Stock options are not an expense.

Once again, the Financial Accounting Standards Board is at odds with the business community, and the latest skirmish is over accounting for stock options. The board's exposure draft on stock options$follows several complex standards involving pensions, other postretirement benefits and income tax allocation, but, as we see it, the stock-option ED isn't an example of even-handed standard-setting. Who's right and who's wrong? And what's driving the FASB's decision-making?

The FASB's attempt to extend expense accounting to all fixed stock options has some serious problems, the primary one of which is that fixed stock options simply do not easily fit the expense mold. The FASB's conceptual framework states that "expenses are outflows or other using up of assets or incurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities. ..."

Of course, a stock option has value to the recipient. However, that value is an indirect measurement of the actual value of employment services, and you can't easily measure that when a company offers stock options in lieu of cash remuneration. A direct measurement takes into account the difference between cash salaries with and without stock options. Nevertheless, concentrating on the employment services helps you to understand the nature of the stock-option transaction.

If the option price is greater than the market price throughout the exercise period, recipients probably won't exercise the options. If beneficial services stem from the stock option, these services will have a limited, even nominal, value. But, unlike with usual expenses, there's no real cost to the stock option in this case. Under the proposed new rules, there would be a charge to income for this phantom expense with an offsetting rise in paid-in capital. So, has a loss really occurred, since the stock options apparently have been unsuccessful? You can't justify this because you made no expenditures for employment services; they were compensated with stock options. Our present accounting (under APB Opinion 25), however, is symmetrical: You record no expense and ultimately receive no real benefits, although the stock options may have had value at the grant date.

When the options are exercised, the increase in the share price above the exercise price may well result from the stock-option incentive, which, of course, was what the company intended. Therefore, the "expense" itself arises from the very benefit it was supposed to create. The expense is as much effect as it is cause, unlike any other expense. When security prices rise, thinking of stock options as an expense is a real paradox.

The problem stems from this: The fixed stock option, as an equity instrument, differs significantly from performance plans and stock appreciation rights. In the two latter situations, both involving expenses, the firm actually gives employees either stock or cash. The rationale is to help employees avoid up-front cash expenditures, which are required under fixed stock options. With the fixed stock option, a firm gives its employees an instrument that, if exercised, results in more cash flowing into the firm. While it's true the stock is purchased at a discount, the discount may well stem from the incentive efforts of the employees.

Another problem is stock-option capitalization and amortization. Evidence exists that companies adopt almost half of all stock-option plans without decreasing their other forms of compensation. So the FASB's position that stock options displace cash remuneration is questionable. When a company doesn't reduce compensation, it may simply be hoping for a windfall of employee efforts that could lead to higher security prices. But the idea that the stock option is an asset in this windfall is even more dubious than saying stock options replace other compensation.

The fixed stock option is an ingenious financial instrument that may create a win-win situation for a firm and its employees. If the firm does well through the efforts of its employees, both parties benefit. If the employees don't merit the incentives, the firm may save on compensation costs. The exceptions to this rule are, from the employee's perspective, when security prices don't rise and, from the company's perspective, when a rise in the stock price is mainly attributable to general market conditions, not employee efforts.

For all of these reasons, we believe the FASB should focus on accounting for similar transactions in a similar fashion and allow for differences only where real differences exist. Take, for example, lease transactions. In many cases, firms should capitalize lease transactions because they're largely alternative means of financing asset acquisitions. But when it comes to stock options, the FASB shouldn't erode the real differences between fixed stock options and stock appreciation rights or performance-type plans by trying to bring about artificial comparability among them. If the playing field isn't level to begin with, the board's efforts shouldn't artificially level it.

BRING OUT THE ACCOUNTING TEXTBOOKS

To better understand the stock-option transaction, apply the equity theories of accounting to the relationship between the company and its shareholders. The oldest equity theory, and the one that present-day accounting still heavily relies on, is the "proprietary" theory (the sum of the assets minus the sum of the liabilities equals the sum of the owner's equities). According to this theory, the assets belong to the owners, who are also saddled with the liabilities. Thus, the firm and its owners are totally interconnected.

In the modern corporation, of course, the shareholders aren't personally responsible for the firm's debt. Under the proprietary theory, you possibly could construe stock options as expenses since management's exercise of the options dilutes the nonemployee shareholders' ownership percentage of the firm. But this is debatable. One of the underlying reasons for using stock options as compensation is to make employees part of the game by aligning their interests with the owners', giving them an incentive to perform, which will in turn increase stock prices and ultimately benefit the owners. From the proprietary perspective, this is hardly an expense to outside shareholders.

Applying the "entity" theory (the sum of the assets equals the sum of the equities) to stock options makes the idea that they're an expense even more remote. Under this newer theory, the equities include both debt-holder and shareholder claims, and the right-hand side of the balance sheet represents how the assets have been financed. Because there's a sharp distinction between the firm and its shareholders, even diluting the ownership by exercising stock options won't make the options an expense because changes in ownership proportions are separate from the firm itself. And forget any notion of an "opportunity cost" to the firm for issuing shares below market value because the market value of the entire firm may increase as a result of the stock-option transaction. Stock options don't easily fit the category of expenses under the entity theory because there's no outflow of resources from the firm to management.

