Peeling away financial reporting issues one layer at a time

Stock Compensation Accounting: A Drop in the Ocean Against a Tide of Management Greed

When FAS 123R came into effect in 2005, it had been finally ordained that stock option grants must be accompanied by some modicum of expense recognition.  The FASB had fought the good fight and had won — sort of.  A couple of days ago, NYT columnist Floyd Norris wrote a story that conclusively established that FAS 123R was little more than a pyrrhic victory: how Blackberry’s executives “abused the [accounting] rules on executive stock options” to enrich themselves whilst shareholder value crashed and burned.

In a nutshell, BlackBerry’s executives had over the years granted themselves about 83 million at-the-money options to purchase shares with an average strike price of $4.38.  From Mr. Norris’s telling, it appears that Blackberry paid about $36.10 on average to acquire shares on the open market that they then turned around and sold to executives for $4.38/share as options were exercised.  Roughly speaking, that’s about $3.5 billion in value that BlackBerry shareholders delivered to executives in exchange for only $400 million in aggregate exercise price.

Mr. Norris doesn’t report the amount of option expense that was recognized, but it would seem to be even lower than the aforementioned $400 million. In that regard, I ran a plain vanilla Black-Scholes grant-date valuation of an at-the-money option assuming 10-years to expiration, volatility of 40% and a risk-free rate of 3%. By this rough estimate, the option values would have been only 55% of their exercise prices — which for BlackBerry would be around $220 million.

If you accept my rough calculations, the overall effect of the options programs went something like this: a net transfer from BlackBerry shareholders to employees of $3 billion in cash, ostensibly for services rendered (ignoring the hidden backdating of the options that also occurred); yet, only $220 million of expenses were reported.*

Mr. Norris goes on to explain that BlackBerry executives may have been attracted to options as a form of compensating themselves, not because options aligned top management’s incentives with shareholders’ aspirations (which they don’t), but because reported earnings would not come close to reflecting the actual transfer of wealth that had occurred.  With the benefit of hindsight, one must ask whether that money might have been put to better use by paying dividends (BlackBerry has never paid any) or investing in projects aimed at stemming the erosion in BlackBerry’s competitiveness.  If accounting standard setters had done a better job of ensuring that the economics of equity-based compensation would be reasonably reflected in the financial statements, then maybe some of that cash would have been put to a different use.

As far as it takes us down the financial reporting road, Mr. Norris’s column is great stuff; but if I were reading it as a non-accountant, I wouldn’t know whether I should demand change to the system or be merely resigned to the fact that accounting is flawed and not capable of producing a more faithful representation of economic events:

“None of this explains BlackBerry’s fatal error, of not managing to be the company that figured out where technology was going.  But it does explain why shareholders who believed in the company when times were good did not prosper as they might have.”

This is where I come in.  In point of fact, the accounting loophole that BlackBerry’s executives and their ilk exploit on a regular basis is maddeningly simple to close.  To fully reflect the economic transfer of wealth, compensation cost has to be measured by the value of the option when it is ultimately exercised (i.e., $3 billion) instead of the value at the grant date from as long as 10 years ago (i.e., $220 million).

It’s hard to believe given all the hand wringing from non-investor “stakeholders” that has spanned decades, but accounting for equity-based compensation is an extremely simple problem that lends itself to an extremely simple solution. Ironically, the FASB was starting to come close, but they backed off for the sake of keeping the dim prospects of convergence with IFRS alive.  It’s a story that may not be as compelling as the one that Floyd Norris tells about BlackBerry — unless you’re an accounting wonk.

As I described in a post from late 2007 (and here we are almost six years later!), the FASB and IASB undertook a very consequential convergence project to determine when a financial instrument that belongs on the right-hand side of the balance sheet should be classified as a liability or as equity.  The outcome of the project would determine if a derivative financial instrument such as a stock option granted to employees could be classified as a liability; hence, according to existing rules on derivatives the options would have to be measured at fair value with changes in the measurement reflected in income.

Amazingly, 30 years after it begin its deliberations on this issue, the FASB finally declared, in its Preliminary Views document, that henceforth, the only items that should be admitted as equity were common stock and retained earnings.  This was definitely a sign of substantial progress, including better measurement of stock compensation expense.  If implemented the preliminary views would have been an abuse-proof standard to put an end to the vicious cycle of rules-based standards and financially engineered evasive actions like BlackBerry’s.

But the fly in the ointment was that the putatively principles-based IASB quickly rejected the FASB’s straightforward and reasoned solution.  As a result, this important project has been tabled, because the IASB wants the distinction between equity and liabilities to remain as clear as mud.

