06 Jan 2003  Research & Ideas

Why Expensing Options Doesn’t Solve the Problem

Stock options for executives have certainly been abused, but reforms requiring companies to expense option grants on their financial statements don't solve the fundamental problems, argues Harvard Business School professor William A. Sahlman.

 

It is fascinating to observe pundit after pundit come down strongly on the side of expensing stock options in the reported financial statements, as if that were the silver bullet for combating corporate malfeasance and resolving all our accounting problems. But the proposals under consideration can do no more than palliate public outrage. What we need is a much more comprehensive look at the recent scandals so that we can begin to figure out what the real issues are.

As a start, let's consider one of corporate America's biggest villains: Enron. Certainly the company was liberal with stock option grants, though not as liberal as many others. In fact, expensing options in Enron's accounts would have changed reported profits by only about 10%, whereas the change would have been around 30% for Microsoft, which has received no criticism for its options programs.

The real accounting scandal at Enron had nothing to do with the failure to expense options. Rather, it related to a failure to disclose something else entirely on both the income statement and the balance sheet. Enron had taken advantage of some very liberal (and economically nonsensical) accounting rules that allowed the company to transfer assets and liabilities to certain so-called special purpose entities (SPEs). According to the Powers report, which was published by a special committee of Enron's board after the company entered bankruptcy protection proceedings, Enron's management used the SPEs simultaneously to overstate income and understate debt. For example, Enron would sell certain assets to new SPEs, booking a gain on the sale. Then, in quite a few of the transactions, Enron would repurchase the very same assets within months at a slightly higher price. These were not legitimate sales; they were instead short-term, unrecorded loans to Enron. What's more, several of Enron's officers were partners in some of the SPEs. Because these officers had more to gain from their SPE ownership than from their ownership of Enron (an obvious conflict of interest), they might have been tempted to structure transactions that were favorable to the SPE but not to Enron.

The furor over expensing is, if anything, a sideshow distracting us from deeper flaws in accounting standards, compensation philosophy, and professional standards in the financial services industry.
—William A. Sahlman

Were some of these issues disclosed in Enron's financial statements and related footnotes? Yes, they were, but even the special committee of the Enron board of directors later described the disclosures as "obtuse" and woefully inadequate. A careful and skilled analyst could never have figured out all of the possible problems at Enron from its reported financial statements. In this regard, current accounting for stock options actually serves as a model for disclosure, in some respects. Investors are given lots of information about stock option plans, including some that can help them assign a value to the options granted. In sharp contrast, investors in Enron could not judge the value—on the basis of the information they were given—of the contingent liabilities that Enron had incurred either for itself or for its complex SPEs.

But even much fuller disclosure would not have saved Enron or, for that matter, WorldCom or Adelphia. The failures at those companies were more likely caused by a combination of fraud committed by individuals, inadequate control and governance systems that tolerated clear conflicts of interest, and a frothy market in which analysts failed to do even the simplest reality checks on reported cash flows. Those analysts who took WorldCom's reported income as proof that it was doing well would have come closer to the truth if they had simply calculated free cash flows. Then they would have seen the capital expenditures that the company was reporting falsely in order to conceal the true level of its operating expenses. All the required information was there: It just was ignored by the investment community.

The real accounting scandal at Enron had nothing to do with the failure to expense options.
—William A. Sahlman

Even if the proposed rules for stock option accounting end up discouraging the use of stock options, the potential for fraud, and grotesquely outsized gains, will not be reduced. Any compensation system that is based on performance has the potential to encourage cheating. Only ethical management, sensible governance, adequate internal control systems, and comprehensive disclosure will protect the investor against disaster.

The tensions in the American business model surrounding the way companies measure and track their performance are much less black-and-white than the popular press would have us believe. The furor over expensing is, if anything, a sideshow distracting us from deeper flaws in accounting standards, compensation philosophy, and professional standards in the financial services industry. If the advocates of expensing win their small point and the spotlight on corporate America fades away as a result, I fear that we will end up having done nothing at all to prevent unscrupulous executives from yet again stealing their investors' money.

Excerpted with permission from "Expensing Options Solves Nothing," Harvard Business Review, Vol. 80, No. 12, December 2002.

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