Canadian Perspective to the Enron Collapse: Accounting Treatment of Stock Options

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3 June 2003

The Honourable Leo Kolber
Chair, Accounting Standards Board
The Standing Senate Committee on Banking, Trade and Commerce,
The Senate
Ottawa, ON K1A 0A4

Re: Canadian Perspective to the Enron Collapse: Accounting Treatment of Stock Options

Dear Senator Kolber:

The Association for Investment Management and Research^® (AIMR^®) is pleased to present its views to the Standing Senate Committee on Banking, Trade and Commerce in its efforts to examine and report upon the present state of the domestic and international financial system and provide a Canadian perspective to the Enron collapse. As users of financial statement information for investment decision-making, we understand the importance of transparency in financial reporting and wholeheartedly support the expensing of executive and employee stock options and recording that expense at fair value.

Introduction

AIMR is a global, non-profit organization of over 64,000 investment professionals in 117 countries, 56,000 of which are holders of the Chartered Financial Analyst^® (CFA^®) designation. We also have 127 affiliated Member Societies and Chapters in 46 countries. Over 8,000 AIMR members live and work in Canada. The AIMR mission is to be a leader of the investment profession globally by setting the highest standards of education, integrity and professional excellence. We are best known for the CFA examination program. This year, over 100,000 candidates worldwide were registered for the June 2003 CFA Examinations. AIMR has appeared before this committee before on issues related to professional excellence and integrity when we spoke about analyst independence and the requirement for independence and objectivity in the AIMR Code of Ethics and Standards of Professional Conduct.

AIMR also serves its mission through its advocacy activities. AIMR regularly reviews and responds to major new regulatory, legislative, and other developments that may affect investors, the investment profession, investment decision-making, and the efficiency and integrity of global financial markets. We have a long history of recommending, and arguing for, better and more useful financial reporting and disclosure - on behalf of all users of financial statement information, not just AIMR members or other investment professionals.

AIMR Supports Expensing of Stock Options at Fair Value
AIMR believes the logic behind the argument for expensing stock options at fair value is incontrovertible and expressed in the following four principles:

Stock options awarded to executives and other employees are compensation;
Compensation is a cost of the production of goods and services;
All costs of production should be recorded appropriately as an expense in the income statement; and
In estimating the amount of the expense to be recorded, the most economically valid amount is the fair value of the options at date of grant which should be allocated to expense over the vesting period of the options.

Companies' failure to expense the fair value of stock option compensation in the income statement results in understatement of not only the cost of compensation, but also the cost of production. Consequently, when these costs are understated, net income is overstated.

Securities regulators recognize that investors and other users of financial statements have a critical need for accurate, complete, understandable, and unbiased financial information. Investors require this information in order to formulate informed investment decisions on which they can act. Put slightly differently, without high quality, accurate, complete, and unbiased financial statements and other financial information, investors cannot make the best investment decisions and markets cannot be efficient or effective in their primary role of allocating capital.

Currently, the only form of compensation that is not required to be expensed in the income statement is stock option grants to employees. That is,

If compensation is paid in cash, it is expensed;
If it is paid in goods or services, it is expensed;
If the stock option terms are variable, including incentive based compensation, it is expensed.

Moreover, if options are awarded to any non-employees- for example, attorneys for their services to the company- the options must be expensed. We do not believe that the form of the currency of payment should determine the accounting and financial reporting for that payment.

In 2001, to test our belief that information about the value of stock option grants was useful information for investors and should be properly recorded, AIMR conducted a global survey of our members- investment professionals who are expert in the analysis and use of financial statements- to determine their views on the relative merits of the fair value expensing of stock options. The principal results of the survey were:

88 percent survey respondents stated that stock options awarded to employees are compensation; and
83 percent believed that the compensation should be expensed at fair value in the income statement.

The views expressed in the survey confirmed that our previous efforts to change the accounting for stock options were not misplaced. We first expressed this view in the AIMR position paper, Financial Reporting in the 1990s and Beyond (1993) and it has informed all of our formal comment letters on this issue to the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission in the United States and the International Accounting Standards Board since and informal discussions with the Canadian Accounting Standards Board (AcSB). We fully supported the AcSB adding the accounting treatment of stock options to their agenda. So that you may better understand the extent of our arguments on the merits and methods of expensing stock options at fair value, we attach recent letters to the FASB and the IASB.

