The two major accounting standards bodies seem intent on rushing to judgment about expensing stock options without thoughtful consideration of alternatives and, most importantly, an accurate valuation model. It’s time for Congress and the Securities & Exchange Commission to step in to make sure these efforts don’t stunt entrepreneurship, which drives economic growth.
On Nov. 7, 2002, the International Accounting Standards Board (IASB) issued ED2, Accounting for Share-Based Payments, a proposal which requires stock options to be expensed using fair value at grant date. Later that month the U.S.-based Financial Accounting Standards Board (FASB) issued an invitation to comment on the differences between ED2 and the current U.S. accounting standard, FAS 123. As we all know, FAS 123 prefers that companies’ expense of stock options be based on fair value but only requires that the fair value be disclosed in the footnotes of the financial statement.
At the March 12 FASB board meeting the board cursorily reviewed the 293 comment letters and decided to add a project on stock-based compensation to its agenda.
On April 21, FASB’s board unanimously agreed that stock options are an expense that should be recognized accordingly in financial statements; the economic event being measured occurs at grant date; and the “measurement basis” should be “fair value.”
It’s tough to know where to begin the critique.
First, no method exists to value employee stock options accurately and reliably. How tragic it will be if, at precisely the time we must be going the extra mile to restore investor confidence, FASB adopts a standard that will inject materially inaccurate numbers into company financial statements. As venture capitalists investing in private companies, we know that stock options in private companies have no value at the time of grant because realization of value depends on future events. At the time of issue the stock options are rights to purchase common stock, junior to the preferred stock purchased by VCs. Unless the company performs according to aggressive (and by definition speculative) forecasts, the common stock is typically worthless. Intel’s CEO has recently written in detail about the difficulty of valuing such options in public companies as well.
Second, the process undertaken by FASB is fundamentally flawed. These results appear to be pre-ordained; the rulemaking process has been put on a fast track without explanation; and the board shows little interest in considering dissenting viewpoints.
Third, there is no consensus whatsoever that employee stock options are even an expense. Accounting and financial experts disagree on this core point-one on which the FASB expressly did not seek comment.
It is, therefore, essential that the SEC and U.S. Congress exercise appropriate oversight over FASB and, importantly, control over the public policy implications of an ill-advised change in accounting rules. Reps. David Dreier (R-Calif.) and Anna Eshoo (D-Calif.) and Sens. John Ensign (R-Nev.) and Barbara Boxer (D-Calif.) have introduced bills to do just that. Unlike mandatory expensing, these bills would ensure that shareholders and potential investors have accurate and meaningful financial information while companies can continue to grant stock options.
Specifically, the bills mandate that within 180 days the SEC shall require a company’s quarterly filings to include (1) a plain English discussion of the dilutive effect of stock option plans; (2) expanded disclosure of the dilutive effect of options on the company’s earnings per share; (3) prominent placement and increased comparability of all stock option related information; and (4) a summary of the stock options granted to the five most highly compensated executive officers.
Further, the bills state that the SEC shall examine the effectiveness of the new disclosures in increasing transparency to current and potential investors for a three-year period, during which the SEC shall not recognize any new accounting standards related to the treatment of stock options. Finally, the bills direct the Secretary of Commerce to conduct a comprehensive study and analysis of broad-based employee stock option plans.
Congress and the SEC must examine the critical roles they play in creating an effective environment for entrepreneurship and economic growth while ensuring that investors have the information they need.
Craig A.T. Jones is the managing partner, president and co-founder of Ticonderoga Capital. He has more than 19 years of industry experience. He sits on the board of the NVCA and is co-chairman of its Government Affairs Committee.