Tuesday, October 24, 2006

To the Trucking Industry: Hire Me!

Fred Whittlesey
Compensation Venture Group, Inc.

An article in today's CFO.com email blast - "Will a Driver Shortage Cost Companies?" - highlights the need for ROI-based analysis of compensation practices. A spokesperson for GE Capital is quoted: "Truck driver turnover ranges between 130 percent and 140 percent, which equates to replacing employees every eight months, Tse says. "It takes a toll on the organization both from a resource standpoint and from a cost standpoint," she adds. As a result, trucking businesses are looking at ways to attract and retain employees by giving bonuses, increasing paid leave, and reducing paperwork."

This person goes on to point out that "When trucking companies can't stay staffed up, they're limited to how much they can haul." Hard to aruge with that logic. Take away my keyboard and it's almost impossible to post to a blog (given the sorry state of voice recognition software).

So, hire me! No, not as a truck driver, I wouldn't be very good at that even though I've never been at fault in an accident and haven't had a moving violation in over 15 years (that last one in 1991 on a three-point turn technicality was SO petty.) Hire me to help you understand the screaming opportunity to use ROI-based compensation analysis to fix the problem. OK, end of shameless self-promotion.

I have seen many executives agonize over a couple of percentage points in pay increases, then leave that meeting to go to the next one discussing capacity shortages, revenue shortfalls, and earnings impact. Hmmm. Just like this trucking article.

An ROI analysis would likely show that a turnover rate of 135% per year and an average turnover cost of, say, a conservative 30% of base wages (that by the way is extremely conservative) would easily fund a significant pay and/or benefits increase that would solve the attraction and retention problem and save not only the trucking industry but the downstream supply chain customers (like you and me), from this projected crisis.

It's pretty easy, but it requires someone in HR with financial savvy to talk to someone in Finance, and the combined viewpoint to get to the CEO and the Board of Directors. And in some organizations that is much more of a challenge than attracting, retaining, and motivating truck drivers. Isn't that sad?

Attend my webcast, The Real Meaning of ROI for Compensation Professionals, sponsored by WorldatWork on 01 November at 9:30am PST. (Sorry, there's another shameless self-promotion.) Remember to change your clocks on 29 October or you’ll get to the webcast an hour before I do.

The nice thing about web-based meetings is that we are insulated from trucking-based supply chain issues. But let’s hope the truck-transported coffee gets to our offices on time because if it doesn’t that could indeed be a crisis resulting from this trucking problem, especially in Seattle where that would be reasonable cause for calling in sleepy.

Monday, October 23, 2006

Peek-a-Boo I See You (and your Black-Scholes assumptions)

Fred Whittlesey
Compensation Venture Group, Inc.

I try to stay on top of what has become an almost-daily flow of news affecting executive and equity-based compensation. But I'll admit that I hadn't seen the Public Company Accounting Oversight Board's ("PCAOB" which apparently is sometimes pronounced "peek-a-boo" in accounting circles) new statement, issued 17 October, regarding the valuation of stock options, when I wrote the preceding blog post here 21 October. This is both a bit prescient and humorously ironic.

After more than three years of effort by many public companies to arrive at a "more accurate" valuation of employee stock options, as required by FAS123 and now FAS123R, PCAOB has caught wind that perhaps some companies may be aggressively using certain assumptions that lower the reported value of options granted, thus lowering expense and increasing reported profit.

Wow! I guess no one from PCAOB has been attending the many professional conferences over the past few years where accountants, actuaries, and others have been presenting their ideas on how best to accomplish this. Hardly a well-kept secret, this one.

What I find interesting is that the Board's Statement indicates that such practices may constitute fraud. As I said on 21 October, it continues to amaze me that widely-publicized broadly-practiced methods of calculating and reporting hypothetical "expenses" related to stock options now fall into the category of "fraud". I'm neither a lawyer nor accountant but I don't think one needs to be either to have observed that hundreds of companies have over the past few years reduced their option valuation assumptions and significantly lowered the reported expense accordingly.

This is why I advise all of my clients that the methods and numbers used for financial reporting, while required by the FASB and the SEC, should never, ever, ever be used for compensation analysis and planning purposes. When such tactics reduce reported expense and artificially inflate profit, they have an even more nefarious effect: reducing the "value" of stock options granted to employees and executives. And if the "value" of each option has been reduced then, as the logic goes, we need to grant more options to them. Which of course again raises expense. But these increases often go, this time, to the executive population rather than the broader employee population. Clever.

No one in the investment community is fooled by artificially low Black-Scholes values and no sophisticated investor accepts financial statements as published - they are reworked through extensive financial modeling, based on cash flow, not hypothetical profit - to determine a company's value. These analysts drive the market so there is a significant check-and-balance system around companies' reported option expense. No such system yet exists, however, for executive compensation. Despite improvements in disclosure, heightened investor attention to the topic, and the growing sophistication of Compensation Committees of Boards of Directors, these option valuation games can indeed be damaging to the corporate governance process. That can only be fixed by recognizing that the real money spent on "managing" option expense is an expensive financial reporting exercise and that real compensation decision-making treats that as only one input, and a minor one at that.

