65 Tax Notes 1149

Tax Notes

NOVEMBER 28, 1994

LENGTH: 2007 words

DEPARTMENT: Letters to the Editor (LTE)

CITE: 65 Tax Notes 1149

HEADLINE: 65 Tax Notes 1149 - PROFESSOR JOHNSON REPLIES TO FASB.

AUTHOR: Johnson, Calvin H.

University of Texas School of Law, Austin, TX

TEXT: 15 NOV 94

To the Editor:

FASB's mission. I am a friendly critic of FASB because I believe in FASB's mission. FASB creates the standards for financial accounting which is the yardstick by which corporate performance is measured. Accurate yardsticks help the stock market allocate capital away from the bad investments and toward the good. Bad yardsticks, ignoring costs, get in the way of good investing. Bad number systems also do harm because they lead to bad management decisions. The purpose of the Vietnam War, for instance, became to maximize 'body count' because the number system used, 'body count,' overwhelmed alternative ways of judging how the war was going. Corporate managers cannot manage what they do not measure.

For stock options, FASB should provide a measure of the corporation's compensation cost as early as reliable measurement is possible -- but no earlier. FASB is shooting itself in the foot by insisting, for quite unnecessary and unpersuasive reasons, that cost must be measured upon grant of an option even when far more reliable measurement can be made as the bargain itself arises. Nothing in good accounting theory or accounting history prevents FASB from relaxing a bit and delaying the measurement date until the bargain arises.

Early is sometimes reliable. Sometimes it is possible to measure the value of a stock option reliably at grant. If so, the corporation should report that value as cost because investors need to know about future costs and calamities as early as possible. If the corporation, for instance, gives employees warrants traded on a market or options that strongly resemble marketable warrants, then grant should be the measurement date. And when grant is a reliable measurement date and the employee has no significant influence over stock prices, the employee's subsequent gain from the option (if any) can reasonably be treated as investment gain rather than compensation.

Stock options are a profit-sharing plan. Some options, however, have no ascertainable value when granted. They provide only a framework for computing future compensation. Such stock options are not granted to make a liquidated, cash-like settlement. Rather the option is used by the parties to defer settling cost until they can see how well the executive and the corporation perform.

Long-term, nonmarketable compensatory options for top management are a kind of profit-sharing agreement. Under a regular profit- sharing agreement, the employee is paid according to the employer's future accounting profits and FASB requires accrual as the future profits become known. For a stock option, the executive gets a compensatory bargain according to future rises in the price of the corporation's stock. Stock options are a superior form of profit- sharing agreement because stock price can take account of many factors affecting corporate performance that are not incorporated in GAAP 'profits.'

Michael Eisner, for instance, was given stock options when he came over to Walt Disney Company in 1984. In 1992 he exercised a third of the options for a gain of $187 million. The Disney director who negotiated for the company in 1984 told a reporter in 1992, 'In no way did I think it would be worth that much to [him], but in no way did I think the company would be worth that much either.' One can imagine the 1984 negotiations: Eisner asks for an extra $1 million; the company refuses, but both parties agree that if Eisner can successfully lift the price of Disney stock, then he is well worth a great deal of compensation. Eisner spent the years from 1984-1992 increasing his compensation by working hard to pump up the price of Disney stock.

Eisner's stock options are like the cut of box office receipts that Arnold Schwarzenegger gets for making a picture. Schwarzenegger may negotiate a 2-percent cut of the profits or a 10-percent cut of the box office receipts when his compensation package is settled, but in either case, we have to wait until Schwarzenegger makes the picture and the box office receipts come in before we can tell how much Schwarzenegger is to be paid. For both Eisner and Schwarzenegger, the negotiated pay package gives him nothing but an executory contract of unsettled value. For both Eisner and Schwarzenegger, the compensation is set only after the pumping is done.

Schwarzenegger is ultimately paid in cash, while Eisner is paid with stock, but that is a difference without a distinction. Stock for the issuing corporation is nothing but a proxy for the future cash that the corporation must pay out of its stock. Stock represents nothing but the discounted present value of the cash the market expects the corporation to pay out on its stock.

Intentional understatement of costs. Even if we wanted to value Eisner's options in 1984, no honest job could be done. We could use a Black-Scholes pricing model to try to compute the investment value of a long-term Disney option in 1984, but the model would understate the compensation Eisner gets. Black-Scholes requires a measure of the volatility of Disney stock and the volatilities pulled from stock fluctuations over a short time do not reliably apply to 20-year options like Eisner's. Compensatory options also commonly have earn- out and forfeiture restrictions attached to them and there are no data relevant to the CEO's options that help us evaluate the impact of the restrictions. Most importantly, however, Eisner's return in 1984-1992 is not an investment return. He made no investment in Disney in 1984 to which his $187 million profit could be attributed. His first investment occurred in 1992 when he exercised his option. Eisner's $187 million return in 1992 depended on how hard and successfully he pumped up prices from 1984 to 1992 and that is compensation.

