The Requirement to Expense Options: A Reactionary and Deleterious Response to Outrage

Abstract

In 2004 the Financial Accounting Standards Board issued Financial Accounting Statement 123R which, among other things, mandates that firms report the estimated fair of employee stock option grants and other forms of equity compensation and apply the expense to their reported earnings. This paper argues that the reasons FASB provides for the necessity of this change - accurate accounting for a value given, comparability among other domestic companies, and comparability internationally - are not only goals that are not met by the change, but that the implementation of FAS 123R is actually a reactionary measure to public outcry and outrage over excessive executive compensation and is designed to reduce executive compensation. Further, even if this surreptitious purpose - which is outside of FASB's scope - is met, it is met in a way that fails to further investors' information needs and fails to offer new comparability efficiencies. While the focus of my inquiry and analysis regarding FAS 123R is on employee stock options, primarily to executives, because options are often granted as just a part of a compensation package they must be addressed in the context of an entire employee compensation package, particularly an equity compensation component. Thus Parts I and II of this paper discuss executive compensation and equity compensation generally. Part I very briefly introduces equity compensation. Part II focuses on the general social and economic issues surrounding executive compensation, particularly equity compensation. Equity compensation is presented in the context of contemporary discourse, discussing bargaining issues, equity effects on manager behavior, necessity to the firm, and public perception. Part III introduces two administrative actions designed to address these issues, FASB's FAS 123R and the SEC's more recent requirement of a Compensation Discussion & Analysis. Part IV addresses FASB's main justifications for implementing FAS 123R and finds that those justifications are fallible in that they are either (at best) debatable or (more likely) simply incorrect. Finally, Part V presents the idea that FAS 123R may help to chill outrage, argues that outrage is the driving factor behind FAS 123R, and discusses some of the economic and financial effects of the implementation of FAS 123R.