Friday, October 20, 2006

The Uncertain Value of (Backdated) Options

An article posted this week on CFO.com, "What's a Backdated Stock Option Worth?" discussed an issue underlying some of the current option backdating controversy: If backdating (however defined) occurred, what is the dollar amount of the event? The article highlights a fundamental discrepancy between two accounting rules, APB25 and FAS123. The author makes the point, reinforced by a consultant, that the Black-Scholes option pricing model - essentially required by FAS123 - says that a $5.00 discount on an option is worth less than $5.00. APB25 says it's worth exactly $5.00. So which is it?

One set of accounting rules for stock options, issued in 1972 (APB25) continued in effect until 2004. Sort of. A contradictory set of accounting rules issued in 1995 (FAS123) was made optional rather than mandatory because the Financial Accounting Standards Board (FASB) bowed to political pressure and made this "correct" accounting optional. But only until 2004 when the FASB made the revised version of the rule, FAS123R, mandatory, because it was more correct than FAS123. In other words, the FASB decided that APB25 was wrong and FAS123 was right, but allowed companies to continue using APB25 - or FAS123 if they wanted - for 10 years all because of politics. Well, there's a nice way to govern the financial statements of publicly-traded corporations.

Between 1995 and 2005 companies were faced with understanding two sets of rules and trying to discern when the optional rule (FAS123) was in fact not optional versus the ongoing mandatory rule (APB25). Hmmm...red means stop, and green means go. But, if you want red to mean go and green to mean stop, that's OK too. You just have to disclose which color means stop or go, and then drive accordingly. And during those 10 years, only 3 cars were stopping for a green light while the other 7,000 kept stopping at a red light, so things seemed OK. No one crashed.

Back to the CFO.com article. It goes on to discuss why or why not $5.00 is really $5.00 which, unfortunately, has become a cottage industry in America. This academic exercise has generated tens of millions of dollars in consulting fees for some fortunate actuaries and accountants. But it raises the question of whether a $1 million "backdating" is really only, say, $200,000 because that is what the FASB had decided but not enforced until 2004. That's a pretty wide discrepancy coming from a bunch of accountants, isn't it? And how interesting that the actuaries and accountants have profited greatly from this discrepancy. I haven't really heard of anyone being criticized for that.

So, let's recap: A backdated stock option "granted" at a price of $10.00 when the company's stock was trading at $15.00 was subject to two different sets of rules. The backdated stock option either was an "expense" of $5.00 or an "expense" of some other amount, based on the Black-Scholes option pricing model, but that other amount depended on several assumptions plugged into a statistical formula. And this only applies if one determined that the "measurement date" was different from the "grant date" and there is a fundamental discrepany there, too, between APB25 and FAS123. (And that is a topic for another blog, another day.)

Most important is the question of how two different sets of accounting rules can apply at the same time, and a critic, years later, can pick and choose which part of which set of rules happens to apply. (By the way, CPA firms are paid to ensure that a company knows the appropriate rule is followed correctly.) There are layers of complexity around the option backdating issue regarding the "grant date" and "measurement date" and when certain administrative processes created each of those. The author of the CFO.com article adds another layer that should be considered: if FAS123 was in effect, then a $5.00 discount from backdating was not a $5.00 event. Depending on the Black-Scholes assumptions, it was a little less or a lot less than $5.00. But many companies have admitted that they didn't pay much attention to their Black-Scholes assumptions because the FAS123 number was just a footnote and was not the accounting rule that they chose. So we really dont' know how much less than $5.00 it was. And if FAS123 was only kinda-sorta in effect, what of the grant date and measurement date issue - kinda-sorta also?

The FASB said in 1995 "here's a rule, we would like you to, but you don't have to, use it for real financial reporting, but follow it anyway." And, 6 to 10 years later, if you didn't use it properly then you might be an option backdater.

Huh? Exactly. For those of us in the compensation field it's fascinating to follow the ongoing debate and how so many people can continue to disagree about the value of a stock option, backdated or not. It's not so fun, however, to see scores of companies spending millions of dollars to help uninformed critics understand that the accounting rules in the 1990s were in many cases not rules at all, but a morass of indecision by the organization (the FASB) empowered by an important government agency - the Securities and Exchange Commission. The same agency that may now be filing charges against those companies for not following the confusing and contradictory rules. Didn't you know that you should have stopped at that green light and driven through the red light back in 1998? What the heck is wrong with you?

20-20 hindsight is fine for those who like to criticize the hometown quarterback's performance on Monday morning, because that's all in good fun and sport. But 20-20 hindsight 400 Monday mornings later about poorly-defined and ambiguously-implemented accounting rules borders on the absurd. No, it's not on the border. It's absurd.

Well, I guess life imitates art, and accounting is just an art, not a science. Or is it that art imitates life? I never can remember which way it is. It's so confusing. Just like APB25 and FAS123 and FAS123R.