Cooked Books, Seasoned with Stock Options
by Clay Risen

Coke's doing it. The Washington Post is doing it. And if Warren Buffett and Sen. Carl Levin (D-Mich.) had their way, everyone would be doing it — accounting for stock option disbursements on their balance sheets, that is. To some, the question of whether stock options should count on the bottom line may seem an arcane footnote to the larger debates surrounding recent corporate scandals, but it's one of the hottest issues in corporate regulation, and for good reason: After 10 years in which startups and blue chips alike hid trillions of dollars in compensation expenses behind options disbursements, bringing the practice to light may very well sink our already fragile recovery.

A stock option is essentially an IOU, a promise that an employee can buy a certain amount of stock when it reaches a certain price. And by giving options in lieu of cash, companies benefit in a number of ways. First, obviously, they report lower employee costs. And when employees cash in, the tax owed on the transaction can be deducted by the company — a nifty trick that allowed option-dependent companies like Microsoft to almost erase their tax obligations during the 1990s. And by exercising their options, employees are injecting money back into their employer, an artificial cash inflow that is often obscured to make it look like the company is making more than it really is.

If this doesn't sound shady, it's the next step that crosses the line: By feeding hundreds of millions worth of stock options into executive coffers, companies give their CEOs an enormous incentive to cook the books. Worse still, top executives also know better than anyone else how their company's quarterly reports are going to look, and it's no surprise that at the core of many of today's scandals is a CEO who sold off stock before it took a nose dive, leaving him high and dry but regular investors — and the company's option-holding rank-and-file — sinking like a rock.

So the obvious answer, say Coke, Buffett and Levin, is to require companies to report stock options as costs, just like they would cash salaries. Levin has so far been stymied in his attempts to get legislation urging the Federal Accounting Standards Board to change its rules on the issue, but Senate Majority Leader Tom Daschle (D-S.D.) promises to bring it up again in the near future.

The last time this idea came to the fore, in 1994, the Senate voted 88-9 to pressure the FASB to drop the plan, a vote led by none other than Sen. Joe Lieberman (D-Conn.). Dozens of CEOs rallied to the cause, and virtually every business magazine was up in arms against the idea (Malcolm Forbes Jr. said in his eponymous magazine that it was "one of its most asinine, destructive proposals ever"). The FASB ultimately rejected the proposal in favor of a requirement that, starting in 1997, companies would have to include a footnote about stock options on their balance sheets, but nothing more.

Unfortunately, today the answer isn't so simple; in the early 1990s, in the midst of recession, executive pay was a hot issue, and the stock option — an idea that still reeked of smoky boardroom elitism — was a target of political and public rage. But with the mid-'90s recovery and the subsequent Internet boom, the issue was quickly forgotten — not only because things were once again looking rosy, but because so many companies, especially dot-com startups, turned to stock options as a way to keep costs low and give employees more of an incentive to improve the bottom line. The stock option was not only one of the major engine of growth (real or imaginary) during the 1990s, but today it's status as free money is so central to most corporate cost structures that to force it into the next column would push more than a few companies over the edge.

In turning to the stock option-as-cost-panacaea, Microsoft, as it did so often during the 1990s, led the way. The image of the "Microsoft millionaire," who held a middling position but made money overnight thanks to a generous stock option plan, became both the norm and the ideal; it was common for pre-IPO companies to pay their employees in huge blocks of stock options on the hope that the first day of public trading would make them all rich.

The Silicon Valley small business, the once-hallowed engine of the New Economy, was also a stock option junkie — in 1998, Inc. magazine noted that "74 percent of the companies with less than $50 million in sales, and 68 percent of those with fewer than 100 employees, offered stock-option plans to all employees. ... Meanwhile, in those companies, the median value of options granted equals roughly 37 percent of an engineer's — and 265 percent of a CEO's — base salary." And by the late 1990s, it wasn't just employees who got paid in options — landlords, office suppliers, consultants, even law firms took paper promises over cash.

Indeed, it's possible that, had the FASB changed its rules in 1994, the Internet bubble might never have appeared in the first place; after all, most of the growth was just market exuberance, itself often driven by the sort of semantic distinctions that corporate accounting thrives on. According to a 1998 study of the top 145 firms in the United States, the research firm Smithers found that stock options inflated corporate profits by a third. Of particular note was Microsoft — had the software giant reflected its stock option outlays in its cost-to-earnings report, the $4.5 billion in profit it announced in 1998 would have actually been a loss of $15 billion. In reality, Microsoft did lose that money, but because of the vagaries of accounting, it — and so many other firms — were able to hide their losses.

The implications are astounding. Consider it: All that talk of a new economy, of knowledge creation upsetting the old rules of economic cycles — hog wash. You could call it a lie, except that everyone knew about it — had virtually come to blows over it — in 1994. 1990s investor exuberance was nothing more than cognitive dissonance, an implicit agreement to look the other way while companies shunted more and more costs into stock options in order to turn around and report dazzlingly high profits. Indeed, new economy gurus who marveled at skyrocketing high-tech profits seem, in the cold light of the recession, either ridiculously naïve — or disgustingly cunning.

Unfortunately, all this puts the country in a very uncomfortable position. Because while corporate accounting practices are coming under increasing attention, companies nevertheless continue to keep stock option disbursements essentially off the books. If Levin and Buffett have their way, hundreds of operations will be forced to drastically alter the look of their balance sheets — and not in a very positive light, either. What looks healthy today will appear sickly tomorrow; if Microsoft was running a $15 billion loss in 1998, how well is it doing now? Given how strongly this country has tied itself to the stock market over the last decade, such a change could push us into an economic hole that will take years to dig out of, years of mass layoffs and bankruptcies. And you thought things were bad now ...

E-mail Clay Risen at risenc@yahoo.com.