ACCT323, Ch. 16, Reading 16b
Answer the following questions:
1. For many years, stock option/warrant compensation given to executives was expensed at intrinsic value and the fair value was only disclosed. Because most accountants/economists argued that the compensation should be expensed at fair values, the FASB finally mandated this treatment, although it was very controversial. What is the difference between the intrinsic value and fair value of a stock option or warrant?
2. According to a letter to the FASB from the U.S House (See Article1 below), what are the main arguments presented for not expensing stock option compensation at fair value? (Other articles are also provided later in the document for further reference, if needed.)
3. According to another letter written a few days later to the FASB from the U.S. Senate (See Article 2 below),
(A) What are the main arguments made for expensing stock option compensation at fair value?
(B) What are names of three organizations and three people that are for expensing stock options at fair value?
4. Which side do you support? Why?
5. Why do you think politicians are involved in this issue, which should normally be addressed by a private standard-setting organization (FASB)?
FYI: The FASB finally did issue a new statement (SFAS No. 123R) requiring stock option compensation to be recorded at fair values. Although there’s been an occasionally outburst of dissent, the new rules have been adopted with surprisingly little complaint, at least not nearly in proportion to the ruckus before the rule was adopted. This seems to illustrate human nature quite well.
6. Articles 3 and 4 below describe the scandal about backdating stock options. Complete the following:
(A) How can an executive benefit from the backdating of stock options?
(B) Why is such backdating considered scandalous?
(C) How many companies were under investigation for this practice?
(D) List two of the famous CEOs supposedly involved.

ARTICLE 1
Congress of the United States
House of Representatives
Washington, DC 20515
January 30, 2003
Financial Accounting Standards Board
MP&T Director - File Reference 1101-001
401 Merritt 7
P.O. Box 5116
Norwalk, Connecticut 06856
Dear Sir or Madam:
In response to the Financial Accounting Standards Board's recent Invitation to Comment on accounting for employee stock options, we write to express our strong opposition to any proposal which would mandate the expensing of broad-based stock option plans. We appreciate the opportunity to provide our comments and request that FASB give its highest consideration to them.
Events of the past year have eroded investor confidence and contributed to significant concern about the adequacy of our laws, rules and policies governing corporate oversight, financial reporting, and accounting practices. Restoring investor trust, revitalizing our capital markets, eliminating corporate fraud and abuse, and growing America's economy are objectives each of us shares.
We do not wish to set accounting standards. However, in light of the proposed International Accounting Standards
Board (IASB) standard that would mandate the expensing of employee stock options, and FASB's close coordination with IASB, we believe it is important to express our strong concerns about an approach that would limit transparency, truthfulness and accuracy in financial reporting, precisely at a time when America and its investors need these qualities the most. The public interest will not be served by an accounting standard that results in the disclosure of inaccurate corporate financial information and a flawed picture of company performance.
It is apparent to us that a mandatory expensing standard lacks a clear and widely accepted accounting rationale.
Accounting experts have vastly divergent views as to whether employee stock options should be accounted for as a cost to be deducted from earnings. Many respected, independent experts find that the "cost" of employee stock options is already accounted for and disclosed to investors through diluted earnings per share. Investors would be better served by full and complete disclosure of this diluted earnings per share number.
Additionally, pricing models currently available, such as Black-Scholes or slight variations on it, were designed for entirely different kinds of options that have little in common with employee stock options. The same model can produce widely differing results depending on the particular guesstimates a company decides to use. Highly subjective numbers that are not reliable or meaningful are of no use to investors, and in fact, hurt their ability to make informed decisions. We concur with the view recently expressed by one expert that "[i]f anything, expensing options may lead to an even more distorted picture of a company's economic position and cash flows than financial statements currently paint." (William Sahlman, Professor of Business Administration, Harvard Business
School, "Expensing Options Solves Nothing," Harvard Business Review, December 2002.)
Moreover, mandatory expensing would effectively destroy broad-based stock option plans, which enhance financial opportunities for workers at all levels, stimulating economic growth and productivity. Broad-based employee stock options plans play a vital role in America's economy, helping employees, shareholders, and companies alike. A recent study found that broad-based plans - which grant options to most, if not all, employees
- have bestowed significant economic benefit on tens of thousands of "rank and file" workers over the past two decades, enhanced productivity, spurred capital formation, and fueled the growth of some of our nation's most innovative companies. The Rutgers University researchers make a compelling case that such plans are a form of
"partnership capitalism," that "makes most companies more competitive and creates more wealth for shareholders." (Blasi, Kruse, and Bernstein, In the Company of Owners)

Commendably, FASB has just recently required more timely and extensive disclosure of information about employee stock options. In light of the serious negative consequences and dislocation likely to arise from mandated expensing, it seems more prudent to allow the new disclosures to work and perhaps, supplement them further with additional and more investor-friendly information. Accurate, timely and rigorous investor-friendly disclosures would do more to inform investor decision-making than new overlapping mandates hastily applied.
Accounting principles that foster transparency, truthful and accurate financial reporting, and meaningful disclosure are critically important to help investors make informed investment decisions, and to foster efficient and growing capital markets. We support accounting principles that serve the public interest in this way, and we do not think a mandatory expensing standard meets this test.
At a time when our government is searching for new ways to stimulate the economy, we need a clear vision about the importance of broad-based stock option plans to the nation's entrepreneurial soul and the workers and investors who are part of it. We should adopt policies that encourage and expand the availability of broad-based stock option plans, not destroy them.
Sincerely,
Reps. David Dreier, Anna G. Eshoo, Darrell Issa, Jay Inslee, Joseph Crowley, Adam Smith, Dennis Moore, Zoe
Lofgren, Carolyn McCarthy, Gary Miller, Cal Dooley, Jerry Weller, Pete Sessions, Ron Kind, Jennifer Dunn, Mike
Honda, Rick Boucher, Bob Goodlatte, Lamar Smith, Tom Davis, J.D. Hayworth, Jane Harman, Doug Ose, David
Wu, Joe Barton, Rick Larsen, Amo Houghton, Dennis Cardoza, Steve Israel, George Nethercutt, Darlene Hooley,
John Boehner, Mike Simpson, Greg Walden, C.L. "Butch" Otter, Jeff Flake, Chris Cannon, John Carter, Heather
Wilson, Bob Etheridge

