No option but to comply

That's the situation in which IBM and other tech companies now find themselves as they begin to expense stock-option compensation plans.

Yeah, the Cranky Economist knows we've all been down this road before, and have spent many sleepless nights pondering whether we should or shouldn't expense these options. But I wasn't blogging then. So I'll take this opportunity to throw in my two cents on why this expensing rule is a bad idea.

There are two reasons. First, it's not clear that these options are really an expense. Second, it's crystal clear that it is impossible to assign a meaningful value to them.

Why are they not an "expense"? Take a step back and consider what an option is. For those of you not in the know, it is a contract that gives the holder the right to trade a stock at a particular price (called the "strike price") at a particular time. (The options under discussion are "calls" that let the bearer buy the stock; a "put" lets you sell it.) Call options can be a veritable gold mine if the strike price is less than the market price (the "spot price") on the day the option is exercised. You buy the stock at the cheap strike price, and turn around a sell it for the higher spot price.

But how is this an "expense"? It's not a cash outlay on the part of the company in the way that a salary or benefits are. The contracts are most often fulfilled by creating equity on demand as employees opt to cash out their options (most options can be exercised at any time before expiration) -- that is, it just prints up more stocks that it then sells at the strike price instead of the spot price. So the "cost" to the company is that it is selling a portion of this equity at below-market price. But is that truly an "expense"? The company still gets some cash for its equity, even if it gets less cash than it would on the market.

Certainly nothing in life is free -- these options are an "expense" for someone. That someone is existing shareholders, who find their equity stake (and thus their earnings per share) diluted by the creation of extra equity to fulfill these contracts. Which is why information about options-based compensation has always been included in financial reports, even if it has not been included in profit and loss calculations.

One reason it isn't included in those calculations is the second objection I noted above: It is difficult, if not impossible, to value options in any meaningful way. The value to the employee is obviously the difference between the strike price and the stock price on the day the option is exercised. But how do you guess today what that value will be at some indeterminate point in the future? In markets for traded options, traders can guess (but only guess) at the value of options contracts, and the market will generate an average guess that is as good as any. But how can you begin to guess at the value of an option that isn't traded? Any result you come up with will inevitably be arbitrary. Thanks to the new accounting rules corporate guesses will be arbitrary in a uniform way. But a uniform rule requiring every accountant to aver that the earth is flat doesn't lead to any meaningful revelation about the nature of the cosmos.

So, thanks to the public's combination of confusion over, and revulsion at, how options were used at Enron, we are now left with a regulation that, curiously, will bring less transparency and comprehensibility, not more, to corporate balance sheets. Well done.