statement 123(R) in considerable detail. Throughout this publication they have included the actual text from Statement 123(R) and other standards (presented in shaded boxes) followed by their interpretations of that guidance (EY comments made within the guidance are included in bracketed text).


    "Options and the Deferred Tax Bite:  Just when you thought it couldn’t get any more complicated," by Nancy Nichols and Luis Betancourt, Journal of Accountancy, March 2006 --- http://www.aicpa.org/pubs/jofa/mar2006/nichols.htm

    EXECUTIVE SUMMARY

    Implementation of FASB Statement no. 123(R) goes beyond selecting a method to value employee stock options. CPAs also must help companies make the necessary tax accounting adjustments to properly track the tax benefits from stock-based compensation.

    Statement no. 123(R) requires companies to use deferred tax accounting for employee stock options. An option’s tax attributes determine whether a deductible temporary difference arises when the company recognizes the option-related compensation expense on its financial statements. Companies will treat nonqualified and incentive options differently.

    Companies that did not follow the fair value approach of Statement no. 123 must establish an opening pool of excess tax benefits for all awards granted after December 15, 1994, “as if” the company had been accounting for stock options under this statement all along. To do this CPAs must do a grant-by-grant analysis of the tax effects of options granted, modified, settled, forfeited or exercised after the effective date of Statement no. 123.

    Certain unusual situations may require special handling. These include cases in which employees forfeit an option before it is vested, the company cancels an option after vesting or an option expires unexercised, typically because it is underwater. CPAs also need to be cautious of possible pitfalls when options are underwater, when the company operates in other countries with different tax laws or has a net operating loss.

    Calculating the beginning APIC pool and the ongoing tax computations required by Statement no. 123(R) is a complex process requiring careful recordkeeping. The newly approved simplified method adds yet another set of computations companies need to perform. CPAs should encourage companies to begin making these calculations as soon as possible as some require tracking down historical information.

     


    An innovative method of accounting for employee stock options. 
    The question is whether employees take a hit and how much the hit becomes if they must eventually exercise options at less than full market value.  Of course the company might issue more options to them to make up the difference which it seems to me defeats the purpose somewhat.

    When the new rules regarding the expensing of options go into effect over the next year, technology firms, like Cisco Systems Inc., will be among the hardest hit. Billions of dollars are stake in Silicon Valley with its high concentration of technology firms. But unlike other firms that are scrambling to meet the new requirements in the next fiscal year, Cisco is seeking approval from the Securities and Exchange Commission (SEC) for an innovative method of accounting for employee stock options. The new method was proposed to the SEC by Cisco in March, 2005, an anonymous source told MarketWatch. The plan calls for Cisco to sell a small number of option-backed securities through an investment bank each time the company issues stock options to employees. The securities, which would be available only to large institutional investors, would carry the same terms and restrictions as employee stock options. These securities would be priced using the same Dutch method used by Google, Inc. for its initial stock sale last year, however, the restrictions are expected to reduce the value of the securities. Cisco would account for options issued at the same time at the same price as the securities, rather than at the price as it would be set under current rules. It is anticipated that since the price would be lower the dent made in earnings by expensing the options would also be reduced. “In order to get an accurate valuations for stock option valuation, Cisco is working on a market instrument that would match the same attributes of an employee stock option,” Cisco said in a statement to MarketWatch on Thursday. “We are awaiting guidance from regulators on this instrument.” In response to a reporter’s question, William Donaldson, chairman of the SEC said: “I think it’s a very interesting approach.”
    "Cisco Proposes Option for Options," AccountingWeb, May 13, 2005 ---
    http://www.accountingweb.com/cgi-bin/item.cgi?id=100901 

    As you may recall, Cisco and other companies in the past have taken a tremendous advantage of a discrepancy between GAAP rules and tax rules prior to the revised FAS 123 due to be implemented next year.
    When the options are exercised there is cash foregone rather than a cash outlay. The company simply issues stock for cash at the exercise price and foregoes the intrinsic value (the difference between the market value and the exercise price). In spite of fact that cash never flows for intrinsic value of employee stock options, Cisco has enjoyed a tremendous tax break (millions in some years and over a billion in at least one other year) in tax deductions for the cash foregone.  In other words, a company like Cisco might report over $1 billion in net profit to shareholders and a net loss to the IRS when requesting a a large tax refund.  The revised FAS 123 eliminates the intrinsic method of GAAP accounting for stock options and forces fair value to be expensed at the time of vesting.  Now Cisco is proposing a method of reducing the reported “fair value.”

    Bob Jensen’s threads and illustrations of employee stock option accounting are at  http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm


    "TRANSFERABLE STOCK OPTIONS (TSOs) AND THE COMING REVOLUTION IN EQUITY-BASED PAY"
    by Brian J. Hall, Harvard Business School
    This link was forwarded by Roger Collins --- http://www.sternstewart.com/content/journal/info/161hallfinal.pdf 
    Trinity University students may access file on the path J:\courses\acct5341\theory\TransferableOptions.pdf
    Bob Jensen's threads on employee stock options are at http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm


    Question
    Does the bursting of the subprime bubble shatter the theory of Black-Scholes hedging of market risk?

    "Inside Wall Street's Black Hole,"  by Michael Lewis, National Business News, March 2008 Issue ---
    http://www.portfolio.com/news-markets/national-news/portfolio/2008/02/19/Black-Scholes-Pricing-Model/?PMID# 

    The striking thing about the seemingly endless collapse of the subprime-mortgage market is how egalitarian it has been. It's nearly impossible to draw a demographic line between the victims and the perps. Millions of ordinary people ignorant of high finance have lost billions of dollars, but so have the biggest names on Wall Street, and both groups made exactly the same bet: that real estate values would never fall. Stan O'Neal, the former C.E.O. of Merrill Lynch, was fired for the same reason the lower-middle-class family in the suburban wasteland between Los Angeles and San Diego may have lost its surprisingly nice home. Both underestimated the likelihood of an unlikely event: a financial panic. In retrospect, the small army of Wall Street traders who lost tens of billions of dollars in subprime-mortgage investments looks as naive and foolish as the man on the street. But there's another way of viewing this crisis. The man on the street, for the first time, acted on the same foolish principles that have guided the behavior of sophisticated Wall Street traders for the past few decades.

    If you had to pick a moment when those principles first appeared a bit shaky, you could do worse than the 1987 stock market crash. Black Monday was the first of a breed: a panic that suggested disastrous economic and social consequences but in the end had no serious effects at all. The bursting of the internet bubble, the Asian currency crisis, the Russian government bond default that triggered the failure of the hedge fund Long-Term Capital Management—all of these extreme events seemed, in the heat of the moment, to have the power to change the world as we know it. None of them, it turned out, was that big of a deal for the U.S. economy or for ordinary citizens. But the 1987 crash marked the beginning of something else too—a collapse brought about not by real or even perceived economic problems but by the new complexity of financial markets.

    A new strategy known as portfolio insurance, invented by a pair of finance professors at the University of California at Berkeley, had been taken up in a big way by supposedly savvy investors. Portfolio insurance evolved from the most influential idea on Wall Street, an options-pricing model called Black-Scholes. The model is based on the assumption that a trader can suck all the risk out of the market by taking a short position and increasing that position as the market falls, thus protecting against losses, no matter how steep. Nearly every employee stock-ownership plan uses Black-Scholes as its guiding principle. A pension-fund manager sitting on billions of U.S. equities and fearful of a crash needn't call a Wall Street broker and buy a put option—an option to sell at a set price, limiting potential losses—on the S&P 500. Managers can create put options for themselves, cheaply, by shorting the S&P as it falls, and thus, in theory, be free of all market risk.

    Good theory. The glitch was discovered only after the fact: When a market is crashing and no one is willing to buy, it's impossible to sell short. If too many investors are trying to unload stocks as a market falls, they create the very disaster they are seeking to avoid. Their desire to sell drives the market lower, triggering an even greater desire to sell and, ultimately, sending the market into a bottomless free fall. That's what happened on October 19, 1987, when the sweet logic of Black-Scholes was shown to be irrelevant in the real world of crashes and panics. Even the biggest portfolio insurance firm, Leland O'Brien Rubinstein Associates (co-founded and run by the same finance professors who invented portfolio insurance), tried to sell as the market crashed and couldn't.

    Oddly, this failure of financial theory didn't lead Wall Street to question Black-Scholes in general. "If you try to attack it," says one longtime trader of abstruse financial options, "you're making a case for your own unintelligence." The math was too advanced, the theorists too smart; the debate, for anyone without a degree in mathematics, was bound to end badly. But after the crash of 1987, individual traders at big Wall Street firms who sold financial-disaster insurance must have smelled a rat. Across markets—in stocks, currencies, and bonds—the price of insuring yourself against financial disaster rose. This rise in prices and the break with Black-Scholes reflected two new beliefs: one, that huge price jumps were more probable and likely to be more extreme than the Black-Scholes model assumed; and two, that you can't manufacture an option on the stock market by selling and buying the market itself, because that market will never allow it. When you most need to sell—or to buy—is exactly when everyone else is selling or buying, in effect canceling out any advantage you once might have had.

    "No one believes the original assumptions anymore," says John Seo, who co-manages Fermat Capital, a $2 billion-plus hedge fund that invests in catastrophe bonds—essentially bonds with put options that are triggered by such natural catastrophes as hurricanes and earthquakes. "It's hard to believe that anyone—yes, including me—ever believed it. It's like trying to replicate a fire-insurance policy by dynamically increasing or decreasing your coverage as fire conditions wax and wane. One day, bam, your house is on fire, and you call for more coverage?"

    THE PROBLEM

    This is interesting: The very theory underlying all insurance against financial panic falls apart in the face of an actual panic. A few smart traders may have abandoned the theory, but the market itself hasn't; in fact, its influence has mushroomed in the most fantastic ways. At the end of 2006, according to the Bank for International Settlements, there were $415 trillion in derivatives—that is, $415 trillion in securities for which there is no completely satisfactory pricing model. Added to this are trillions more in exchange-traded options, employee stock options, mortgage bonds, and God knows what else—most of which, presumably, are still priced using some version of Black-Scholes. Investors need to believe that there's a rational price for what they buy, even if it requires a leap of faith. "The model created markets," Seo says. "Markets follow models. So these markets spring up, and the people in them figure out that, at least for some of it, Black-Scholes doesn't work. For certain kinds of risk—the risk of rare, extreme events—the model is not just wrong. It's very wrong. But the only reason these markets sprang up in the first place was the supposition that Black-Scholes could price these things fairly."

    Continued in artricle

    Jensen Comment
    Although the Black-Scholes Model may be popular when companies are valuing stock options, the fact of the matter is employees tend not to like this model for employee stock options because they place a higher premium on the possibility that the options will take at worthless value --- http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm

     


    Things to Consider When Valuing Options

    FASB Rules That Companies Must Begin Deducting Stock Options From Profits Next Year --- http://biz.yahoo.com/ap/041216/accounting_rules_7.html 
    This applies to all employees under the FASB ruling, but the U.S. House of Representatives under heavy tech industry lobbying approved (312 for, 111 against) legislation to limit expense treatment for stock options to only those granted to the top five officers of a company. 
    Does anybody know the status of this pending legislation?
    See http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm

    December 16, 2004 Reply from Dennis Beresford
    The Senate never acted on this so the House bill dies at the end of the year. It could be reintroduced in the new Congress but certain key Senators have expressed strong opposition so most observers think a legislative override of the new FASB standard is unlikely.


     

    Accounting Standards are Not Neutral (i.e., they change management decisions)

    Question
    How do you value a capped option?

    Answer
    Beats me, but the Black Scholes model component for time value must be modified.  But then the BS model doesn't work too well anyway since employees tend to value uncapped options much lower than BS model estimates (mostly out of fear that their options will tank).  They will accordingly reduce their estimates of value even lower if the options have caps.  I leave it up to you to explain to students why options with seven year expiration dates have lower value than traditional ten year dates, which in turn will result in higher corporate earnings per share if seven year expirations are used.  Hint:  It all has to do with that time value component of option value.

    "Stock-Option Plans Get Revised to Meet New Rule," by Linlling Wei, The Wall Street Journal, December 30, 2004, Page C3 --- http://online.wsj.com/article/0,,SB110435344663812226,00.html?mod=todays_us_money_and_investing 

    Companies are giving their stock-option plans makeovers.

    In preparation for an accounting mandate that they treat employee stock options as an expense, companies are slashing option grants, replacing garden-variety options with various forms of stock compensation or tweaking the features of standard options.

    "Most companies are looking at 'what are the alternatives?' " said Judy Thorp, national partner in charge of the compensation and benefits practice at KPMG.

    One move under consideration, pay specialists say, is to cap the potential gain an employee or an executive can get from cashing in options. Tech Data Corp., for instance, already has won shareholder approval to issue such "maximum-value" stock options. Applera Corp. recently asked shareholders to vote on a similar proposal. Officials at both companies weren't available for comment.

    A cap can make options less costly to companies than traditional options. It also "eliminates a concern of some investors that the open-ended nature of a traditional option could result in windfall gains for employees or executives," said Carl Weinberg, a compensation expert in the human-resources practice at PricewaterhouseCoopers.

    Stock options give recipients the right to buy their companies' shares at a fixed price within a certain period. They pay off only if the stock price rises, unlike stock grants that companies have long had to count as expenses. Employees, compensation experts say, tend to exercise their options well before the rights expire, which typically occurs 10 years after the grant date.

    Stock options grew in popularity during the 1990s. About 14 million American workers -- or 13% of the work force in the private sector -- hold options, according to professors at Rutgers University and Harvard University.

    Under the new Financial Accounting Standards Board rule, companies will have to deduct the value of stock options from profits, beginning in mid-2005. The options are valued when they are issued, and companies spread the cost out over the vesting period. Technology companies -- heavy issuers of options -- could continue to lobby Congress to derail the rule, but analysts see little chance of congressional intervention.