ARTICLE 2

ARTICLE 3
Options backdating is the process of granting an employee stock option that is dated prior to the date that the company granted that option. When done intentionally, the practice is equivalent to giving cash to the grantee at the expense of shareholders. Whether it is illegal will depend on the particular facts and circumstances because you can steal directly or through obfuscation.
Abuses reported in the media recently include cases like those of Steve Jobs with Pixar when executives would look back over several months and chose the date on which they wanted the right to buy shares of the company they were being paid to manage; and they chose the date when the price was lowest. This results in a value of the option most favorable to the employee receiving it. This practice reduces the risk of share price going down for the year. Some backdating situations are less manipulative and intentional, such as company granting stock options at exercise price equal to the company's lowest stock price during the prior month to smooth out volatility in its stock price, or just a delay between when the grant is approved and when it is communicated to employees and priced.
In 1992 the SEC had imposed a rule requiring companies to report executive stock options in detail. If not for that rule, executives could still be hiding backdating options from shareholders. Even after the rule, some executives got away with it for years because they could legally delay reporting option grants for so long that it was virtually impossible to figure out whether any individual grant had been backdated.
Since the Enron scandal, Congress enacted Section 409A of the Internal Revenue Code to deal with such nonqualified deferred compensation. Backdated stock options would be considered discounted stock options triggering additional taxes and penalties at vesting or exercise. Most of the legal issues arising from backdating are a result of the grantor falsifying documents submitted to investors and regulators in an effort to conceal the backdating. The practice of backdating itself is not illegal, as it is granting of discounted stock options. What is illegal is the improper disclosures, both in SEC filings and financial records.
Research History
David Yermack, a New York University finance professor, in 1995 studied data that companies were obligated to publish, under a 1992 SEC decree, the exact dates of options grants in proxy statements. Previously, dates were disclosed within often ignored filings. He found a pattern that the stock prices often declined in value just prior to the options grant and rose afterwards. He theorized these were timed to precede good news and follow bad news. In 1997, his findings were published in the Journal of Finance.
Finance professors David Aboody of UCLA and Ron Kasznik of Stanford followed with a study of companies that grant options at the same time every year and found a similar patter, indicating timing of news.
Finance professor Erik Lie of the University of Iowa in 2004 noted that many options grants were timed to exploit marketwide price depressions that nobody, including insiders, could predict leading to the conclusion that at least some of the grants must have been retroactive.
Terminology bullet dodging delaying an options grant until just after bad news spring-loading timing an options grant to precede good news symmetric spring-loading where members of the board who approve the grant are aware of the forthcoming good news asymmetric spring-loading where members of the board who approve the grant are unaware of the forthcoming good news

Overview of the Options Backdating Scandal
Academic researchers had long been aware of the pattern, exhibited by some companies, of share prices rising dramatically in the days following grants of stock options to senior management. However, in late 2005 and early
2006, the issue of stock options backdating gained a wider audience. Numerous financial analysts replicated and expanded upon the prior academic research, developing lists of companies whose stock price performance immediately after options grants to senior management (the purported dates of which can be ascertained by inspecting a company's Form 4 filings, generally available online at the SEC's website) was suspicious.
Backdating stock options is not necessarily illegal. Backdating becomes illegal when a company's shareholders are misled as a result of the practice. For instance, public companies generally grant stock options in accordance with a formal stock option plan approved by shareholders at an annual meeting. Many companies' stock option plans provide that stock options must be granted at an exercise price no lower than fair market value on the date of the option grant. If a company grants options on June 1 (when the stock price is $100), but backdates the options to May 15 (when the price was $80) in order to make the option grants more favorable to the grantees, the fact remains that the grants were actually made on June 1, and if the exercise price of the granted options is
$80, not $100, it is below fair market value. Thus, backdating can be misleading to shareholders in the sense that it results in option grants that are more favorable than the shareholders approved in adopting the stock option plan.
The other major way that backdating can be misleading to investors relates to the method by which the company accounts for the options. Until very recently, a company that granted stock options to executives at fair market value did not have to recognize the cost of the options is a compensation expense. However, if the company granted options with an exercise price below fair market value, there would be a compensation expense that had to be recognized under applicable accounting rules. If a company backdated its stock options, but failed to recognize a compensation expense, then the company's accounting may not be correct, and its quarterly and annual financial reports to investors may be misleading.
Although many companies have been identified as having problems with backdating, the severity of the problem, and the consequences, fall along a broad spectrum. At one extreme, where it is clear that top management was guilty of conscious wrongdoing in backdating, attempted to conceal the backdating by falsifying documents, and where the backdating resulted in a substantial overstatement of the company's profitability, SEC enforcement actions and even criminal charges have resulted. Toward the other extreme, where the backdating was a result of overly informal internal procedures or even just delays in finalizing the paperwork documenting options grants, not intentional wrongdoing, there is likely to be no formal sanction -- although the company may have to restate its financial statements to bring its accounting into compliance with applicable accounting rules.
With respect to the more serious cases of backdating, it is likely that most of the criminal actions that the government intends to bring will be brought in 2007. There is a five-year statute of limitations for securities fraud, and under the Sarbanes-Oxley Act of 2002, option grants to senior management must be reported within two days of the grant date. This all but eliminated the opportunity for senior management to engage any meaningful options backdating. Therefore, any criminal prosecution is likely to be based on option grants made Sarbanes-
Oxley took effect, and the deadline facing the government for bringing those prosecutions is approaching.
Backdating has been identified at more than 130 companies, and led to the firing or resignation of more than 50 top executives and directors of those companies. Notable companies embroiled in the scandal include Broadcom
Corp., UnitedHealth Group and Comverse Technology, and KB Homes.
Some of the more prominent corporate figures involved in the controversy currently are Steve Jobs and Michael
Dell. Both Apple and Dell are currently under SEC investigation.
United States income tax issues
According to the February 9, 2007 WSJ (Page A3) article IRS Urges Companies to Pay Taxes Owed By Workers
Unaware of Backdated Options the government will go after taxpayers on such options but will pursue the company for rank and file employees.

