A Much Needed Accounting Lesson for Two Senators

Nothing good comes from bad accounting, and many of the bad things that happen are easy to predict: excess bonuses to management, negative NPV investments, underfunding of pension plans, etcetera, etcetera, etcetera. Yet, the instance I'm writing about in this post has a special flavor.

Savvy managers may know that the accounting rules they are exploiting fall far short of good, but others, in stark contrast to their status in society and evident sophistication in other matters, take the solemn pronouncements of the FASB for gospel. Recently, two U.S. senators have apparently forgotten or are oblivious to the fact that the making of financial reporting standards is more like the production of sausage than the engraving of the Ten Commandments by Moses on Mt. Sinai. Consequently, they have introduced a bill to model the tax deduction for stock-based compensation after the low-grade pork in a tube known to the accounting cognoscenti as Codification Topic 718 (formerly SFAS 123R).

The senators in question are Carl Levin (D-Michigan) and Sherrod Brown (D-Ohio). A couple of weeks ago, they introduced a bill to eliminate the so-called 'excess tax benefit' from issuing stock options to employees. The two senators note that the amount of expense reported for financial reporting purposes (for example, in SEC filings) is quite often less than the amount of the tax deduction taken per the tax return, and they seem to think that the so-called 'excess tax deduction' amounts to a government giveaway to corporations. If financial reporting measures stock-based compensation 'right' (and it surely does not), then by their logic it's wrong to receive a deduction that's greater than the expense reported for financial reporting purposes.

Bless their little hearts, but Levin and Brown (and surely other senators) are oblivious to the reality that the accounting evils lie in the financial reporting rules, and not the income tax rules. It is the financial reporting rules that are fraught with inconsistencies, for they were designed to systematically understate the cost of compensating employees.

The Economic Measure of Stock Compensation Cost

I'll be the first to admit that, when it comes to taxes, I'm sort of a babe in the woods myself. But, the complexity that is misleading the senators does not lie in the tax rules. The tax rules in this respect are simple, and a review of the fundamentals ought to be sufficient to set the stage for my accounting lesson to them.

There are two kinds of deductible expenses for tax purposes. The first type is the cost of productive resources that are consumed; examples include depreciation of productive assets, rent of productive assets, costs of inventory acquired and subsequently sold, and salaries of employees. The second type, financial cost, was at one time more controversial; and the most straightforward example is interest cost of debt.

Many decades ago, interest costs were seen to be fundamentally different than the costs of using productive resources. They were merely distributions to stakeholders, i.e., more analogous to dividends than costs of production. Eventually, though, in response to political pressure from railroads and other large corporations, taxing authorities adopted a shareholder perspective to tax deductions. In regards to interest costs, they should be deductible since they reduce the maximum amount that could be distributed to shareholders. In other words, from the perspective of the shareholder, expenditures on productive resources and the interest are both costs that reduce the amount of funds available to be distributed to shareholders.

Moreover, the tax law straightforwardly provides for the amount of interest that may ultimately be deducted as the difference between the total amount borrowed and the amount ultimately paid back to the lender. There is nothing magical about this, and it is consistent with the measurement of other tax deductible costs, including the stock-based compensation rules that are being challenged by Senators Levin and Brown.

So, one problem with their bill is that if you believe that the tax deduction for stock-based compensation should be consistent with interest costs, then you should agree that the ultimate cost of stock compensation should be the intrinsic value realized by the employee when the stock options held are recognized. And, in principle, the answer should not change whether the options are net settled, physically settled, or in the form of stock appreciation rights.

The Free Accounting Lesson

The foregoing is so mundane, I feel almost ashamed to have written it. But, I needed to do that to tee up the really interesting part: somehow, these two senators (and probably a few more) are either being grossly disingenuous or are laboring under the mistaken belief that U.S. GAAP on stock-based compensation (Topic 718) must be 'right,' since it was issued by the FASB after a decade of "due process." In point of fact, it is an embarrassing political compromise that was allowed to survive because its most outstanding feature is that it generally reports only a small portion of the full cost to shareholders of such programs (as I explained in the previous section).

Surely, the senators are aware that it was only relatively recently that U.S.GAAP began to require any recognition of compensation expense for stock options. The controversy was intense, and the best the FASB could do against stiff political resistance when they promulgated FAS 123R was to require that stock compensation expense be limited to the value of the options on the date they were granted – as opposed to either the date on which they were earned ('vested') – or most accurately and consistent with the measurement of other expenses, the date the options were exercised.

For example, assume that an employee is granted an "at-the-money" option to purchase one share of her employer's common stock for $8 per share, and she eventually exercises the option when the share price is $20 per share.

The option was granted on January 1, 20x1, at which time it was valued at $2 per share. It vests (i.e., becomes exercisable) four years later, and expires three years after that. The fact that a company's earnings reported to its shareholders is reduced by only $2 (and spread out over the four-year vesting period) while the amount of wealth transferred from shareholder to employee is $12 (i.e., six times greater than the $2 recognized for financial reporting) is one of the most glaring inconsistencies in gazillions of pages that comprise U.S. GAAP (or IFRS, for that matter).

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Bless these innocent children, who happen to be U.S. Senators, and keep them forever. Will they ever come to realize that the so-called 'excess tax deduction' (a financial reporting concept, not a taxation concept), which they have decried with indignation and sanctimony, is a blatant misnomer? A more accurate moniker would be 'insufficient financial reporting deduction', for the failure of GAAP to record the full amount of wealth ultimately transferred from current shareholders to employees.

Dear senators, GAAP is not gospel, and much of the time it is not even good. And, don't just take it from me. As one retired FASB member, David Mosso, now ruefully admits, GAAP (or IFRS – take your pick) is a "garbage truck."