As we were saying, requiring firms to treat stock options as expenses will degrade, not improve, the quality of information available to investors. Now we have confirmation from the horse's mouth. A research report I received in my capacity as a 401(k) account holder says:

[Wall] Street is now debating how investors will react to GAAP results that include stock based compensation expense. We expect investors to ignore GAAP and focus on the pro-forma results.

While the concept of expensing options sounds attractive, the reality is somewhat contorted. The companies do a Black-Scholes calculation to value the options each quarter, then allocate these costs to different line items. In effect, increased volatility in their stock price can shrink margins and decreased volatility widens margins. That won't make results more realistic in our book. It will create static that reduces the investor's ability to discern fundamental earnings drivers. It also creates the potential for self-serving assumptions about expected volatility and/or the risk free interest rate. If a company makes the quarterly consensus by reducing the expected volatility of its options, investors won't find out until the 10K is filed. Thus, we expect investors to look for ways to unwind GAAP [Generally Accepted Accounting Principles] to get more instructive pro-forma results. Again, they already do just that with Microsoft and many other companies that adopted FAS123R early. (Emphasis added.)

So, the forces of ignorant self-righteousness have once again managed to make everyone worse off, at considerable expense.

Except that the "expense the options" forces are not so ignorant, being led by such sophisticates as the public employee pension funds and St. Buffet.

To repeat prior points, the people who want options treated as expenses have self-interested reasons for promoting this position, and they have successfully snookered the U.S. Congress into inaction.

The tech community, which favors options, also let itself be snookered -- into fighting the battle as if it were a technical discussion of accounting principles instead of a political struggle with people who understand perfectly well that the new rules will degrade the quality of information available to investors, and don't care.

posted by James DeLong @ 8:43 AM | Accounting

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