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After reading your September article regarding the Sarbanes-Oxley Act of 2002 (“Sticker Shock“), my only comment is: what an incredible bunch of whiners. Somebody needs to remind these financial executives that this is what they should have been doing all along.
I would be curious to know where these individuals got their accounting degrees. When I was in school (35 years ago), Accounting 101 emphasized the role of the accountant in ensuring the integrity of the numbers we presented so management and stockholders could understand the cost of doing business and make appropriate, informed decisions. Along came the Foreign Corrupt Practices Act and its requirement to ensure that internal controls were strong through internal audit.
The reason that these financial executives are now whining and wringing their hands is that for the past 20 years they and their external auditors have not exercised their fundamental responsibility of ensuring that internal controls were in place at their companies and working properly. Frankly, I would be surprised if any current-day CFO understood their own companies’ numbers sufficiently enough to discuss them in any detail. Ask one of them to explain their accounting approach to “lower of cost or market” in inventory valuation at a local subsidiary or division level. I would likewise be surprised if they could explain how their cost of sales is calculated. These are two fundamental and important valuations for any publicly traded company.
Sarbanes-Oxley is a long-overdue mandate by federal regulators. This legislation will restore confidence in the financial numbers being created (and I use the term “created” loosely) by Corporate America. For the past 25 years, the financial statements published by the majority of American companies have not been worth the paper they were written on.
Sarbanes-Oxley got it right by requiring greater disclosure requirements, executive certification, and a whistle-blower vehicle. Every time you peel back the covers of one of these scandal-ridden companies you find that the culture was such that if you raised an issue of misconduct you were fired. Real transparency is the only way to overcome this culture. I agree with Tyco’s Eric Pillmore that these procedures will not necessarily prevent misconduct, but they will at least bring them to the light of day and force senior management to deal with them before the company and its stakeholders are hurt.
Can Nontraditional CFOs Succeed?
While it might be efficacious to think outside the box when considering a CFO candidate who does not have a traditional accounting and finance background (Your Move, “Roads Less Traveled,” August), I think it’s important to note that this approach seems to apply solely to large companies.
It is doubtful that this option will work in a smaller company, where the chief financial officer must usually be an accounting and finance jack-of-all-trades and master of most. The smaller company simply does not have the luxury that a large company has of providing accounting and finance support staff to help shepherd a nontraditional CFO in negotiating accounting and finance issues.
Dominick M. Furlano
The Aspen Group Inc.
If I were a non-CPA CFO defendant in litigation involving a financial restatement due to accounting errors, I would blame it on the trained accountants: “They told me it was in accordance with GAAP. How was I supposed to know it wasn’t?” I’m not sure what the jury would do with that, but it seems to me that a non-CPA CFO would be held to a lower standard of care than a CFO with CPA credentials.
Raymond J. Land, CPA
Senior Vice President and CFO
Genencor International Inc.
Palo Alto, California
Disagreement over the Options Debate
Your August cover story (“Who Rules Accounting?“) presented a one-sided and misleading account of the current debate over expensing employee stock options.
The reporter failed to mention that expensing could destroy many broad-based employee stock option plans that grant stock options to rank-and-file workers and management. We believe these plans encourage innovation and hard work, which has led to increased productivity and employee ownership, especially in the high-tech sector.
No one has suggested that granting stock options to rank-and-file workers is responsible for the accounting frauds and other corporate scandals that have led to the Financial Accounting Standards Board’s reconsideration of this issue. Yet, if FASB decides to expense employee stock options, these beneficial programs could be harmed. FASB has adamantly refused to consider these factors in its deliberations.
Reps. David Dreier and Anna Eshoo have introduced legislation that requires the Securities and Exchange Commission to do what FASB won’t—study the effect of dismantling these broad-based plans, which have become an important cog in the country’s economic engine. Dreier and Eshoo are simply asking for someone to look at the baby before it gets thrown out with the bathwater.
The article also ignored the critical issue of how to value stock options if they are to be expensed. Theoretical valuation methods could seriously mislead investors. Even adamant expensing advocates like Warren Buffett have said that Black-Scholes, the most widely used valuation method, doesn’t work for valuing employee stock options.
Another major question not asked in this article is how expensing stock options will prevent future corporate scandals and accounting frauds. Those misdeeds were the result of poor corporate governance or illegal activity, not stock options. Nothing FASB is considering will stop people from using bad judgment or breaking the law.
