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As published in Investor's Business Daily, Thursday, April 25, 2002
The political bang from Enron's collapse may have dissipated, but the legislative fallout has only begun. In the name of eradicating so-called "Enron accounting," Sens. Carl Levin, D-Mich., John McCain, R-Ariz., and Rep. Pete Stark, D-Calif., have introduced legislation to make it tougher for companies to grant stock options for workers.
The bill would deny millions of hard-working Americans employed in a broad cross-section American industries - from high technology to mass retail - an opportunity to own a piece of the company they are helping to build. It would also have particularly devastating consequences for the high-technology sector and, perhaps, turn a lingering technology recession into a technology depression.
In violation of generally accepted accounting principles established by the Financial Accounting Standards Board, the bill would require companies to forecast the future value of stock options as a "compensation expense" on their financial statements at the time the options are granted.
Otherwise, Congress would raise companies' taxes when workers' options are finally exercised by denying them the right to deduct the appreciated value of the options on corporate tax returns. Had the bill been in effect last year, for example, Cisco would have paid more than $1 billion in added taxes, Oracle's taxes would have gone up almost $ 1 billion and Sun Microsystems would have faced a $650 million tax hike.
Treating the estimated value of stock options as a "compensation expense" on financial statements at the time options are granted would cause a firm's expenses to rise automatically as the value of its stock rose.
This would set off a vicious feedback loop in which a rising stock price would automatically lower net income - perverse, to say the least. The stock price would cease to be a reliable indicator of a firm's future earning potential.
Far from clarifying a company's financial situation, the McCain/Levin/Stark accounting rule would send confusing and misleading signals to investors and lenders.
Levin seemed impervious to the negative economic consequences of the bill when he issued a press release stating, "The bankruptcy of the Enron Corp. has brought to light a long-standing problem in how some U.S. corporations use stock options to avoid paying U.S. taxes while overstating earnings. Stock options are a from of stealth compensation because they do not, under current accounting rules, have to be shown as an expense to get a tax reduction."
The facts are, stock options do not constitute compensation, stealth or otherwise; they are a means by which workers are given an opportunity to invest in the company. Stock options are simply a modern, formalized means by which all of a company's workers can become entrepreneurs and invest in the company with sweat equity, contributing human rather than financial capital.
"The common practice in Silicon Valley," explains Floyd Kvamme, chairman of Empower America and an experienced Silicon Valley entrepreneur and venture capitalist, "is to use stock options as a way to give employees a chance to own a piece of the company, not as a back-door means of compensation."
Through Incentive Stock Options, employees can buy shares that are treated like long-term investments if held for more than one year, and under current law these holdings do not provide the company any special tax treatment or deduction. Only when the employee sells the shares before a one-year holding period are these holdings treated as short-term investments requiring the employee to pay income taxes on the gain. That then triggers a legitimate offsetting tax deduction for the company.
Requirements for nonqualified options call for short-term-investment tax treatment regardless of how long the employee holds the shares, so the employee pays tax even if there is no sale, and, again, the company takes a legitimate offsetting tax deduction.
This practice is the one prescribed by FASB; it's fair, simple, accurate and it works. Stockholders and potential investors are not deceived because the dilution effects of the stock options on earnings per share are fully disclosed in a footnote to the financial statement.
The only way supporters of the Levin/McCain/Stark legislation are able to fabricate a need to replace the tried-and-true FASB practice with the one they advocate is by making several unsubstantiated, static assumptions.
First, in order to justify forcing a firm to treat an increase in its equity value (i.e., the appreciation in the value its stock) as an "operating expense," the government must pretend that the firm sacrifices revenue by "selling" stock to workers at a lower exercise price than the price it could have received if it sold the stock on the open market.
This false premise pyramids on top of another dubious static assumption: that the earnings growth and the appreciation in stock value that occur between the time the options are granted and the time they are exercised would happen anyway without stock options.
In other words, the bill's sponsors maintain that stock options have no real incentive effects. This presumption flies in the face of solid empirical evidence that stock options foster substantial productivity growth and increase earnings considerably, which causes the stock price to rise.
The other phantom problem the Levin/McCain/Stark bill seeks to remedy is the untidiness of companies having to report one thing to the Internal Revenue Service and another to their investors and creditors. Unfortunately, two methods of accounting - one for investors and lenders and one for the IRS - are required not just for stock options but for a large variety of transactions under the current complex, burdensome and incomprehensible tax code, including how companies report and account for depreciation, inventory valuation, foreign sales and treatment of deferred tax assets and liabilities, to name a few.
As long as Congress insists inappropriately on taxing the appreciation of asset values as if it were "income" - whether it be taxing capital gains generally or taxing the appreciated value of stock options in particular - it will continue to be necessary for the IRS to demand accounting practices for tax purposes that are at variance with generally accepted accounting principles, and there will always be the need for companies to maintain two sets of books. What's wrong here is not that companies "keep two sets of books"; what's wrong are the unsound congressional tax polices that give rise to the need for the second set of books.
In 2001 Enron imploded, in part, because it was caught reporting projected earnings as if it were current profit. The irony of the Levin/McCain/Stark "solution" is that it would mandate "Enron in reverse."
In an effort to prevent the next Enron, the bill would mandate companies to expense stock options on their financial statements before there exists any offsetting revenue attributable to that expense.
Moreover, it would require companies to construct their financial statements by second-guessing the stock market and forecasting the future value of its stock, a fool's errand by anyone's standards.
The bill's problems don't end there, however. This legislation also would overturn existing U.S. accounting practices in a mindless exercise in European Union-style harmonization.
In just the last year, the Bush administration was forced to fight off an ill-conceived OECD plan to punish low-tax jurisdictions, such as the U.S., to help the high-tax jurisdictions in the EU protect their eroding tax bases.
Now, the newly minted International Accounting Standards Board, with the support of the EU, is seeking to "harmonize" global accounting standards. And they have chosen the contentious issue of stock option reporting as their test case.
Never mind the fact that FASB already has dealt with this issue satisfactorily, and never mind the fact that no country in the world requires companies to expense stock options granted to workers. The IASB has the unmitigated gall to demand that its novel, untested standard become the global standard for stock option accounting.
If one believes that harmonization of accounting standards is necessary, it would make more sense for the IASB to adopt the FASB standard as the global standard. The Levin/McCain/Stark bill amounts to nothing more than a bad solution in search of a problem. Stock-option accounting did not cause or even contribute to the fall of Enron. Hence, this bill would not prevent future Enrons.
This bill, if passed, would seriously cripple the venture capital industry and further impair the already beleaguered tech sector of our economy.
Stock options are a means for start-up companies to attract talented personnel who want to own a piece of their company. Moreover, stock options are one of the most powerful forces for the democratization of capitalism yet conceived.
Sometimes the best solution is no solution at all, which is precisely the case with stock options. The current accounting method works fine.