    Some companies, including Exxon Mobil Corp. and insurer Progressive Corp., have stopped granting stock options altogether. Instead, they make grants of restricted stock, or shares that recipients can't sell for a set period. Because they provide a more certain payoff, companies usually can dole out fewer such shares. It is also easier for companies to value these shares.

    Other companies, like SBC Communications Inc., are turning to stock grants that are paid out only when specific financial or operational targets are met. Shareholders favor such "performance shares" as a way to align compensation more closely with investors' interests. Microsoft Corp. has decided to give its top 600 managers shares tied to the company's performance.

    Shareholders of Intel Corp., meanwhile, have approved a new option plan that, among other changes, requires employees to exercise options in seven years instead of 10. At aluminum company Alcoa Inc., new stock options will have a six-year lifespan instead of 10 years. Options with shorter lives have a lower value.


    Research by Stanford University accounting and economics faculty add empirical evidence on how firms manipulate ("Gaming of the System") footnote disclosure of employee stock options under FAS 123.  The study add strong empirical support to the forthcoming FASB new standard that will require booking of options on the date of vesting.

    "Toting Up Stock Options," by Frederick Rose, Stanford Business, November 2004, pp. 21 --- http://www.gsb.stanford.edu/news/bmag/sbsm0411/feature_stockoptions.shtml

    Accounting for employee stock options thus has been a riddle. After some 30 years of dispute and countervailing pressures, options are once again the focus of accounting debate. Companies currently must follow a Financial Accounting Standards Board ruling cobbled together in 1995, when the last major battle over options accounting was fought. Forces that favored compulsory expensing lost that earlier policy debate. The current rule, known as FAS 123, came into effect for fiscal years ending after December 15, 1995, and began to lift the veil around options. But, while FAS 123 requires employers to disclose some calculations for employee options grants in financial notes, there is no stipulation that costs be expensed on the corporate income statement. The FASB and its supporters were routed at the last minute and compelled to permit a giant loophole. The loophole frees employers to avoid income statement recognition of options expenses by opting for the 1972 Opinion 25 that had allowed avoidance of options expensing in the first place. FAS 123 added the requirement for footnote disclosures.

    Now, the Financial Accounting Standards Board is again moving toward requiring options expenses. “Let the mud-slinging begin—again,” CFO Magazine sniped earlier this yearAnd indeed it did. Global pressure played a hand this time. The International Accounting Standards Board—Business School professor and associate dean Mary Barth is a member—has adopted requirements much like those of FAS 123, but stipulating that the calculations be used to determine income statement expenses. The international standards will come into force January 1, at which time American accounting standards could be weaker than elsewhere if solutions aren’t set in the United States.

    But on this round of debate there has been new insight. In a potential breakthrough, two Stanford professors created a key to the accounting quandary. An approach proposed by economists Jeremy Bulow and John Shoven identifies a feature common to virtually all current employee option programs and uses that to overcome many of the problems of uncertainty that blocked options expensing in the past. Accounting and securities regulators expressed considerable interest in Bulow and Shoven’s proposal, and earlier this year a Financial Times opinion piece endorsed the approach. Importantly, the Financial Times piece was written by a triumvirate of options experts that included Robert Merton, who with Myron Scholes was awarded the 1997 Nobel Memorial Prize in Economic Sciencesfor groundbreaking options valuation analysis developed with the late Fischer Black that has emerged as the “Black-Scholes” formula.

    Bulow, who is the Richard A. Stepp Professor of Economics at the Business School, and Shoven, the Charles R. Schwab Professor of Economics and director of the Stanford Institute for Economic Policy Research, opened up this accounting approach by chopping up the continuous time of an option’s run into discrete units. We’ll consider the theory in more detail, but it is important to first look at present accounting problems with options.

    Accounting Dissected
    Graduate School
    of Business research has produced disconcerting evidence that while current accounting footnotes influence investors and add to their understanding of a company, they appear to have been used at times in distorted ways that fail to fully reflect the weight of employee stock options. Mary Barth and Ron Kasznik, together with David Aboody of the Anderson School of Management at UCLA, in a paper this year found that options—even where they are absent from the income statement—are viewed by investors as a cost to the firm. The study sampled more than 750 companies between 1996 and 1998 with elaborate statistical checks.

    Barth, Kasznik, and Aboody used footnote disclosures required by FAS 123 to consider assumptions used by the reporting companies. These notes require an estimated value of options grants using the Black-Scholes formula. The calculation appraises the time value of options through an assumed risk-free interest rate, projected volatility of the stock, and forecast dividend yield. There is thus considerable guessing about future periods as much as a decade ahead. If investors believed that options stimulated employees to substantially improve performance—rather than just dipping into the shareholders’ cookie jar—companies with substantial employee options outstanding should perform better, not worse. Yet the Stanford researchers found that the market performance of those stocks with higher estimated options expenses lagged stocks with less. In short, whether the numbers are right or wrong, investors have their opinions, do react, and often don’t like what they see.

    GSB researchers moreover unearthed distressing signs that investor faith in FAS 123 footnotes could be misplaced. A separate work by Barth, Kasznik, and Aboody finds that wide management discretion over assumptions used in calculations has at times understated publicly reported options expenses. Analyzing over 3,800 corporate financial results during the years 1996 to 2001, the researchers concluded that understatement of these expenses was more likely in cases where companies granted large quantities of employee options and were active in capital markets, thus exposing themselves to more scrutiny by banks and investors.

    Manipulation of key numbers is easy. While Barth, Kasznik, and Aboody noted little fudging of interest rate assumptions, which can be compared with other forecasts, they found that company estimates of future stock volatility, dividend yield assumptions, and expected option life were subject to “downward management” by firms anxious to keep perceived option costs low and implicit earnings high.

    Moreover, research by Kasznik and Aboody several years ago found that company managers tend to stick a thumb on the scales when it comes time to set stock option exercise prices—either releasing bad news shortly before options were usually granted or holding off good news until options were set. In either case, exercise prices would be depressed—to the prospective advantage of management option recipients.

    Timeline Solutions
    Such “gaming of the system” could be substantially reduced under the Bulow and Shoven approach. In their central thesis, the two economists write: “Most companies’ long-term options are not really very long term at all. While an option may technically expire after 10 years, the employee only has 90 days to exercise if he either quits or is fired. Therefore, what an employee with a vested option really owns at any given time is a 90-day option.” This understanding of a short, finite period greatly simplifies options accounting. With this short window, a Black-Scholes calculation can be based on far firmer estimates, using well-established short-term interest rates, recently observed stock volatility, and current dividend rates—and for larger firms, direct market prices of publicly traded options—to yield a firm expense number.

    To implement this method, firms would expense the value of 90-day options at the beginning of each quarter, the value determined by the exercise price and the current stock price. This expense would be offset partially by the ending (intrinsic) value of any 90-day options expensed in the previous quarter and not exercised. Firms would have some flexibility in choosing when to begin expensing unvested options, but they would be taking the risk of a large charge if the stock price rose before expensing began because there is no offset in the first quarter that an option is expensed.

    This approach prompted keen interest. “The Bulow-Shoven method appears to remove one of the last valid arguments against expensing options. In the coming months, all sides of this debate will have to reconsider their views and positions,” wrote Financial Engineering News in a recent article.

    But the Bulow-Shoven proposal arrived late on the scene and conflicted in some important parts with standards the FASB had put forth in draft policy earlier this year. It also differed from the International Accounting Standard that is to come into effect on January 1 after extensive efforts to coordinate with U.S. standards. While the economists found substantial initial interest among regulators, the FASB in early August voted to stick with its earlier proposed revisions. Minutes of the board’s meeting indicate the board—contending in part that elements of the approach were at odds with current accounting concepts—sidestepped the economists’ proposals.

    Bulow is sympathetic with the FASB’s position. “It’s very tough for these regulators,” he notes. “Accounting rules pre-date modern financial theory, and the regulators must develop each rule with an eye toward how it affects everything else.” He likens the problem to computer coding complexity. Microsoft’s current Windows software is far bulkier and more convoluted than modern Linux coding “in part because it must be made backward compatible to previous systems, which in themselves were developed to be backward compatible all the way back to DOS.” Even so, once opened up, the economic interpretation of options accounting may yet give rise either to restructured employee incentives or eventually to yet another accounting change, he suggests. “For a variety of reasons, most people not in the business of charging for option valuation software or suing companies would be better off if we adopted some version of Bulow-Shoven,” he says.

    Continued in article


    One of the Dumbest Bills in the History of the U.S. Congress (only not quite as dumb as a new law passed by the Indiana Legislature).
    An obvious example of the junk compromises that lobbying money can buy.  Either stock options are booked as expenses or they are not booked as expenses.

    From The Wall Street Journal Accounting Educators' Review on July 22, 2004 

    TITLE: House Passes Curb on Expense Rules for Stock Options 
    REPORTER: Michael Schroeder 
    DATE: Jul 21, 2004 
    PAGE: C3 
    LINK: http://online.wsj.com/article/0,,SB109035089345768760,00.html  
    TOPICS: Financial Accounting, Financial Accounting Standards Board, Stock Options

    SUMMARY: The House approved legislation to limit expense treatment for stock options to only those granted to the top five officers of a company. This legislation responds to a standard proposed by the Financial Accounting Standards Board (FASB) requiring expense treatment for the value of all employee stock compensation. "The House vote gives the tech lobby, led by Cisco Systems Inc. and Intel Corp., a significant victory over a weighty list of policy makers who argued against Congress intruding in standard-setting...."

    QUESTIONS: 1.) Describe the current accounting and reporting requirements for employee stock options. What standard establishes these requirements?

    2.) Describe the changes proposed by the FASB in this area of accounting. Hint: you may verify your understanding of the proposal by reading the document on the FASB's web site at http://www.fasb.org/draft/ed_intropg_share-based_payment.shtml 

    3.) Again reference the FASB's exposure draft via the following link http://www.fasb.org/draft/ed_intropg_share-based_payment.shtml  What were the FASB's reasons for proposing this change? Why hasn't this required accounting been implemented before now?

    4.) What are Congress's reasons for proposing this legislation? Who supports the legislation?

    5.) As a professional accountant, are you concerned about Congress passing laws regarding the development of accounting standards? Why or why not?

    6.) Refer to the related article. How are the companies who support this legislation in Congress described as 'irresponsible'? How is this issue of stock compensation tied to stock buy back programs?

    The House, responding to lobbying by technology companies, overwhelmingly approved a bill that would limit the required "expensing" of stock options.

    The bill overrides a proposal by a national accounting-standards panel that would have required companies to expense the value of all stock options. In their 312-111 vote, the lawmakers instead approved legislation to limit the expensing rule to options granted only to the top five officers of a company. The Financial Accounting Standards Board had proposed earlier this year that companies subtract the value of all employee stock compensation from company profits.

    The House vote gives the tech lobby, led by Cisco Systems Inc. and Intel Corp., a significant victory over a weighty list of policy makers who argued against Congress intruding in standard-setting in the wake of major accounting-fraud scandals beginning with Enron Corp.

    Among strong supporters of stock-option expensing as a means to improve the accuracy of financial statements are Federal Reserve chairman Alan Greenspan, Treasury Secretary John Snow, and Securities and Exchange Commission William Donaldson. Mr. Greenspan warned Congress earlier this year "it would be a bad mistake for the Congress to impede FASB," because the proposed accounting for stock options "strikes me as correct."

    Still, the measure faces stiff opposition in the Senate. Even though a comparable bill is pending in the Senate with 25 co-sponsors, Richard Shelby (R., Ala.), who chairs the banking committee, has pledged to block any effort by Congress to meddle in rule-making by FASB, an independent accounting-standards body based in Norwalk, Conn.

    Sen. Peter G. Fitzgerald (R.,Ill.), joined by Sens. John McCain (R,., Ariz.), Carl Levin (D., Mich.) and Richard Durbin (D.,Ill), introduced a resolution to protect FASB's independence and integrity under its assault by the House. But critics of the bill say they are worried that House leadership may attempt to short-circuit the process by inserting an amendment in a must-pass appropriations bill that would derail FASB's stock-options proposal.

    In approving the measure, a bipartisan roster of members argued that the proposal would cause hits to earnings, particularly for small technology companies, and hurt start-up companies that depend on stock options as an important compensation tool to attract talent. The accounting rule would mostly penalize the rank-and-file employees of small companies who depend on company stock for an important part of their compensation, bill supporters said.

    --- RELATED ARTICLES --- 
    TITLE: Microsoft Can Count. Intel Can't. 
    REPORTER: Jesse Eisinger 
    PAGE: C1 
    ISSUE: Jul 21, 2004 
    LINK: http://online.wsj.com/article/0,,SB109035182748468780,00.html 

    Tech companies have a choice of two paths, and both were on display yesterday.

    Microsoft Corp. -- long viewed by laymen, computer geeks and the feds as the Darth Vader of the technology world -- decided to do right by shareholders. After a long period of anticipation, the company finally figured out what it wants to do with its Olympian mound of green, and it chose wisely.

    Microsoft decided to give back to shareholders even more cash than investors had been expecting. The company raised its ongoing dividend, giving the company about 1% dividend yield; said it would buy back $30 billion of stock over four years; and said it would issue a special $32 billion one-time payout. (See related article.)

    And then there is the path of the irresponsible. It has been chosen by Intel Corp. and Cisco Systems Inc. and denizens of Silicon Valley. Nonetheless, these companies are celebrated by investors and accorded huge multiples. These are the companies that refuse to pay significant dividends, hoard cash and buy back stock merely to mask the massive dilution that comes from their shareholder-damaging stock-option programs.

