Big Names in Finance Seek Repeal of Option-Cost Rule

Amid a deepening federal investigation into companies’ past stock-option practices, a group of prominent economists and finance experts has stepped in with a surprising proposition: It wants to repeal an option-reform measure adopted last year.

The rule at issue requires companies to deduct from their earnings the value of options granted to employees. Supporters of the measure, including billionaire investor Warren Buffett, say it simply forces companies to account for the cost of stock options as they would any other expense.

Silicon Valley technology companies have vigorously opposed option expensing, and their cause has been taken up anew by a group that includes Los Angeles venture capitalist Kip Hagopian, former U.S. Treasury Secretary Paul H. O’Neill and Nobel-Prize-winning economists Milton Friedman and Harry Markowitz.

Hagopian acknowledged that trying to restart the option-expensing debate during the government’s probes of possible option abuses might appear to be a case of bad timing. But he said the issue of accounting for options was entirely separate from whether executives handed out options improperly.

Writing in the latest issue of a UC Berkeley business school journal, Hagopian argues that stock options aren’t an actual corporate expense but rather a “gain-sharing instrument.”

The cost of issuing options is borne by shareholders rather than by the company, Hagopian says, because shareholders face potential dilution of their ownership stake if employees exercise options and add to the total of outstanding shares.

By forcing companies to formally include an option cost on their income statements, accounting rule makers “simply made a mistake,” said Hagopian, a well-known Wall Street figure who helped launch Los Angeles-based venture capital giant Brentwood Associates in 1972.

Hagopian’s opinion piece in the Berkeley journal was co-signed by 29 other finance professionals and economists, including O’Neill and Friedman. The group plans to petition the Securities and Exchange Commission to revisit the option-expensing rule.

An option is the right to buy stock at a set price for a specific period. Prosecutors in recent weeks have filed criminal charges against former executives of two technology companies in connection with option grants, and the SEC has said it is investigating more than 80 companies.

A principal focus of the government’s probes is whether companies routinely “backdated” option awards in the late 1990s and early in this decade so that executives and other employees were able to buy shares at the lowest possible prices in a given period. Backdating could amount to fraud if it wasn’t disclosed to shareholders.

Corey Rosen, executive director of the National Center for Employee Ownership and an expert on stock options, said he believed that even if the option-expensing rule had been on the books years ago, “it wouldn’t have made a difference” to executives who were intent on secretly backdating option grants.

Still, Rosen said he believed Hagopian’s proposal to rescind the expensing rule “has zero chance of going anywhere” given the unfolding scandal.

Hagopian’s thesis is likely to get an enthusiastic reception from many California technology companies that have long been heavy issuers of stock options.

The technology industry fought for years to persuade financial regulators that recording a cost for options on company income statements would unfairly reduce reported profit. Those arguments held sway through the 1990s: Companies were required only to show an estimated cost of their options in financial report footnotes.

But in the wake of scandals involving Enron Corp. and other companies in 2001 and 2002, critics of option accounting said it was deceptive to relegate option expensing to a footnote. The Financial Accounting Standards Board, the principal accounting rule maker, voted in 2004 to mandate formal expensing of options. The SEC approved that decision last year, and the change became effective for most companies this year.

Hagopian asserts that under FASB’s own terms, options don’t meet the definition of a corporate expense, which he says entails “the past, current or future consumption of cash.”

An option grant, he wrote in the report, “is a unique instrument that provides for the sharing of shareholders’ gains with the employees of the entity owned by the shareholders.” Any option cost, therefore, “is borne by the shareholders and not the entity that grants it.”

Edward Leamer, an economics professor at UCLA, said he had long believed that formal option expensing made sense. He said he changed his mind after reading Hagopian’s views.

“FASB treats options as if they are any other kind of expense. They are not,” said Leamer, who agreed to be one of the co-signers of Hagopian’s report.

Other accounting experts, however, said they believed that the argument for recording options as a corporate expense was on solid ground.

Randolph Beatty, dean of USC’s Leventhal School of Accounting, said a simple way to view options is that they are “given in lieu of cash, and therefore have real value” to the company as well as to the recipient.

The idea that companies should expense options was articulated in an oft-cited 1992 commentary by Buffett.

“If options aren’t a form of compensation, what are they?” Buffett wrote. “If compensation isn’t an expense, what is it? And if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”

Hagopian said he believed he was answering Buffett’s questions in proposing a new definition of options. But FASB spokesman Gerard Carney, at the organization’s headquarters in Norwalk, Conn., said Wednesday that the ideas that Hagopian had raised “are not new issues.

“In fact, the board carefully considered these views and thousands of others in coming to a decision that is in the best interest of investors and capital markets,” Carney said.