In the face of the unsolvable problems in valuing stock options at grant, FASB is unfortunately reacting by authorizing understatement of management compensation. In the Exposure Draft, FASB told companies whose stock was not traded on an established market that they could ignore volatility, when valuing options, under what was called the 'minimum value method.' Ignoring volatility for high volatility stocks can however mean that 90 percent of the value of an option is missed. According to a Wall Street Journal report, FASB is considering allowing even public corporations to understate the compensation cost on purpose. The reduction would range from 10 percent for options that could be exercised immediately to 40 percent for options that could be exercised only after five years. /1/ Management has legitimate concerns that options might be overvalued when measurement of the value is not reliable. But FASB is reacting to the legitimate concerns by blessing what is known to be material understatements of cost. FASB is allowing the manager of a corporation to understate his own compensation in his official reports to his shareholders and that is shameful.

Retreat to the high ground. All this is totally unnecessary. FASB has an easily defensible position on the high ground just by retreating a bit in time. There, it can easily repel the assaults by its critics. The compensation that Eisner gets from his stock options can be reliably measured over 1984-1992 by looking to the bargain that his stock options give. If the corporation debits the cost as the bargain arises, then exercise by Eisner would be no surprise. All that would be debited at exercise would be the increase in price since the last accounting period. In total, over the period Walt Disney Co. would account for $187 million, which represents the discounted present value in 1992 of the cash the market expects Disney to pay out on the bargain part of the stock that Eisner got.

Metaphysical nonsense. Apparently FASB insists that stock options must be valued when granted because of some misdirected ideas about the essential nature of 'equity.' FASB gets it right for 'phantom stock plans' in which the executive is paid in cash, according to how far the price of corporate stock rises. FASB recognizes that in a phantom stock plan, the ultimate cash payment is the compensation (which is accrued over the life of the plan), even when market price depends on factors that are not within the executive's control. The holder of a stock option has no more of a capital investment in the firm prior to exercise than the beneficiary of a phantom stock plan does before the plan is settled.

Having gotten it right for cash-settlement plans, FASB needs to correct itself about stock-settlement plans. There is no viable distinction between plans settled in cash and plans settled with stock. The debit (corporate cost) is the same, whether the credit (form of payment) is to cash, to debt, or to stock. Stock is nothing but a very expensive way for the corporation to pay out future cash.

FASB has claimed that it must value stock options at grant because a stock option is an equity, rather than a liability. Equities must be valued when issued, it is said, because an equity is a 'nonreciprocal transfer' much like the receipt of a charitable contribution. /2/

Stock options are an equity, all right: anything that can be settled by issuance of stock is an equity from the start. /3/ Still, issuance of stock is a cost on the corporate level that had better be reciprocal. If the managers have not gotten something back for the valuable stock they give out, they have breached their fiduciary duties to the existing shareholders. Even within the [quite dubious] nonreciprocal framework, in any event, there is no need to value the services contributed by Eisner or Schwarzenegger to their respective movie companies before they have done their pumping.

Summary and conclusion. When a company grants stock options traded on an established market or market-like options, then compensation can be reliably measured at that time. But when the options have no readily ascertainable value at grant, then it would be a mistake to try to measure cost then, especially when the result is a material understatement of the compensation that managers take from their shareholders. Stock represents nothing more than the discounted value of the cash the market expects the company to pay out on the stock. A later date to measure the bargain the manager gets will be a more reliable measure of the future cash the corporation has dedicated to the executive. Since the executive makes no investment until exercise, FASB has no serious problem in distinguishing between compensation and investment return. Long-term stock options represent the profit-sharing agreements in which the manager earns his gain by pumping up the price of the stock over the term of the option before he makes an investment. FASB can reliably measure the cost of compensation as the stock price the executive will share in becomes known.

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Sincerely yours,

Calvin H. Johnson

Andrews & Kurth Centennial

Professor of Law

University of Texas School of

Law

Austin, TX

November 15, 1994

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FOOTNOTES

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/1/ Lee Berton, 'FASB Stock-Option Plan Faces Changes That May Lessen Damage to Earnings,' Wall St. J., Nov. 6, 1994 at A-2, A-6.

/2/ Statement of Financial Accounting Concepts No. 6, Elements of Financial Statements par. 137 (1985). While par. 137 describes nonreciprocal transfers to include receipt of a charitable contribution, there is nothing there that requires the issuance of stock to be treated as a nonreciprocal transfer.

/3/ Notice 94-47, 1994-19 I.R.B. 9.

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