And you thought accounting was dull? After staging a highly public debate last year over how to account for goodwill in mergers, Washington lawmakers and business lobbyists are at it again in a high-profile battle over another seemingly arcane accounting rule—whether employee stock options should be treated as an expense. A high-powered lineup that includes, among others, über-investor Warren Buffett, President George W. Bush, and Federal Reserve chairman Alan Greenspan have weighed in on the current accounting rules, which do not require companies to include the value of most stock option grants as employee compensation and, hence, to subtract them from pretax profits. Critics argue that the practice permits companies to inflate reported earnings and, presumably, stock prices. Executives and boards, however, are focused on the importance of stock options as a means of attracting and retaining talent.

There is plenty of heat in this debate, but unfortunately far too little light. Indeed, the discussion of accounting treatment and its effect on share prices is something of a red herring, distracting discussion from the more important issue: do stock options as they are currently structured do a good job of aligning the interests of shareholders, who own companies, with the interests of the executives who manage them?

For the most part, they do not. Particularly among mature companies, much of the share price movement over a three to four year period is driven by environmental factors that are beyond management's control. Among the factors they can control, it is clear that managers have ample—some would say too ample—opportunity to behave in ways that are not necessarily in the interests of the shareholders they serve. While the ongoing war for top executive talent does necessitate substantial performance-linked compensation, we believe that such rewards can be structured much more appropriately.

What is really at stake?

Since 1993, when the US Financial Accounting Standards Board last grappled with the issue, corporations have had a choice as to how they treat stock-based compensation in their financial statements. The first option, under Accounting Principles Board (APB) Opinion 25, requires expensing the difference between stock price and option-exercise price. Because most option grants are made at an exercise price equal to current stock price, this sum is typically zero and produces no impact on reported earnings. The second option, under Statement of Financial Accounting Standard 123, is to expense the fair value of the options on the date they are issued, estimated using an option pricing model.

Given their focus on earnings, it is not surprising that most CEOs typically opt for the APB 25 approach. In fact, while 99 percent of the companies making up the S&P 500 offer employee stock option plans, only two, Boeing and Winn-Dixie Stores, report the cost of options as expenses on their financial statements. Whatever their accounting approach, companies typically deduct options as an expense for tax purposes, calculating the deduction as the difference between the share price on exercise and the option-exercise price.

This divergence in the way companies account for options has caught the eye of lawmakers. A bill introduced in February in the US Senate would force companies to expense options against reported earnings. Many CEOs and investors fear that the reduction in reported earnings from such a change would reduce share prices. We believe that this concern is misplaced. If reported earnings are to be at all comparable across corporations, the fair value of option grants should be deducted from earnings. Furthermore, it is unlikely that the change in treatment will have a significant impact on stock prices. Many studies have demonstrated that accounting changes, and indeed accounting differences across companies, have no significant stock price impact. Capital markets are able to see through such differences, as long as the relevant information is publicly disclosed.

Refocus the debate

Perhaps the accounting treatment is the simpler issue. A more valuable debate for shareholders would be to examine the structure of stock options. Consider that in recent years stock options have reached 50 to 60 percent of the total compensation of CEOs of large US corporations. Most are issued with an exercise price at or above current market price, and as the share price rises, the management team earns additional compensation.

At first glance this seems a logical way to align the interests of managers and shareholders, since in theory option-holding executives would have a common interest with shareholders in seeing stock price appreciation. But the theory can be thwarted in two important ways.

Not all stock price appreciation is equal. When a stock rises as a result of good strategic or operational decision making by the management team, additional compensation through option value gains is well deserved. However, stock options can also gain significantly in value as a result of several additional factors—the general economic environment, the interest rate environment, leverage, and business risk. All else being equal, as the economic environment improves, as interest rates fall, as leverage rises, and as business risk rises, the value of an executive's options will also rise.

However, interest rate related gain is not the result of management's actions, and increasing leverage or business risk (for example by taking on new risky business-development opportunities) is not necessarily in the best interests of shareholders. In addition, improvement in the general economic environment is clearly outside of management's control.

From the executive's perspective, stock options that decline in value as interest rates rise can hardly be considered a motivation. Similarly, most dedicated executives are unlikely to opt to be compensated merely for changing the risk profile of the business, preferring instead to be compensated for clear, transparent actions, on both the strategic and operational front, that improve business performance.

There are limits to downside risk. Even if option contracts were structured to more closely tie executive reward to value-creating actions, the current structure of most company options plans places less risk on managers in the case of poor performance than on shareholders. If unsuccessful strategic and operational decision making leads to a stock price decline, shareholders continue to lose until the decline bottoms out. Managers, though, have a limit to their downside exposure through option holdings; once the stock price falls significantly below option-exercise price, their options are essentially worthless (unless there remains a significant time period before exercise date). Their downside to this extent is limited. Furthermore, they can frequently expect to be issued repriced options at the new lower stock price, further limiting their overall downside.

Correcting for the variables of interest rate movements, economic cycles, and other environmental issues is not as straightforward as it appears. Companies, compensation consultants, and academics have pondered the issue for decades without coming up with easy solutions, precisely because fully aligning incentives via a compensation plan is so complex. Executive option contracts could be structured to adjust for economic conditions as reflected, for example, by overall market or sector performance, interest rates, leverage, and risk. Some commentators have even proposed so-called outperformance options, in which value creation is linked to an executive's ability to generate returns that outperform those of peers. These approaches can improve alignment between shareholder and manager interests, but only to some extent.

On the question of shareholders' greater exposure to downside risk, one possible solution would be to begin to move away from such a heavy focus on options in favor of compensating executives with a greater proportion of, for example, restricted stock—equity securities where the potential to sell is limited for some period of time. Direct equity securities of the type held by ordinary shareholders would seem to align shareholder and management interests well. Moreover, if they represent a sufficiently significant proportion of the net worth of each member of the management team, they would ensure that each executive has sufficient interest at play. In the case of such securities, the executives would presumably have to be compensated for the restriction on their ability to diversify their investment portfolio. This could be done simply, for example through issuance at an appropriate discount to market value.

While this is an area in which more research has to be done, it is clear that a framework and tools already exist to develop potential solutions to better align incentives while retaining the upside performance-based reward necessary to attract and retain key talent.

How stock options are accounted for is unlikely to have any significant stock price impact. Those debating the issue today would better serve investors and business at large by agreeing to treat options as an expense and move the debate forward to the issue of option structure and executive compensation more generally. That debate, at least, has much more potential to improve alignment of incentives and allow executives to clearly see and benefit from their value-creating actions.