Accounting Today - September 2011

shareholders are presently obliged
to distribute to the employees. We
defy anyone to extract that relevant
information from today’s impen-
etrable footnotes.
Spirit
FROM PAGE 18

THE EYES OF TAXES ...

Compounding the insufficiency of GAAP is the treatment of income taxes. Because the tax law has the employer deduct the options’ value as of the exercise date instead of the grant date, a permanent difference between book and tax income is created. In a bizarre twist dating back decades, the permanent savings from deducting the excess of the real cost over the grant date value is not credited to earnings but to additional paid-in capital. Huh?

Consider this paradox: Even though Congress understands how much options really cost, accountants obliviously report too little compensation expense and too much tax expense!

NON-TRUTH AND
CONSEQUENCES

Under GAAP and IFRS, diligent statement readers slog vainly through mind-numbing abstruse disclosures to glimpse at best a fuzzy picture of the total value transferred to employees. What should bother every honest accountant is that this lack of complete information utterly fails to provide an effective check on option use that would prevent it from spiraling to obscene levels. Clearly, these inferior standards have enabled negative management behavior.

We have a favorite saying, “What
you measure, you manage,” which
has this corollary: “What you don’t
measure, you don’t manage.” These
thoughts aptly describe a power-
ful force behind the tremendous
growth in exploitative executive
compensation.

A NON-ACCOUNTING
SOLUTION

Certainly, one way to bring about more rational use of options is to force managers to tell the whole truth about how much they are taking for themselves. However, we have another way to change their behavior, specifically by having the corporation pay intermediaries to provide options and assume the risk. This arrangement would eliminate existing practices that subject stockholders to unlimited downside risk for the options’ future value and the possibility of massive dilution upon exercise.

We propose that a financial inter-
mediary would serve as an “option
fund.” Instead of issuing its own
options, a corporation would pay
an upfront fixed cash amount to a
fund to write and issue third-party
options to employees according to
the compensation plan. The fund
managers, not the shareholders,
would assume the risk of future
option value increases, which they
could then mitigate by hedging.

THE BOTTOM LINE

Capital markets need high-quality financial statements to help them figure out what’s going right or wrong. At the same time, GAAP and IFRS should reinforce ethical stewardship over firm resources by clearly displaying the consequences of managerial decisions. Unfortunately, today’s weak disclosure requirements do not overcome poor GAAP and IFRS, and thus invite managers to keep plunging back into the options trough.

More than that, everyone should be sobered and frustrated when they assess the minuscule return for the massive time and energy that has been wasted on IFRS convergence and adoption in the U.S.

Just think how much better off
the whole world would be if that
effort had been directed toward ac-
tually improving accounting for op-
tions and resolving so many other
financial reporting issues. AT
be taken to improve compliance with professional stan-
dards in key audit areas.

or state regulators that could limit or restrict a firm’s acceptance of new clients or practice areas; the risk of failing its peer review; and the risk of adverse publicity and the impairment of professional reputation. That could result in loss of clients and a negative impact on employee retention, recruitment and morale. AT

Dan Hevia is a shareholder with Gregory, Sharer & Stuart, and an experienced peer review team captain and chair of the American Institute of CPAs’ Peer Review Board.

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