Deferral of recognition into employee's gross income
According to Section 83 of the Code, employees who receive property from the employer must recognize taxable income in the year in which that property vests (is free from restrictions and other risks of forfeiture). Stock options granted which exercise price below the then current fair market value has intrinsic value equal to the difference betwen the market price and the strike price. Such backdating may be construed as illegally avoiding income recognition because falsely under-reporting the market price of such stocks makes them appear to have no value in excess of the strike price at the time the option is granted.
Denial of deduction under Section 162(m) of the Tax Code
The 1993 Clinton tax increase amended the Code to include Section 162(m) which presumptively makes compensation in excess of one million dollars unreasonable for public companies. As the Tax Code only allows a corporate deduction for reasonable compensation to employees, Section 162(m) needed an exception for performance based compensation. According to the September 5, 2006 Joint Committee on Taxation background briefing if the CEO or other top executive gets stock option grants with exercise price equal to market price, then the options granted would be presumed to be reasonable because they would be performance based . However, if the exercise price is below the market price so that they are in the money , then the compensation will not be performance based because the option would have intrinsic value immediately. (See page 5 of the background briefing).
As an economic and practical matter, backdating and cherry-picking dates with the lowest market price of the underlying stock may be evidence that the options granted were not reasonable compensation because it would not be performance based and therefore corporate deductions taken would be denied.
ARTICLE 4
FAQ: Behind the stock options uproar
By Declan McCullag http://news.com.com/FAQ+Behind+the+stock+options+uproar/2100-1014_3-6098457.htm
Story last modified Wed Jul 26 11:54:41 PDT 2006
The tech industry's stock option backdating scandal appears to be gathering steam.
Last week, federal investigators announced criminal charges against former executives of Brocade
Communications Systems, and they're hinting that more cases may be on the way. Meanwhile, Silicon Valley's top lawyers are scrambling to assuage their clients' fears, and the U.S. Security and Exchange Commission has said that the investigation will expand beyond technology companies to other publicly traded outfits. Already, some companies have begun restating years worth of financial results.
To try to answer some questions about what's going on, CNET News.com has compiled the following list of frequently asked questions.
Q: What is stock option backdating?
Backdating, which refers to the practice of altering the dates of grants, is a way for employees of a company to make additional money from stock options. While it's not necessarily illegal, in many cases it could be.
Q: Which companies are under investigation?
The Securities and Exchange Commission said last week that at least 80 companies are the subject of a probe.
Also, some companies have independently confirmed that they've been contacted by federal investigators. Those include Altera, Applied Micro Circuits, Asyst Technologies, CNET Networks (publisher of CNET News.com),
Equinix, Foundry Networks, Intuit, Marvell Technology Group, RSA Security and VeriSign. In addition, other companies, such as Apple Computer and The Cheesecake Factory have announced their own, preemptive investigations.

Q: How do stock options work?
Stock options give the recipient the right to buy a share of a company's stock at a price called the strike price, which is equal to the value of the stock on a certain date. If, for example, the strike price is $10 and the shares now trade at $15, each option would be worth $5. (The options would be worthless if the stock fell to, say, $7.)
Think of options as coupons you can sell. If you have a coupon to buy a Ferrari for $110,000, and the market price of the car is $120,000, your coupon is worth $10,000. But if you're lucky enough to have a coupon that lets you buy a Ferrari for a mere $50,000, your piece of paper would have a far more handsome market value of
$70,000.
The same goes for stock options. If an executive is able to change the grant date of an option retroactively--for instance, to when the stock was trading at a lower price--the options become more lucrative. That's what some corporations allegedly did.
Stock options by themselves are not problematic or controversial. They're a way to recruit and retain good employees, and they tend to align employees' interests with those of shareholders. Millions of Americans hold stock options. What's at issue here is whether some top executives--typically CEOs--committed fraud when obtaining them.
Q: How widespread is the practice of backdating?
Nobody knows for sure. One method academics have used to measure the pervasiveness of backdating is to review stock option grants to executives to see if an unusual number are clustered around dates when the stock is trading at a low value. Then, when the stock increases, the executives benefit.
Q: What has this technique shown?
Erik Lie, a finance professor at the University of Iowa's College of Business, has evaluated thousands of option grants and found that it was statistically improbable for them not to have been backdated at many companies.
A paper by Randall Heron, an associate professor at Indiana University's business school, published on July 14 estimates that 18.9 percent of unscheduled grants to top executives from 1996 through 2005 were backdated or manipulated. The pair estimates that 29.2 percent of firms manipulated grants to top executives at some point between 1996 and 2005.
Q: Under what circumstances is backdating legal or illegal?
Backdating is not necessarily illegal. If a company's executives are up-front about it with shareholders and the government, everything's probably fine.
The problem, though, is that the allegations that have come to light have not included full disclosure to shareholders, payment of extra applicable taxes, and earnings statements that reflect the modified grant dates.
Any of those three categories could yield civil (and perhaps criminal) legal action.
Q: What kind of legal charges could companies face?
It depends on the individual circumstances. But in general, backdating a stock option (without communicating this to shareholders) could run afoul of tax laws, securities regulations and laws prohibiting fraud.
The Securities and Exchange Commission, the U.S. Attorney's office in San Francisco, and the U.S. Attorney's office in New York have been conducting parallel investigations.
Q: Would the IRS get involved?
Paul Caron, a visiting professor at the University of San Diego School of Law and author of the TaxProf blog , outlined two possible tax law violations in an e-mail to CNET News.com.
Stock option backdating
Some Bay Area companies have announced that they've been contacted by the U.S. Attorney's office in northern
California. Typically the contact comes in the form of a grand jury subpoena. They include:
Altera

Applied Micro Circuits
Asyst Technologies
CNET Networks
Equinix
Foundry Networks
Intuit
Linear Technology
Marvell Technology Group
Maxim Integrated Products
Openwave Systems
Power Integrations
Redback Networks
VeriSign
Zoran
One consideration, Caron said: Did the companies take the backdating into account when calculating how much they owed under the tax code, which limits a public company's deduction of employee compensation to $1 million? Second, do the backdated options constitute "nonqualified deferred compensation," in which case the companies may be liable for excise taxes?
Q: Why are companies restating earnings?
If they had stock options that were backdated and not disclosed, that essentially provides executives (or other employees, but typically executives) with extra compensation. That's an expense that must be disclosed to shareholders.
Q: What's going on with Brocade Communications Systems?
Federal officials held a press conference on July 21 in San Francisco to announce civil and criminal charges relating to allegations of stock option backdating by former top executives of the networking-gear manufacturer.
Gregory Reyes, Brocade's chief executive until 2005, and Stephanie Jensen, the company's vice president of human resources from 1999 to 2004, are facing civil and criminal charges. In addition, Antonio Canova, Brocade's former chief financial officer, is facing civil charges.
Q: What are the allegations against Reyes?
The FBI has not alleged that Reyes backdated stock options for his own financial benefit. Rather, he's accused of backdating stock options to lure an unnamed employee to take a "high-level sales position." An FBI affidavit says
Reyes told Jensen to backdate an offer letter by more than two months to benefit from a more favorable share price in late 2001.
Reyes' attorney has defended his client as wrongly accused, saying "financial gain is always the motive in securities fraud cases, and here there was none. There is not even an allegation of self-enrichment, or selfdealing."
Q: That's backdating. What's "spring-loading?"
It's almost the opposite of backdating. The stock options are awarded just before news, usually positive, is announced. The shares increase in value and--presto--the options are worth more. It works like this: If a CEO expects to make a new product announcement, he could allocate himself options when the stock is valued at $20.
Then, after the announcement boosts the share price to $25, each option would be worth $5.
In a conference call on July 13 to announce a federal stock option task force, U.S. Attorney Kevin Ryan said the task force will be investigating spring-loading as well. "Then you have both insider trading and you have an accounting issue," Ryan said. "An old-fashioned cooking-the-books fraud." Q: Would fixing executives' grant date to, say, July 1 every year fix things?
Even if grant dates are fixed and happen at the same time every year, there's still room for shenanigans.
Academics have found some evidence that CEOs time the release of negative information to happen just before a scheduled grant date, and release positive information after a scheduled grant date.

