Editor’s note: Local Tech Wire will publish commentary provided by The Competitive Enterprise Institute out of Washington, D.C. on occasion. This week’s ” c:\spin” column, as CEI labels it, concerns stock options and was written by James V. DeLong, Senior Fellow, Project on Technology and Innovation at CEI. U.S. companies cheerfully slit each other’s throats in the marketplace, the courts, and the halls of Congress. But on one thing they stand together like a band of brothers, and with Old Testament fervor: Thou shalt not require that stock options granted to employees be treated as a corporate expense. Of the 500 companies on the S&P list, only two are mavericks.

In 1994, the Financial Accounting Standards Board, goaded by the SEC, made some moves toward requiring that options be expensed. This was turned back in favor of a simple disclosure requirement that permits investors to draw their own conclusions about the significance of potential dilution.

Now, controversy has resurfaced. In late 2000, the International Accounting Standards Board issued a staff report advocating an expense approach, with the value of the stock options determined by a complex options pricing model. The fallout from the Enron affair has also put all accounting issues in play, and Senators Carl Levin (D-MI) and John McCain (R-AZ) recently introduced a bill requiring that options be expensed if a company takes any tax deduction for them. Some accountants and investment analysts are supporting an expense approach, and Arthur Leavitt, former SEC Chairman, said that his “biggest regret” is his failure to force companies to follow the initial FASB recommendation. Option-granting U.S. companies are again girding for battle.

The argument in favor of treating options as a corporate expense seems simple. Accounting should provide a realistic picture of a business. If a firm trades stock options for inputs such as labor, then failing to reflect their value understates the costs to the company of buying the inputs, and thus overstates earnings. Period.

The opponents counter with a battery of complexities. Valuing options presents tricky problems on which there is no agreement. For whatever approach is adopted, people who disagree will actually be misled by the earnings statement. And it will be difficult for them to recreate an uncorrupted earnings estimate. Besides, say the options grantors, messing around with stock options will discourage their use, doing particular damage to start-ups and high tech, and to what point? A tidier number that may or may not really reflect reality? T. J. Rodgers, Silicon Valley CEO, calls the proposals “destructive.”

So, say the companies, the logical course is the current FASB policy — disclose options as potential dilution (no one disagrees with that) and let investors apply whatever valuation technique they favor.

The companies should win again, because the “options are compensation” idea, despite its sound bite appeal, is indeed too simplistic. Options are not solely intended to reward employees for labor inputs, as if they were automatons. Options are designed to align employees’ incentives with the interests of other stockholders, and thus, hopefully, to improve the quality of their inputs and increase future earnings.

It is no accident that options flourish in high tech companies that depend heavily on intellectual capital, not physical assets, and the accountants are wrong to assume that they can link the value of options to current earnings. They are misperceiving the basic nature of the modern high tech enterprise, which consists not of sharply divided capital versus labor, but of a shifting and nuanced partnership between contributors of finance and contributors of intellect.

So the accountants should stop trying. Disclosing the potential dilution provides the necessary information, and trying to do more will create an illusion of exactitude coupled with a reality of confusion.
To contact CEI, visit its Web site at: www.cei.org