One of the canards in Silicon Valley’s arsenal of canards about required recognition of stock option expense is that “we don’t know how this will affect the markets – we need a study over the next three years!” (Long enough to hope that regime changes in Congress will help them.)

Before the SEC released its long-awaited SAB 107, dealing with implementation of Statement 123(Revised), the Commission’s Office of Economic Analysis did some homework. They presented their “Economic Perspective on Employee Option Expensing: Valuation and Implementation of FAS 123(Revised)” to chief accountant Don Private investment Custodian eleven days before his office released SAB 107.

The OEA put together a concise, readable document that defuses the bogus issues raised by the opponents of the stock compensation standard. It’s a highly readable document – about seven pages – and worth a read if you’re at all interested in the stock option brouhaha. The OEA had this to say about the forecasted devastation on the markets when option expensing is required:

“Benefits from the expensing of employee options

o Improved transparency of financial condition.

Companies that expense their employee options voluntarily have tended to experience a positive or neutral stock-price movement at the announcement of the decision to expense. This is consistent with a favorable market reaction to an improvement in the transparency of the cost of employee stock options.”

In short, we’ve seen companies adopt the upcoming policy already in the real world, and the markets liked it or were ambivalent.

Another canard: how can volatility be reliably estimated for option pricing models? From the OEA paper:

“There is nothing new about the essential requirement to make estimates of future outcomes, as in estimation of future stock volatility and option term

o FAS 123(Revised) and the staff guidance in SAB 107 are very clear that companies are required to use all information that is available at the time of grant to estimate the relevant parameters for their valuation models. This recognizes that estimates of future outcomes will in this setting not typically equal the future realizations of those outcomes.

o FAS 123(Revised) does not appear to require efforts to estimate future volatility and term

parameters beyond what was required under previous disclosure rules. Under FAS 123, companies are already required to provide estimates of the fair value of employee stock options in footnotes.

o Companies routinely incorporate estimates of important cost items in their financial statements. For example, pension accounting already requires that companies make estimates of future cash flows, employee retention rate, employee retirement dates, longevity of their employees; other postretirement benefit accounting requires the estimation of future medical costs – all of which raise challenges beyond what is encountered in the estimation of future volatility and term of employee stock options

under FAS 123(Revised).” (Emphasis added.)

The reason that this particular passage grabbed my attention is that phrase “There is nothing new.” It’s the one phrase that could sum up all of the arguments against recognition stock option compensation: there is nothing new. All of the arguments against the standard are the same chestnuts we’ve been hearing for the last ten years. And there is nothing new about the challenges of estimation in accounting for options in Statement 123(Revised) and its companion SAB 107. It’s good to see the OEA mention that pension and OPEB accounting involves far more difficult inputs to estimate. Yet firms don’t seem to mind pensions and OPEB accounting.

A Taxing Future

There will be many patterns to sift out of the Section 404 internal control reports, no doubt. We know all too well that one particular internal control weakness will be likely to emerge: controls over lease accounting.

There’s one other emerging area of unusually frequent weakness (though far from as common as lease accounting errors), and that’s in the area of taxes. Consider these examples arriving in the past couple weeks’ 10-Ks or 8-Ks:

Calpine reported material weaknesses over the basics of reporting income taxes. Its chief issues: ineffective controls over tax impacts of funds repatriated from Canada; properly splitting tax provision between continuing and discontinued operations; flawed communications between the accounting and tax departments regarding the tax provision; and documentation of justification for tax stances taken. Taken together, the problems led to the restatement of 2004 interim financial statements.

First Industrial Realty Trust reported that it had improperly allocated all of its income tax provision/benefit to discontinued operations, instead of continuing operations, gain on real estate sale, and discontinued operations.

Conagra Foods reported more serious problems than mere allocations to different buckets in the income statements: preliminarily, to correct its tax accounting the firm will take a cut out of after-tax profits in fiscal 2003 and fiscal 2004 in the range of $150 million to $200 million all told – and correcting the errors will involve cash outlays of similar size.

For undergraduate students of accounting, maybe there’s a career path being outlined in the entrails of the Section 404 reports: if you think that being an auditor is hard, maybe it would be less taxing to be a tax expert. (That was unforgiveable.) Seriously, there has been a glut of internal control weaknesses showing up for taxes; watch this space for more.