Q: How did the Sarbanes-Oxley (SOX) law change things?
After Sarbanes-Oxley took effect in August 2002, companies were supposed to report stock option grants within two days. That makes backdating more difficult and is generally thought to have curbed the practice.
But Sarbanes-Oxley probably has not eliminated backdating. A November 2005 paper, P. Narayanan and H.
Nejat Seyhun, finance professors at the University of Michigan's business schoool, analyzes grants made before and after the law's effective date.
They found that about 24 percent of stock option grants are reported late. The conclusion? "Backdating and camouflaged timing appear to be practiced even after SOX, especially by smaller firms."
In a follow-up paper, Narayanan and Seyhun add: "We find that executives can increase their compensation even in the post-SOX era by playing the dating game and reporting their options late. Our findings indicate that a manager receiving a large grant of 1,000,000 shares of a typical company's stock can increase the value of their grant by about $1.23 million, or 8 percent, by reporting 30 days late."
Q: Why is there this emphasis on stock options? Why don't CEOs just ask for a raise?
Blame the U.S. Congress. Sec. 162(m) of the U.S. tax code limits companies' ability to deduct pay for certain executives if the amount exceeds $1 million a year.
There's an exception in the tax code, however, for "performance-based compensation," which includes stock options. So companies can save on taxes by handing out lucrative stock options instead of lucrative salaries. In addition, executives themselves benefit by exercising the stock option and waiting a year to sell the stock. That qualifies as a capital gain and is currently subject to only a federal income tax of only 15 percent.
Why else would Apple CEO Steve Jobs, Yahoo CEO Terry Semel, and Google CEO Eric Schmidt only ask for $1 in salary? (In fact, if Congress had simplified the tax code and made CEO salaries fully deductible, it's likely that no backdating scandal would have occurred. Of course, honest CEOs would help too.)
Q: What lawsuits have been filed by investors over stock option backdating?
Apple faces a number of suits filed on behalf of shareholders and pension plans in federal and state courts in
California. The complaints, which accuse company executives of manipulating stock options to maximize returns, name past and present officers, such as Jobs, Chief Financial Officer Peter Oppenheimer and even Apple board member and former U.S. Vice President Al Gore.
A handful of cases involving similar allegations and parties are pending in California federal court against chipmaker Rambus. And earlier this month, video game software company Activision revealed in a financial filing that it had been sued in Los Angeles Superior Court for "purported improprieties" in its handling of past stock option grants.
Other targets of similar suits include semiconductor manufacturer KLA-Tencor and wireless and broadcast communications site operator American Tower.
Outside the tech sphere, health care services provider UnitedHealth faces several suits in Minnesota federal court filed by individual shareholders and pension funds claiming the company's top executives and board members received billions of dollars worth of illicit stock option grants.
ADDITIONAL ARTICLES ON STOCK OPTION COMPENSATION
Accounting for Employee Stock Options

before the
Committee on Small Business and Entrepreneurship
United States Senate
April 28, 2004
This statement is embargoed until
10:00 a.m. (EDT) on Wednesday, April
28, 2004. The contents may not be published, transmitted, or otherwise communicated by any print, broadcast, or electronic media before that time.
Madam Chair, Senator Kerry, and Members of the Committee, thank you for the opportunity to present the findings of a Congressional Budget Office (CBO) report on accounting for employee stock options.
(1) The purpose of the report was to examine the way in which the recognition of the cost of such options--as in the Financial
Accounting Standards Board's proposal to require the expensing of compensatory stock options for publicly traded firms (2) --would improve the measurement of net income. In my remarks today, I wish to make three points:

Granting stock options to employees results in a cost to the firm that is equivalent to cash and other noncash compensation. Like the cost of other compensation, the fair value of options is an expense to the granting firm.

Valuing employee stock options is more difficult than valuing cash compensation, but the difficulty does not appear to preclude the recognition of their fair value, especially when compared with the intricacy of some other calculations of compensation expenses.

Recognizing the expense of employee stock options would not change the economic fundamentals of any business, large or small. Thus, any economic effect of this accounting change would derive from altering investors' perceptions of the expenses and net income of some firms. To the extent that recognized net income is closer to its underlying economic value, more accurate perceptions would be broadly beneficial.
Compensating Employees with Options Is Costly to the Firm
Granting options or other benefits in lieu of cash compensation is an exchange of value for labor services. A fundamental objective of financial accounting is to tally operating flows of resources into and out of the reporting entity in order to measure the net gain or loss from operations during the specified period. Including the fair value or cash equivalent of compensatory options and recognizing that value as an outflow of resources when the corresponding labor services are provided--the vesting period--brings accounting practice closer to economic reporting of total expenses and net income.
Several aspects of that observation merit discussion. First, CBO's analysis is entirely consistent with the notion that stock options are valuable to employees. Indeed, if not, employees would not accept options instead of other compensation.
Second, it may be the case that the value of options differs among employees or shifts over time. The focus of accounting for expenses and net income, however, is on the cost of compensation to the firm at the time that the labor services are provided. Expensing over the vesting period the fair value of stock options when they were granted reports that cost for the firm. As detailed in the CBO report, subsequent changes in valuation represent a shift of resources among firms' stakeholders but not a change in the cost of labor compensation.
Finally, stock options can be cost-effective in attracting and retaining a skilled workforce. Any beneficial incentive or productivity effects will be reflected in earnings, as reported in net income. A fair display of cost-effectiveness will be achieved by also showing the cost of labor services. The demonstrated effectiveness of options as an incentive-based compensation tool makes it desirable that proposals to recognize the value of options do not prohibit their use by any company.

Valuing Options Can Be More Difficult Than Valuing Some Other Forms of Compensation
Compared with pay and purchased fringe benefits such as employee health insurance, employee stock options are more difficult to value because their price is usually not observed directly. In addition, features such as vesting periods, forfeiture provisions, and restrictions on transferability make valuation more complicated than for options without those features. However, advances in financial analysis now permit reasonable valuation of a wide variety of such warrants, as attested by their presence in many investment portfolios--including that of the federal government.
Some perspective on the difficulty of valuing options may be provided by comparison with another form of employee compensation: health benefits for retirees. To value those costs, the firm must project numerous uncertain future conditions, including employees' tenure, retirees' marital status, trends in health and mortality, changes in medical technology, and the cost and utilization of medical services years hence. That is, the valuation exercise is forward-looking and incorporates uncertain and volatile prices. Current valuation methodologies for employee stock options address an analogous situation, with the advantage that robust options-pricing models are now in the standard toolbox of MBAs. In short, the challenge does not appear to be unique or fraught with such practical difficulty that one would prefer a value of zero, which is currently permitted. Moreover, as the demand for such valuations increases, one should anticipate further analytical advances and a growing supply of service providers.
Recognizing the Fair Value of Options Would Not Change the Economic Fundamentals for Any Business
Cash flows available to conduct operations will not be affected by the form of accounting disclosure in financial statements. Customers, product markets, and competition will be unchanged. Small and large businesses will face the same labor market conditions, and they will have the same tools available to attract highly productive labor. In fact, the underlying financial facts will be precisely the same for all businesses after any new accounting standard is adopted.
Thus, the channel for any possible real economic effect would be a change in investors' valuation of businesses.
For savvy investors and most firms, expensing would provide no new information and, therefore, no change in value. That situation exists because the current standard requires firms to calculate and disclose, in audited notes, the fair value of the options granted and the effect that recognizing them as an expense would have on reported net income. For those investors willing to refer to that disclosure, information required by the proposed standard is already available. Expensing would only make that information more easily accessible and broadly available. Nonetheless, it has been argued that there will be a significant decline in the prices of stocks as a result of expensing. The experience of companies that have already begun to expense options in the United States,
Canada, and the European Union argues against any significant overall effect.
Another concern has focused primarily on businesses too small to be tracked by market analysts. The belief that expensing employee stock options will reduce their stock prices has prompted some businesses to declare that they will stop granting options rather than recognize the expense, regardless of the benefit of the options to the firms or to their employees. The economic importance of entrepreneurial firms and the informed nature of these reports suggest that they be taken seriously. Perhaps investors in some firms would be surprised to discover the effect of options on earnings. Such businesses would suffer a decline in stock prices and an increase in the cost of equity capital, with potentially sizable near-term losses for managers and employees. But in the same way that some businesses might have been relatively overvalued as a result of understated compensation costs, other firms have been relatively undervalued. The latter would enjoy an increase in stock prices as a result of the accounting change, permitting near-term expansion of markets and employment. Therefore, the effect overall would be smaller than for any single firm.
Such dynamics reflect the fact that improved information and valuation would tend to divert new investment from firms with less productive opportunities toward others with more productive ones. That is, a potential economic benefit for the economy as a whole from the proposed accounting standard would be to increase the flow of capital to those businesses that could use it more productively, as indicated by their higher net income.
This completes my statement, Madam Chair, but if I may, I would like to submit the CBO report on this topic for possible inclusion in the record.

1. Congressional Budget Office, Accounting for Employee Stock Options (April 2004).
2. Financial Accounting Standards Board, Proposed Statement of Financial Accounting Standards: Share-Based
Payment (No. 1102-100, an amendment of FASB Statements in No. 123 and 95), March 31, 2004, available at www.fasb.org/draft/ed_intropg_share-based_payment.shtml
.
STOCK OPTION ACCOUNTING:
“Déjà Vu All Over Again”
By Professor Terry Warfield
In the wake of the dot-com and general market meltdowns caused by accounting, audit and disclosure weaknesses, the Sarbanes-Oxley Act of 2002 was passed and is getting fairly good reviews from management, regulators and investors for restoring trust in our capital markets.
Congress and market regulators, however, are still calling for action by the Financial Accounting Standards Board
(FASB) – the private-sector setter of accounting standards – to address the “gaps” in GAAP (generally accepted accounting principles). Ten years ago, the FASB first proposed that companies be required to expense the cost of stock options, only to back off in the face of pressure from business (especially high-tech firms) and Congress.
Last March, FASB issued a new proposal that, if adopted, would significantly change the accounting for stockbased compensation. The proposal generated considerable controversy and in October, FASB announced a sixmonth delay in the long-awaited plan.
At this point, mandatory expensing of stock-option pay would not begin until the third quarter of 2005 for companies with calendar fiscal years, and opposition to the proposal may build to the point that federal legislation is passed to block the proposal for good. Let’s examine this controversial accounting proposal and see how its development has been a great learning vehicle for our accounting students here at the School of Business.
New Accounting for Stock Options
Historically, accounting rules permit companies to report little compensation expense when stock options are issued to employees in exchange for services. Th is is because expense for stock options is based on the “intrinsic value” of the option on the date of grant. Intrinsic value is the difference between the market price of the stock and the option price – the price at which employees can purchase company shares. By issuing options to employees
“at the money,” the intrinsic value is zero and no compensation expense is recorded. Not surprisingly, most stock options are issued at the money and as a result, the expense related to stock options is left out of income.
To address this omission, the FASB has proposed required expensing with measurement of expense based on fair value of the options granted. The expensing requirement would have a significant impact on income. One recent study by Bear, Stearns estimates that 2003 operating income of the S&P 500 would have been 8 percent lower had options been expensed.
How does the FASB, a private, independent body, decide whether to issue a new standard? The Board solicits input on its proposals, receives comment letters and holds public hearings. The FASB commonly conducts field studies to gather information on possible implementation issues on proposed rules. Only after considering all input does the FASB issue a standard.
Where from Here
To date, after receiving input on its proposal, the FASB appears headed toward approving a standard requiring the expensing of equity-based compensation. Not everyone agrees that stock-based compensation should be included in income. Those opposed to expensing stock options generally cite the following reasons in testimony to the FASB: 1) the cost of employee options is dilution of existing stockholders’ equity, and therefore it should not be reported as an expense; 2) existing models for measuring the actual compensation are inaccurate and therefore misleading; 3) expensing stock options will distort the company performance because it is a non-cash charge.
In contrast to when the FASB last proposed expensing options in the early 1990s, even most opponents today agree that some expense should be recorded for equity-based compensation. However, this has not stopped a minority of financial reporting constituents from mounting a “full-court press” on the FASB to halt the issuance of the proposed standard. In addition to lobbying the FASB, these opponents have lobbied Congress. For example, a recent bill passed in the House of Representatives would override the FASB standard and require companies to expense only the options issued to the top five managers (a similar bill is pending in the Senate). These opponents (represented primarily by companies in technology companies, which are heavy users of

compensatory stock options) also argue that by requiring expensing of all options, companies will stop issuing options, negatively affecting their competitiveness.
As we have learned from Enron, WorldCom, and other recent failures, credibility of financial reporting is fundamental to the efficient operation of our capital markets.
Others, including the chairman of the SEC, the four largest public accounting firms, Federal Reserve Board
Chairman Alan Greenspan, major investor groups (and this author) support the FASB’s proposal, noting that options are an expense just as cash compensation is an expense. Goods and services received in exchange for stock options result in a cost and should be recognized as such in the financial statements. Because a valuable financial instrument is being exchanged for employee services, fair value is the most relevant measure of compensation cost. The proposed standard would treat stock-based compensation like other forms of compensation, which is faithful to the economic substance of stock-based compensation arrangements and would increase the ability to compare information reported about stock-based and cash compensation plans. These are the important qualitative characteristics that contribute to the usefulness of financial statements.
Changes in the economic and financial reporting environments in the past 10 years also reinforce the need for an enhanced standard. Most notable are recent business and accounting failures mentioned earlier. During the late
1990s, we witnessed numerous business, auditing, and accounting failures, which raised new concerns about, and demand for, high quality and transparent accounting practices. To many, the accounting for stock-based compensation is an example of less than transparent accounting, by omitting from financial statements an important cost of business. Indeed, beginning in 2002, a number of companies began to voluntarily switch to the fair value method for recording compensation expense related to stock options; by June of 2004 over 600 public companies were using the fair-value method. A major reason for this change was to show the investing community that these companies believed in fair and transparent financial reporting. However, because some companies include stock-based compensation expense in income and others only disclose the pro-forma effects, comparability concerns have been raised.
For all of these reasons, there is broadbased support for the FASB’s proposal. I believe the FASB’s decision to require stock option expensing in 2005 will strengthen investor confidence in the financial statements of all companies, thereby lowering their cost of capital. The efficient allocation of capital depends on high-quality accounting.
Political Considerations
Opponents of the proposal are pursuing political means to affect the outcome of the accounting standard-setting process. A bill to block the FASB’s rule change was passed by the House this past summer (although the Senate so far has refused to take up the bill). These efforts are unfortunate because they may undermine the authority of the FASB at a time when it is essential that we restore faith in our financial reporting system. Indeed, I believe that political pressure on the development of accounting standards, and in particular, assailing the FASB’s role as an independent body, have contributed to the chain of events that led to the corporate scandals of the last several years.
It is important to understand that transparent financial reporting – by recognizing stock-based compensation expense – should not be criticized because companies will report lower income. We may not like what the financial statements say, but we are always better off when the statements are faithful to the underlying economic substance of transactions. Various legislative proposals that call for reporting only part of the expense for stock options in income – are not. Some proposed bills might even preclude companies that have recently begun voluntarily expensing the cost of options from reporting the full cost of their compensation plans
As we teach students of accounting, such reporting is biased – it may be in the interests of managers of some companies but it does not well serve financial reporting or our capital markets. Biased reporting not only raises conc erns about the credibility of these companies’ reports, but of financial reporting in general. Consider companies that do not use stock options. Why should they be made to look worse because they use a different form of compensation? As we have learned from Enron, WorldCom, and other recent failures, credibility of financial reporting is fundamental to the efficient operation of our capital markets. Even good companies get tainted by biased reporting of a few “bad apples.”
An additional source of bias in financial reporting arises when political interests attempt to circumvent the due process in the setting of accounting standards in the private sector.
A Great Learning Opportunity
The unfolding controversy over stock option accounting has provided a great learning opportunity for our students. It provides a great case study on the important accounting concepts of relevance and reliability and helps illustrate how each contributes to the usefulness of accounting reports. This issue also drives home the importance of life-long learning and continuing professional education. Within the past 25 years, professional accountants have had to stay informed on changes in accounting standards in this area at least three times. The

issue also illustrates the importance of the political process and its impact on accounting standards and practice.
Students can see the importance of the FASB’s due process.
Accounting standards can affect behavior. They need to be conceptually sound and accepted by those affected by them. It is my hope that political pressures do not override good accounting.
Executive Education offers programs in ESOP Management. Managing an Employee-Owned Company will be held January 11-13 at the Fluno Center.
Visit www.uwexeced.com/advancedmanagement/esop.htm
for details.
Copyrig ht © 2006 The Board of Regents of the University of Wisconsin System
Last Modified: Friday, October 07, 2005; at 1:18:03 PM
Who Rules Accounting?
CFO.com
Congress muscles in on FASB -- again.
Craig Schneider , CFO Magazine
August 01, 2003
Dennis Beresford is having flashbacks these days, and they are anything but pleasant. Congress is once again trying to derail the Financial Accounting Standards Board's efforts to require companies to expense stock options.
And for the former FASB chairman, the lawmakers' moves are a painful reminder of what happened during his tenure at the board's helm nearly a decade ago. "It's déjà vu all over again," says Beresford, now a professor of accounting at the University of Georgia.
Under intense pressure from Capitol Hill, FASB under Beresford backed off of a similar proposal in 1994, compromising not only the board's position on expensing but its very independence as a standard setter. It took years for the board to buck congressional pressure again, this time on new, far-reaching rules on derivatives and business combinations. Of course, FASB's submission to Congress did nothing to prevent lawmakers from scolding the board for the cautious pace of its its deliberations on accounting issues related to the Enron scandal.
No one in Washington, D.C., claims to desire an end to the independent setting of accounting rules, at least in public. The legislators insist they are merely trying to aid the struggling economy by encouraging greater use of entrepreneurial incentives.
But will keeping stock options off the income statement have the desired effect? Many observers contend that while FASB's 1994 decision not to require options expensing may have inspired entrepreneurs, it also certainly motivated executives to pump up their companies' stock prices by whatever means necessary. In fact, the widespread use of nonexpensed stock options is generally thought to have led not to economic strength, but to inflated stock-market valuations, excessive executive compensation, accounting frauds, bankruptcies, and the loss of approximately $5 trillion.
Some managers may welcome congressional efforts to reinflate the stock- market bubble, but forcing FASB to back down on options could instead undermine whatever confidence in the financial markets investors have since regained. "The capital markets need high-quality, unbiased information to make allocation and pricing decisions," says FASB board member G. Michael Crooch. "Managing accounting data for some hoped-for economic result is too risky and dangerous."
A Simple Bill
The current fight is still in its early stages. Until recently, in fact, the latest debate over expensing was limited to arcane issues involving valuation methodology. But now Congress has reentered the picture, and its legislative steps would render the outcome of the debate about valuation methods all but moot.
At first glance, the bill introduced in March by Rep. David Dreier (R-Calif.) and co-sponsored by Rep. Anna G.
Eshoo (D-Calif.) — H.R. 1372, or the Broad-based Stock Option Plan Transparency Act of 2003 — sounds innocuous enough, calling as it does for enhanced disclosure of stock-option plans.