    As Microsoft was announcing its shareholder-friendly plan, Silicon Valley was sitting on the shoulders of members of Congress, whispering sweet nothings in their ears. As in, stock options cost nothing. And 312 members of the House listened.

    That was the number of congressmen who voted for the Baker Bill, a measure that damages efforts of the Financial Accounting Standards Board to enact rules mandating the expensing of stock options. The bill violates FASB's independence and fights the inevitable. Hundreds of companies have moved to voluntarily expense stock options because compensation costs companies money -- no matter what Silicon Valley will have Congress believe.

    Continued in the article

    July 24, 2004 reply from David Albrecht [albrecht@PROFALBRECHT.COM

    I prefer to think that the House was injecting a little sanity into the process. If the FASB would stop trying to accomplish social purposes with their rules, I'd be a lot happier.

    To be sure, there is no actual dollar cost to the company when it issues stock options to employees. Hence, in my opinion, there should be no expensing (expense=the cost of doing business).

    The option program must be ratified by elected representatives of the shareholders, so it is OK with that group. Why, oh why, does the FASB persist in promoting certain social agendas?

    If there was to be any accounting for the stock options, then it should be through comprehensive income. However, the FASB has gutted that in its quest to be politically correct and try to limit an options practice that directly enriches the many (executives and stockholders) over the interests of the many (employees).

    And Bob, I don't think I have an uneducated view, so don't persist in calling me dumb (a reasonable inference from the subject of your e-mail). I really don't like being called dumb. So knock it off!

    David Albrecht

    July 25, 2004 reply from Bob Jensen

    Hi David,

    I think you missed the point David. Are you defending the legislation itself as being smart rather than dumb?

    The DUMB part of the law passed by Congress is that it doesn't resolve anything in accounting. The bill would not be dumb if it banned all expensing of employee stock options. The bill would not be dumb if it required expensing of employee stock options. The magic number five is the DUMB part.

    I did not say that expensing stock options is dumb. I did not say that NOT expensing stock options is dumb. What is dumb is the legal declaration of a magic bright line number five. The "top five" employee stock options are legally declared expenses and all other employee stock options are legally declared not expenses.

    For example, if the fifth executive on the ladder at Cisco is awarded stock options having a value of $3.2 million, this becomes legally an expense under the new U.S. House legislation. Fifty three other executives at Cisco receiving options valued at $3.1415926535897932384626433832795 did not receive anything of worthwhile under this legislation and there is no expense.

    This is a little like declaring Pi to be legally 3.20 for the first five years of school and a non-terminating decimal 3.1415926535897932384626433832795... after grade five (see Glen Gray's message on the Indiana Legislature's new definition of Pi). Following the new Indiana Law, a new chapter must now be added to the History of Pi --- http://www-gap.dcs.st-and.ac.uk/~history/HistTopics/Pi_through_the_ages.html 

    In any case, when was David Albrecht ever associated (never by me) with a non-expensing stock option accounting theory? I assume you were being factitious. Just because you declare stock options not to be an expense in your email message is a religious argument. It won't sell unless you can back it by an argument that sells. At the moment arguments on both sides are selling, although I think Silicon Valley executives are selling for reasons of deceit rather than theory that I can buy into. And yes I am aware of some sound arguments for not expensing stock options, especially those of Walter Schuetze --- http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm 

    Do you think that Silicon Valley is spending millions on this lobbying effort to defend the pureness Walter Schuetzes' theoretical arguments or to defend a theory of deception that earnings are really higher because an employee receiving $3.1415926535897932384626433832795 million in stock options really did not cost anybody anything. Either the employee is being deceived or investors are being deceived by following this new bright line of five legislation.

    Cisco argues out of both sides of its mouth when it comes to cash flow and stock options.  It argues that there is no expense for intrinsic value on the date of vesting since there is value granted but no cash flow.  Cisco argues that there is tax expense on the date of exercise even though there is never cash flowing out of the company for options at any time.   

    When the options are exercised there is cash foregone rather than a cash outlay.  The company simply issues stock for cash at the exercise price and foregoes the intrinsic value (the difference between the market value and the exercise price).  In spite of fact that cash never flows for intrinsic value of employee stock options, Cisco has enjoyed a tremendous tax break (millions in some years and over a billion in at least one other year) in tax deductions for the cash foregone.

    Given that there is cash foregone in the case of options, the apparently unresolvable accounting issue is whether to deduct the expense on the accrual basis (i.e., deduct the value on the date of vesting) or the cash basis (on the date of exercise).

    However, if we follow David Albrecht's argument that cash must actually flow out of Cisco for there to be compensation expense, then we might also come to the conclusion that there is never to be recognized compensation expense since cash never actually flows even when options are exercised.  When employees exercise their options the company has simply sold them some stock. Would Cisco ever hate this if the U.S. Tax Code followed the same line of reasoning.

    Of course cash can actually be made to flow since a company could issue stock at full price and simply give employees a cash "bonus" equal to intrinsic value.  In the end, the accounting issue really becomes one of accrual versus cash basis accounting.  Since we estimate bad debt and warranty expenses on an accrual basis before cash actually flows, it makes more sense to me to do the same thing with stock options since GAAP is rooted in the accrual basis for financial reporting.   

    The tax code is more complex and inconsistent than GAAP since it has a greater cash flow orientation (e.g., for bad debts and warranty expenses) even though there are some accrual items as well (e.g., inventory buildup).

    Thus I would argue that the question is not one of whether there is cash flow or no cash flow.  The question is whether one adopts an accrual accounting for options or the present cash foregone basis of accounting on the date of exercise.

     

    Bob Jensen

    July 25, 2004 reply from Dennis Beresford [DBeresfo@TERRY.UGA.EDU]

    I'd be interested in why you believe stock option expense should be included in comprehensive income rather than the income statement. Should the issuance of restricted stock be treated similarly? What principle or other guideline do you think should be used to determine what goes into one of these measures vs. the other? The FASB (along with the IASB) is in the process of reconsidering the notion of comprehensive income and I'm sure they would be interested in views on this topic.

    I agree with Bob Jensen's assessment that the recently passed House of Representatives bill is one of the dumbest things that group has done. The House would have been more honest if it had simply passed a bill that said something like, "A lot of companies have told us that expensing options will hurt the economy and we believe them." Instead, they have characterized the bill as a "compromise" saying that it will deal with the "real problem" of certain executives receiving obscene amounts of total compensation (this may be the "social purpose" that you allude to). Thus, the bill calls for recording expense for only the five most highly compensated individuals and assuming no volatility in determining the value of the options for those individuals. If dumb isn't the right way to describe that approach, how about idiotic, insane, or similar terms?

    It's been ten years since I had to deal with this issue at the FASB and I'm certainly glad that the target is on someone else's back this time around and not mine. However, I do have to say that it pains me to see that we are still not having what I would call a fully informed debate on this subject. I had fully expected the opponents to expensing stock options to dream up a number of new arguments this time around, but they are simply recycling the old ones. The House action can't be characterized as anything than the purchase of a position through political contributions. I'm keeping my fingers crossed that the Senate won't be so dumb.

    Denny Beresford
    University
    of Georgia

     


    Stock Option Expensing Will Take a Bite Out of the Apple

    Why Silicon Valley Hates the Impending FASB Rule to Expense Employee Stock Options
    "What Could Crunch Apple Shares," by Alex Salkever, Business Week, July 12, 2004, Page 11 --- http://www.businessweek.com/@@kvT6e2YQdnTg7RMA/premium/content/04_28/c3891031_mz003.htm?se=1

    These are heady days for Apple (AAPL ) shareholders. Stoked in part by the success of the iPod music player, Apple shares have surged to nearly $34 recently -- the highest in four years. The runup would seem to validate a recent wave of bullish analyst reports. But Apple's earnings per share could fall dramatically if it's forced to expense stock options under new Financial Accounting Standards Board (FASB) rules.

    The accounting change also could expose another weakness: In the last four quarters, Apple earned $32 million after taxes from interest on its $4.6 billion cash horde. That's nearly twice as much as the $18.5 million in operating income it would have earned under the pending FASB rules, says Albert Meyer, principal of 2nd Opinion Research. "Is it a tech company or a credit union?" Meyer asks.

    If stock options had been treated as a cost, Apple's $179 million in earnings over the last four quarters ended on Mar. 27 would have fallen 69% -- significantly more than the potential drops of under 50% for other tech companies such as Dell. Out of 86 tech companies, Apple was among the 12 with the biggest hit to estimated 2005 earnings, according to Merrill Lynch (MER ).

    To match its interest profits, Apple would need to double earnings from operations in the next 12 months. That could be hard when Apple says margins on its iPods will drop in the coming year. Apple declined to comment.

    The SEC is not yet done with Apple: Where were the KPMG auditors?

    "Apple's Former CFO Settles Options Case:  Finance Official Ties CEO Jobs To Stock Backdating Plan," by Carrie Johnson, The Washington Post, April 25, 2007; Page D01 --- Click Here

    A former chief financial officer of Apple reached a settlement with the Securities and Exchange Commission yesterday over the backdating of stock options and said company founder Steve Jobs had reassured him that the questionable options had been approved by the company board.

    Fred D. Anderson, who left Apple last year after a board investigation implicated him in improper backdating, agreed yesterday to pay $3.5 million to settle civil charges.

    Chief executive Steve Jobs has not been charged in the probe. (Alastair Grant - AP)

    Complaint: S.E.C. v. Heinen, Anderson

    Separately, SEC enforcers charged Nancy R. Heinen, former general counsel for Apple, with violating anti-fraud laws and misleading auditors at KPMG by signing phony minutes for a board meeting that government lawyers say never occurred.

    Heinen, through her lawyer, Miles F. Ehrlich, vowed to fight the charges. Ehrlich said Heinen's actions were authorized by the board, "consistent with the interests of the shareholders and consistent with the rules as she understood them."

    Anderson issued an unusual statement defending his reputation and tying Jobs to the scandal in the strongest terms to date. He said he warned Jobs in late January 2001 that tinkering with the dates on which six top officials were awarded 4.8 million stock options could have accounting and legal disclosure implications. Jobs, Anderson said, told him not to worry because the board of directors had approved the maneuver. Regulators said the action allowed Apple to avoid $19 million in expenses. Late last year, Apple said that Jobs helped pick some favorable dates but that he "did not appreciate the accounting implications."

    Explaining Anderson's motive for issuing the statement, his lawyer Jerome Roth said: "We thought it was important that the world understand what we believe occurred here."

    Roth said his client, a prominent Silicon Valley figure and a managing director at the venture capital firm Elevation Partners, will not be barred from serving as a public-company officer or board member under the settlement, in which Anderson did not admit wrongdoing. Roth declined to characterize the current relationship between Anderson and Jobs.

    The SEC charges are the first in the months-long Apple investigation. Jobs was interviewed by the SEC and federal prosecutors in San Francisco, but no charges have been filed against him.

    Steve Dowling, a spokesman for Apple, declined to comment on Jobs's conversations with Anderson. Dowling emphasized that the SEC did not "file any action against Apple or any of its current employees."

    Government authorities praised Apple for coming forward with the backdating problems last year and for sharing information with investigators. Apple has not publicly released its investigation report.

    Continued in article


    "SEC charges former Apple executive in options case:  The SEC accuses Apple's former general counsel of fraudulently backdating stock options," by Ben Ames, The Washington Post, April 24, 2007 --- Click Here

    The SEC said it did not plan to pursue any further action against Apple itself, which cooperated with the government's probe, but it stopped short of saying its investigation was closed. Commission officials declined to comment on whether possible charges could still be filed against Jobs or other current officers.
    "Options troubles at Apple remain despite SEC case against 2 former officers," Associated Press, MIT's Technology Review, April 25, 2007 --- http://www.technologyreview.com/Wire/18587/

    Bob Jensen's fraud updates are at http://www.trinity.edu/rjensen/FraudUpdates.htm

    Bob Jensen's threads on employee stock option accounting under FAS 123 are at
    http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm

    Bob Jensen's threads on KPMG's woes are at http://www.trinity.edu/rjensen/Fraud001.htm#KPMG

    "Backdating Woes Beg the Question Of Auditors' Role," by David Reilly, The Wall Street Journal, June 23, 2006; Page C1 --- http://online.wsj.com/article/SB115102871998288378.html?mod=todays_us_money_and_investing

    Where were the auditors?

    That question, frequently heard during financial scandals earlier this decade, is being asked again as an increasing number of companies are being probed about the practice of backdating employee stock options, which in some cases allowed executives to profit by retroactively locking in low purchase prices for stock.

    For the accounting industry, the question raises the possibility that the big audit firms didn't live up to their watchdog role, and presents the Public Company Accounting Oversight Board, the regulator created in response to the past scandals, its first big test.

    "Whenever the audit firms get caught in a situation like this, their response is, 'It wasn't in the scope of our work to find out that these things are going on,' " said Damon Silvers, associate general counsel at the AFL-CIO and a member of PCAOB's advisory group. "But that logic leads an investor to say, 'What are we hiring them for?' "

     

    . . .

    While the Securities and Exchange Commission has contacted the Big Four accounting firms about backdating at some companies, the inquiries have been of a fact-finding nature and are related to specific clients rather than firmwide auditing practices, according to people familiar with the matter. Class-action lawsuits filed against companies and directors involved in the scandal haven't yet targeted auditors.

    Backdating of options appears to have largely stopped after the passage of the Sarbanes-Oxley corporate-reform law in 2002, which requires companies to disclose stock-option grants within two days of their occurrence.

    Backdating practices from earlier years took a variety of forms and raised different potential issues for auditors. At UnitedHealth Group Inc., for example, executives repeatedly received grants at low points ahead of sharp run-ups in the company's stock. The insurer has said it may need to restate three years of financial results. Other companies, such as Microsoft Corp., used a monthly low share price as an exercise price for options and as a result may have failed to properly book an expense for them.

