Walter P. Schuetze 8940 Fair Oaks Pkwy Boerne, TX 78015 USA
Phone: 210-698-0968 Email: schuetzewalterp@aol.com
March 25, 2002
Senator Charles E. Schumer
United States Senate
Washington, DC 20510
Dear Senator Schumer:
Accounting for
Stock Options Issued to Employees
At the hearing of the Senate
Committee on Banking, Housing, and Urban Affairs on Tuesday, February 26, 2002,
in response to your question, I said that, for technical accounting reasons, I
would not charge expense for stock options issued to employees. I said that I would explain why.
First, I will define a
term. The word “expense” means (1) a
decline in the value of an owned asset, as for example when an account
receivable, which was thought to be collectible, goes bad, or (2) the using up
of an owned asset, as for example, using cash to pay for advertising. (Technically, an expense arises when an
obligation to transfer assets (to use up assets) arises, for example, on the
receipt of goods or services where payment of cash in satisfaction of the
obligation is delayed in accordance with normal business terms.)
The Financial Accounting
Standards Board, in one of its Concepts Statements, defines assets as
“…probable future economic benefits obtained or controlled by a particular
entity as a result of past transactions or events.” (That definition is followed by six paragraphs of more than 600
words explaining the definition.) The
International Accounting Standards Board’s definition of assets is similar to
the FASB’s in that it is based on “economic benefits.” Under that definition of assets, the receipt
of services from employees is an economic benefit, and the using up of that
economic benefit is an expense. (For
FASB mavens, see paragraphs 25—31 of Statement of Financial Accounting
Concepts No. 6, “Elements of Financial Statements,” especially paragraph
31, and paragraph 88 of Statement of Financial Accounting Standards No. 123,
“Accounting for Stock-Based Compensation.”)
The value of that economic benefit is hard if not impossible to measure
directly, so it is measured indirectly by reference to the cash paid to the
employee by the employer, state and Federal taxes paid by the employer on
account of the employee/employer relationship, and the cost of medical
insurance, maternity leave, child care, vacation, sick leave, and other
benefits furnished to the employee by the employer.
Defining assets as probable
future economic benefits, as the FASB does, results in an expense on the receipt
and use of services from employees in exchange for stock or stock options. The value of the economic benefit received
is measured indirectly by reference to the fair value of the stock or stock
options issued to the employees. If, as
is generally the case, the stock is restricted stock or if restricted options
are issued, the measurement of the fair value of the stock or the options
generally is done by formula because reference cannot be made to a market price
of the stock or option.
So, if you like the FASB’s
definition of assets, that is, economic benefits, you get an expense when stock
or stock options are issued to employees as the FASB recommended in its
Statement 123 issued in 1995 unless you think that it results in “double
counting,” which I will explain later on.
I do not like the FASB’s and
IASB’s definition of assets; “economic benefits” is too ambiguous, amorphous,
and indeterminate. It is not
workable. Only FASB and IASB accountants
know what the term “economic benefits” means, but they cannot explain the term
in words that ordinary folk and investors and creditors understand. When I was on staff at the Securities and
Exchange Commission as Chief Accountant and as Chief Accountant of the Commission’s
Division of Enforcement, I found “economic benefits” to be so pliable that
almost any expenditure, cost, or debit can be said to qualify as an asset, or
at least so it is asserted by registrants and their auditors, lawyers, and
expert witnesses when challenged by the Commission’s staff or the Commission
itself, either informally or in court.
(For proof, I can show you the court filings by respondents and their
very distinguished expert witnesses.)
Moreover, using that definition of assets allows junk—rusty junk--to get
onto corporate balance sheets—junk that cannot be sold to anyone and therefore
has no market value whatsoever—for example, goodwill, deferred income taxes,
income tax benefits of operating loss carryforwards, development costs,
direct-response advertising costs, debt issue costs, and capitalized interest
cost said to relate to the acquisition of fixed assets. The FASB and IASB say that junk has probable
future economic benefits. I say
nonsense. That junk does not and cannot
earn a penny. When it comes time to pay
bills or make contributions to employees’ pension plans, that junk is
worthless. Showing that junk as assets
on corporate balance sheets misleads investors. Showing that junk as assets allows stock prices to soar when the
corporate balance sheet is bloated with hot air.
In my accounting model, which
I have recommended to the FASB and IASB, I define assets as follows: CASH, claims to CASH (for example, accounts
and notes receivable), and things that can be sold for CASH (for example,
securities, inventory, trucks, buildings, oil and gas reserves, and
patents). Ordinary folk and investors
and creditors understand my definition of assets. Nothing ambiguous about it.
There are no rusty junk assets on balance sheets prepared using my
definition of assets. And, when assets,
as I define assets (and liabilities, as I define liabilities), are shown on
corporate balance sheets at their market prices as I have recommended to the
FASB and IASB, the balance sheet presents the corporation’s true economic
financial condition, not financial position that is determined by reference to
the FASB’s mountain of rules and formulas for computing or determining asset
and liability amounts, the result of which is not understandable by investors,
creditors, and other users of financial statements.
