Recent corporate failures have called into question the integrity, ability, and compensation of some corporate executives. The increased use of stock options to inflate executive compensation and hide the resulting cost has given rise to demands to visibly account for such costs.

FASB had proposed expensing options when granted at a fair value determined by a Black-Scholes or a standard binomial model. This idea was not a popular among influential CEO’s and congressional pressure, since incinerated, caused FASB to compromise its proposal. SFAS 123 requires footnote disclosure but allows companies to exclude the cost of out of the money options from income statement expenses.

There are problems. Model assumptions must be made which can substantially affect cost recognition, for example, future price trends and volatility must be estimated. There are other complicating factors, which decrease the applicability and reliability of the models. There are questions about the models themselves even with simplifying assumptions, for example, option models may work well for short-term liquid assets but they may fail for long-term illiquid liabilities. The biggest drawback is that these models do not fit the theory or practice of accounting today. They are subject to abuse and are be too complex to be routinely used.

How would Accounting For The Future (AFTF) cope with stock option costs?

AFTF is based on the Present Value of Expected Cash Flows (PVECF) where the expected cash flows take into account relevant contingencies, such as the expected work-lifetime of the grantee of options. The cash flow would be recognized* upon exercise as future price less grant price of shares discounted with respect to contingencies and the historic cost of capital. The future share price is inherent in the AFTF model; simply discount the existing cash flow model projected forward from that future date. The more optimistic the model the greater the current option cost. This enforces a natural discipline.

The simplicity and disciplines of AFTF, illustrated by the stock option treatment, permeate AFTF. This suggests a fundamental robustness and reliability.

A Better Solution

It is desirable that compensation be closely linked to performance, both as a motivating cause and as a rewarding effect. Reported earning are short-term measures often managed by management. They may not represent actual earnings. They may not represent management ability or success in adding long-term or even short-term value. Often decisions or actions that add value have negative current earnings effects. Capital expenditures, new hires, employee training, R&D, layoffs, discontinued operations, indeed almost any worthwhile investment or action, has a current cost and future benefits. At best, the current accounting model measures these benefits to the extent of the cost (if capitalized).

AFTF measures the net long-term benefits (cash flows) appropriately discounted at the cost of capital, producing shareholder value added. This is the best measure of management performance and a suitable basis for management compensation. See Accounting For The Future, Chapter 8: Management Solutions, Incentives, for further discussion.  There is a tight link between AFTF value and stock price; options are not needed to reward for stock performance.

*AFTF recognizes cash flows (past, present, or future) when they occur but attaches a present value measure to those cash flows. The result of this two step process of cash flow recognition and present value measurement is the recognition of value. This is a key tool in reliably translating past experience and future expectations into a decision-useful present value. This, of course, is not a foreign concept, but it helps to have an explicit definition.