    At the PCAOB advisory group meeting, Scott Taub, acting chief accountant at the Securities and Exchange Commission, said there is a "danger that we end up lumping together various issues that relate to a grant date of stock options." Backdating options so an executive can get a bigger paycheck is "an intentional lie," he said. In other instances where there might be, for example, a difference of a day or two in the date when a board approved a grant, there might not have been an intent to backdate, he added.

     

    "The thing I think that is more problematic is there have been some allegations that auditors knew about this and counseled their clients to do it," said Joseph Carcello, director of research for the corporate-governance center at the University of Tennessee. "If that turns out to be true, they will have problems."

    Continued at http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm


     

    Following on the heels of a similar IASB international requirement.  
    Lobbying bribes will pour into Congress!

    Share-Based Payment—an amendment of Statements No. 123 and 95 
    (Proposed Statement of Financial Accounting Standards) --- http://www.fasb.org/draft/ed_intropg_share-based_payment.shtml 

    On March 31, 2004, the Financial Accounting Standards Board (FASB) issued a proposed Statement, Share-Based Payment, that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. The proposed Statement would eliminate the ability to account for share-based compensation transactions using APB Opinion No. 25, Accounting for Stock Issued to Employees, and generally would require instead that such transactions be accounted for using a fair-value-based method.

    The Board invites comments on all matters in the proposed Statement, particularly on the specific issues discussed in the Notice for Recipients section. Respondents need not comment on all of the issues presented and are encouraged to comment on additional issues as well.

    Continued at http://www.fasb.org/draft/ed_intropg_share-based_payment.shtml


    PwC provides a summary of major issues in the hot debate over how to account for stock options --- http://www.pwcglobal.com/extweb/pwcpublications.nsf/docid/F108DCCEFCCF1D5385256E9A006C7005


    "Expensing Options: An Overblown Storm," by David Henry, Business Week, April 1, 2004 --- http://www.businessweek.com/bwdaily/dnflash/apr2004/nf2004041_0928_db035.htm 
    FASB, the accounting rulemaking body, has heard plenty from opponents of its new proposal. Their chances of prevailing are slim, however.

    NO REPEATS.
    Representative Richard H. Baker (R-La.) announced just hours after FASB posted its draft on Mar. 31 that he will hold hearings on its impact before his capital-markets subcommittee of the House Committee on Financial Services. He says the rule could stifle new companies and job creation. "I fear FASB is beginning to stand for Flatten All Startup Businesses," he said.

    Still, this time around observers doubt FASB will buckle again -- or have to. Current board members generally view the 1994 episode as a debacle that must not repeat itself. It damaged FASB's credibility as a principled rulemaker and weakened the board's resolve to back rules that corporate executives might not like, even if they would help investors.

    In the interim, many experts agree, executives have become even more aggressive in their ploys to use accounting rules to pump up earnings to drive up stock prices -- and their options payoffs. FASB Chairman Robert Herz has been stoically saying for months that part of his job this spring will be going to Washington to be publicly harangued.

    LITTLE IMPACT. Besides will power, FASB has momentum on its side. Not only have nearly 500 companies volunteered to begin expensing options but they've generally seen no bad consequences from doing so. A study of 335 of those companies by Towers Perrin, a compensation consultant, found no impact on their stock prices.

    The proposed rule would likely reduce reported earnings of S&P 500 companies by less than 3%, according to analysts at Bear, Stearns & Co. That's down sharply from the 18% hit they would have been felt had the rule been in effect in 2002. The reason for the decline: Other earnings have increased, and companies have been issuing fewer options and apparently shifting to other forms of pay.

    At the same time, despite the efforts of U.S.-based tech-industry lobbyists, the International Accounting Standards Board recently adopted a similar expensing rule that will apply next year to more than 7,000 companies listed in Europe.

    Continued in the article


    At long last, the IASB decrees that employee stock options must be booked!

    Message from SmartPros on February 22, 2004 --- http://www.smartpros.com/x42573.xml

    Feb. 20, 2004 (San Jose Mercury News) — International accounting rule-makers decreed Thursday that companies must begin to deduct the cost of stock options from corporate profits starting in 2005, dealing a blow to the U.S. technology industry that had been hoping global political pressure would derail the rule.

    The long-anticipated rule by the International Accounting Standards Board will affect an estimated 7,000 publicly traded companies in 90 counties, but not the United States.

    But the IASB's counterpart in the United States, the Financial Accounting Standards Board, plans to issue a similar proposal in March. And the two accounting groups have been working closely together to make the two rules as symmetrical as possible.

    "It doesn't change much in terms of what's happening in the United States, but it certainly dashes any hope the IASB would back down," said Ellie B. Kehmeier, a deputy national tax leader for Deloitte & Touche in San Jose. "And it provides a decent preview of what to expect when FASB issues its draft standard sometime in March."

    The London-based IASB developed the global standard because a mish-mash of national rules generally do not require companies to account for options on their financial statements. That has resulted in understated expenses and inflated profits, IASB Chairman David Tweedie said in a release.

    The rule, Tweedie added, "will improve the qualify of financial reporting by giving a clearer and more complete picture of an entity's activities, which will assist investors and other users of financial statements to make informed economic decisions."

    The U.S. tech industry -- which doles out options more heavily than other industries -- has lobbied hard against such rules and sought political intervention in Washington. Though many still hold out hope, there is a growing sense that such rules are inevitable, said Roger Stern, a partner with Wilson, Sonsini, Goodrich & Rosati, a high-tech law firm in Palo Alto.

    "A lot can happen between crouch and leap," Stern said. But, he added, "I think most people think mandatory option expensing is inevitable."


    As the FASB and SEC struggle to join the International Accounting Standards Board (IASB) in requiring the expensing of stock options when vested (which I think is the best accounting alternative), the large and powerful technology industry lobby is swinging its weight around the halls of Congress to get its own way.

    "Expensing of Stock Options Isn't the Answer, Readers Say," The Wall Street Journal, March 26, 2005 --- http://online.wsj.com/article/0,,SB107964329516259426,00.html?mod=technology%5Ffeatured%5Fstories%5Fhs

    Lee Gomes said in Monday's column that tech executives opposed to stock-option expensing would get an F from their old business school professors. While I still believe as much, I must concede they would get A's from their college writing teachers, as I received a number of vigorously-argued critiques of the accounting rule change I was supporting. Many readers agreed with the column, but since I compared opponents of stock option expensing to Chicken Little, it's only fair to turn this forum over to them.

    * * *

    Craig R. Barrett
    Chief Executive Officer
    Intel Corp.
    In today's article you go to great pains to point out that we should have accurate reporting (honest accounting) of earnings and use this as a main thesis in defending the expensing of stock options. You (and others) are quick to point out that options are an expense and should be counted as such. The only problem is that after many, many years of trying, FASB and others have been unable to come up with anything that approximates an accurate expensing method. Just go and see how accurate the expensing that Coke used for their options tuned out to be in retrospect. Or how about the billions of dollars of expense that companies like Cisco Systems Inc. and Intel Corp. would have to take for options that might never be exercised?

    You quickly bypass this trivial issue with the tired excuse that the rest of our accounting methodology is inaccurate, so why worry? If our accounting is so inaccurate, why not urge FASB to get back to the real basics of the problem (cash accounting)? What about Sarbanes-Oxley, supporting inaccurate reporting of corporate results as just the natural result of poor guidelines from FASB.

    As a CEO I find this trivialization of accounting almost as insulting as your insinuation that the supporters of stock options "would have earned F's from their old business school professors." I would like your side in this argument to address these issues:

     FASB's proposed accounting for options is just plain inaccurate, and everyone knows it. Why will a single, inaccurate number be better than the several pages of detailed option data we currently provide, if our goal is to provide clear and transparent accounting to shareholders?
     
     Why isn't the current dilution of earnings per share the best possible information to be provided to shareholders? After all, shareholders will approve all option programs and options are really just a dilution of ownership.
     
     Many accountants feel that options are not a true expense, despite FASB's view. Why is this not considered?
     
     And yes, we do raise the jobs issue as part of the debate. The Chinese Communists are promoting the use of options, and not for competitors of Coke or other companies who expense options but whose options are typically given to only the top few employees, but for high tech companies like Intel and Cisco. You can ignore this aspect if you choose, but I doubt those who do have run a company in high tech and competed with the rest of the world.
     
     My predictions if expensing wins:
     
     Companies will return to pro forma accounting to give an accurate representation of their financials -- this will marginalize FASB.
     
     Trial lawyers will have a field day with the inaccurate methods used to account for option expensing -- how can they possibly ignore the billions of dollars of inaccurate expenses taken when stock prices don't follow expected trends? CEOs knew or should have known that their choice of option expensing algorithms were inaccurate.
     
     U.S. companies will reduce their use of options, to their competitive disadvantage compared with companies in emerging economies. (We are competing in the future with Asian companies, not the Europe of the IASB.)
     

    Your argument ignores these details. We may yet lose the battle on expensing, but trivializing our motives really misses the point.


    Frank Huerta
    San Carlos, Calif.

    I think that incentive options help fuel Silicon Valley, especially in a start-up. However, the difficulty that I see with expensing the options is the value you assess for the expense.

    I am one of those students that took options and futures in business school at Stanford and have actually gone through the mechanics of pricing options via the Black-Scholes and binomial models (two of the methods being proposed to value options). The key components in these models are the stock price, strike price, interest rates, time to expiration, dividend, and volatility. Of these, the volatility is the one unknown and requires approximation (typically the computer models use a log-normal distribution of stock prices of PAST performance for this predictor of future volatility, a reasonable estimator that may not always be accurate).

    This volatility estimator creates one problem. The option pricing models generates a number that may be used for accounting purposes, but is that the right price? Rather, is it a market clearing price? Options are traded every day for public companies for a price based on supply and demand and the other factors mentioned above. The market determines the volatility by looking at the past, but also the future of the business and its environment and that adjusts the price. The volatility that is derived from the price of exchange traded options is known as the "implied volatility." So, really, the market "creates" the volatility, not the model.

    Now for public company options, it might make sense to expense the price of the employee options based on the market price of the exchange-traded options. But this assumes that the employee options match the exchange-traded options in type (American or European), strike price and time to expiration, but that is rare since most employee options are long term (expiration dates of 10 years) and exchange-traded options are usually less than one year, although LEAPS go out a few years typically. So do the pricing methods proposed represent the "true" value of the options in the absence of a market clearing price? Likely not.

    In addition to the volatility question, the restrictions imposed on corporate employee option holding and trading impact the "true" value of these options as defined by Black-Scholes or the binomial method. Issues such as: 1) vesting period or "cliffs" (an employee has to hold the option for a set amount of time before he/she can exercise it); 2) trading windows or only certain times or in which the options can be exercised; 3) employee options can be exercised only if they are in the money; and perhaps most importantly 4) the inability to trade the employee option in a market, all create a deviation from the conventional pricing methods for options.

    An option has value right up until it expires. Thus, the day the employee is given an option (usually at the money), it has value. This is the value that should be expensed by the company in the period it is incurred. But what is the value? Black-Scholes and binomial pricing do not account for a "lock up" period, and the employee cannot take advantage of that value because he must wait the period of the cliff (say a year), wait for a trading window to open outside of a quiet period, and hope that the option is in the money. Nor can he/she sell the option along the way to capture its value. Even if the employee option is underwater after the cliff, it still has value according to the option pricing models, but the option holder cannot take advantage of this and thus the market is not efficient -- a stipulation of the models.

    A good discussion of this topic is on this Web site. Hull and White wrote one of the classic text books on options. In this report (Adobe Acrobat required), they discuss the problems with determining the correct value of employee options and try to come up with a model for pricing them (of which I would need to study more to be convinced, but it is not what the FASB is proposing).

    The point is that if companies are going to expense the value of employee options, then they need a better method than what has been proposed to assign and capture the "true" value of those instruments. Otherwise, the numbers will be wrong, and I don't want a new item mucking up income statements and balance sheets any more than they already are. Hull and White and others propose new models, but how do we know if the numbers will be right (volatility assumptions, etc.)?

    An interesting idea would be to allow a market to develop for employee options (you may need more supply but I'm sure investment banks could make more money). Then the "true" price can be determined for that derivative instrument and that value can be expensed in or close to the period it is incurred. Companies may have problems with aligning employees with long term incentives since you may have people that receive an option on the first day of employment and then sell them into the market for the money, but there are ways around this.


    Martin Mobley
    LL.M. Candidate
    Georgetown University Law Center

    I'm glad you didn't let the facts get in the way of a good story -- it's more entertaining that way. Given its inclusion in The Wall Street Journal, however, I would have expected your editorial to more than just occasionally delve into reality. As it is, your column on stock options expensing is sensational and misguided (at best).

    You begin by telling high-tech executives not to worry about expensing options because Coke did it and "Not only has the sky not fallen, not much else bad has happened." What in the world does Coke have to do with the high-tech industry? Coke and the soft drink industry, which have been around for a combined one billion years, are nothing like high-tech companies and the high-tech industry. Neither is Coke's use of stock options, which in 2002 Coke expected would equate to about one cent per share.

    You go on to say that "Silicon Valley managers are busy making arguments that would have earned them F's from their old business-school professors." A bold assertion from someone who never once -- in an article suggesting that those who expense options are less than honest -- even bothers to explain why stock options should be expensed. Your references to "bad accounting," lines "being peddled" by companies, and the perverse nature of "rejecting honest accounting" are uninformative. They do, however, seem to be the type of "stock option horror stories" you compare to the monsters that kids believe are under their beds at night.

    Although the "point" doesn't appear to have been made, why don't I take a crack at the "counter-point," anyway? Expensing options doesn't make a whole lot of sense. Where is the expense? An option merely gives its holder the right to purchase the company's stock at specific price during a certain period of time. How does that at all change the fundamental financial position of the company? It doesn't. The company has not expended a thing. It has only given someone the ability to buy some of its stock that it has set aside for that purpose.

    If a holder does eventually exercise, has the fundamental financial position of the company changed then? Yes -- for the better! When holders exercise options, it is a capital-raising event for the company -- the company now has MORE money, not less. There will just be more pieces of the corporate pie. Calling the initial grant of the option an "expense," makes about as much sense as calling the proceeds the company receives from its exercise "income."

    The real issue here is disclosure. You stumbled across that reality in the part of your piece where you equate the FASB proposal to the "surgeon general's warning on a pack of cigarettes in bigger type." Compelling stock option disclosure through a strained accounting entry, however, is not the way to go. The FASB proposal tries to force a square peg into a round hole. The focus should be on the potential dilution effect of the stock options' exercise on existing shareholders -- the fact that there will be more pieces of the pie with a potentially less than offsetting increase in the size of that pie. This is the salient discussion, and it cannot be communicated through an accounting entry.


    Others at http://online.wsj.com/article/0,,SB107964329516259426,00.html?mod=technology%5Ffeatured%5Fstories%5Fhs



    From The Wall Street Journal Accounting Educators' Review on May 27, 2004 

    TITLE: Google Search: How Does It Value Its Shares? 
    REPORTER: Scott Thurm 
    DATE: May 13, 2004 
    PAGE: C1 
    LINK: http://online.wsj.com/article/0,,SB108439355400909719,00.html  
    TOPICS: Financial Accounting, Financial Analysis, Financial Statement Analysis, Stock Options

    SUMMARY: Jack Ciesielski, publisher of Analysts' Accounting Observer, used Google's disclosures of compensation expense and deferred compensation from its employee stock option plans to estimate the value corporate officers place on their soon-to-be-issued stock.

    QUESTIONS: 

    1.) In general, summarize the two ways in which Mr. Ciesielski estimated the value placed on Google shares by corporate officers.

    2.) What disclosures did Mr. Ciesielski use to estimate the value placed on Google shares by corporate executives? In general, what standards and laws require these disclosures? What specific SEC requirement provided useful information in the disclosures for the first quarter of this year?

    3.) Focus on the method of estimation using the deferred compensation account and the SEC requirement reflected in the accounting during the first quarter of this year. Where is "deferred compensation" under stock option plans included in the financial statements? What amount is included in that account? How could Mr. Ciesielski determine that Google added $75.4 million to that account?

    4.) Focus on the estimation using the Black-Scholes formula. What is that formula designed to estimate? What inputs must be used to make this estimate? How could Mr. Ciesielski, and Professor Larcker, run this model "backwards"?

    5.) What advantage in the marketplace can an analyst obtain by being able to use accounting information in such a clever way as Mr. Ciesielski has done?

    Reviewed By: Judy Beckman, University of Rhode Island 
    Reviewed By: Benson Wier, Virginia Commonwealth University 
    Reviewed By: Kimberly Dunn, Florida Atlantic University

    Bob Jensen's threads on valuation are at http://www.trinity.edu/rjensen/roi.htm 


    From The Wall Street Journal Accounting Educators' Review on February 27, 2004

    TITLE: Foreign Firms to Expense Options
    REPORTER: David Reilly
    DATE: Feb 19, 2004
    PAGE: A2 LINK: http://online.wsj.com/article/0,,SB107713353964432916,00.html 
    TOPICS: Financial Accounting, Financial Accounting Standards Board, International Accounting Standards Board, Stock Options

    SUMMARY: Firms following International Financial Reporting Standards (IFRS) will be required to expense stock options as of January 1, 2005. European companies "have realized this is coming and have changed their ways of remunerating employeses," said an analyst with UBS in London. Questions focus on understanding the use of IASs in comparison to USGAAP and on the implications of accounting standards for economic behavior.

    QUESTIONS:
    1.) What factors determine which companies follow International Financial Reporting Standards (IFRS)? What standards currently govern European companies' reporting practices?

    2.) What are the major differences between current USGAAP and the new IFRS on stock compensation?

    3.) How much will the standard being adopted by the IASB influence development of a new accounting standard on stock compensation in the US? What other factors influence the potential change in US reporting in this area?

    4.) An analyst with UBS in London is quoted: "The big European companies have realized this is coming and have changed their ways of remunerating employees." Should accounting standards impact economic contracting and behavior? Support you answer.

    Reviewed By: Judy Beckman, University of Rhode Island
    Reviewed By: Benson Wier, Virginia Commonwealth University
    Reviewed By: Kimberly Dunn, Florida Atlantic University

    --- RELATED ARTICLES ---
    TITLE: Major Economies at Loggerheads Over Global Accounting Rules
    REPORTER: Andrew Peaple
    ISSUE: Feb 08, 2004
    LINK: http://online.wsj.com/article/0,,SB107628352527524027,00.html


    "Whither the Stock Option? by Ira Kay, Financial Executive, March/April 2004, pp. 46-49 --- http://www.fei.org/mag/articles/3-2004_comp.cfm 

      While stock options lose more luster as executive motivators, compensation committees face challenges, including selecting other forms of stock incentives.

       During the late 1990s, companies issued billions of dollars worth of stock options to motivate their employees. Those days are likely over, for a variety of reasons, including potential new rules requiring companies to expense them. But getting the best out of executives through other forms of stock incentives - including actual ownership - will no doubt continue, according to a recent study of executive compensation conducted by Watson Wyatt.

       Indeed, stock options' best days may be behind them - not just because they will soon have to be expensed, but because institutional investors are increasingly worried about them. Moreover, there is perennial concern over perceptions of excessive CEO pay and disconnects between pay and performance. Finally, there is the crisis in governance created by corporate accounting standards and a gap between the cost and value of options created when a company's future accounting cost of stock options exceeds their value to employees.

       These factors do not appear to be lessening in importance and have already resulted in a huge drop in the value of options granted to employees. From 2001 to 2002, the value of stock option grants at major companies fell by 29 percent, from $139.6 billion to $99.6 billion.

       When data for 2003 becomes available, it will likely show a further decline of 10 percent to 15 percent from 2002. The magnitude of this drop cannot be overstated: the only other event in the history of executive compensation as important is the sharp increase in executive pay levels that took place during the 1990s. However, the recent bull market has softened this trend, as 2004 values are expected to be up from 2003.

       Some analysts believe that the decline in option value was caused entirely by stock price declines - for example, a company granting one million stock options at $30 in 2001 and one million at $20 in 2002. Other things being equal, their value would have declined by 33 percent, solely due to stock price movement. But this is not what happened. In fact, declines in both stock price and the number of stock options granted are responsible.

       For the average company, the 29 percent total decline in stock options value cited above came about as a result of a 20 percent decline in the average number of stock options granted to all employees, from 7.6 million to 6.1 million, and a 16 percent decline in the average value per option, from $17.25 to $14.50, almost entirely due to stock prices falling.

    Options Reflected in Stock Prices

       Consistent with findings in a prior study, investors consider stock option expenses as real expenses, even if reported only in the footnotes. As expected for a bear market year, the relationship was negative: those with the highest option expenses in 2002 had the lowest total returns to shareholders (stock price appreciation plus dividends). Dividing up the 998 major companies in the recent Watson Wyatt study into three groups, the companies with the lowest option expenses - those with a 2002 expense of $266 per employee - had total return of negative 4.3 percent. Those in the highest expense group, with a 2002 expense of $3,997 per employee, had a total return of negative 12.4 percent.

    Pay and Performance Linked

       Another important finding is that pay and performance are strongly linked. Analysis shows a strong, positive relationship between company performance and executive compensation levels. For example, companies whose CEOs had higher total pay opportunities from 1998 to 2002, as measured by their total direct compensation over the five years, had higher total returns to shareholders during the period than those with CEOs having lower pay opportunities. The relationship between pay and performance is apparent in other measures as well:

    ·         Annual increases in a CEO's total cash compensation are positively related to the company's stock performance.

    ·         CEOs of companies that performed below a one-year total return to shareholders median had a decline in actual pay and stock option profits in 2002.

    ·         Companies having CEOs with high stock ownership were superior investments compared to those with low ownership. Companies with high CEO ownership realized a three-year median total return of 3.9 percent for their shareholders for the period ending December 2002, while low CEO ownership companies saw a return of negative 3.4 percent on their investment during the period.

    ·         Investors are willing to pay a premium for companies where senior management and shareholder interests are aligned.

    Stock Option Overhang Declining

       Stock option overhang has continued to grow - despite efforts by a large number of firms to reduce their overhang levels between 2001 and 2002 - primarily from a large reduction in the amount of options being exercised. Stock option overhang is a measure of potential dilution from granted and approved stock option programs (calculated as options granted and outstanding, plus shares that remain to be granted, expressed as a percentage of total shares outstanding). The average stock option overhang increased one-half percentage point over the average of the same time last year - from 15.6 percent in 2001 to 16.1 percent in 2002 for companies with December 2002 year-ends.

       However, there is strong evidence of a decline in the growth rate of overhang during this same period. Between 1997 and 1999, overhang levels increased at an annual rate of 11.8 percent, while growth slowed to 7.9 percent between 1999 and 2002. Moreover, the earlier growth occurred as a result of larger option grants and more extensive programs covering more employees during a bull market. The current increase can be attributed to fewer options being exercised as they are increasingly out of the money (worth more than the current price of the stock), due to declining share prices without an offsetting decline in new share authorizations.

       There are substantial differences in overhang levels by industry (see Figure 2). Technology and health care firms have consistently exhibited higher overhang levels than other industries, while utilities have exhibited the lowest levels of overhang. This is consistent with economic theory, which predicts that stock-based incentive compensation is more important in industries with a high share of value derived from intellectual property.

       The study also found that firms with higher overhang levels have more options outstanding and higher run rates (a measure of shares granted annually to employees, which are calculated as options granted and expressed as a percentage of total shares outstanding).


    Continued in the article


    "Equity Compensation: The Future Is Now,"  by Blair N. Jones and Jesse Purewal, Financial Executive, March/April 2004 --- http://www.fei.org/mag/Exclusives/3-04.cfm

    In lieu of simply replacing stock options with the next 'big thing,' two consultants say companies have an opportunity to strategically rethink their approach to equity compensation.

    Although the spate of corporate scandals and accompanying backlash on stock options are seemingly starting to recede, changes resulting from these events are just now taking hold as the Financial Accounting Standards Board (FASB) moves ahead with issuing new rulings on stock option accounting.

    A number of high-profile companies as diverse as Microsoft Corp., Kraft Foods Inc., Progressive Casualty Insurance Co. and Amazon.com Inc. have replaced at least some stock option grants with restricted stock. Dilution caused by large stock option grants, the egregious behavior of a few executives who allowed short-term stock price to serve as the hallmark of success and tighter corporate governance requirements for shareholder votes (loss of the broker vote), have made new equity authorizations less of a sure thing.

    The implication of these events is that board compensation committees and management teams have had to start with a clean slate when designing long-term incentive strategies. But, therein lies an opportunity: Rather than simply basing changes and adjustments to equity plans on accounting considerations and stock performance, companies now have an chance to strategically rethink their approaches to equity compensation. Which begs the question: Are companies doing so in a thoughtful manner, or simply acting like lemmings by chasing the "next big thing" to replace stock options?

    Before answering that question, it is important to consider the changes companies have already begun making to their stock option and other equity incentive programs over the last two years. For the most part, companies have responded to the stock option backlash by making some changes to stock option programs, but not by eliminating stock options altogether. According to a September 2003 survey of 336 publicly traded U.S. companies, conducted by Sibson Consulting and WorldatWork, the prior 18 months had seen companies make changes to the size and mechanics of stock option grants, including vesting, terms and the timing and frequency of grants. These changes have occurred primarily in response to shareholder concerns, accounting scandals and internal concerns about the company's ability to attract, retain and motivate employees. This survey was a follow up to a similar Sibson/WorldatWork survey conducted in March 2002. A comparison of both surveys' findings provides insight into the direction these changes are taking.

    Fewer stock options for lower levels. Any discussion of changes to stock option accounting invariably raises concerns that reported earnings will suffer even if there is no change in company performance. Associated with this concern is the warning issued by some opponents of stock option expensing that an accounting change will cause companies to reduce or rescind stock option awards to lower-level employees, thereby hurting certain segments of the workforce more than others. So far, that warning is proving to be prescient. Changes to stock option plans are primarily affecting lower-level employees, according to the both the 2002 and 2003 surveys.

    Eligibility for stock options decline at lower levels. While eligibility remains largely unchanged for employees at the professional level and above, employees below that level saw eligibility decline. For example, two thirds of sales staff were eligible for stock options in 2002, but only half were eligible in 2003. Eligibility among nonexempt employees fell from 37 percent in 2002 to 27 percent in 2003. Additionally, the survey found that the value of stock option grants over the 18-month period of March 2002 to September 2003 decreased more for non-exempt employees than for any other group.

    Restricted stock on the rise. With stock options losing appeal, companies are looking for alternative equity-based incentive vehicles. Enter restricted stock. More companies use or plan to use restricted stock than any other vehicle to replace or supplement stock options. Approximately 60 percent of companies responding to the survey plan to grant restricted stock by September 2004, and more than 40 percent have already established restricted stock as a component of compensation for at least some employees. (See box at the end, "Restricted Stock: Caveat Emptor," for cautions about this trend.)

    Performance counts. Companies are taking steps to tie stock option eligibility more strongly to company performance and evidence of value creation. The survey found that 28 percent of companies now use group, unit or company performance to determine stock option eligibility, compared to 17 percent in the earlier survey.

    Stock option effectiveness still a question mark.

