07 April 2011

Accounting issues

Some thoughts toward what will eventually become chapter 7 of my book, the chapter on Accounting and Valuation.

... The problem is not simply that the wrong accounting choices fool the tax authorities. The problem is not even that they fool investors. For our purposes in this book, the gravest difficulty is that the wrong accounting choice can prove a means by which management fools itself about the value of its company, its reserves of cash and other assets, and its strategic options. ["Big Oil's Accounting Methods" etc. 2006.]

Consider to understand this an accounting issue less obviously tied to inflation than the LIFO/FIFO imbroglio. Consider the question of the expensing of stock options.

In the dotcom-a-go-go years of the 1990s, neither the law nor accepted accounting principles required employers to recognize that in issuing stock options to their employees they had in effect expended enterprise wealth, i.e. stock options were not expensed.

Stock options were a critical part of the compensation package for many of the high-tech start-ups that give those years their distinctive flavor. The practices of not expensing such options allowed start-ups to show a profit sooner than otherwise would have been the case, and this in turn helped keep the original investors happy, while allowing start-ups to bring in new investors.

That was the argument -- when arguments came to be necessary -- for continuing to use stock options without calling them an expense. Yet it was also the argument for calling them an expense. For the obvious problem with the use of stock options was that they diluted the value of the company's equity. At some point some number of the options will be exercised and this increases the amount of stock outstanding -- there is a larger supply of that stock, then, capable of satisfying whatever the market demand may be.

For internal managerial purposes, too, it is important to know what is happening and what is likely to happen to the value of equity. It has a great impact on the company's ability to raise money quickly, on its ability to purchase other firms or to maintain its independence against those who would purchase it, and so forth.

Indeed, one could make an argument that the Financial Accounting Standards Board's politically motivated retreat from an expensing mandate was a signal -- something akin to a starter's pistol -- for the dotcom boom. In 1993 the FASB recommended a rule that would have installed expensing as part of the generally accepted accounting principles (GAAP) in the United States.

[My readers will want to know a bit about what the FASB is, if I have not already provided that info.]

Joe Lieberman (D-Conn.) a Senator from the state where the FASB has its headquarters, sponsored a Senate resolution declaring that the new proposed accounting standard would have "grave consequences" for entrepreneurs.

Indeed, on March 25, 1994, roughly 3,000 gathered at the San Jose Convention Center, in San Jose, California, protesting the threat posed by those distant Connecticut accountants to their beloved stock options. Kathleen Brown, the state treasurer, daughter of the once-and-future Governor Jerry Brown, addressed the crowd.

According to an account in FORTUNE, she shouted, "Give stock a chance," and the crowd loved it.

Lieberman and like-minded folks did manage to kick up enough of a fuss so that the FASB backed down, and continued to allow Silicon Valley and its favorite accountants to pretend that they were giving out something costless.

In face of political pressure, the FASB retreated. It said that in the main body of their books, companies could continue to pretend that options were, in effect, free. The retreat was not complete, though, because the FASB still required disclosure in footnotes.

This seemed like an awkward compromise to everyone, and unsurprisingly debate continued. By 1197 two analysts, Micahel L. Goldstein and Jonathan Freedman, had estimatef that the profits that corporations were showing about 5% the artifact of this rule and increased use of oiptions it encouraged.

The debates were kicked up several notches in intensity after the dotcom collapse. Heck, the debate was on The Simpsons. In an episode that aired in April 2002, ["I Am Furious (Yellow)"], Bart and Lisa were briefly employees of a dotcom company, paid in options. The company goes broke, and the siblings discover that their options are worth $0. But they have one million of them!

Bart to Lisa, "What's one million times zero?" then in a low growl he continues, "and don't tell me zero!"

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