Accounting for stock options - am I missing something?

Large sums associated with the exercise of stock options have raised questions of excessive executive compensation and focused attention on an issue that was dormant for years. Many arguments have been advanced -- both pro and con -- regarding the decision of the Financial Accounting Standards Board to issue a proposal requiring companies to recognize an expense for all stock compensation awards, including stock options.

For stock options the expense would be measured as the fair value at the date the option is granted. "Fair value" would be derived from projections of future market value of the stock using Black-Scholes or some other mathematical model. After a three-year disclosure period, companies would be required to deduct the expense from earnings. FASB Chairman Dennis R. Beresford has stated that the "present practice in accounting for stock options produces inconsistent results ... which impairs the credibility of financial statements. We believe that our current proposal would improve this area of financial reporting."

There has been a lot of debate about the value of options. Certainly they have a value. Why else would they be welcomed by corporate executives? But how does one determine the value of an option? Its value at the time of grant can only be measured by the prospects for future appreciation in the market value of the underlying stock. While a number of sophisticated valuation models have been developed, like the Black-Scholes model, none have proven to be reliable indicators of future value.

Although many options have proven to have extraordinary value, others, perhaps in equal numbers, have proven to have no value at all. Options for the purchase of stock whose price remains under water have no value and ultimately will expire without being exercised. And whether or not the options ultimately have value over their exercise period, is it appropriate to charge against earnings any expense based on future stock market value projections? I think not!

The SEC's new proxy rules already require disclosure of executive stock options, and several organizations, including the Council of Institutional Investors and the National Association of Securities Dealers, have called on the FASB to follow the disclosure approach rather than charging an expense to earnings. While FEI's Committee on Corporate Reporting has jurisdiction within FEI over technical accounting and reporting issues and has not yet commented on the FASB action, my experience in administering stock option programs convinces me that the FASB is barking up the wrong tree.

Lost in the rhetoric about accountability to stockholders is the simple fact that all proposals for the establishment of stock option and other stock compensation plans must be voted on and approved by current stockholders. In my view, when the stockholders approve a stock option plan, they are authorizing the board of directors to implement and administer the plan on their behalf. They expect that the plan will more closely align the interests of management with those of the stockholders. If the expected result is achieved and the company's shares appreciate in value, the stockholders agree to share a portion of that appreciation with the management that contributed to the positive outcome. When options are exercised, there is an increase in the number of shares outstanding and per share values are affected, but net earnings are unchanged and there is no expense to the company.

My view of accounting for stock options obviously differs from that of the FASB and it may be overly simplistic. Am I missing something?

P. Norman Roy President Financial Executives Institute