The silly actions arise because EDS has a variety of stock option plans. Like most managers, those at EDS didn't just want to issue stock because that would reduce the earnings per share (and the book value per share). So they planned on future acquisitions of their own shares. Buying treasury shares and then issuing them to recipients in a stock option plan would avoid diluting earnings per share.

 

Then the executives at EDS got smart. They employed their sophisticated models and concluded that, yep, the stock prices had to go up. They obtained the forward purchase commitment to lock in the price. If they could commit to a price of say $60 per share and the price went up to say $100 per share, then they would save $40 per share and use that cash for something else.

 

By selling puts, they also bet that stock prices of EDS were going up. The put gives the holder of the put an option to sell the stock at a set price, say $60 per share. If the price goes up, then the holder of the put lets it expire and EDS banks the amount it obtained upon selling the put. On the other hand, if the price goes down, say to $35 per share, then the holder of the put would sell the stock to EDS at $60 per share and EDS would lose $25 per share.

To make a long story short, EDS gambled that their stock was going up, but in fact it kept going south. EDS lost a bundle estimated at around $225 million.

 

The story raises two points. First, accounting rules say that you do not recognize gains or losses for transactions in your own stock. This rule made a lot of sense when first implemented, as it played a role in removing incentives from managers to engage in wash sales. But I wonder whether it's time to make a distinction between equity transactions and gambling transactions. If the EDS managers had engaged in hedging, I would likewise not recognize any gains or losses. In this case, however, there is no hedge; instead, this set of transactions is purely speculative. I think EDS should recognize gambling losses to the tune of $225 million.

Second, I wonder whether the EDS managers are guilty of one of the –feasances, whether mal– or mis– or one of the others. Let the investors decide their risk preferences and choose investments based on those risk preferences. Managers do not have the right to throw away shareholder value just because it has some whim about which direction the stock market will be heading.

 

Managers should manage. Let investors do the investing. And accountants should recognize gambling losses as they occur.

J. EDWARD KETZ is associate professor of accounting in Penn State's Smeal College of Business Administration. Check out his column, where you'll find more articles on controversial, cutting-edge topics.