Finally, the reporter didn’t point out the fundamental concept that earnings dilution already accounts for the real cost of employee stock options.
Oversimplifying this issue does not help to inform CFO’s readers on this very important debate.
William E. Keitel
Senior Vice President and CFO
I agree wholeheartedly with Netflix CFO Barry McCarthy, who suggested that the lawmakers are being disingenuous about the beneficiaries of the proposed legislation to expense stock options. First of all, I do not agree with the expensing of stock options, but probably for very different reasons than Representatives Dreier and Eshoo.
As someone who has received numerous stock options from two Fortune 500 companies over the past decade, I’ve yet to be in a position to exercise a single one. So the notion of stock options being “compensation” is a farce. Ask the rank-and-file employees of companies like Corning, Lucent, Nortel Networks, or JDS Uniphase whether they view stock options as an integral part of their compensation package and I’m sure you’ll get a resounding no. Yet under the proposed rules, those same companies would have been required to expense hundreds of millions of options that would never be exercised.
The fact is, most options granted never get exercised. The granting or exercising of a stock option has nothing to do with the results of operations and therefore does not belong in the income statement. It costs the corporation nothing, but it does impact the shareholders, and that impact is appropriately adjusted for in the diluted-earnings-per-share calculation. That’s my view, and many others agree, but the Financial Accounting Standards Board does not.
I respect FASB’s view, and if it passes a standard that says stock options should be expensed, I will gladly comply. Dreier and Eshoo should do the same by respecting what FASB does and not interfere in the rule-setting process.
As Mr. McCarthy said in the article, “Whenever you have large public companies that think their ox is going to be gored by a change in accounting principle, there is going to be a battle about the outcome.” But who are Dreier and Eshoo battling for? Large public companies that provide campaign donations or the employees of these companies who will lose future stock options?
If the answer is the poor folks who lose stock options, then where was Congress in 1992 when FASB passed SFAS 106, which had a tremendous impact on employees, as many companies abandoned or curtailed their postretirement health-care plans as they were now forced to expense these plans on an accrual basis? I can’t think of an accounting standard that has had a greater impact on the lives of all working people, retirees, and their families, yet I didn’t hear of any senators or representatives showing up at those hearings, appearing on television, or trying to pass legislation to prevent its approval. So let’s be clear about who and what the lawmakers are fighting for.
The U.S. economy will survive the expensing of stock options. Creativity and innovation will not be stifled as Dreier claims. New ideas and products will find their way to the marketplace. As far as I know, Thomas Edison and Henry Ford didn’t need stock options to invent and develop new products and processes. But if Congress is allowed to politicize accounting rules, the U.S. economy may not be able to flourish in the long run as corporate earnings become susceptible to political whims.
External Reporting and Accounting Policy
Investors need better information regarding employee stock options, but the current debate on expensing such options is misdirected, for two reasons. First, the value of a company depends on its ability to generate cash flows, but expensing stock options doesn’t affect cash flow. Second, and most important, the claim on value held by option grantees reduces the claim on value held by current stockholders, but expensing options (or not expensing options) doesn’t address this issue.
My recommendations, based on corporate valuation theory and practice, would provide the information needed by investors. These are:
(1) Calculate the estimated aggregate market value of employee stock options (using Black-Scholes or other option-pricing models as described in FASB 123), and report the estimated value in a balance-sheet account that is separate from common equity accounts (in much the same way as preferred stock is reported separately).
(2) Update the estimated market value each reporting period (that is, “mark to market” the options, following the precedent set by the reporting of stock-appreciation rights in their post-vesting period).
(3) Directly reduce common equity by an amount equal to the change in the reported value of employee stock options each period without showing an expense on the income statement (just as foreign currency translations and unrealized changes in derivatives positions cause a direct reduction in common stockholders’ equity without being shown as an expense on the income statement).
Reporting stock options in this manner would be more helpful to investors than the currently allowed treatments. In addition to providing more helpful information to investors, reporting options in this manner should be more palatable to senior managers and their lobbyists because no option expense need be shown on the income statements.
To summarize, this method of reporting would be better for investors but less objectionable to those opposed to expensing stock options.
Prof. Michael C. Ehrhardt
University of Tennessee