In my accounting, I do not get
an expense for the issuance of stock options (or stock for that matter) to
employees in return for their services.
No asset, as I define assets, is used up and no asset, as I define assets,
declines in value as the result of the issuance of a stock option—thus, no
expense. I will use a simplified
example to explain why no corporate expense arises on the issuance of a stock
option to employees or on the vesting or exercise of the option. For simplicity, I use stock instead of stock
options, but the result is exactly the same as if I had used options.
Year 1. Assume that on Day 1 of Year 1, all 100 US
Senators form the Senate Investment Club (hereinafter, “SIC”), and each Senator
contributes $100 cash for a total of $10,000 in exchange for 100 shares of SIC
for a total of 10,000 shares. During
the 250 business days of Year 1, each Senator takes her/his turn at the wheel
managing SIC for 2.5 days, making investment decisions, collecting cash
dividends and interest, and reinvesting the cash. At the end of Year 1, the combination of cash dividends and
interest and increases in the market value of SIC’s stocks and bonds brings
total assets to $10,900.
Assume that a professional
investment manager would charge 1% of average assets to manage a mutual fund
such as SIC. Question: Should SIC have a charge to expense of $105
(10,000 + 10,900 = 20,900 x .5 = 10,450 x .01 = 105), representing the value of
the services contributed by the 100 Senators during the year managing SIC as
measured by what an investment manager would have charged, along with a
corresponding contribution to capital of $105?
The answer is No. There was no
asset, as I define assets, having a value of $105 that SIC owned during Year 1
that was used up. There was no asset,
as I define assets, that SIC owned during Year 1 that declined in value by
$105. Thus, no expense.
Year 2. Assume that on Day 1 of Year 2, the 100
Senators decide to hire Warren Buffett to manage SIC for Year 2 and to pay Mr.
Buffett, at the end of Year 2, cash equal to 1% of average assets during Year
2. Assume that at the end of Year 2,
SIC’s assets have increased in value from $10,900 to $11,700, before a
reduction for the 1% of average assets (or $113) paid to Mr. Buffett.
Question: Is the $113 paid to Mr. Buffett an expense
in Year 2? Answer, Yes. An asset—namely cash of $113—was used up. The using up of an asset is an expense.
Year 3. Assume that on Day 1 of Year 3, Mr. Buffett
and the Senators agree that at the end of Year 3, in return for Mr. Buffett’s
managing SIC for Year 3, each of the Senators will convey to Mr. Buffett one
share of the stock of SIC instead of paying Mr. Buffett cash equal to 1% of the
average assets of SIC during Year 3.
(Or, in the alternative, SIC will issue 100 shares of SIC stock to Mr.
Buffett.) Come the end of Year 3, SIC’s
assets stand at $15,000, and each Senator conveys to Mr. Buffett one share of
stock of SIC. Thus, Mr. Buffett
receives SIC stock worth $150 from all of the Senators at the end of Year
3. Had Mr. Buffett and SIC continued
with the 1%-of-average-assets arrangement as in Year 2, SIC would have paid Mr.
Buffett cash of $133 (11,700 – 113 = 11,587 + 15,000 = 26,587 x .5 = 13,294 x
.01 = 133).
Question: In Year 3, should SIC have an expense of
$150, $133, or zero? If there is an
expense of either $150 or $133, there is a contribution to capital of like
amount. The answer is zero. No asset, as I define assets, of SIC having
a value of either $150 or $133 was used up during Year 3. No asset, as I define assets, that SIC owned
during Year 3 declined in value by either $150 or $133. Thus, no expense.
Showing an expense, as would
be done using the FASB’s and IASB’s definition of assets, in either Year 1 or
Year 3 is, in my opinion, as if or pro-forma accounting. As if something was done that was not
done. As if cash had been paid
out. I think that accounting should be
based on the facts of what was and what is, not what might have been if
something that was not done had been done.
What happened in Year 3 was
that 100 Senators had their ownership in SIC reduced by 1% by each conveying
one share of stock of SIC to Mr. Buffett.
(If SIC had issued 100 shares of SIC stock to Mr. Buffett, exactly the
same result would have obtained.) After
Year 3, there are 101 owners of SIC.
Each of the Senators—in her/his personal income statement for Year 3—has
an expense of 1% of $150, or $1.50, but SIC has no expense. The expense of the owners of SIC is not
imputed to SIC. SIC accounts for its
assets and expenses, not its owners’ assets and expenses. Some say that the corporation has a cost
when stock or options are issued to employees in return for services and that
cost must be accounted for. What
cost? There is no cost to the
corporation. The cost is that of the
owners of the corporation as shown in the reduction of their percentage
ownership of the corporation.
Remember the definition of an
expense: the using up of an asset or the decline in value of an asset. Imputing reductions in 100 owners’ (the
Senators’) interests in SIC to SIC as an expense in Year 3 implies that SIC’s
stock is an asset of SIC. That is
fundamentally wrong. The stock of an
entity is never an asset of the entity.
