Friday, October 20, 2006

The Uncertain Value of (Backdated) Options

An article posted this week on, "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). 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 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 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.

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