    Despite changes in programs, companies still struggle to achieve their key goals for stock option plans. A majority of respondents report that their plans are only moderately effective at helping to achieve key objectives such as attracting and retaining talent, focusing employee attention on corporate performance and aligning shareholder and employee interests. Even so, equity is still a compelling benefit to most employees. Sibson Consulting Group's 2003 "Rewards of Work" study, which focused on the attitudes of 1,108 workers about the "deal" between employer and employee, found that one fourth of workers who have not received stock options or grants in the prior 12 months would switch employers for just 40 shares of a $10 stock. Workers who had received stock options or grants in the prior 12 months were a little harder to entice but would still change employers in exchange for 100 shares of the same value.

    The future of incentives

    To avoid the lemming syndrome, companies need to clearly define design objectives for long-term incentive plans. Few companies can depend on a single incentive vehicle to address all objectives, and simple tweaks to existing stock option plans are likely to be insufficient. A complementary plan or plans that focus on intermediate drivers of shareholder value may be in order.

    If a new performance-based plan is to be introduced, financial executives will play a central role in identifying appropriate measures and goals for these plans. Performance measurement is at the heart of good long-term incentive design. Poorly chosen measures, at a minimum, can lead to a sub-optimal plan and, at worst, to significant unintended consequences. Well-chosen measures and goals can enhance organizational focus and lead to superior performance.

    Continued in the article


    In the table below, I present a series of messages between me and a friend who was trying to make a case for expensing stock options at intrinsic rather than full value (intrinsic plus time value).

    What if Employees Work for Free?

    The following series of message took place between me and a friend, Dr. X,  who was trying to make a case for expensing stock options at intrinsic value rather than full value along the lines advocated by Ira Kawaller at http://www.kawaller.com/pdf/AFP_jan04.pdf 

    Initially, I should probably note that FAS 133, IAS 39, CICA 13, and most other accounting standards require booking of both purchased and written options at full value and adjusting this value continuously for changes in both the intrinsic and the time value changes in option value over time.  The one major exception is employee stock options that are scoped out of those standards and covered elsewhere such as in FAS 123 that took the frustrating approach that firms may choose between either booking or not booking employee stock options provided current values are disclosed in a footnote.

    This has made reporting standards for employee stock options highly inconsistent with standards for accounting for all other options such as commodity options held for speculation or hedging purposes.  The FASB and the IASB are intending to soon set this straight by requiring that all options be carried at full value (intrinsic plus time value) at all times.  In the exchange of messages below, Dr. X tries to make a case for booking only at intrinsic value, which would then make accounting standards for employee stock options still inconsistent with standards for all other options.

    All these standards on options other than employee stock options conform to effectiveness tests for hedging under Paragraph 63 of FAS 133 that allows effectiveness testing based upon intrinsic, minimum, or full value when booking the full value of options used for hedging purposes.  The best place to begin after reading Paragraph 63 is Example 9 in FAS 133 beginning in Paragraph 162.  You can also download my 133ex09a.xls Excel workbook from http://www.cs.trinity.edu/~rjensen/ 

    You can read more about intrinsic value versus full value at http://www.trinity.edu/rjensen/caseans/IntrinsicValue.htm 
    When an option is first written (sold) or purchased, its value equal to the price of the option is usually all time value since there is not yet any intrinsic value at the initial stock price.  Intrinsic value is equal to the amount that the option is currently "in-the-money" due to a favorable difference between the option's strike (forward) price and the current spot price.  The bottom line of Kawaller's argument for intrinsic value booking of stock options is as follows:

    Of course, readers of financial statements shouldn’t be blind-sided about this expense — and they needn’t be. An easy to- implement remedy is to record changes in the intrinsic value of these options through earnings throughout the options’ lives. That way, as underlying stock prices appreciate, and exercise becomes a more likely prospect, expenses associated with the options will be transparently displayed.  http://www.kawaller.com/pdf/AFP_jan04.pdf 

    The series of messages that took place between me and Dr. X are shown below.  In the end, Dr. X phoned me and conceded that he had changed his conclusion in favor of my conclusion that it is far better to make all options accounting standards consistent with the present FAS 133 requirements to carry options at current full value (intrinsic plus time value) at all times.  

    I invite you to show me any flaws in my logic.


    Jensen Message 1

    Hi XXXXX,

    In return for your help, I have posted a working draft of the differences between FAS 133, IAS 39, and CICA 13 at http://www.trinity.edu/rjensen/caseans/canada.htm 

    You might find this somewhat useful. Please inform me of any errors.

    With respect to stock options, you argue for booking employee stock options at intrinsic value and not booking time value. This makes accounting for those options inconsistent with the FAS 133 requirement for booking speculations in commodity options (which must be booked at current full value).

    Are you also advocating modification of FAS 133 for commodity speculation options? And if so, why not argue the same for forward contract speculations?

    Bob Jensen


    XXXXX Reply 1

    I agree that booking employee stock options at intrinsic value is inconsistent with FAS 133 requirements for booking all other options at full value, but I think the change is worth it.

    I make a distinction between the value of the option to the employee and the cost to the company. For the former, the full value of the option is clearly what matters, and this value, of course, varies as time progresses and as the option moves in- and out-of-the money. On the other hand, I view the true cost to the company to be the intrinsic value at the point of exercise. Since this option is granted for free, the time value may be of theoretical relevance, but it has no bearing on cost born by the company. Why, then, should the company have to spend all kinds of time and money trying to value something that has no practical import?

    Forwards are different. If you use a forward, you’re gain or loss will always (as far as I can see) be a function of the changes in forward prices. Ignoring the forward premia or discounts would give wrong answers.

    Even so, I would like hedge accounting to be changed for options. But that’s another story…

    Thanks for your responses.

    XXXXX


    Jensen Message 2

    Hi Again XXXXX,

    I guess I’m still an old accrual-based bookkeeper. I think the accrual is what we account for irrespective of cash flows. When we book a speculative commodity option on Day 1, there is cash flow for 100% time value equal to the option’s price (premium). There’s generally no intrinsic value on Day 1. In the case of a stock option, there is no cash flow for a premium, but there is a “premium,” in theory, that is equal to the minimum time value on Day 1 that an employee is willing to take in lieu of cash wages. From an accrual standpoint there is little difference between accruing a premium versus paying it in cash. Of course the accrual may never have to be paid in cash, but a lot of accruals booked into the accounts never get paid in cash (e.g., portions of estimated warranties) due to the roll of the dice later on in time.

    And I don’t see a fundamental difference between forward contracts and options in terms of time value decay. Time value of option and forward contracts both decay to zero on the date of expiration. Payoff is computed in both types of contracts on the basis of intrinsic value. The only difference in theory is that purchased options, unlike written options, have a bounded loss and unlimited gain, whereas speculative forward contracts do not have bounds in either direction. Perhaps this is one of the reasons option values are more volatile and intrinsic value effectiveness tests are more popular with options. However, FAS 133 still requires that time value changes in both option and forward contracts be booked to full value (intrinsic plus time value) such that there is no difference in booking their values under FAS 133.

    Since one of the major controversies in FAS 133 is how difficult it is to get hedge accounting for the time value of options, perhaps we should advocate that options be accounted for differently (by not booking time value) than other derivatives that require booking of changes in time value. This would be consistent with your argument that employee stock options should not get booked for changes in time value.

    Most definitely, I do not buy into your acceptance of inconsistent accounting rules for commodity options held as speculations versus employee stock options issued as speculations. My argument is that we either book time value in both instances (which is what the FASB is going to require very soon) or we do not book time value for both types of options.

    As a compromise that runs counter to conservatism, we might book time value gains but not losses for purchased options since the losses are bounded by the initial premium.

    Employee stock options are really more like written options than purchased options from the company’s perspective. The employee’s losses are bounded by the initial time value, but the company’s potential losses are unbounded and equal to the unbounded possible gains to the employee. Of course enormous losses from stock options that go deep into the money are offset by the company’s joy that those enormous losses must be accompanied by a soaring price for the company’s shares.

    So maybe you should advocate that either stock options be accounted for like written options in FAS 133 or that written options in FAS 133 be accounted for like the intrinsic value booking that you advocate for employee stock options but not for commodity options. Judging from your written comments you prefer intrinsic value booking for employee stock options. Why can’t this also be the case for all written options in FAS 133?

    Bob Jensen


    XXXXX Reply 2

    Whew!

    One thing at a time...

    Do you agree with these two points?

    1. if company X issues an option and does not receive payment for it, over time the economic gain or loss to the company is equal to – Pend, where Pend is the value of the option at its termination.

    2. Pend will be zero if the option goes unexercised or it’s the intrinsic value if the option is exercised.

    If you agree with those two statements (and I think you must), you should see that time value doesn’t enter into the company’s gain or loss.

    To say that the company received payment in kind (i.e. labor services) doesn’t cut it. If an employee works without pay, do we record these services?

    XXXXX


    Jensen Message 3

    Hi Again XXXXX,

    Actually we do book the value of an employee’s donated services in many instances that would be consistent with booking time value changes in stock options under “b” shown below:

    Donated Services. FAS No. 116 establishes criteria for recognizing donated services. Services must be recognized as contributions if either of the following criteria is met:

    the services create or enhance nonfinancial assets (such as volunteers erecting a building), or the services require specialized skills, are provided by individuals possessing those skills, and would typically need to be purchased if not provided by donation. FAS No. 116 lists examples of services requiring specialized skills: accountants, architects, carpenters, doctors, electricians, lawyers, nurses, plumbers, teachers and other professionals and craftsmen.

    However, employees who are paid in stock options really are not donating free services. They are simply willing to accept the time value of an option in lieu of what they would otherwise demand in a cash wage.

    Bob Jensen


    XXXXX Reply 3

    When you book those donated services, are they booked as an expense? What are the debits and credits?

    XXXXX


    Jensen Message 4

    Hi Again XXXXX,

    Debit Wages Expense and then allocate like we do any wages to  such things as  Patents, Buildings, Inventory) or a liability if the donation is a forgiveness of debt.

    Credit Contribution Revenue (or for major asset donations or debt forgiveness, the credit may go to donated capital that is essentially like paid-in capital)

    In the case of employee stock options that become worthless, the credit should go to Paid-in Capital or something equivalent.  In theory, I would prefer crediting revenue for expired employee stock options since this is really equivalent to gambling revenue.

    The asset such as a building or inventory is then expensed as usual over time or all in one year if the value expires within the year. Most donated services are things like pro bono services of lawyers or doctors. There is a complex problem if the services are in anticipation of future paid services such as when a lawyer provides free legal work or a systems analyst works for free in anticipation of future paid services. FAS 116 requires that the services be entirely pro bono. Volunteer work from non-skilled workers like teenage volunteers on a clean up site are not scoped into FAS 116.

    Actually, if an employee accepted stock options that have no time value whatsoever, I would argue that this would really be a donated service. Booking the fair value of such services rendered under FAS 116 would lead to better accounting since strange things might happen without booking the value of those “donated” services. For example, widgets costing $1,000 per widget across 51 weeks when the employees are paid $100 per hour may appear to cost only $200 in Week 52 when each employee agreed to accept totally worthless stock options for 40 hours of labor in some religious celebration or catastrophic event. Accepting totally worthless stock options is equivalent to donating services.

    However, virtually all employees who accept stock options in lieu of a portion of cash wages are not receiving worthless options. These options have time value that is in theory equal to the amount of reduced cash wages. Hence, these options are not donations of service.

    Interestingly enough, under the present FAS 116 and FAS 123, the fair value of services rendered for worthless options might be booked to into widgets, whereas services rendered for valuable stock options are not booked into the widgets inventory. Inventory becomes understated if something of value is given versus correctly valued of something worthless is given for skilled and valuable donated services.

    Something is wrong in not booking time value of stock options even if there is a chance that the options will never be exercised. We also book anticipated warranty expenses even though there is a chance that the accrued expenses are overstated. Conservatism in auditing suggests that it is far better to overstate than understate expense accruals. Somehow this got lost in the shuffle when it came to stock options.

    Bob Jensen


    XXXXX Reply 4 (by phone conversation)

    I never views this from the perspective of donated services and had no idea that most donated services were booked as revenue.

    From this perspective, booking employee stock options at full value rather than intrinsic value makes more sense and is consistent with the standards of accounting for other types of options.

    I no no longer buy into Ira Kawaller's arguments at http://www.kawaller.com/pdf/AFP_jan04.pdf 


    You can read more about intrinsic value versus full value at http://www.trinity.edu/rjensen/caseans/IntrinsicValue.htm 

    The entire mess of accounting for derivative financial instruments is covered at http://www.trinity.edu/rjensen/caseans/000index.htm

     

     

    October 31, 2003 Update News
    FASB agrees to propose expensing stock options At its meeting yesterday (October 29, 2003), the US Financial Accounting Standards Board agreed to expose, for public comment, a standard that would require companies to expense the fair value of stock options granted to employees. The proposal would likely be issued in February 2004 and, if adopted, would take effect in 2005. The IASB published a similar proposal last year (Exposure Draft ED 2) and is expected to issue a final standard during the first quarter of 2004, also effective in 2005. Currently, companies in the United States are permitted, but not required, to recognise stock options as part of employee compensation cost. Several hundred listed companies (out of about 15,000) recognise the expense. Even if they elect not to charge the cost to expense, companies must disclose the fair values of options granted. Current IFRS require neither expensing nor disclosure of the fair values of share-based compensation. Both the FASB and IASB proposals would apply to all companies, not just publicly traded ones.
    Paul Pacter, IAS Plus, October 30, 2003 --- http://www.iasplus.com/index.htm 

    Bob Jensen's threads on stock option accounting are shown below.

     

     

     

     

     

    April 1, 2002

    Senator Charles E. Schumer
    United States Senate

    Washington, DC  20510

     

    Dear Senator Schumer:

     

    The disagreement between President Bush and Alan Greenspan regarding accounting for employee stock options (ESOs) is noted in Appendix C of this letter.

