Accounting for the Buyback Boom - The Next Step for Options and Equity Expensing
32 Pages Posted: 16 Mar 2007
Date Written: March 13, 2007
Stock buybacks boomed in the first years of the 21st century even while their returns trended towards 0%. Unlike dividends, which can never be mispriced and treat all shareholders equally, buybacks can be "good" (when shares are underpriced) or "bad" (when shares are overpriced) and may systematically favor one group of shareholders over another. "Bad buybacks" are now estimated to generate over $10 billion annually in excess costs borne largely by public (non-management) shareholders. Various works have identified options as a stimulant to the use (and misuse) of buybacks. This essay goes the additional step of suggesting that equity accounting has accelerated the boom.
Whether options should be expensed was extensively debated before SFAS 123R was adopted in 2004, and focus then shifted to the merits of competing valuation models. But, in all the sound and fury, either exhausted by the initial debate or mesmerized by the subsequent models, accounting authorities neglected to rest the mechanism for option expense recognition on the most elemental foundation: The actual value of an option grant.
Eventually, an option is worth something or nothing. However, in a practice peculiar to option compensation recognition, estimated and actual expense remain unreconciled. Though submitted to the IRS for a tax credit, the expense otherwise is neither recorded nor reported.
Other equity transactions, most notably stock buybacks, are unique in being excluded from income reports.
Opposition to accounting changes may be intense, but correctly recording and reporting equity transactions would likely encourage dividend payouts and return stock buybacks to a more appropriate role as a tool to capitalize on undervaluation. Accounting for options is so off base that a change in policy seems reasonably likely within a relatively short time (more than two years, less than a decade). The timeframe for a review of equity accounting for buybacks may be longer since buyback accounting does not currently appear to be a subject of great interest.
Keywords: sfas 123r, stock buyback, share buyback, equity accounting, options, options accounting
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