Now the Fed enters standards battle

Last week it was the turn of Greenspan and president Bush to pep up investor confidence as the lawmakers on Capitol Hill went about creating a battery of laws in a clumsy bid to prevent a repeat of the current crisis.

Amid the obsessing about the length of jail sentences for egregious examples of greed there appears to have been little hard thinking about the federal government’s role in setting accounting standards.

For at the very core of the current crisis has been the unfettered growth of incentive stock options and the way issuing companies have been accounting for them to create a false picture of their finances. Coca-Cola and Washington Post – in which options reform advocate Warren Buffett holds major stakes – last week announced they would begin to include stock options on their expense reports. Another handful of companies, including Ford, HJ Heinz and Gillette said they are considering a change.

Buffett, founder and chief of Berkshire Hathaway, the investment company, believes expensing stock options will go a long way to restoring investor confidence.

A staggering $8 out of every $10 paid to US executives comes in the form of options. Reform advocates claim expensing options will provide shareholders with more accurate earnings numbers, which, in turn, should help restore investor confidence.

It would also reduce the incentives top executives have to pump their stocks through short-term earnings manoeuvres in the hope of cashing in big option gains.

But opponents of reform, particularly those in high technology companies, argue they are an indispensable tool for cash-poor start-up companies to attract and retain top talent. At present, most companies disclose in a footnote the bottom-line effect of the options granted to employees.

There are no universal standards for expensing options; all valuation methods require major assumptions and estimates. Any move to expense options will reduce the accuracy of income statements and leave them open to manipulation, the naysayers claim. Deducting the cost of options will reduce earnings, which is likely to drive down share prices.

For example, it would have cut the Standard & Poor’s 500-stock index’s 2001 earnings-per-share of around $24.70 by more than 24%.

Rather than take the hit to earnings, companies are more likely to issue far fewer options which could result in lower morale and the loss of a key tool for attracting new talent, they claim.

Opponents lobbied hard to oppose an amendment proposed by Senator Carl Levin calling on the financial accounting standards board to review the issue within a year.

It is eight years since the FASB – which sets the rules for American businesses – proposed forcing companies to record stock options as an expense but backed down under pressure from Senators. Congress has managed to sidestep the issue at least three times in the past five months. Even the board of the world’s largest pension scheme, the California Public Employees’ Retirement System, shelved a staff proposal for reform. Now there is renewed pressure for the most important post-Enron issue to be addressed. Greenspan predicted in Congressional testimony that the FASB, under its new chairman Robert Herz, would vote in favour of a switch.

Hertz, who is also expected to be in favour of the push an international set of accounting standards, is believed to have the backing of chief securities regulator, Harvey Pitt, chairman of the Securities Exchange Commission. Pitt, who was mauled by the media and politicians for being too close to the top accounting houses, has stepped up his crackdown on alleged malfeasance and reforms to make the system more transparent.

The International Accounting Standards Board, the rule-setting body charged with creating a set of international accounting standards, has unanimously approved draft accounting rules that would require companies to treat stock options as expenses.

Hertz has served as part-time IASB board member and is believed to be sympathetic to a principle-based approach, unlike the US that has traditionally favoured detailed standards. It would be a hard sell made a little bit easier by the extraordinary groundswell for change in the wake of recent scandals.

Also, with Congressional elections coming up in November, both parties are shooting high to seize the electoral advantage of being seen by the public as the most determined to clean up the system. Congress is to put the FASB on a more independent footing by requiring all public companies to contribute to its funding, thus making it less vulnerable to pressure from companies holding the purse strings.

If lawmakers fail this time round then recent problems are likely to return in an even more virulent form next time ‘infectious greed’ cripples the system.

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