Optional Reading

by Edgar J. Steele

January 2, 2005

"Oh, stewardess, I speak jive."
  --- Barbara Billingsley, as jive-interpreting passenger in "Airplane!," the movie (1980)

Originally, I intended this simply to be an email alert to a selected group of people that I know to be interested in things financial.  Then, I decided the subject has broader implications and might even be of interest to those who have no investments to speak of, as it illustrates the moral poverty of modern America's rule by corporate oligarchs.  That's part of the reason why it is optional reading today, class.  The rest of the reason is because it actually concerns options - employee stock options, to be exact.

I speak financial, to coin a phrase, so please allow me to interpret something I deem to be of great significance.

I don't really follow the accounting profession much anymore.  In fact, not since that gray day in 1973 Seattle, when I concluded my fourth interview with one of the (then) "Big Eight" accounting firms by telling the interviewing partner that I didn't want to work for them.   I went directly to my hotel room and called the remaining four, canceling my upcoming interviews with them, as well.  Then I called and canceled my appointment to take the CPA exam in San Francisco the following month, though I already had studied for it.  So much for the value of my Master's Degree in Accounting from Cal Berkeley (then one of the very top Graduate Business programs in America, ranked below only Harvard and Stanford).

All the people I had met were so...gray.  I couldn't bear the thought of working for them...with them...becoming one of them, though I had worked as an accountant already for a couple of years.  That led to my first job as a Financial Analyst in San Francisco's Financial District with a major international firm that never paid a penny of US tax (a story for another day, as the reasons why still exist and still redound to the detriment of American taxpayers).

Because I no longer follow the accounting or financial professions very closely is why it took two weeks for me to become aware of the following press release:  http://www.fasb.org/news/nr121604_ebc.shtml, issued by the FASB (Financial Accounting Standards Board, which regulates the Accounting profession very closely), concerning the expensing of stock options granted to officers and employees by firms.  

Here is a link to the FAQ (Frequently Asked Questions) page concerning the FASB's stock options opinion (really a mandate, though they call it an "opinion"), which is kind of a short cut to what's interesting and intelligible:  http://www.fasb.org/project/123r_faq.pdf.

Here is a link to the statement itself, which runs to nearly 300 pages in length:  http://www.fasb.org/pdf/fas123r.pdf.

Bottom line:  As of June 15, the value of stock options must be expensed by American business firms.  They will be, too, as all accountants, both those with independent auditors and those who are privately employed, will follow the FASB, no matter how loudly their employers might protest.  There are a variety of methods to value those options, however, so look for some wiggle room in that arena.

Remember, stock options are how so many people were lured to work at tech startups and put in such long hours for relatively low salaries. This also is how officers (who control their company's boards, make no mistake) plunder the value of their own companies, right under the noses of investors who provide startup funds and working capital, usually folks just like you and me, a great many of whom took a bath when the tech stock market crumbled in 2002.  Some lost their life savings.  You can bet most companies' executives didn't, though.  How do I know?  Remember, stewardess, I speak financial.

Without the "off-statement" handling of stock options, there would never have been a high-tech stock market boom in the first place.  Indeed, that boom and the resultant skinning of so many ordinary Americans are what led the FASB to issue its current edict.

Here's how the FASB explains the need for this new rule change:  "Users of financial statements...expressed to the FASB their concerns that (the current handling of stock options) results in financial statements that do not faithfully represent the economic transactions affecting the issuer, namely, the receipt and consumption of employee services in exchange for equity instruments.  Financial statements that do not faithfully represent those economic transactions can distort the issuer's reported financial condition and results of operations, which can lead to the inappropriate allocation of resources in the capital markets."  FASB Statement of Financial Accounting Standards No. 123 (Dec 2004).  (emphasis supplied)

"...the inappropriate allocation of resources in the capital markets."   In other words, a lot of good people lost their life savings to a bunch of shysters, bankers and con artists.

Add in questionable, even patently illegal, business transactions, which have become widespread during the past thirty years, and you get a recipe for investor fraud.

Because I speak financial, let me interpret the FASB's words for you:  "Pigs get fat and hogs get slaughtered.  You hogs screwed over way too many ordinary investors."

Think Global Crossing.  Think Enron.  Think Ken Lay, still at large.

For only another five months, when exercised, stock options will result in a hit just to the value of a company's stock then held by others.  Stock option transactions always have been "off-statement," meaning having no impact to a company's income statement or balance sheet, simply being relegated to footnote status in a firm's financial statements.  

It's like a firm that sells a mortgaged asset to its bank, then leases the asset back, expensing the monthly lease cost.  Immediately, the firm's balance sheet cleans up by removal of the debt associated with the asset (the asset value goes, too, of course, but the debt removal is of far greater significance to financial ratios followed by bankers and analysts), though the future obligation to pay for the asset actually has increased due to lease fees and transaction costs.  At least, in the leasing example the income statement still takes a hit. 

With stock options, never is there a financial statement hit taken by the company.  The hit always is borne by existing shareholders, whose stock values become diluted as the company merely issues new stock to employees exercising their options...a non event for income-statement purposes.  A direct lift from existing shareholder wallets, in other words, which are worn close to a part of the anatomy which serves as the basis for the old chestnut "taking it in the shorts," a procedure distinguishable only by being more visible.

The only exception is for that rarity called "Treasury Stock," which is stock bought by a company in the open market with after-tax retained earnings and then held in a special equity account, rather than being retired.  Very few options ever are fulfilled by the transfer of Treasury Stock, so it really does not merit discussion.

Clearly, there will be a huge amount of stock option exercises and cancellations during the next few months.  Option exercises always are accompanied by selling, of course.  Insider selling, at that, of which there already has been a record amount in recent months.  Nobody ever exercises options and holds.

A pro-rata valuation of options existing as of June 15 is required, with an FASB-required restatement of prior period financial statements then to take place.  The accounting entry is:  debit expense and credit liabilities, just like wages, which is what stock options are, after all.

P/E (Price/Earnings) ratios, already stratospheric by historical standards, will evaporate altogether for many firms (divide by zero or a negative and get infinity).  Microsoft's P/E ratio, for example, will be infinite for most of its existence, right through today.  Microsoft, the most profitable tech company in history, has never made a single penny if one recasts its financial statements to reflect the expensing of stock options since its inception.  What do you suppose will happen to stock prices, which ultimately derive their value from earnings, once stockholders get a whiff of how badly they have been had?

I consider this to be the most significant change in accounting procedures in decades.  It could result in the destruction of tech stocks overnight.  Indeed, if people followed stuff like this, the market already should have tanked.

Don't say I never warned you.  After all, stewardess, I speak financial.

Get out of stocks and bonds and do it now.  I can't say it any more plainly.  Stay out of dollar-denominated assets, too - the dollar is down 40% in the past couple of years, in case you haven't noticed, and its modern decline has only just begun.  

Think you're doing ok with your stocks, given the market's recent rebound from the 8,000s to the 10,000s?  Wrong.  In 2002 dollars, the Dow actually has gone from 8,000 to 6,000.  You actually lost 25% of your nest egg over the past two years!  What good will it do you for the market to double (more likely to suffer an absolute decline, actually) while the dollar falls by half?  

Fundamentals and historical P/E ratio analysis dictate a coming market of about 4,500, less than half what it is today, when ratios revert to their mean averages, and revert to the mean they always do, rest assured.  And that is before financial statements get restated for stock options, by the way, which will make things much worse for some.  At the same time, the dollar probably will decline by another 40 or 50 per cent.  Net result to those of you who stand pat:  a loss of about 75% of the purchasing power of your stock market investments during the coming few years.  Factor in the 25% decline of the past two years and you are looking at a net loss of 85%!  

Never have I seen the stock market represent a worse investment than it does at this moment.  Don't forget, I speak financial.

While we have discussed America's burgeoning twin deficits, both fiscal and trade, I haven't really stressed the importance of the bothersome Russian and China moves to cement relations with countries that have provided America's energy needs shortfall up to now, such as Canada and Venezuela.  Can you say "$5-per-gallon gas," boys and girls?  Now I read that America has, for the first time, suddenly become a net importer of food.  This is truly bad news which can only get worse for three reasons:  (1) the unending tidal wave of illegal immigration, (2) the plummeting dollar which has no hope of revival due to America's huge trade imbalance and (3) international downward pressure on American trade barriers to foreign foodstuffs.  

How on earth did Bush manage to destroy our food import/export surplus, too?  This is bad news, folks, piled atop worse news.  

Fasten your seat belts and return your tray tables to their full, upright positions.  Place your head between your knees until further notice.

New America.  An idea whose time has come.

-ed

Copyright 2005, Edgar J. Steele

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