     

    On March 25, 2002, Walter P. Schuetze, former Chief Accountant of the Securities and Exchange Commission, wrote you a letter that leaves no doubt that he opposes booking of employee stock options when they are granted.  That letter is now on the Web at http://www.trinity.edu/rjensen/theory/sfas123/schuetze01.htm

     

    I am writing this response in order to point out some opposing arguments.  My response is on the Web at http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm

     

    Mr. Schuetze is a friend, and my arguments below are academic.  Nothing personal in any way is intended. 

     

    Since 1964, Walter Schuetze has been an advocate of exit value (liquidation) accounting in which all marketable assets are booked at what they would sell for if liquidated at auctions.  Because Walter is advocating an accounting model that has never caught on for going concerns in the U.S. (inspite of a few expensive and ill-fated experiments such as in a Rouse Company and Days Inn annual reports decades ago.)  In the U.S., however, exit value accounting is required for firms classified as non-going concerns and for personal financial statements. 

     

    One of the long-time advocates of exit value accounting was Australia’s Ray Chambers --- http://fisher.osu.edu/acctmis/hof/chambers.html .  Probably the best-known book in this area is The Theory and Measurement of Business Income by Edgar O. Edwards and Philip W. Bell (University of California Press, 1964). 

     

    You can read the following criticism of proposed exit value accounting at http://www.trinity.edu/rjensen/theory/00overview/theory01.htm

     

    Exit value reporting is not deemed desirable or practical for going concern businesses for a number of reasons that I will not go into in great depth here.  Disadvantages of Exit Value (Liquidation, Fair Value) Accounting

    1.      Operating assets are bought to use rather than sell.  For example, as long as no consideration is being given to selling or abandoning a manufacturing plant, recording the fluctuating values of the land and buildings creates a misleading fluctuation in earnings and balance sheet volatility.  Who cares if the value of the land went up by $1 million in 1994 and down by $2 million in 1998 if the plant that sits on the land has been in operation for 60 years and no consideration is being given to leaving this plant?

    2.      Some assets like software, knowledge databases, and Web servers for e-Commerce cost millions of dollars to develop for the benefit of future revenue growth and future expense savings.  These assets may have immense value if the entire firm is sold, but they may have no market as unbundled assets.  In fact it may be impossible to unbundle such assets from the firm as a whole.  Examples include the Enterprise Planning Model SAP system in firms such as Union Carbide.  These systems costing millions of dollars have no exit value in the context of exit value accounting even though they are designed to benefit the companies for many years into the future.

    3.      Exit value accounting records anticipated profits well in advance of transactions.  For example, a large home building company with 200 completed houses in inventory would record the profits of these homes long before the company even had any buyers for those homes.  Even though exit value accounting is billed as a conservative approach, there are instances where it is far from conservative.

    4.      The value of a subsystem of items differs from the sum of the value of its parts.  Investors may be lulled into thinking that the sum of all subsystem net assets valued at liquidation prices is the value of the system of these net assets.  Values may differ depending upon how the subsystems are diced and sliced in a sale.

    5.      Appraisals of exit values are both to expensive to obtain for each accounting report date and are highly subjective and subject to enormous variations of opinion.  The U.S. Savings and Loan scandals of the 1980s demonstrated how reliance upon appraisals is an invitation for massive frauds.  Experiments by some, mostly real estate companies, to use exit value-based accounting died on the vine, including well-known attempts decades ago by TRC, Rouse, and Days Inn.

    6.      Exit values are affected by how something is sold.  If quick cash is needed, the best price may only be half of what the price can be by waiting for the right time and the right buyer.

    7.      Financial securities that for one reason or another are deemed as to be "held-to-maturity" items may cause misleading increases and decreases in reported values that will never be realized.   A good example is the market value of a fixed-rate bond that may go up and down with interest rates but will always pay its face value at maturity no matter what happens to interest rates.

    8.      Exit value markets are often thin and inefficient markets.

    Instead of criticizing exit value accounting, what I would like to do is mainly criticize stock option accounting under the present FAS 123 standard.  However, in the Appendix A to this letter, I will also criticize stock option accounting under the exit value model proposed by Walter Schuetze.

     

    Actually, the Financial Accounting Standards Board (FASB) fought long and hard for a tougher standard that required booking of stock options.  Ultimately, power centers from industry and the U.S. Congress forced the FASB to weaken FAS 123.  So here is what is wrong with the present accounting rule.

     

    1.      Asymmetry
    How can employees receive something of great value from a company that reports that no value has been sacrificed?

    Employees are willing to take reduced cash earnings in order to receive vested options.  My best example is a recent Stanford University graduate in computer science who went to work for almost nothing in lieu of receiving a signing bonus of stock options valued at nearly $1 million.  Stock options do have value.  Employees will make enormous cash wage sacrifices in order to obtain these options, and analysts have good ways of valuing these options.  But companies make no sacrifices in the financial statements for real sacrifices being made when stock options are granted.  Walter argues that the sacrifices are being made by shareholders rather than corporations, but in many instances the companies have an intent to buy treasury stock to make good on stock option obligations.

    2.      Inconsistency
    Under FAS 133 and 138, most other types of options must be booked and maintained at fair value.  For example, if Company Tech uses market options to hedge profit on a short sale of $100 million of inventory not yet on hand, the purchased options must be booked and adjusted at least every 90 days.  Suppose that the options lock in a profit of at least $25 million.  

    Company Tech could have instead locked in a profit by building the inventory such that the short sale is covered.  If employee stock options were used to compensate employees building the inventory, the employee options probably won’t be booked whereas the market options must be booked.  Even though market options or employee options can be used for the same purpose to lock in the profit, the hedge accounting differs like night versus day if the hedges are from employee s options rather than market-purchased options.

    Cash labor expenses of employees building inventories are booked as inventory assets and expensed when those inventories are sold.  Failure to book stock option value that employees accept in lieu of cash wages can lead to tremendous distortions in financial statements.  Inconsistencies between comparisons of otherwise similar firms arise if one firm (Company Cash) pays all cash wages versus the other firm (Company Option) that pays minimal cash wages and makes up the difference in stock options.  I illustrate this in the Appendix A to this letter.

    Identical inventory may end up being booked in Company Cash for millions of dollars more than in Company Option.  For example, Company Cash might book its DVD player for $100 per unit, and Company Option might book its DVD player for $50 even though the DVD players are virtually identical in features.  Differences in the financial statements between these two companies arise from the inconsistent way cash wages versus option wages are booked. 

    Suppose this example is taken to an extreme where an Oregon division of a company builds Model 468 DVD player for cash wages and a California division builds Model 468 DVD player for stock options.  We then have a situation where the Model 468 DVD players might be carried at vastly different inventory values even if the players are all shipped to the same warehouse in Nevada.

    3.      Misleading Asset, Earnings, and Equity Balances (Especially Cash)
    Suppose Company Cash and Company Option also sell warranty services on products.  Solid companies like Company Cash will usually pay cash salaries and wages to employees who actually perform the work under the warranty contracts.  Cash-deficient firms (such as dot.com and other technology companies) typically will induce employees to work for minimal cash wages and accept stock options to save on cash outflow at the time. 

    Assume Company Option is such a cash-deficient firm.  When employee stock options are not booked, it is possible to construct scenarios in which Company Option has vastly superior-looking financial statements than Company Cash even though the stockholders in Company Option are really in far worse shape.  Once again I refer you to the Appendix A of this letter.

    4.      FAS 123 May Render It Impossible to Compare Investment Alternatives
    Under FAS 123, companies have a choice as to whether to book employee stock options or not to book employee stock options.  For example, Boeing is a huge company with lots of employee stock options that are booked and expensed when the options are granted.  Although this is exemplary accounting in my viewpoint, Boeing takes a hit with lower reported earnings per share and ROI when investors compare Boeing with the majority of other companies worldwide that do not book and expense stock options when they are granted.

    5.      Organization Costs and Outside Service Costs
    If a company issues stock to outside accountants and lawyers for services in forming a corporation, the company is required to estimate the value of those services and debit the value as an asset called Organization Costs and Credit Common Stock and Paid-in Capital.  If the company instead issues stock options to outsiders in lieu of common stock, the option value must be is booked with the debit going to Organization Costs and a credit going to Options.  The main difference in the accounting is that FAS 133 requires that the Options account must subsequently be carried at fair value whereas actual stock is not adjusted for fair value subsequent to the transaction date.

    If a company issues stock to inside (employee) accountants and lawyers for services, the company is required to estimate the value of those services and debit the value as an asset called Organization Costs and Credit Common Stock and Paid-in Capital.  However, if options are given instead of actual shares of stock, the accounting differs greatly depending upon whether the recipients are outsiders versus employees.  Employee stock options do not have to be booked, whereas outsider stock options must be booked at estimated values. 

    The same inconsistency applies to services purchased with options subsequent to a firm’s initial organization.  If option must be valued for accounting purposes for expensing of outside services, why is this not the case for inside services?

    I would contend that the main reason companies, especially cash-deficient companies, fought so hard when the Financial Accounting Standards Board (FASB) proposed booking of stock options has nothing to do with accounting theory.  It has everything to do with dressing up the income statements and balance sheets. 

     

    In an Appendix A to this paper, I will provide a rather extreme illustration of why companies, especially Silicon Valley companies, ran to lobbyists when the FASB proposed booking of employee stock options in a similar manner to the booking of stock options issued for goods and services received from non-employees.

     

    Very truly yours,

        Bob

    Robert E. Jensen


     

    APPENDIX: A
    The Nobel Cash Versus Nobel OptionCase

     

    After earning a Nobel Prize in Medicine, Kent Nobel formed two companies by issuing 10,000 shares of stock for each corporation in exchange for his personal cash savings.  One company is called Nobel Cash and the other is called Nobel Option.  Aside from the initial cash expenditure and the customer attraction of his name, Kent Nobel turned the entire operation entirely over to employees. 

     

    Each company had only one highly skilled employee.  The Nobel Cash employee agreed to cash wages, whereas Nobel the Nobel Option employee received an option to purchase 15,000 shares of stock.  At the end of five years, she was entitled to exercise her option by paying out $10 for a share of stock having a par value of $1 per share.  Actual value of the option depended upon the performance of her company and its outlook for the future that is extrapolated, in part, from past performance.

     

    Both companies earned $2 for every $1 spent and had exactly the same revenue performance.  To simplify the illustration, it will be assumed that no return was possible on any idle cash.

     

    Accounting outcomes are shown in the ledger accounts below:

     

     Accounting Under Both FASB and
    Walter Schuetze’s Accounting Models

    Schuetze and FASB’s  FAS 123 Accounting

    Schuetze and FASB’s  FAS 123 Accounting

    Cash at the beginning of Year 1

    $10,000  

    $10,000  


    Year 1
    Revenue
    Labor Expense
    Net Profit
    Cash
    Capital
    Retained Earnings
    Earnings Per Share

    Nobel Cash
    Year 1

    $20,000
    $10,000
    $10,000
    $20,000
    $10,000
    $10,000
    $1

    Nobel Option
    Year 1

    $20,000
    $00,000
    $20,000
    $30,000
    $10,000
    $20,000
    $2


    Year 2

    Revenue
    Labor Expense
    Net Profit
    Cash
    Capital
    Retained Earnings
    Earnings Per Share

    Nobel Cash
    Year 2

    $40,000
    $20,000
    $20,000
    $40,000
    $10,000
    $30,000
    $2

    Nobel Option
    Year 2

    $40,000
    $00,000
    $40,000
    $70,000
    $10,000
    $60,000
    $4


    Year 3

    Revenue
    Labor Expense
    Net Profit
    Cash
    Capital
    Retained Earnings
    Earnings Per Share

    Nobel Cash
    Year 3

    $80,000
    $40,000
    $40,000
    $80,000
    $10,000
    $70,000
    $4

    Nobel Option
    Year 3

    $80,000
    $00,000
    $80,000
    $150,000
    $10,000
    $140,000
    $8


    Year 4

    Revenue
    Labor Expense
    Net Profit
    Cash
    Capital
    Retained Earnings
    Earnings Per Share

    Nobel Cash
    Year 4

    $160,000
    $80,000
    $80,000
    $160,000
    $10,000
    $150,000
    $8

    Nobel Option
    Year 4

    $160,000
    $000,000
    $160,000
    $310,000
    $10,000
    $300,000
    $16


    Year 5 Before Options are Exercised

    Revenue
    Labor Expense
    Net Profit
    Cash
    Capital
    Retained Earnings
    Earnings Per Share

    Nobel Cash
    Year 5 Before

    $320,000
    $160,000
    $160,000
    $320,000
    $10,000
    $310,000
    $16

    Nobel Option
    Year 5 Before

    $320,000
    $000,000
    $320,000
    $630,000
    $10,000
    $620,000
    $32


    Year 5 After Options are Exercised

    Cash
    Capital
    Retained Earnings

    Nobel Cash
    Year 5 After

    $320,000
    $10,000
    $310,000

    Nobel Option
    Year 5 After

    $780,000
    $160,000
    $620,000

    Year 5 Liquidation Distribution of Cash
    Kent Nobel
    Employees

    Nobel Cash
    $320,000
    $0

    Nobel Option
    $312,000
    $468,000

    Cash Flow Summary for Life of Company
    Kent Nobel
    Employees

    Nobel Cash
    $320,000
    $310,000

    Nobel Option
    $312,000
    $468,000

     

    Note that the Nobel Cash and Nobel Option accounting outcomes illustrated above would be generated out of either the current FASB rules or the exit value model proposed by Walter Schuetze.  Both models are identical for a company that has only cash as an asset and no liabilities.

     

    Over the five year period, the reported performance of the Nobel Option company was much better than the other company with earnings per share reported twice as high every year on the exactly the same revenue as the other company.  After five years of operations, Nobel Option had a cash balance of $630,000 compared with only $320,000 for the company that had to pay higher cash wages every year.