But the bill, which has attracted considerable bipartisan support, including that of half the Democratic presidential hopefuls, first demands a three-year study by the Securities and Exchange Commission to assess the potential impact of broad-based stock-option plans on the economy.
Meanwhile, the legislation would impose a moratorium on new FASB rules related to stock options, so if the board went ahead and mandated expensing anyway, the SEC would be barred from recognizing the rule as part of generally accepted accounting principles (GAAP).
So much for independently set accounting standards.
Back to the Future
In the face of similar pressure nine years ago, FASB's retreat enabled it to live to fight another day. But board members and others involved in that decision now regret the move. Former SEC chairman Arthur Levitt admits that urging FASB to back off was "the biggest mistake I made" during his eight-year tenure.
The International Accounting Standards Board (IASB), FASB's international counterpart, is clearly concerned about the impact the bill could have on accounting standards in general. "If the U.S. Congress or political authorities in other countries seek to override the decisions of the competent professional standard setters...accounting standards will inevitably lose consistency, coherence, and credibility," warned Paul A.
Volcker, former Federal Reserve Board chairman and current chairman of the foundation that oversees the IASB, in written testimony.
But Eshoo and Dreier represent districts in California where incentive stock options are still sacrosanct. And to be sure, high-tech companies, many in their early stages and strapped for cash, rely on stock options as incentives for employees as well as for executives. According to these lawmakers, expensing would hobble the ability of such start-ups to attract talent and, in turn, stifle innovation in the U.S. economy. "This is a public-policy issue," said Dreier in his testimony at the hearing in June. "This is not an accounting issue."
Yet it's hard to see how accounting is not public policy when the public relies on financial statements prepared under U.S. GAAP to determine whether companies deserve its capital. In FASB's view, options should be included in the income statement like other forms of compensation expense, because that would give shareholders a more honest picture of a company's finances than burying the impact of options in the footnotes.
Investors applaud the stance. "If the result of having [option-based pay] expensed means you do away with the plans," says Peter Clapman, senior vice president and chief counsel of corporate governance at TIAA-CREF, "it means that it was never a particularly good form of compensation in the first place, because it shouldn't depend on accounting treatment."
The IASB, for its part, agrees with FASB. And there's nearly universal agreement that the capital markets would benefit from a single global standard for financial reporting on this item as well as others.
Of course, it's not surprising that FASB's congressional opponents claim their legislation does nothing to compromise FASB, which was established in 1973 as a replacement for the American Institute of Certified Public
Accountants's Accounting Principles Board.
With a board of seven paid, full-time members intended to keep standard setting a function of the private sector,
FASB's structure is supposed to ensure its independence from private interests that might interfere with its primary objective of creating neutral accounting rules. And while the Securities Exchange Act of 1934 gives the
SEC the authority to set standards, the commission delegates that authority to FASB.
Lest Congress forget these facts, current FASB chairman Robert H. Herz reminded members during a recent
House subcommittee hearing on H.R. 1372. "The moratorium," he proclaimed, would likely establish a "potentially dangerous precedent" and "signal that Congress is willing to intervene in the independent, objective, and open accounting standard-setting process based on factors other than the pursuit of sound and fair financial reporting."
Herz also noted that such interference would be "inconsistent with the language and intent" of the Sarbanes-

Oxley Act of 2002, which includes added measures to ensure FASB's independence. He warned Congress that unlike his predecessors, he's "not gun-shy" about promulgating that view.
But Herz's warnings fell on deaf ears. Eshoo agrees that Congress "should not get into writing accounting standards" and that "FASB should be able to retain its independence." How exactly can that circle be legislatively squared? "If we are prevented from issuing what we consider to be a better and high-quality standard," notes
FASB's Crooch, "that's not very far from setting a standard."
Damned Economy
Dreier and Eshoo, however, adamantly defend their efforts. "I'm not doing anything that's counter to my constitutional obligations," Dreier insists. Eshoo says much the same thing. "I wish there were a meeting of the minds [with FASB]," she says, "but if there isn't, then I believe that it is absolutely appropriate. It is not interference, it is Congress exercising its responsibility relative to our nation's economy." She adds: "FASB has not been willing to examine anything except expensing, and economic issues be damned. I think we can do better than this."
Dreier jests that he could — but wouldn't — flip FASB's claim by saying "that they're tampering with our ability to create policies that encourage economic growth."
But there's reason to believe that Dreier and Eshoo are mistaken about the need to restrain the board to help the economy. Consider Netflix, an online DVD rental service that went public in May 2002 and announced this past
June that it would expense options. Expensing, says CFO Barry McCarthy, provides the company with
"consistency in financial reporting." And he doesn't expect the decision to have a negative impact on his ability to raise new capital. "In my experience," he says, "investors increasingly distinguish between accrued expenses and real cash expenses."
What's more, McCarthy suggests lawmakers are being disingenuous about the intended beneficxiaries of the legislation. "Whenever you have large public companies that think their ox is going to be gored by a change in accounting principles," he says, "there's going to be a battle about the outcome."
Battle-hardened FASB members aren't taken aback by what's happening. "Standard setting is not a popularity contest and shouldn't be a popularity contest," notes Jim Leisenring, who was vice chairman of FASB during the earlier debate over expensing, and one of the two members who did not succumb to congressional pressure in the final vote. Leisenring, now a member of the IASB, says, "I believe FASB made a mistake in backing down, but they did so in the context of having no support from anyone."
A Delaying Tactic
How will the new battle turn out? Because of the dangers posed by the proposal in Congress, some observers predict it won't get very far. "I don't believe in the face of continuing revelations of accounting misdeeds that
Congress is likely to destroy the standard-setting process," says Levitt. "It's just a delaying tactic."
Levitt isn't alone in dismissing the threat. TIAA-CREF's Clapman believes some lawmakers who may have been comfortable 10 years ago openly favoring the high-tech-industry position on options are reluctant to do so today.
"A congressman or -woman who looks at this knows that their position is being scrutinized in ways that were not the case back in 1993," he says.
What's more, big accounting firms like Ernst & Young and shareholder lobbyists like the Council of Institutional
Investors have reversed their opposition to expensing, while nearly 300 public companies, including Microsoft, have adopted it during the past 18 months in anticipation of a change in the rules. While Microsoft recently abandoned new options grants in favor of restricted stock, the technology bellwether has also decided to expense options already granted.
The SEC has historically supported FASB's decisions, and chairman William H. Donaldson is on record as favoring the board's efforts to expense options. FASB "has put itself on the line and said there's an expense