FROM A FINANCE PERSPECTIVE

In Accounting 101, we learned a corporation is a separate and distinct legal entity. In Finance 101, we learned the corporation's value is equal to the present value of the expected future cash flows available to all claimholders. In valuing individual projects, we should treat each one as a mini-firm, separating the investment decisions from the financing decisions. Hence, we'll forecast the incremental cash flows from assets, excluding any cash flows associated with financing (such as interest, principal payments and dividends).

This is entirely consistent with the entity theory. In essence, you treat a project as if it were all equity-financed. Capital distributions to debtholders and equity-holders aren't considered costs. After you forecast the cash flows, you estimate a discount rate that reflects the project's risk. The discounted value of the expected future cash flows minus the cost of the project gives you the project's net present value.

Performing a separate analysis to make the financing decision is key. The point is that the value of the project is equal to the value of the cash flows from the project, regardless of how it's financed. The financing decision is a decision to pay those cash flows to specific claimholders, such as bondholders, preferred shareholders or common shareholders. So, conveying stock options to employees is a financing, not an investment, decision.

The valuation procedure is another reason to reject the notion of stock options as expenses. Unlike tradable options or warrants, the stock option's calculated value doesn't reflect the collective wisdom of the market. The Black-Scholes option pricing formula is based on assumptions about the parameters needed to value the option. It assumes, among other things, that the stock's volatility is known and constant over the life of the option; that changes in the stock price are very small and occur continuously; that the short-term, risk-free interest rate is known and constant; that the option may be exercised only at expiration; that the stock pays no dividends; and that no takeovers or other restructuring events will result in the premature end to the option's life.

According to the Black-Scholes model, you must forecast these parameters. For instance, consider the variability in the rate of return on the stock. Of course, this volatility isn't constant over time, so you may have to forecast the "volatility of the volatility," as Fisher Black himself noted.

Takeovers present other problems. If you make an acquisition for cash, it will result in the premature exercise of an option on the target firm, which will lower the value of the option. However, if you pay a large premium for the stock, the value of the option may increase. On the other hand, if you make the acquisition with stock, the stock options on the target firm may become stock options on the acquiring firm. The stock of the acquiring firm may have different characteristics than that of the target firm.

The point isn't that you can't estimate the parameters or adjust them for unique circumstances, but that the forecasts and adjustments may be extremely uncertain, subjective and imprecise. And they wouldn't necessarily be consistent with the consensus of the market. The precision and verifiability implied by including a calculated value of the stock options on a financial statement is specious.

MANY MASTERS

Stock options are the latest in a line of transactions in which FASB standards have hit business hard. In pension accounting, under SFAS 87, the FASB switched to projected salaries to determine current pension expenses, even though future salaries are totally executory and largely beyond the control of current management. In SFAS 96, the board very conservatively implemented deferred tax asset recognition, although it corrected this in SFAS 109, even though deferred tax assets and liabilities still aren't discounted. In other postretirement benefits, the FASB employed future health-care cost trending, even though such estimates can be wildly unpredictable.

The pattern continues with stock options -- despite all the questions that business has raised about whether an expense really is present.

To understand the current standard-setting situation, consider the FASB's particular institutional position. The SEC, of course, is empowered by Congress to set accounting standards. While the relations between the SEC and the FASB (as well as its predecessors) have largely been cordial, the possibility still exists that the SEC could pull the plug at any time.

So, when members of Congress start screaming that stock options have been "excessive," the FASB is extremely likely to listen quite carefully. This doesn't mean the board won't also listen to its business constituency. It can, and it does. Unfortunately, business really has no other place to go, because the continued existence of the FASB probably is still preferable to turning the standard-setting reins over to the SEC or, worse, to the more draconian solutions Congress might propose. The result is an extremely difficult situation for the FASB, although we believe the board should try to use the conceptual framework more consistently to ward off political interference.

Given the politics of the standard-setting process, the FASB's stock-option capitalization proposal may well be an attempt to curb usage of the fixed stock-option instrument because the financial press has frequently reported on some rather large individual holdings of stock options. If stock options are excessive, then surely the solution isn't to propose that an intangible asset with little verifiability be capitalized and followed by some very dubious expense amortizations. What's more, while the FASB is supposed to be neutral on the economic consequences of its actions, enacting the proposal could put a damper on developing emerging businesses. Does the FASB want to discourage the use of stock options in response to Congressional criticism, which is a clear transgression of neutrality?

We hope continued business protest will cause the FASB to pull back from a stock option standard without any merit. According to the Wall Street Journal (June 9, 1994), the FASB "will concentrate on measuring stock-option costs rather than on whether the FASB proposal would hurt the economy or is bad accounting theory," a devastating admission.

We believe the market can maintain control over stock options -- first, via the earnings-per-share measurement, where stock dilution occurs if the market price exceeds the option price and, second, from adequate disclosure, even though the FASB says these controls aren't sufficient. We hope the board will reject a chaotic solution to a nonexistent stock-option problem.

Dr. Wolk is Aliber professor of accounting at Drake University in Des Moines, Iowa, and Dr. Rozycki is assistant professor of finance, also at Drake University.