As I have repeatedly stated of late, the current crisis in financial markets is a source of genuine concern. It is not a passing reaction to a few bad numbers, an external shock, or disappointing earnings. In fact, the economic statistics are good, no major new threats have surfaced, and a number of companies have “beat the Street” in their performance. Even the irascible Mr. Greenspan is talking things up. The problem is at the core of the market itself—people don’t believe the numbers!
Having defined the problem, there is a political feeding frenzy to find solutions. The President is talking tough (although the market doesn’t seem to be listening), the Senate unanimously passed a bill, the House passed a weaker one (the leadership is trying to keep it weak but is facing mutiny among many members from both parties as it goes to a conference committee), and state officials around the country are putting their two cents worth in as well.
At the same time, there is a fierce lobbying effort behind the scenes to weaken the proposed restrictions; many trade associations are walking the fine line between appearing to support reforms and not alienating their members; and accounting boards and regulators are scrambling to prepare new guidelines.
The main source of controversy revolves around the treatment of stock options in corporate records. The reformers want to treat them as current expenses, thus reducing reported earnings and (at least theoretically) providing a more realistic picture of overall performance. Most corporations (probably temporarily—but they don’t know that yet) fear dire consequences from such a change and are resisting mightily (though quietly). There are a few exceptions. Coca-Cola and Bank One have decided to account for their options as expenses, and I suspect others will follow. The market is in a mood to reward disclosure, and that in and of itself is a powerful force.
The strange thing about this whole issue is that, despite the intensity of the battle, it is really much ado about nothing—a classic case of form over substance. The “substance” is the information itself; if it is fully and properly disclosed with no shenanigans, it doesn’t matter where you put it. The thing that the market does best is process information. If it has the right data, it will accurately assess and value firms with marvelous efficiency.
If the options are recorded as expenses, the market will instantaneously adjust to the fact that “new” earnings and “old” earnings are not the same thing. It will look to future prospects, not past numbers, in setting stock prices.
On the other hand, if the options are reported elsewhere, the market will assess performance with full knowledge of the effects of dilution (and analysts will most likely publish earnings with and without options included); investors will respond accordingly. Either way, the adjustments occur within a matter of nanoseconds, and the outcome is the same.
I like the idea of including options in expenses, but all the fuss is misplaced. If the market has the right information, the market knows what to do with it. The key is to get the substance right; the form is irrelevant.