Warren Buffett rips into stock option accounting

MarkRubinstein

　　[Headnote]
　　Warren Buffett is arguably America's most influential investor. A legend in his own time, he is considered to be the world's second richest (after William Gates) person. He has achieved capitalist superstar status by having made brilliant portfolio investments via Berkshire Hathaway Inc., the $117 billion holding company, in such stellar performers as Coca-Cola, Gillette, Walt Disney, American Express and the Washington Post Company (and more recently in GEICO, Executive Jet Aviation and General Re), each one an American corporate icon and many of them market leaders around the world.
　　Berkshire Hathaway's annual report is must reading for stock analysts and individual investors alike. The chairman's letter is mined for clues to companies and industries that interest the master. It is laced with homespun advice and self-deprecating remarks in which he takes to task his and partner Charlie Munger's occasionally errant decisions ("Overall, you would have been better off last year if I had regularly snuck off to the movies during market hours.").
　　The 1998 annual report chairman's letter contains, in effect, three brief essays. One challenges his fellow CEOs and directors to reconsider the real costs of stock options issued to themselves, their employees and directors. The second roundly criticizes CEOs' addiction to managing earnings to meet analysts' forecasts. The third takes to task the management of merged and acquired companies who do the deals to juggle assets and liabilities that will artificially smooth and enhance future earnings. At the root of this commentary is Buffett's concern that CEOs manage for current stock price appreciation, at the expense of longer-term considerations built around strategies that will drive corporate earnings. At this year's annual meeting in Omaha, a pilgrimage attended by thousands, he said "We don't worry about the performance of the stock; we worry about the performance of the company."
　　The first brief essay, titled "Accounting-Part 1,"appears below. Buffett's comments on managed earnings and restructuring legerdemain will appear in future issues.
　　Accounting-Part 1
　　Our General Re acquisition put a spotlight on an egregious flaw in accounting procedure. Sharp-eyed shareholders reading our proxy statement probably noticed an unusual item on page 60. In the pro-forma statement of income-which detailed how the combined 1997 earnings of the two entities would have been affected by the mergerthere was an item stating that compensation expense would have been increased by $63 million.
　　This item, we hasten to add, does not signal that either Charlie [Munger] or I have experienced a major personality change. (He still travels coach and quotes Ben Franklin.) Nor does it indicate any shortcoming in General Re's accounting practices, which have followed GAAP to the letter. Instead, the pro-forma adjustment came about because we are replacing General Re's longstanding stock option plan with a cash plan that ties the incentive compensation of General Re managers to their operating achievements. Formerly what counted for these managers was General Re's stock price; now their payoff will come from the business performance they deliver.
　　The new plan and the terminated option arrangement have matching economics, which means that the rewards they deliver to employees should, for a given level of performance, be the same. But what these people could have formerly anticipated earning from new option grants will now be paid in cash. (Options granted in past years remain outstanding.)
　　Though the two plans are an economic wash, the cash plan we are putting in will produce a vastly different accounting result. This Alice-inWonderland outcome occurs because existing accounting principles ignore the cost of stock options when earnings are being calculated, even though options are a huge and increasing expense at a great many corporations. In effect, accounting principles offer management a choice: Pay employees in one form and count the cost, or pay them in another form and ignore the cost. Small wonder then that the use of options has mushroomed. This lop-sided choice has a big downside for owners, however: Though options, if properly structured, can be an appropriate, and even ideal, way to compensate and motivate top managers, they are more often wildly capricious in their distribution of rewards, inefficient as motivators, and inordinately expensive for shareholders.
　　Whatever the merits of options may be, their accounting treatment is outrageous. Think for a moment of that $190 million we are going to spend for advertising at GEICO this year. Suppose that instead of paying cash for our ads, we paid the media in ten-year, at-the-market Berkshire options. Would anyone then care to argue that Berkshire had not borne a cost for advertising, or should not be charged this cost on its books?
　　Perhaps Bishop Berkeley-you may remember him as the philosopher who mused about trees falling in a forest when no one was around-would believe that an expense unseen by an accountant does not exist. Charlie and I, however, have trouble being philosophical about unrecorded costs. When we consider investing in an optionissuing company, we make an appropriate downward adjustment to reported earnings, simply subtracting an amount equal to what the company could have realized by publicly selling options of like quantity and structure. Similarly, if we contemplate an acquisition, we include in our evaluation the cost of replacing any option plan. Then, if we make a deal, we promptly take that cost out of hiding.
　　Readers who disagree with me about options will by this time be mentally quarreling with my equating the cost of options issued to employees with those that might theoretically be sold and traded publicly. It is true, to state one of these arguments, that employee options are sometimes forfeited-that lessens the damage done to shareholders-whereas publicly offered options would not be. It is true, also, that companies receive a tax deduction when employee options are exercised; publicly-traded options deliver no such benefit. But there's an offset to these points: Options issued to employees are often re-priced, a transformation that makes them much more costly than the public variety.
　　It's sometimes argued that a non-transferable option given to an employee is less valuable to him than would be a publicly traded option that he could freely sell. That fact, however, does not reduce the cost of the non-transferable option. Giving an employee a company car that can only be used for certain purposes diminishes its value to the employee, but does not in the least diminish its cost to the employer.
　　The earning revisions that Charlie and I have made for options in recent years have frequently cut the reported pershare figures by five percent, with ten percent not all that uncommon. On occasion, the downward adjustment has been so great that it has affected our portfolio decisions, causing us either to make a sale or to pass on a stock purchase we might otherwise have made.
　　A few years ago we asked three questions in these pages to which we have not yet received an answer: "If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?"
　　[Author Affiliation]
　　Warren E. Buffett is chairman of Berkshire Hathaway Inc. and a director of Coca-Cola Company, Gillette Company and Washington Post Company. This article is copyrighted and used with permission.