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Accounting Should Follow, Not Drive, Decision Making

Scott Taub | September 3, 2013

I recently came across some evidence that stock option issuance is down significantly, as many companies switch to other forms of compensation, such as restricted stock. This move is consistent with the views of many compensation experts who say restricted stock is a more efficient means of compensation that better aligns management and shareholder interests.

Of course, if restricted stock is a better form of compensation, why did stock options ever become as popular as they did? In my view, the answer is quite clear—until just a few years ago, stock options received very preferential accounting. As we all remember, the accounting for fixed stock options—those whose value was dependent only on stock price and not on the employee's performance or any other factors—used to be no accounting at all, so long as the option was not in-the-money when it was granted.

Once the preferential accounting for fixed stock options was removed by the issuance of FASB Standard No. 123(R), Share-Based Payment, which became effective in 2006, companies steadily moved away from this form of compensation. Even those companies still using stock options are choosing options with performance conditions much more frequently. The change in the accounting standards has made the accounting for different forms of equity compensation, including restricted stock, fixed stock options, and performance-based stock options, roughly equal in that all are recognized as expense based on the fair value of the award.

Although many companies fought vigorously against this accounting change, they (and their shareholders) are better off now. Without the biased accounting that caused companies to favor fixed stock options, compensation plans can now be selected based on substantive characteristics related to economics and performance.

Past Accounting Subsidies

These situations where U.S. Generally Accepted Accounting Principles essentially subsidize one form of transaction or structure such that the companies make business decisions they wouldn't otherwise make shouldn't happen. Accounting is designed to show the effects of the business transactions, not to decide which business transactions occur. When the accounting does favor a particular transaction over others in ways that don't reflect economic differences, GAAP has failed. FASB did us all a favor by finally getting rid of the accounting subsidy for fixed stock options. FASB has corrected a few other accounting subsidies over the years, improving both business decisions and financial reporting in the process.

We needn't go back too far to see a particularly terrible example of what an accounting subsidy can facilitate. The accounting standards related to securitizations and special-purpose entities that applied prior to 2010 were created with the specific intent of allowing certain kinds of securitizations to achieve off-balance-sheet treatment. This very favorable accounting encouraged securitizations, but did not encourage companies involved to do a good job monitoring the risks they took on in securitization transactions, since those risks were not on the balance sheet. This accounting encouraged the risk taking that led to the credit market crisis a few years ago. Eliminating the so-called “qualifying special purpose entity” and other provisions that facilitated off-balance-sheet accounting despite retained risks should reduce the chance of something like that happening again.

Going back further brings us to the days of pooling-of-interests accounting, in which a company could buy another without burdening its balance sheet and future income statements with the purchase price of the acquired entity. I remember frequently hearing from clients that a particular acquisition would only be made if pooling-of-interests accounting could be achieved. I found it baffling that whether a huge acquisition would occur was dependent upon esoteric accounting interpretations.

If restricted stock is a better form of compensation, why did stock options ever become as popular as they did? In my view, the answer is quite clear—until just a few years ago, stock options received very preferential accounting.

Of course, one of the things that was required for pooling-of-interests accounting to even be a possibility was payment in stock, not cash. That the value of the stock demanded by sellers often exceeded the value they would have accepted in cash did not stop companies from going the stock route and, essentially over-paying, so long as they could benefit from pooling-of-interests accounting. The subsidy provided by the accounting treatment made up for the over-payment. FASB finally killed off pooling-of-interests accounting in 2001 and the capital markets have been much better for it.

Looking back even further, before the 1993 implementation of FASB Standard No. 106, Employers Accounting for Post-retirement Benefits Other Than Pensions, there was no accounting required for a promise to provide employees with life-time health insurance after retirement. Instead, the cost was only recognized on a “pay-as-you-go” basis, which meant the expense was recorded long after the employee service was provided. Statement 106 required that the cost of such post-retirement healthcare promises be recorded, like pension costs, as the employees provided service, such that it was fully-accrued by the time of retirement. Companies that had such post-retirement healthcare arrangements argued against being required to accrue for the promises.

Lo and behold, once companies were actually forced to account for these promises, they began to realize just how expensive they were. As the saying goes, what gets measured gets managed. And the requirement to measure and record the liability for post-retirement healthcare benefits led directly to companies better understanding the true cost of these promises. Since Standard 106 was implemented, many companies have reduced and eliminated this part of their compensation plan after realizing the true cost of providing it.

Today's Target

While this walk down memory lane has been fun, you might be wondering what relevance it has today. One of the biggest accounting subsidies that FASB has not yet eliminated is the beneficial accounting applied to operating leases. A lessee in an operating lease can get an asset, take on an obligation to pay for the asset, and record nothing on its balance sheet. Buying the same asset while paying for it over time instead involves recording an asset that must be depreciated and debt to reflect the amounts to be paid over time.

The ability to keep payment obligations off the balance sheet represents a significant accounting subsidy for operating leases. This likely causes companies to make different business decisions by providing an artificial incentive to the “lease” side of a buy vs. lease analysis. Many companies might well be able to obtain cheaper financing for asset acquisitions from a lender than they can from an asset lessor. Even when leases are done through financial institutions, the need to set up a separate leasing facility, rather than allowing a company to simply use existing lines of credit, adds complexity and cost to the acquisition process. Nonetheless, this is the method often pursued because the accounting subsidy is considered to outweigh the additional costs of leasing. Indeed, the accounting subsidy for operating leases is so “valuable” that there are professionals who specialize in structuring leases to achieve operating lease accounting.

FASB has recently issued a second exposure draft in a long-running project to replace the current lease accounting standards with a new model that would require lease obligations to be recognized on the balance sheet,  thus eliminating most, if not all, of the accounting subsidy that currently exists for operating leases.

That is why the material I saw on the decreased use of stock options resonates for me today. It reminds me that, even though there are many things I don't like about the current lease exposure draft, U.S. GAAP would be improved significantly if this proposal were finalized, because it would remove the accounting subsidy for operating leases. I don't like that the current proposal has two methods of accounting for leases, one of which involves a measurement of the lease asset that can most honestly be described as a “plug.” Nonetheless, the proposal still gets all leases on the balance sheet.

I have had concerns with some of the other standards that have fixed accounting subsidies—for example, I didn't like that goodwill amortization ended when poolings did, and I'm not enamored with today's models dealing with securitizations and special-purpose entities. But when I step back, I must admit that the benefit of fixing the biased accounting that previously existed far outweighed any of the negatives associated with the replacement standards. I expect that the same will be true of lease accounting, even if FASB doesn't change the things I don't like about the latest proposal. That's why I continue to support the lease proposal, even if I think it's been made much more complicated than it needs to be.

Of course, there are plenty of other accounting subsidies still out there. Hopefully, FASB can continue to chip away at them. In fact, when I think of projects I'd like to see FASB take onto its agenda, those that eliminate biased accounting currently in GAAP are at the top of the list. Convertible debt accounting, consider yourself on notice.