You will recall that the FASB investigated and debated this issue during the early 1990s, and it issued an exposure draft that would have done pretty much the same thing as the present version. But Congress reared its ugly head, flush with campaign donations from those who didn't want to communicate economic reality to their investors and creditors. The Securities and Exchange Commission backed down and the FASB was left alone to stand for integrity in financial reporting. Alas, in the end board members tossed in the towel, perceiving the political winds against them, and we received not only a watered-down, toothless standard in FAS 123, but we also endured the economic meltdown in the early years of this century. I believe the events causally connected.

Since some high-tech managers and some of their boys and girls in Congress want to continue to tell accounting falsehoods, I suggest that we disclose the logic of our position. If nothing else, they might learn the value of transparency. In this essay, I wish to review the problem of stock options in corporate governance and review why they necessitate expensing. In addition, I wish to propose an amendment to the exposure draft that would improve the cash flow statement.

The problem
A few high-tech executives wail, "This standard will eliminate stock options!" If so, good riddance! For too long the public has heard the rhetoric about the benefits of stock options -- how they would better align the interests of the managers with those of the shareholders. The idea seemed tantalizing inasmuch as managers, with their shares of stock, might think more like an investor. Were we ever wrong!

While stock options allow the option owner to enjoy gains as the stock price appreciates, it protects the option holder from any pain due to decreases in the stock price. Unlike stockholders, those managers who hold stock options do not face any downside risk. Worse, if stock prices do not move sufficiently up so that managers can garner some significant economic gains, then they simply reload the stock options with lower strike prices. How many investors have the ability in an environment of sputtering stock prices to go back in time and decrease the purchase price of their shares? Unlike Michael J. Fox, investors do not possess time machines.

In addition, very few compensation plans differentiated between market effects and the financial results due to the efforts of corporate managers. During a time period such as the 1990s, a CEO could be a dolt and still have his or her stock price go up. Felicitous stock returns might result from the efforts of other actors in the economy and not from the work of the corporate executives. In other words, the stock option plan did not really reward a firm's own managers for their successes; instead, they rewarded these executives for the growth in the overall economy, regardless of who provided the impetus for growth.

Such stock option plans often had relatively short periods of time. In such cases, one can forget about managers' taking the long-run perspective. They realize that the returns during the period of their stock options determined what they received personally.

In short, stock option plans do not align the interests of managers with those of the shareholders and they encourage short-term planning. Worse, they provide perverse incentives for managers to fiddle with the books to augment one's personal wealth. No wonder Nobel prizewinner Joseph Stiglitz called stock options corporate theft.

Fortunately, many business enterprises have reviewed their compensation packages and have amended these concerns. Let's hope that many more join them.

Why expense?
Whether we expense the stock option depends merely on whether one wants to communicate the results of the entity's operations to those outside the organization. If words have meaning, then we ought to resist any attempt to obscure what managers are doing.

In Concepts Statement No. 6, the FASB plainly states that "[e]xpenses are outflows or other using up of assets or incurrences of liabilities … from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major or central operations." If stock options have value to managers as part of their compensation package -- and we know that they do -- then the employment of stock options is an ongoing central operation.

Stock options consume assets or incur liabilities in either of two ways. The first and most obvious way of consuming assets rests with treasury stock purchases. Entities that exploit stock options also tend to have extensive treasury stock repurchase programs. This activity clearly and directly uses up assets -- specifically cash. If the firm does not make treasury purchases, then it must issue more shares of stock. This action deprives the company of cash it otherwise would receive when the firm issues stock. Either way, the firm consumes assets, and so stock-based compensation constitutes an expense.

So let's quit playing Alice in Wonderland games, pretending that words can mean whatever some self-aggrandizing manager wishes them to. An expense is an expense is an expense -- and it belongs on the income statement, not buried in the footnotes.

The CEO of Intel, Craig Barrett, wrote a commentary derailing accounting reforms, which appeared in the Wall Street Journal on the same date as the publication of FASB's exposure draft. His chief argument, such as it is, rested on the unreliability of option pricing models. Not once, however, does he ever acknowledge that measuring compensation as zero is itself an unreliable amount. Indeed, this blunder often is orders of magnitude worse than anything produced by the Black-Scholes model or the binomial ("lattice") model. It would clear the err if Mr. Barrett would acknowledge this point.

A proposal to correct the cash flow statement
Mr. Barrett ends his polemic with the adage that the FASB should "get back to the basics of accounting principles based on cash, not imaginary expenses." While thinking about that point, I recalled that Albert Meyer of 2nd Opinion Research has advocated an adjustment to free cash flow that deducts the cash outlay for treasury stock purchases when employed for the purpose of reducing the dilution of earnings per share caused by stock-based compensation. They both have excellent points, so I propose that the FASB modify its exposure draft to account for the cash flows involved with stock-based compensation.

The FASB creates some of its own ambiguity with the residual definition of cash flows from operating activities. The reader will recall that the board defined cash flows for investing activities as those cash flows dealing with the purchase or sale of long-term assets or investments or the like. Then it defined cash flows from financing activities as proceeds or outlays dealing with equity instruments or debt instruments. Any other cash flow it considered as part of operating activities.

The board partially redeems itself in paragraph 23 of FAS 95, where it states, "Cash outflows for operating activities [include] … b. Cash payments to other suppliers and employees for other goods or services …." I interpret this sentence to say that any and all cash outlays that pertain to the compensation of employees belong under the operating activities umbrella. That sounds as if it should include treasury stock transactions when such deals are consummated so as to compensate employees upon the exercise of their stock options.

I know of no firm that does this, so I suggest that the FASB add this requirement before issuing the final version of this standard. Such a position simplifies the computation of free cash flow. Even more importantly, it bolsters the idea that, contrary to the rhetoric of CEOs such as Craig Barrett, firms that have stock options plans really and truly consume cash because of the treasury stock repurchases.

To the investors reading this essay: until the FASB fulfills this request, I strongly advocate that you follow Albert Meyer's proposal when you compute free cash flow. The subtraction of cash spent for reacquiring stock produces a more accurate and a more reliable estimate of free cash flow.

Conclusion
This essay greatly exceeds the typical length of my columns, but I think much is at stake. While greed motivated men like Ken Lay, Jeffrey Skilling, John Rigas, Bernard Ebbers, and Dennis Kozlowski, the pathetic accounting treatment of stock options in FAS 123 provided the opportunities for accounting abuse. They could consume the resources of the business enterprise without the effects hitting the income statement. And the backing down by the FASB and by the SEC gave these gentlemen the bravado to continue to abort good accounting principles.

I urge those in favor of accounting integrity to fight the good fight against those in the high-tech industry and in Congress who apparently think it acceptable to distort corporate communications to the investment community.

J. EDWARD KETZ is the MBA Faculty Director at the Smeal College of Business at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals, and columnist of The Accounting Cycle.