There are two arguments that critics of expensing stock options have put forward recently that we feel we must address. We believe these arguments are without merit in this debate.

The expensing of stock options would bring economic harm to venture- and growth-stage companies. These companies rely heavily on stock options to compensate employees and requiring expensing at fair value would make it more difficult to attract sufficient capital and employees; and
The fair value at date of grant is not known with certainty but must be estimated, thus introducing a measure of uncertainty into the financial statements.

Companies Need to Use Stock Options to Attract Quality Management
We understand and support companies' need to attract and retain high quality management; they are essential to a company's success. In fact, we do not oppose the use of stock options as a form of compensation if that is what will attract and retain the best individuals. What we cannot condone is companies' claim that using stock options as compensation demands keeping the value of this compensation hidden from investors and depriving them of the critical, useful information they need to make informed investment decisions.

Hiring quality employees is a worthy objective, but it is not a financial reporting objective and should not influence decisions about what and how to report information about a company's economic condition and results of operations. The fundamental objective of financial reporting is, and must be, to present a company's economic condition and results of operations to investors and other financial statement users as accurately, fairly, and without bias as possible. Arguments based solely on non-reporting objectives have no place in a financial reporting discussion. We reiterate: To provide complete, accurate, fair and unbiased information to investors, all revenues and expenses must be recorded in the income statement, and all assets and liabilities in the balance sheet.

Measurement Uncertainty: Valuing Stock Options Requires Estimation
Those who are knowledgeable about financial reporting methods understand that each and every number in the financial statements, with the possible exception of cash, is necessarily an estimate. (And there are times when even "cash and cash equivalents" include estimates.) The values of receivables, inventories, property, plant, and equipment, intangible assets as well as of pensions, lease obligations, and other liabilities, are based on recorded historical costs (sometimes estimated) which are adjusted, either initially or over time, using various assumptions and estimation methods. Estimation is, and has always been, an inherent part of financial reporting. Since application of all accounting standards involve some degree of estimation and measurement error, we cannot understand companies' specific concerns about estimation error with respect to stock options. We believe that companies may be more comfortable estimating useful lives, long-term rates of return, bad debt expense, and loan loss reserves, because they have experience using those estimation methods. We are confident, however, that companies will gain the needed experience and hence confidence in estimates of the fair value of stock options, too. We also trust that valuation methodologies will improve when there is a need for them to do so.

Trillions of dollars in options are currently traded worldwide using estimates based on the Black-Scholes model or other option valuation techniques. Indeed, some of the same companies that object to the use of such models to estimate the fair value of employee stock options use the same models to value other exchange-traded or over-the-counter option contracts that are used for hedging or speculation. When compensation contracts with executives and other employees are under negotiation, these same models are used to determine the number of options that the employees will receive. The same companies who object to the models use for financial statement purposes routinely use the models for internal contracting, including stock option compensation awards and for external contracting.

Finally, no matter how uncertain the estimate of the fair value of these stock options may be, the one number we know is wrong is zero. Any estimation provides better information to investors. In fact, more sophisticated investors use the estimates now provided in footnote disclosures. Isn't it better for all investors if these estimates appear in the financial statements where they can be readily and easily found by everyone? Consequently, we cannot agree that estimation uncertainty is a problem.

Conclusion

We find it instructive that, in the United States, the current Chairman of the Securities and Exchange Commission, William Donaldson, the current Chairman of the Federal Reserve Board, Alan Greenspan, the past Chairman of the Federal Reserve Board, all four of the largest international auditing firms, the FASB, and the IASB, have all stated, on the public record, that they support expensing stock options at fair value. Therefore, we continue to be perplexed by the arguments of those against and the amount of resources expended to keep accurate and unbiased information from investors.

AIMR appreciates the opportunity to comment to the Standing Senate Committee on Banking, Trade and Commerce in their efforts to examine and report upon the present state of the domestic and international financial system and provide a Canadian perspective to the Enron collapse. If you or your staff have questions or seek amplification of our views, please feel free to contact me by phone at +1.434.851.5315 or email at patricia.walters@cfainstitute.org or Rebecca Todd McEnally, CFA, by phone at +1.434.951.5319 or by email at rebecca.mcenally@cfainstitute.org.

Sincerely,

Patricia Doran Walters, PhD, CFA
Senior Vice President, Professional Standards & Advocacy