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    Sunday, August 03, 2003

    Flipside on option expensing

    This comes from the EXPEDITORS INTERNATIONAL 8K posted in June 2003. They post an 8K monthly with replies to people that sent questions to their investor relations. These 8K make for very comical reading. This is part of a response to a question on the value of diluted shares, using the Mad Hatter's tea party for comparison:

    After all, once you allow yourself to descend “down the rabbit hole” into accounting wonderland where procedures are promulgated at the expense of principles, why shouldn’t things just get “curiouser and curiouser” and indeed they have. At this point, it is fair to say that we have answered your question as best we can, but we need to go on in order to blow off a little steam as we try to point out how silly this stock option expensing medicine really is.

    Recording an expense for stock options requires a certain amount of twisting, bending and molding of traditional accounting theory to distill a set of accounting entries that make sense. In the case of stock options, we want to record an expense on the books of the company to record a transaction that in essence is a transfer of value between the shareholders and employees (potential or actual shareholders) - an item for which there is no guarantee that any consideration will, in fact, ever change hands.

    Also, not to be forgotten is the fact that for the period in which expense must be recognized in the income statement, an offsetting credit must go somewhere in order to leave the books balanced. Since we are still doing double entry bookkeeping, debits (expense for employee stock options in this case) must always equal credits. Where can we put that tricky rascal as we record this expense for stock options? Putting it on the income statement would undo the expense so we know that can’t be the answer. That only leaves the balance sheet.

    In all the uproar over the need to expense employee stock options, the ridiculous accounting acts that must be committed on the balance sheet have been glossed over by those who are knowledgeable in accounting matters. They have likely been misunderstood, misinterpreted or otherwise not comprehended by those who aren’t. But, let us explain.

    Two paragraphs ago, we established that every debit needs a corresponding credit and that if we are to expense options, we have to put the credit on the balance sheet otherwise nothing happens. Now, ignoring stuff like contra-assets (accumulated depreciation for example), the balance sheet can be said to be made of assets, liabilities and equity. The asset side is the home of debits while the liabilities and equity generally carry credit balances. Trust us when we say that the credit we get with stock option expensing isn’t a liability so we need to shove this puppy into the equity section.

    In the name of the perceived greater good (stomping out exorbitant stock option grants to a small group of overcompensated management in a select group of firms), the expensing of stock options has made a complete and total mess out of the equity section of the balance sheet. Grossing up the stockholders equity section of the balance sheet (that is what that rascal credit does after all) in order to record an expense for stock options on the income statement (the debit we all seem to want) completes our journey down this accounting rabbit hole and it is about time for tea. Just as grossing up stockholders equity may make no sense, there was little rhyme or reason in Wonderland, tea was at 6:00 and according to the Mad Hatter, it was perpetually 6:00 for no other reason than the Mad Hatter said it was. At the Mad Hatter’s party, only one person got a clean cup, but that is a story for another day.

    Finally, we suspect that the reason things seem to work differently at the other companies you studied, has to do with the success of Expeditors and the fact that our unamortized option value is therefore fairly large according to Black Scholes. The more successful the company, the larger the likely unamortized value. The larger the unamortized value, the more options are initially excluded as anti-dilutive. “I want a clean cup,” interrupted the Hatter: “let’s all move one place on.”

    The most recent 8K tells an analyst that they don't like him and his investors are welcome any time, just not him.

    I don't believe in the end I agree with their argument and issuing restricted stock like Microsoft has, makes option expensing a non-issue anyway.

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