In this column we shall not retrace the steps why management stock options constitute compensation expense. I have made the reasons very clear in Ebay's Stock Options and Here They Go Again. Instead, let's focus on the economic consequences of standards setting by the Financial Accounting Standards Board.

 

Steve Zeff broached this topic in his seminal 1978 article, "The Rise of 'Economic Consequences.'" By economic consequences, he meant the influence of accounting numbers and the information in the footnotes on how managers and users made decisions. In this essay, Zeff describes early applications of this rationale to argue for a particular position. Thus, one might favor a specific accounting treatment because it produced certain "economic consequences" or because alternatives produced deleterious effects.

 

In 1980, the FASB issued Concepts Statement No. 2, "Qualitative Characteristics of Accounting Information." The board correctly identified the two main qualitative characteristics as relevance and reliability. Relevance refers to that which makes a difference by helping users make better decisions. Reliability refers to the dependability of the data and its freedom from error. Importantly, the FASB tied relevance and reliability back to the objectives of accounting it proclaimed in its 1978 Concepts Statement No. 1 -- to provide useful information to the users of financial reports, especially those users external to the business enterprise.

 

Notice what the FASB did. In essence, it said that the economic consequences to investors and creditors and other interested external parties are important when deciding accounting rules. In a given situation, such as deciding whether to expense stock options, the board articulated the significance of investigating the economic consequences to these outside parties. In other words, will expensing stock options help investors to make stock investment decisions or will it help creditors to assess the creditworthiness of the firm?

 

In that same Concepts Statement No. 2, the FASB also enunciated the concept of neutrality. By neutrality the board indicated that it should never issue a standard for the purpose of achieving some particular economic behavior. Among other things, this statement implies that the board should not set accounting standards in an attempt to bolster the economy or some industry sector.

 

Putting the concepts together, one perceives that the board wants to "tell it like it is." Give the financial facts about the entity, keeping in mind that the facts to disclose are those that the investment community wants to see. Those facts comprise the data that are relevant and reliable to investors and creditors. These facts might not be favorable to managers, but then the financial reports are not designed for their benefit or for their pleasure.

 

Why Rep. Eshoo favors telling fibs about corporate stock options is beyond me -- except for the obvious reason to continue to receive campaign contributions from the technology industry. The difficulty with a standard that allows corporate managers to lie is that the numbers and the disclosures might mislead investors and creditors. Even if it doesn't, the investors and creditors will have to commit resources to detect management's prevarications. As we learned during the recent financial meltdown, when managers lie stock prices fall. Doesn't Rep. Eshoo recognize the loss of trillions of dollars of wealth as a significant economic impact?

 

Rep. Eshoo would prefer false and fraudulent accounting that considered the economic impact over honest and truthful accounting that supposedly does not ponder various economic consequences. Such a stance merely points out her lack of understanding of how the system works. Clearly she comprehends how the corporate-government connection operates, but she fails to appreciate the significance of capital markets.

 

Oh, for some Representatives and Senators who prefer truth telling over fabrications!

 

J. EDWARD KETZ is the MBA Faculty Director at the Smeal College of Business at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals.