On Tuesday, July 20th, 2004, The House of Representatives approved HR-3574, the so-called Stock Option Reform Bill, by a vote of 312-111 despite the objections of Federal Reserve Chairman Alan Greenspan, the largest accounting firms in the United States (the so-called “big-four”), the Chairman of the Security and Exchange Commission, the Chairman of the Senate Banking Committee, and billionaire investor Warren Buffett (just to name a few). The bi-partisan measure is, perhaps, the most deceitful and unethical piece of legislation passed within recent decades. As you will see in a moment, the only thing the bill “reforms” is economic reality. If you or a loved one invests in stocks or mutual funds, you may be affected by these changes.
Introduction to Stock Options
In simple terms, a stock option is the legal right to buy or sell shares of stock at a specific price at a specific time. Coca-Cola currently trades around $50 per share; an investor with an option to acquire 100 shares of Coke at $20 per share, for example, would be able to buy those shares for $2,000 ($20 per share x 100 shares). He could turn around and sell them for $50 each on the open market, pocketing the $30 per-share difference for a total profit of $3,000.
Many corporations give these stock options to employees as compensation instead of cash. As a result, the company’s existing shareholders are hurt in two ways:
1.) The shares of stock could have been sold on the open market. Rather than raising $2,000 by selling to the employee at $20 per share, the company could have sold the shares directly to the public, which is willing to pay $50 per share. The $3,000 difference went to the recipient of the stock option instead of the corporation and its shareholders.
2.) The number of shares outstanding has increased, diluting the value of each existing share. An example: Company XYZ reports a $500 profit and has 100 shares outstanding. Each share is worth 1% of the business and is entitled to $5 of the net income. If the CEO of this company is given stock options for five shares and exercised them, the total number of shares outstanding will increase to 105. The $500 profit must now be split among 105 shares instead of 100 shares, giving each the right to only $4.76 - not the $5 to which they were previously entitled. To be fair, some companies will buy five shares on the open market and retire them in order to avoid “diluting” the common stock (dilution is the reduction of the percentage ownership each share represents by increasing the total number of shares outstanding). Although this is preferable, management is still using shareholder money that could have been reinvested in the business, used to start a stock buy back program, pay down debt, or distributed as a cash dividend.
The Role of the FASB in the Stock Option Expense Controversy
The Financial Accounting Standards Board is the independent body given the responsibility of creating the Generally Accepted Accounting Principles (GAAP). The rules set by this body govern what and how a company must report its operations to the owners (i.e., the shareholders). Thwarted by Congress ten years ago in its attempt to mandate options expensing, the FASB managed to require companies to disclose in the notes to the consolidated financial statements the net income it would have reported if it had expensed options using the fair value method on its income statement. Following the corporate excess and frauds of the late 1990’s, the FASB once again took up the fight and was going to require companies to fully reflect stock option expense on the income statement beginning in December, 2004. That is when the House got involved.
HR-3574: The House of Representatives Justifies Its Actions
Essentially, the House of Representatives believes that if stock options are expensed and, as a result, reported net income lowered, investors will not invest capital into businesses. This, in turn will hurt the economy, costing jobs.
The problem with this logic is that the expense already exists; the House is advocating investors simply not be told! This hurts only small investors. Those with accounting backgrounds are capable of picking up a 10K and examining the potential stock option expense while the average, small investor does not have the analytical training to do the same. In essence, the House of Representatives has given permission to corporations to continue burying the evidence in the footnotes, hurting only those who don’t know better.
Among other arguments offered by House Representatives against recording stock option expense are the following:
Stock options are not really an expense
As you have already learned, stock options have very real value. The fact that they may, in certain cases, expire worthless does not make them any less a compensation expense. As one famous businessman put it, “if options didn’t have value, we wouldn’t want them.”
