Accounting for Stock Options   Part One Reasoning By Authority   Part Two Expense, Expense, and Expense   Part Three Why CEOs Fight Stock Option Accounting

Berkeley took this unusual step when Ute Frey, the associate director of marketing and communications at the Haas School of Business, issued a nationwide news release praising the merits of this paper. I wonder why Berkeley is so involved in promoting this essay to the press. My guess is the university either has received something from or wants something from Mr. Hagopian, who happens to be a wealthy venture capitalist. (Editor's Note: See Accounting, Economic Experts Call Expensing Stock Options Improper Accounting]

That aside, the paper is as loony as it is self-serving. Yet again, the high-tech industry is trying to thwart good accounting by advocating the overthrow of Statement No. 123R by FASB and the SEC's support of the pronouncement.

Unfortunately, the reasoning in Hagopian's paper consists of the same pedestrian arguments that are groundless, though impressively packaged. Because this battle is crucial for accounting to improve, I shall spend several columns scrutinizing this article and pointing out its many defects. Specifically, I want to display the essay's illogic of reasoning by authority, re-examine FASB's rationale for expensing employee stock options, critique the discussion surrounding "gain-sharing instruments," and investigate the notion that the cost is accounted for under the treasury stock method for computing the dilutive effect on earnings per share.

The paper starts by listing an impressive number of signatories who agree with the contents of the paper. The list includes a number of Nobel Prize winners. While striking, the list is beside the point. As any student of logic realizes, the appeal to authority is an error in deduction for the obvious reason that authorities sometimes make mistakes. In addition, an appeal to authority does not address the matter at hand; it provides no facts with which one can assess the validity of an assertion and it supplies no logic that dissects the proposition and sheds light on the truth of the matter.

These observations are highly relevant in this case because so many of the signatories are economists with little or no training in accounting. Just because one is an expert in economics does not imply that he or she is an expert in accounting. Markowitz, for example, won the Nobel Prize in 1990 for his work on formalizing and quantifying portfolio risk and return; however, I am unaware of even one paper that he wrote in accounting. Despite his acumen in financial economics, that omission suggests that Markowitz may be ignorant of the concepts, vocabulary, and the methods of financial reporting. While I am willing to listen to Markowitz when he discusses financial economics, why should I accept him as an authority to debate accounting matters?

Another reason for rejecting this type of argumentation is that the other side can amass its own list of authorities. In this case, there are Nobel Prize winners who support the expensing of stock options. Let's consider the cases of Joseph Stiglitz and Robert C. Merton.

Joseph Stiglitz won the Nobel prize in economics in 2001 for his work in the economics of information. Information economics is that branch of economics that looks at information asymmetries (e.g., what happens as a result of managers' knowing more about the firm than shareholders), adverse selection (e.g., the observation that unethical directors are more desirous of D&O insurance than ethical directors), and moral hazard (e.g., how directors lose some of their incentive to oversee the management team when they have D&O insurance).

Stiglitz discusses the accounting frauds of the last decade or so in his book The Roaring Nineties (Norton, 2003), especially in Chapter 5. Stiglitz describes stock options as "ways of maximizing executives' gains at unwary investors' expense," calling them "theft." Indeed, Stiglitz employs his knowledge of economics to conclude that stock options "bear no relationship to the usual economic forces" because "stock options [distort] managerial incentives."

Regrettably, Stiglitz also displays a limited understanding of accounting when he frames his arguments in terms of their balance sheet effects instead of their income statement effects. But, unlike Hagopian, we are willing to show the flaws of our economics experts.

Another economics expert who supports the expensing of employee stock options is Robert C. Merton. Merton won the Nobel Prize in economics in 1997 for his work on options. Independently from and simultaneously with Black and Scholes, he developed a formula for pricing options.

With respect to accounting for stock options, Merton did what an expert in one field but writing in another should do -- he teamed up with experts in the second field. Specifically, he co-authored several papers with Harvard's Robert Kaplan, an accounting professor, and with Boston University's Zvi Bodie, a finance professor. They have written several papers for the Harvard Business Review, but in this series of columns we shall review their summary of the issues in an op-ed piece appearing in the Wall Street Journal on Aug. 12, 2002, "Stock Options: To Expense or Not to Expense."

They launch the op-ed piece by proclaiming, "Despite the pronouncements of a few renegades in our disciplines, we believe that there is near unanimity of opinion among scholars in the field of accounting and finance that the value of employee stock options should be expensed on a firm's income statement at the time they are granted." I don't know how Bodie, Kaplan, and Merton determine this near unanimity, but my own casual observations agree with theirs. The vast majority of my colleagues and associates also believe that stock options should be expensed.

I find it amusing to contrast the signatories to Hagopian's paper and the body of academics. Hagopian's set is loaded with professors at California schools or with executives tied to the high-tech industry. The body of academics comes from all of the United States. Might the influence of the high-tech industry taint the objectivity of Hagopian's experts?

Bodie, Kaplan, and Merton next state their reasons for advocating the expensing of stock options, and we shall explore those reasons in the following columns. For now I simply note that Hagopian never references the Bodie, Kaplan, and Merton papers and, for that matter, he never references any researcher that disagrees with his position. How strange in a debate of this magnitude not to consider the perspectives and the opinions of your adversaries!

To close, the appeal to authority is enticing because it gives the aura that those with brilliant minds adopt a particular point of view. While powerful rhetorically, this approach constitutes a logical error because authorities sometimes make mistakes, such appeals to authority do not address the subject under debate, and the opposing side can solicit its own bevy of experts. Worse, this strategy backfires when the list of experts do not really possess the requisite knowledge base in the field of battle.

With such ignorant experts, the glamour of Hagopian's paper disappears. I could stop my critique at this point, but opponents of the expensing of employee stock options would continue their nonsense. Therefore, I shall resume the critique in the next column by reviewing the arguments by FASB and by Bodie, Kaplan, and Merton.

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J. EDWARD KETZ is accounting professor 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. He also has edited Accounting Ethics, a four-volume set that explores ethical thought in accounting since the Great Depression and across several countries.