Stock Options, Accounting and Monkey-Business - Pass the Tums

I have been sitting back and watching the fireworks around the options backdating “scandal” and feeling, quite frankly, pretty bored. What’s new here? We’ve got poorly-worded (read: vague) accounting rules, corporate boards who have not internalized the fiduciary duty owed to shareholders, weak (read: non-existent) financial disclosure, and not enough really juicy news to go around in summertime. Clearly Boards and Managements all across the U.S. were playing fast-and-loose with the rules, no question. This was certainly not a unique phenomenon in the 1999-2002 time period, and the stock option scandal is merely the latest in a rash of fiduciary and communications breakdowns that plagued U.S. corporations during this period. We know the problems. Those who knowingly played with shareholders’ money without telling them so will pay, some people may go to jail, earnings will be restated across corporate America, and we’ll move on.

But this is all in the past. What about the future? I have seen some press recently around the issue of option expensing, and how the volatility assumptions can be “adjusted” to reflect changes in market conditions. I personally find this topic much more interesting. For example, Intel recently lowered the volatility assumption in their option pricing model from 50% to 26%, lopping off $519 million in expenses to be reflected over the life of the options (according to an estimate by analyst David Zion of Credit Suisse). Certainly Intel’s implied volatility has dropped as it has gotten bigger - this is not an unusual phenomenon - but does today’s 26% represent a drop fueled by company-specific or market-driven factors? Should, maybe, 10-year trailing historical volatility be used in order to create an objective set of rules that can be consistently applied across corporate America, and heavily dilute the effects of overall market volatility on single-stock volatility? Does anyone see what’s going on here?

THIS IS THE PENSION INCOME RECOGNITION GAME ALL OVER AGAIN! Say the stock market has risen and your pension is (temporarily) overfunded. But operations haven’t been so good and you are going to whiff at your next earnings release. Simply goose the expected return on plan assets and let some of this non-cash income flow into the corporation’s financial statements! Makes the bottom line look good, that’s for sure. But is this sustainable? Of course not. It’s total BS. So what happens? Market returns revert to normal, the overfunding drops and maybe switches to underfunding, and all of a sudden instead of pension income gains we have actual (not just accounting) losses. Yet another example of manufacturing short-term results for fame and personal profit which does nothing to benefit the long-term investor.

Now let’s look at this with respect to our options example. Let’s say that stock market volatility falls and single stock volatilities reflect this drop. Ok, this is a point in time. But options are generally 10 years. Do implied volatilities (and the resulting historical) volatilities really remain at rock-bottom levels for 10 years? It hasn’t in my lifetime. So why re-price option expenses to historically low levels when, if you believe in mean-reversion, things will eventually snap back? I can think of only one answer - to make today’s results look artificially good. Now I don’t mean to be picking on Intel - they are playing by the rules (and, let me tell you, they know the rules and the math behind options pricing very, very well) - but this is a fundamental issue with accounting rule-making that simply has to be addressed.

This gets into the concept of rules-based versus concepts-based accounting regulation, and is not a topic I wish to delve into in this blog. But I think a little common sense is warranted here. If the companies themselves continue to fully avail themselves of the inherent weaknesses of the current accounting regime, then it is incumbent upon both analysts and investors to model economic reality - which often means not what we are getting from corporate America.