     

    If both companies had gone public with an IPO, chances are high that the Nobel Option company would have been much more successful in terms of the prices received for each share sold to the public.  But when the companies liquidated after five years, the original shareholder, Kent Nobel, actually obtained less ($312,000) from the Nobel Option company than the $320,000 he received from Nobel Cash.  He also lost voting control of the Nobel Option company while retaining control of the Nobel Cash company.

     

    The above table illustrates why Silicon Valley companies fought so hard against the FASB proposal to book employee stock options.  Technology companies, especially software companies, are typically labor intensive.  By recording virtually no expense for employee stock options over the years, options-heavy companies reported higher earnings per share than companies that relied more on cash wages and less upon stock options.  High option users also look better than companies like Boeing that book employee stock options even when not required to do so by FAS 123.

     

    If the companies did not liquidate after five years, the value to employees could be much higher than the $468,000 liquidation value.  One major reason is the fact that intangibles are not booked, and the revenue growth suggests that there are some unbooked intangibles allowing the companies to double reported revenue every year.  Value could also be less for a variety of reasons, including off-balance sheet financing and diminished optimism for future performance that is not yet reflected in the financial statements.

     

     

    Conclusion

     

    My bottom line conclusion is that failing to book (expense) employee stock options, in traditional or exit value accounting models, creates highly misleading financial reports that inflate earnings per share, retained earnings, and even cash and other assets.  It is also possible to use the cash saved in wages to reduce debt, further improving the attractiveness of the a company that has, in effect, hidden “debt” in deferred employee compensation locked up on stock option plans. 

     

    Walter Schuetze argues that employee stock options are shareholder liabilities rather than the liabilities of the firm.  I agree that employee option holders are not creditors, but they are out there silently gobbling up larger and larger shares of equity in their companies.  The FASB fought long and hard for a tougher standard than FAS 123, but accounting firms like Arthur Andersen fought vigorously to derail the FASB’s attempts to require firms to book stock options when they are granted.  Under either current FASB 123 or exit value accounting, investors are misled by stock option accounting that does not book and expense such options on the grant date.

     

     

    My summary for how the Arthur Andersen fought against the FASB is summarized in the following reference:

     



        
    Bob Jensen's Commentary on the Above Messages From the CEO of Andersen
          http://www.trinity.edu/rjensen/fraud.htm#Blame

     
        
    (The Most Difficult Message That I Have Perhaps Ever Written!)


    APPENDIX: B
    Exit Value Accounting With a Software Account

    Appendix B extends the Appendix A illustration to a situation where half the labor time is devoted to generating revenues and half the labor time is devoted to generating a software asset that has unrealized value appreciation due to labor added each year.  It is assumed that the software qualifies for capitalization under FAS 86.  Nobel Cash Company capitalizes the software at 50% of each years total cash payroll.  Half the labor costs are thereby capitalized and the other half are expensed.

    Half the labor time in the Nobel Option Company is also devoted to software development.  This leads to software value appreciation. 

    The Nobel Cash Company uses historical cost accounting.  The Nobel Option Company uses exit value accounting as envisioned by Walter Schuetze.

       

          

    APPENDIX B

    Historical Cost Accounting

    Schuetze Exit Value Accounting

    Year 1

    Nobel Cash Company

    Nobel Option Company

    Revenue

    $20,000

    $20,000

    Software Value Appreciation

    $0

    $6,000

    Labor Expense

    $5,000

    $0

    Net profit

    $15,000

    $26,000

    Cash

    $20,000

    $30,000

    Software

    $5,000

    $6,000

    Capital

    ($10,000)

    ($10,000)

    Retained Earnings

    $15,000

    $26,000

    Number of Shares Outstanding =

    10,000

    $10,000

    Earnings Per Share =

    $1.50

    $2.60

     

     

     

    Year 2

    Nobel Cash Company

    Nobel Option Company

    Revenue

    $40,000

    $40,000

    Software Value Appreciation

    $0

    $12,000

    Labor Expense

    $10,000

    $0

    Net profit

    $30,000

    $52,000

    Cash

    $40,000

    $70,000

    Software

    $15,000

    $18,000

    Capital

    ($10,000)

    ($10,000)

    Retained Earnings

    $45,000

    $78,000

    Earnings Per Share =

    $3.00

    $5.20

     

     

     

    Year 3

    Nobel Cash Company

    Nobel Option Company

    Revenue

    $80,000

    $80,000

    Software Value Appreciation

    $0

    $54,000

    Labor Expense

    $20,000

    $0

    Net profit

    $60,000

    $134,000

    Cash

    $70,000

    $132,000

    Software

    $60,000

    $72,000

    Capital

    ($10,000)

    ($10,000)

    Retained Earnings

    $120,000

    $194,000

    Earnings Per Share =

    $6.00

    $13.40

     

     

     

    Year 4

    Nobel Cash Company

    Nobel Option Company

    Revenue

    $160,000

    $160,000

    Software Value Appreciation

    $0

    $60,000

    Labor Expense

    $40,000

    $0

    Net profit

    $120,000

    $220,000

    Cash

    $140,000

    $294,000

    Software

    $110,000

    $132,000

    Capital

    ($10,000)

    ($10,000)

    Retained Earnings

    $240,000

    $416,000

    Earnings Per Share =

    $12.00

    $22.00

     

     

     

    Year 5 Before Options Are Exercised

    Nobel Cash Company

    Nobel Option Company

    Revenue

    $320,000

    $320,000

    Software Value Appreciation

    $0

    $132,000

    Labor Expense

    $80,000

    $0

    Net profit

    $240,000

    $452,000

    Cash

    $280,000

    $540,000

    Software

    $220,000

    $264,000

    Capital

    ($10,000)

    ($10,000)

    Retained Earnings

    $490,000

    $794,000

    Book Value Per Share =

    $50.00

    $95.40

    Earnings Per Share =

    $24.00

    $45.20

     

     

     

    Year 5 After Options Are Exercised

    Nobel Cash Company

    Nobel Option Company

    Cash

    $280,000

    $690,000

    Software

    $220,000

    $264,000

    Capital

    ($10,000)

    ($160,000)

    Retained Earnings

    ($490,000)

    ($794,000)

    Book Value Per Share =

    $50.00

    $38.16

    Earnings Per Share =

    $24.00

    $18.08

    I think the main argument against APB 45 accounting in which continues to allow firms not to book ESOs can be found in the following paragraph from FAS 123:

    85. Some people told the Board that a requirement to recognize compensation cost might bring additional discipline to the use of employee stock options. Unless and until the stock price rises sufficiently to result in a dilutive effect on earnings per share, the current accounting for most fixed stock options treats them as though they were a "free good." Stock options have value--employee stock options are granted as consideration for services and thus are not free.

    The above outcomes dramatize how misleading it can be to not book stock options in order to make software assets appear to be “free goods” generated without labor expense.  In Year 5, the Nobel Option Company financial results far surpass the Nobel Cash Company until the ESOs are exercised.  After the ESOs are exercised, the Nobel Option Company’s performance indicates that the ESOs were not such a good deal on a fully-diluted per share basis.

    It can be argued that investors should be able to see through accounting alternatives if there is “full disclosure.”  In FAS 123, the FASB has the following to say about full disclosure.

    Disclosure Is Not a Substitute for Recognition

    102. FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, says:

    Since recognition means depiction of an item in both words and numbers, with the amount included in the totals of the financial statements, disclosure by other means is not recognition. Disclosure of information about the items in financial statements and their measures that may be provided by notes or parenthetically on the face of financial statements, by supplementary information, or by other means of financial reporting is not a substitute for recognition in financial statements for items that meet recognition criteria. [paragraph 9]


    APPENDIX: C
    The Sad State of Tax Accounting for ESOs

    This topic is much too technical for this letter.  However, I gave an examination devoted, in part, to the sad state of tax accounting for ESOs.  The link to this examination (with suggested answers) can be found in the file called Exam02VersionATeachingNotes.htm file at http://www.cs.trinity.edu/~rjensen/Exams/5341sp02/exam02/


     

    APPENDIX:D
    The Disagreement Between President Bush and Alan Greenspan Regarding Accounting for ESOs

    From The Wall Street Journal Accounting Educators' Review on April 13, 2002

    TITLE: Bush Supports Businesses in Debates Over Changing Options Accounting
    REPORTER: Michael Schroeder
    DATE: Apr 10, 2002
    PAGE: A2
    LINK: http://online.wsj.com/article_print/0,4287,SB1018390978662248640,00.html 
    TOPICS: Accounting

    SUMMARY: The proper accounting treatment for stock options is receiving attention again. President Bush is in favor of the current accounting for stock options; however, Federal Reserve Chairman Alan Greenspan is supportive of including stock options as an expense on the income statement.

    QUESTIONS:

    1.) What are stock options? What is an expense? Should stock options granted to executives in exchange for services provided by the executive be included as an expense on the income statement? Support your answer.

    2.) How are stock options currently reported in the financial statements? Why do businesses oppose having stock options reported in the income statement? Should financial statement users care where stock options are reported in the financial statement? Support your answer.

    3.) The Financial Accounting Standards Board was in favor of including stock options as an expense on the income statement. However, as reported in the article, the FASB was assaulted with "dazzling ferocity." Discuss the nature of the opposition to the FASB stock option proposal.

    4.) Recent proposals have suggested that accounting standard setting be removed from the private sector and placed in the public sector. In light of the lobbying efforts resulting from Greenspan's view on accounting from stock options, should accounting standard setting be placed in the public sector? Support your answer.

    Reviewed By: Kimberly Dunn, Florida Atlantic University

    From The Wall Street Journal Weekly Accounting Review on March 4, 2005

    TITLE: Executives Find Restricted Stock Pays Dividends from the Get-Go 
    REPORTER: Phyllis Plitch 
    DATE: Feb 28, 2005 
    PAGE: C3 
    LINK: http://online.wsj.com/article/0,,SB110955473657465520,00.html  
    TOPICS: Compensation, Disclosure Requirements, Dividends, Financial Accounting, Accounting

    SUMMARY: While "restricted stock generally requires continued employment...[and] employees don't have ownership rights on the shares until several years after they are awarded...executives are getting paid dividends on their restricted stock before it has vested." Disclosures of executive compensation often exclude these dividend payments.

    QUESTIONS: 
    1.) What is restricted stock? Why is restricted stock used as a form of executive compensation?

    2.) What does the author say companies indicate as reasons for paying dividends on restricted stock?

    3.) How is it possible that executives may receive dividends on stocks they never end up owning?

    4.) Paul Hodgson, a researcher in executive compensation, estimates that some companies reinvest the dividends for executives holding restricted stock. How does this alleviate the concerns raised in this article?

    5.) Prepare summary journal entries, without dollar amounts, made by companies that award dividends on restricted stock and then require the dividends to be reinvested.

    6.) Compare the results of the transactions described in question 6 to the results of a stock dividend, explaining both similarities and differences. Do you think that these two transactions are perceived differently by stockholders?

    7.) As stated in the article, ""Dividends are additional compensation and should be disclosed as exactly that.'" Are dividends on restricted stock paid to executives included in compensation expense in the income statement? Support your answer.

    8.) What disclosures are required regarding dividend payments? How can analysts and investors "crunch the numbers" using these disclosures to determine dividends received by executives on restricted stock if disclosure of that amount is not made under compensation disclosures?

    Reviewed By: Judy Beckman, University of Rhode Island

    "Executives Find Restricted Stock Pays Dividends From the Get-Go," by Phyllis Plitch, The Wall Street Journal, February 28, 2005, Page C3 --- http://online.wsj.com/article/0,,SB110955473657465520,00.html

    Here's a deal any investor would love: You receive dividends on stock you may never own.

    Sound far-fetched? That is exactly what is happening for many executives reaping dividend payments on restricted stock, a popular form of compensation.

    Restricted stock generally requires continued employment, and most forms are so-called time-vested shares, meaning the employees don't have ownership rights on the shares until several years after they are awarded. But in many cases executives are getting paid dividends on their restricted stock before it has vested.

    What critics find vexing is that investors can find this information only in the footnotes of securities filings. Even then, they have to numbers-crunch to figure out how much executives are getting from the arrangement, which can amount to hundreds of thousands of dollars.

    Take Altria Group Inc. Chairman and Chief Executive Louis C. Camilleri. The tobacco company last year raised its quarterly dividend to 73 cents from 68 cents. Mr. Camilleri, in turn, earned more than $1.5 million in dividends on 450,000 unvested restricted shares held at the end of 2003 and an additional 125,000-share tranche granted in January 2004. The company declined to comment.

    In footnoting the explanation that dividends are paid on unvested shares -- and not breaking out the exact dollar amount -- companies say they are adhering to disclosure rules, because nothing more is explicitly required. But questions about dividend disclosures are coming to the surface as the Securities and Exchange Commission considers requiring companies to be more open about compensation.

    Alan Beller, who heads the SEC's division of corporation finance, recently issued a stark warning to companies that even current rules require them to include in proxies all compensation for the highest-paid executives.

    "Restricted shares are pure compensation," says Paul Hodgson, senior research associate in executive and board compensation at the Corporate Library, a corporate-governance research firm that often takes a hard line on compensation. "Dividends are additional compensation and should be disclosed as exactly that."

    Companies paying the dividend generally declined to comment on the rationale behind the practice. Several stressed that executives have to pay taxes on the dividends at their ordinary tax rate. But because an executive could leave before these shares vest, "it's better to defer the dividends until vesting," says Ira Kay, national director of compensation consulting at Watson Wyatt Worldwide.

    Mr. Hodgson estimates that 90% of U.S. publicly traded companies award dividends on restricted stock, with 85% of those awarding the payments at the time the regular dividend is paid and the remaining 15% reinvesting the dividends.