FASB 123 (Share Based Payment) unlikely to alter capital flows

On December 16, 2020, the Financial Accounting Standards Board issued rulings on the expensing of stock options.

According to the FASB, this rule:

"addresses users’ and other parties’ concerns by requiring an entity to recognize the cost of employee services received in share-based payment transactions, thereby reflecting the economic consequences of those transactions in the financial Statements".

Although the concerns of some may be addressed, the underlying problem is ignored.

For long-term investors, FASB 123 does not even begin to adequately reveal the true cost of option remuneration schemes. Employee option plans are usually associated with corporate stock buyback programs that are used to jack up share prices and give value to executive options.

In some cases, funds involved in stock repurchases may be one hundred times greater than the executive remuneration represented by the options

(See: The Boeing Buyback for a case study).

The Great Misleading Continues

Over the last generation, U.S. corporations have diverted more than one trillion dollars from corporate reserves to push up stock prices to the detriment of long-term investors

(See: Buybacks and Options).

However, FASB 123 pays insufficient attention to this issue and focuses on the supposed theoretical value of options, which certainly is not the true cost to long-term shareholders. The much greater “cost” to investors that is incurred when management diverts cash dividends to stock buybacks is not adequately addressed.

It is not surprising the FASB has not faced squarely the real cost of option-buyback schemes. First, under long-established accounting principles, buybacks are treated as a charge to reserves rather than an expense, and therefore provide a massive loophole through which the real cost of manipulated stock options can be hidden.

Second, company executives have made such a fuss about expensing stock options that the public (and presumably the SEC) believes that “expensing options” constitute a real reform. However, we are reminded of Brer Rabbit and the Briar Patch

(See “How Mr. Rabbit Was Too Sharp for Mr. Fox.”)

‘I don’t keer w’at you do wid me, Brer Fox,’ sezee, ’so you don’t fling me in dat brier-patch. Roas’ me, Brer Fox,’ sezee, ‘but don’t fling me in dat brier-patch,’ sezee.

FASB 123 is unlikely to discourage unfair buybacks (which in FASB 123 are not adequately covered), because corporate executives, given the wide latitude under accounting practices, can easily find other ways to compensate for the “cost” recognition required by FASB 123.

Pseudo-science Gives Respectability to FASB 123

By sanctioning the use of option price models — presumably Black-Scholes, or one of its progeny — the Financial Accounting Standards Board has, in essence, declared that these models will provide “the fair value of an equity share option”.

However, these option models are not at all scientific and, and even if they were, they are presumed to be restricted to circumstances that do not conform to the most common way that executive stock options are employed.

(See: Fallacies of the Noble Gods)

Specifically, the Black-Scholes model requires “perfect markets” which certainly is not the case when corporations are using stock buybacks to ramp up the prices on the exchange in order to give value to their stock options.

One might think that the loud downfall of Long Term Capital Management might have cast some reasonable doubt on the reliability of option-price models, but apparently this has not happened.

(See: When Genius Failed)

The Structure of the Great Bubble Endures

Despite the Sarbannes-Oxley Act, show-trials of Enron executives, tough talk from the SEC, and FASB 123, it appears that the institutional structures that have exerted such powerful upward pressure on equity prices for twenty years, especially the entrenched practice of stock buybacks, continue to be in place.

Indeed, the flow of funds accounts for the equity market in Q2 2004 show stock buybacks to be running at record levels.

The Common Stock Legend still drives 401(k) money into equity mutual funds.

FASB 123 will help to give long-term investors a false sense of security, contributing to the belief that the “excesses of the 1990s” are behind us, when this is not the case.

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