Were the stock of an entity an asset of the entity, the entity’s assets
would be infinite and unlimited. The
stock of an entity is an asset of the owners of the entity. How owners of an entity use their ownership
interests, or what happens to the value of their ownership interests, does not
affect the corporation’s assets or the value of those assets. The corporation does not account for its
owners’ assets or changes in its owners’ assets.
The rearrangement of the
ownership interests in SIC in Year 3 is exactly what happens when a corporation
issues options to employees and the employees exercise the options—there is a
rearrangement of the ownership interest of the corporation. But, importantly, no asset of the
corporation is used up and no asset of the corporation declines in value when
an option is issued or when an option vests or is exercised. Indeed, when an option is exercised, cash
equal to the exercise price comes into the corporation.
Importantly, the issuance of a
stock option to an employee does not change the market capitalization of the
corporation as measured by the market value of the outstanding shares and the
value of the outstanding option; any decline in the market value of outstanding
shares shifts to the option. Thus, no
expense. If there had been a true expense—the
using up of an owned asset or the decline in the value of an owned asset--then
the market value of the outstanding shares and option should have
declined. For example, if the market
value of the stocks and bonds owned by SIC declined by 1%, that decline would
be an expense of SIC. And, that decline
would be reflected—dollar for dollar—in the value of the SIC shares held by the
Senators. But, if the 100 Senators
convey 1% of their shares to Mr. Buffet, or if SIC issues 100 shares to Mr.
Buffett, there is no decline in the value of SIC’s assets—thus, no
expense. And, finally, on the exercise
of an option by an employee, the market value of the corporation’s outstanding
shares should increase by at least the amount of cash that is received by the
corporation on the exercise of the option—again, no expense.
Now take a look at the issue
of double counting. Although net income
in my accounting model is not reduced for an expense equal to the value of
stock or stock options issued to employees, the number of shares in the
earnings-per-share computation is the same in my model as in the FASB’s
model. Thus, the dilutive effect of the
issuance of options or shares is reflected in the earnings per share. Reducing net income by way of an expense
charge for the value of stock or stock options issued to employees—as per FASB
methodology--inappropriately counts the effect twice—that is, the corporation’s
shareholders see net income (the numerator in the earnings per share
computation) reduced and the number of shares (the denominator in the earnings
per share computation) increased—thus, double counting. I will illustrate using Year 3 above.
No
Expense Expense
Net income (15,000 – 11,587) 3413 3413
Deduct value of shares issued to Mr. Buffett (150)** 0
3263 3413
Number of shares 10,150
10,150
Earnings per share .3215** .3363
** The effect
of the expense deduction will be more pronounced in situations where the number
of stock options (and therefore the value of the stock options) exceeds 1% of
outstanding shares as in the SIC example.
Then, if there were a
requirement to impute the value of stock options granted to employees to the
corporation as an expense, as in Year 3 of SIC above, a further question would
arise: What should be done in those
cases, as in Year 1 of SIC above, where employee/owners of corporations are
paid no cash compensation, or nominal cash compensation, and there is no
expense, or nominal expense, in today’s income statements for their
services? For example, Mr. Buffett of
Berkshire Hathaway and Mr. Gates of Microsoft are paid nominal cash salaries by
those corporations. Should there be a
pro-forma charge to expense in the income statements of those corporations for
the true value of Mr. Buffett’s and Mr. Gates’ services, that is, the “economic
benefit,” along with a contribution to capital of like amount? My answer is that no amount beyond the cash
salaries paid should be charged to expense.
If an amount in addition to the cash paid should be charged to expense,
that amount would have to be measured directly by reference to the value of the
services of Mr. Buffett and Mr. Gates.
What would that amount be--$25 million?
$50 million? $100 million? Yet a greater amount? Who would make that measurement? I assume, but do not know, that FASB and
IASB would require an expense. I do not
know how FASB or IASB would measure the value of those services and thus the
expense.
If it would be appropriate to
require a charge to expense in the case of an owner/employee being paid little
or no cash salary, as in the case of Mr. Buffett and Mr. Gates, what would be
done in the obverse case—where owner/employees are being paid more in cash
salaries, bonuses, and the like, than they are worth? To be consistent, would there be a requirement to measure
directly the true value of their services, that is, the “economic benefit,” and
charge any excess to capital as a preferential dividend thereby reducing the
expense charge that is measured by cash salary, bonus, and the like? Not the way I would do the accounting, but
perhaps yes in the FASB’s and IASB’s accounting.
My example above—an investment
club—is simplified for purpose of illustration. But, exactly the same concepts would apply to a manufacturing
company, a service/entertainment company, a high-tech company, or any other
company.
I hope this letter is
helpful. I will be pleased to elaborate
or explain further.
Yours truly,
/s/ WPS
Walter P.
Schuetze
CC: Other Members of the
Committee on
Banking,
Housing, and Urban Affairs