Letter to Financial Journalist

Your report that focused on the shenanigans that take place when it comes to estimating the volatility estimate was most welcome indeed. The problem with stock-based compensation is not necessarily the implied subjectivity of the estimate; although by no means acceptable to me.

Accounting is an art riddled with subjective estimates. However, these estimates eventually face what I would call, a catch-up adjustment; a truing up exercise. For example, assume a company buys a $90 million machine which has a true useful life of five years, but management charges straight line depreciation of $10 million each year, because it estimates the useful life at nine years. The true depreciation charge, based on an economic useful life of five years should have been $18 million per annum ($90/5). By the end of the 4th quarter of year five management's low-ball estimates comes to light as it scraps the machine and takes delivery of its replacement. Assume the scrap value was only $5 million. During the past five years, the company reported a total depreciation charge of $50 million. After scrapping the machine, it has to report a loss on disposal of $35 million. The $35 million loss is the catch-up adjustment; the truing up of the depreciation expense.

Eventually reality catches up with subjectivity. I could have used numerous other examples for illustrative purposes, but just to belabor the point, assume management provides an allowance for doubtful debt of $5 million against a $100 million portfolio of receivables. Once all the receivables have been collected, management is force to compare total collections against the initial value of the portfolio. Assume management only collected $91 million. This means the $5 million allowance (estimate) fell short by $4 million. An additional $4 million in doubtful debts would have to be written off. There is no way management can say: "Too bad, we underestimated the true expense, but thankfully we don’t have to admit to this error in judgment."

When it comes to stock-based compensation, FASB violates accounting conventions as they relate to estimates and says there is no need to true up the expense. Assume management grants options to an executive to purchase 40,000 shares at a strike price of $15 per share. Assume the executive exercises the option when the stock price is $35 per share. The executive gains $800,000 ($35-$15*40,000) on the exercise. Note that this is the amount that the company claims as stock-based compensation on its tax return - the true economic cost of selling stock to an employee at a discount. FASB wants the company to recognize this expense over the period that spans grant date to exercise date, in the same way that it wants the company to recognize the cost of using a machine over its useful life. The Black-Scholes model provides an estimate of this expense. The estimate is highly subjective, in fact so much so that this subjectivity has been one of the main arguments that executives relied on to stall the recognition of the expense in the income statement. There is no need to argue about subjectivity if in the end, FASB stayed true to principles applied to other estimates and mandated that companies true up the expense at exercise date.

Assume Black-Scholes places a value of $500,000 on the above mentioned option grant. By rights, at grant date, another $300,000 should have been required as a catch-up adjustment. That way, management would have been forced to apply a dose of reality to its estimates, in the same way that it has to do when it comes to estimating depreciation and bad debt allowances. The deceit of FASB as it colludes with management to trick investors is fascinating if not disturbing. Unfortunately, when it comes to stock-based compensation FASB has imposed such a tangled web of contradictions and deception that even those well versed in accounting lore are mislead by the numbers. I have highlighted but one of many.

On the same subject, you are no doubt aware that in anticipation of the implementation of the new rules, companies accelerated the vesting of out-of-the-money option. That way, it could avoid having to recognize any future expense relating to these options. Again, a simple requirement to true up the expense at date of exercise would have invalidated such slight of hand. I notice some companies are now issuing out-of-the money options. At first, this appears to be laudable; almost the antitheses of the scandal exposed by the WSJ relating to back-dated option grants. Ever the skeptic, I was wondering whether such out-of-the-money options received special treatment in terms of the new rules, which could mean the recognition of a lower expense that never has to be trued up! It is worth looking into. I might be wrong, but I have serious doubts when it comes to management's actions in general and more so when it comes to accounting.

Three companies that I think do well when it comes to accurately reflecting the underlying economics of their business in their financial statements are Boeing, Gentex and TechData. I'm sure there are others, but here are three that you can use as a point of reference. Linear Technology's CEO is on record saying that the company will never take one-time charges. This is in sharp contrast to other companies, inside and outside of the chip industry that have no problem in identifying one-time charges to try and dress up the numbers. Perhaps one should add Linear Technology to this list.

Albert J Meyer