It’s a shame, because the FASB was on the cusp of real progress.  Ironically, it was just last month when Hans Hoogervorst proclaimed himself the champion of simple solutions. I challenge him to explain why the accounting for equity-based compensation can’t be made better by making it simpler.

* * * * * * 

It’s nice that a venerated journalist like Floyd Norris will, on occasion, bring an important accounting issue to the attention of a national readership.  But, the exploitation of Swiss cheese for accounting rules by executives is pervasive and deserves more attention than the occasional exposé.  Every day, the retirement assets of ordinary people are snatched away from them by their very own fiduciaries (aided by Wall Street ‘consultants’) utilizing all manner of abusive accounting schemes; and all too often as the corporate ship is taking on water.

But, the greater scandal is that capital markets regulators either don’t care enough, or don’t know enough, to protect investors from accounting artifice.

I hope that some of those regulators read my blog, but surely they all read The New York Times.  Which is why I wish that Floyd Norris had completed his own thought, instead of my having to do it for him.

——————–

*Subsequent to posting, I realized that some of these options would have been issued before the effective date of FAS 123R.  I have decided not to make any adjustment for this, as I don’t believe it has a significant affect on the general point I am trying to make through this illustration.

8 Comments

  1. Reply Alex August 28, 2013

    Tom, what do you think about exercise date accounting? It was engineered by respectable Stephen Penman and I really like its mechanics.

    • Reply Tom Selling August 28, 2013

      I thought that my post essentially stated that exercise date accounting is the way to accounting for equity-based compensation. y the way, Ihave a great deal of respect for Stephan Penman, although we disagree on the role of historic costs.

  2. Reply IV August 28, 2013

    Liabilities are “…probable future sacrifices of economic benefits, arising from present obligations of a particular entity, to transfer assets or provide services to other entities in the future” (FASB Concept Statement No. 6, paragraph 35). In IFRS, a liability is, “…a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits” (IASB Conceptual Framework, paragraph 49). Therefore, it would seem, that writing an option against some common stock which is either unissued or in the treasury, would count as a liability under both conditions. It is a future economic outflow — it is a future contingency — it is a future sacrifice of benefits from the stand point of a common stockholder.

    Anyways, stock options are a terrible means of incentivizing management. They are only a clever way for management (and the board) to steal from shareholders. It is my opinion that managerial compensation should *never* be in the form of a derivative. I would probably support a law outlawing *option* based compensation.

    • Reply Tom Selling August 28, 2013

      Actually, a stock option does not meet the SFAC 6 definition of a liability, and this is way the FASB has been struggling with the definition for decades. The problem is that neither a company’s own stock, or an option on shares of a company’s stock meet the definition of “asset.”

  3. Reply David Blair August 30, 2013

    If BlackBerry is using cash to purchase shares on the market rather than issuing them from treasury, it seems a lot more like a liability (which should be recorded at fair value at each reporting date) because it results in an outflow of economic assets. I am not that familiar with FASB but my belief is that IFRS standards would encourage liability treatment in this case.

  4. Reply Steve Rabin September 28, 2013

    Stock comp, in general, is not a cash expense. Most companies settle options out of an equity pool prereserved for that purpose and no cash is consumed at exercise, so liability treatment before exercise.would be misleading when it will become equity upon settlement. ASC 718-10-25-7, 480-10-25-8 and 718-10-35-15 do seem to require liability treatment when the pool is insufficient or becomes insufficient. Not sure what happened at BlackBerry, but let’s recognize that cash repurchase is uncommon, and that ASC718 (FAS123R/Black Scholes) in general overstates stock comp expense, particularly for the many companies we never heard about that issued stock comp which became worthless.

    • Reply Tom Selling September 28, 2013

      Hi, Steve:

      Instead of a CEO, substitute a vendor of inventory who chooses to receive part cash and part stock options in exchange for a long-term supply agreement. Would you also say that only the cash component counts as inventory cost?

      Best,
      Tom

      • Reply BT October 8, 2013

        Something to also consider, even though it often violates Item 10 of Reg S-K (when filing vs. furnishing), management will often report earnings on a Non-GAAP basis, which excludes Stock compensation expense. Even though this violates the requirement that only items which are not recurring should be excluded from earnings (save for EBIT and EBITDA), the SEC has ignored this common exclusion.

        So even, if, as you suggest, the FASB “simplify” these matters, unless the SEC actually take action, most Companies will strip these charges out of the Company’s earnings presented to the investing community. Because most investors are not literate enough to understand this, and because they see it in an SEC filing, they feel comfortable that these must be proper.

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