attached to stock options," Donaldson told the Economic Club of New York in May. "I am waiting restlessly for this to happen." But will Donaldson stick to that position under pressure from Congress or the White House?
With enough political support for the bill, Eshoo predicts that the head of the SEC would find it difficult not to go along. "Certainly, chairman Levitt did," she observes. Levitt himself thinks Donaldson will stick to his guns. "We have an SEC chairman that is solidly behind the expensing proposal," he says.
To be sure, Donaldson also said publicly that he plans to visit with executives in California who oppose expensing options. "I am willing to listen," he said in May. But he told them not to get their hopes up. "As far as I'm concerned," he warned, "we have crossed the Rubicon."
Perhaps. Congressional support for the bill is by no means overwhelming at this point. But Beresford fears that
Sarbanes-Oxley has inadvertently made FASB more vulnerable to political pressure. Previously, about a third of
FASB's annual budget came from voluntary contributions from public accounting firms, the AICPA, and some
1,000 individual corporations.
Under Sarbanes-Oxley, those voluntary contributions are replaced by mandatory fees from all publicly owned corporations based on their individual market capital-ization. But the fees are to be collected by the newly formed
Public Company Accounting Oversight Board. And the SEC oversees the PCAOB.
While Beresford believes the new setup gives FASB more independence from the business community, he says,
"it's not clear that it has more independence from the political process. In fact, it may have less [independence] from Congress and other people in Washington." Under the new arrangement, it's a pretty simple matter for the
SEC to pressure FASB. "The SEC could give them a hard time with their budget," notes Beresford, "and just not get around to collecting the money they made."
In other words, how FASB votes on options expensing may depend on how William Donaldson handles the board's paychecks.
FASB's Surgeons
On its own terms, the legislation now before Congress poses less of a threat to FASB's independence than a bill introduced a decade ago.
In 1993, legislation introduced by Sen. Joe Lieberman (D-Conn.) would have not only nullified the effect of the proposed FASB standard on stock options but also effectively put the board out of business, notes then-FASB chairman Dennis Beresford.
The bill, which garnered broad support, required the Securities and Exchange Commission to redo the whole standard-setting process. Faced with its likely passage and virtually no support for its project by executives, the accounting industry, or the SEC, FASB backed away from expensing, instead requiring disclosure of the cost of options only in the footnotes of financial statements.
The Senate ultimately voted 88 to 9 for a nonbinding resolution that urged FASB not to expense stock options. "It was basically a warning shot," says Beresford, "but the bigger concern was the actual legislation proposed by
Lieberman."
"The difference now is that they're dealing only with the stock-options issue," Beresford says of the bill introduced in March by Rep. David Dreier (R-Calif.) and co-sponsored by Rep. Anna G. Eshoo (D-Calif.). "It's more of a surgical strike."
Since a House subcommittee hearing on the bill in June, 13 representatives have joined as co-sponsors, for a total of 53 bipartisan supporters. That represents more than 12 percent of the total 435 House representatives. A companion bill, S. 979, introduced in the Senate in May by John Ensign (R-Nev.) and co-sponsored by Barbara
Boxer (D-Calif.), faces a more uncertain future despite having a higher level (19 percent) of bipartisan support.

Senate Banking Committee chairman Richard Shelby (R-Ala.) recently said he would deny that bill a hearing in the Senate, believing as he does that lawmakers shouldn't be interfering in FASB's affairs.
But as the outcome of Congress's last battle with FASB over stock options suggests, legislation needn't be enacted to have the desired effect. —C.S.
D.C. Versus the Board
Stock options haven't been the only source of friction between the Financial Accounting Standards Board and its federal overseers. To be sure, the Securities and Exchange Commission has only officially overridden FASB once since the board's inception in 1973. That decision came a few years later, as FASB was writing rules for oil and gas exploration and development costs.
Congress, for its part, has taken an interest in several other FASB projects over the years, including accounting for derivatives and the business combinations and goodwill project. The latter issue, which ultimately eliminated pooling of interests accounting, spawned legislation and arguments that are strikingly similar to those stemming from today's options-expensing debate.
During hearings on the proposed elimination of pooling, for instance, Cisco Systems Inc. CFO Dennis Powell, then corporate controller, warned during a Senate hearing that the proposal "will certainly stifle technology development, impede capital formation, and slow job creation in this country." He further argued that a switch to the purchase model would lead companies with a higher percentage of acquired intangible assets "to report an arbitrary, artificial net-income number that is irrelevant and misleading."
Of course, that view assumes that investors' perceptions are more important to economic growth than business fundamentals, and the bursting of the Internet bubble has thrown cold water on such thinking, at least for the time being. But that hasn't prevented industry lobbyists from rehearsing the argument in the latest battle with FASB.
Yet Barry McCarthy, CFO of online DVD rental service Netflix, thinks such concerns are vastly overblown. "Our investors focus on EBITDA and free cash flow just as much as on net income and net loss in deciding what the enterprise is worth," he says. "The conventional wisdom on Wall Street has been that investors look right through the stock-option charges for tech companies."
According to Silicon Valley, however, they won't if the charges are no longer buried in the footnotes. The question is, is that a good thing or a bad thing? —C.S.
The Same Old Story
The debate over accounting for stock options is 30 years old and counting.
Year Action
1972 The Accounting Principles Board (FASB's predecessor) prescribes intrinsic-value method to measure cost of employee stock option plans.
1984 FASB reconsiders APB Opinion No. 25
(above) to determine whether all stock- based compensation should be included as an expense on income statements.
1988 FASB sets aside compensation project; receives hundreds of comment letters, many objecting to FASB's tentative conclusions on stock options accounting.
1991 Sen. Carl Levin (D —Mich.) introduces bill that would have required companies to treat the value of stock options as an expense.
1992 FASB resumes work on the stock-based compensation project, partly in response to

the proposed federal legislation.
1993 FASB issues exposure draft of proposed FAS
123, requiring that stock options be valued and recognized as expense in a company's reported net income.
Sen. Joe Lieberman (D —Conn.) introduces bill that would have nullified the effect of the proposed FASB standard on stock options.
FASB gets over 700 comment letters, most expressing opposition to options expensing.
Senate subcommittee holds hearings on employee stock options accounting.
1994 FASB conducts public hearings in
Connecticut and Silicon Valley on proposed standard on stock options; thousands of hightech workers stage protest.
Senate votes 88 —9 for nonbinding resolution urging FASB to drop expensing proposal.
FASB decides to require only pro-forma disclosure of stock options.
1995 FASB issues FAS 123, recommending fairvalue method, requiring pro-forma dis- closure of all stock-based compensation expense but not on-book recognition.
2001 IASB says it will consider requiring companies to expense options. Enron Corp. files for bankruptcy.
2002 Senator Levin introduces a bill to require companies to expense options before receiving tax deductions on them.
FASB invites public comment on comparison of FAS 123 and IASB proposed standard, which would treat options as an expense.
FASB issues amendment to FAS 123 to provide alternative methods of transition and additional disclosures for companies that voluntarily expense options.
2003 FASB adds project on stock-based compensation to its agenda to consider whether the cost of stock options should be treated as an expense.
Rep. David Dreier (R —Calif.) introduces bill that calls for more disclosure of stock- option plans but would impose a three-year moratorium on rules for stock options.
FASB votes 7 —0 in favor of expensing employee stock options.
Senate holds roundtable discussion on accounting for stock-based compensation.

House subcommittee holds hearing on accounting for stock-based compensation.
Sources: FEI, FASB