A prominent example is the current debate about whether options grants should count as an expense in corporate financial reports.
In the last decade, options have become a significant component of executive compensation in many industries. Normally, the options are issued with the exercise price set equal to the current price of the stock. If the stock price rises, the executives can exercise their options to buy the stock at the exercise price, giving them strong incentives to increase the price of the stock.
When the option is exercised, the company may decide to issue additional stock to deliver to the options holder. This means future earnings will have to be divided among a larger number of shares, an effect known as dilution.
Suppose you are the sole owner of a company worth $1 million, and you want to hire a chief executive. The candidate for the job says, ''Give me half ownership, and I'll make your company twice as valuable.'' Even if this person succeeds in doing so, it would be a wash for you, since you would end up owning half a company worth $2 million. The chief executive would have to more than double the value of the company for you to be willing to issue those shares.
Company owners -- meaning shareholders -- have to decide whether the chief executive's performance is worth the compensation he asks for. If most of the compensation is in options, the owner needs to balance a hoped-for increase in the company's value against a possible decrease in the value of his shares because of dilution.
The great debate surrounding options is how to value them in the corporate accounts. If a company pays an executive $1 million in cash, it has to deduct it from earnings as a business expense. But if a company gives $1 million worth of options to the executive, no deduction need be reported.
Some accountants, economists and policy makers think this is misleading and want to require that options be counted as an expense like other forms of compensation.
The big problem with this proposal comes in valuing the options. Options compensation packages are issued with lives of up to 10 years, while options markets involve options with much shorter lives -- usually less than a year. So one can't generally use market prices to value option grants.
Accountants could use a formula to estimate the value of an option, but this is problematic for two reasons.
First, the most commonly used method of option valuation, the Black-Scholes formula, assumes that certain statistical properties of the stock price remain constant over time. Though this is a reasonable approximation for periods of a few months, it is unrealistic for 10 years.
Second, the whole point of issuing options is to change the performance of the stock -- so it doesn't make much sense to assume that the statistical properties of the stock will remain constant.
This valuation problem makes it tricky to subtract options from earnings. Furthermore, it isn't at all clear that it is the right thing to do. Earnings aren't reduced when the option is exercised, they are often just diluted -- the same earnings must be spread among more shares. The appropriate arithmetic in the case of dilution is not subtraction, but division.
When companies issue annual reports, they are required to report diluted earnings per share -- what earnings per share would be if all outstanding options (and similar securities) were to be exercised. So the dilution effect is already reported to shareholders.
The trouble is that much of the financial news media -- though not this newspaper -- have reported only basic earnings per share, a number that is quite misleading when there are a significant number of outstanding options. Companies are happy to go along with this fiction, since it tends to hide the real cost of options compensation.
Does it make sense to remedy this problem by subtracting an imprecise estimated value of options from earnings? Or would this just confuse things even more?
I don't know the right answer, but let me propose a test.
Investors are interested in reported earnings, since they indicate something about the future value of the company. So which definition of earnings per share is a better predictor of future stock prices: options-expensed earnings per share or diluted earnings per share?
This is a harder question to answer than you might think, since there are some tricky statistical issues, but at least it might help clarify the terms of the debate.
Meanwhile, there are other options accounting reforms that seem more clear-cut.
First, much of the problem would go away if people paid attention to diluted earnings per share rather than basic earnings per share.
Earnings per share made sense before options compensation became widespread, but that time has long passed and the financial news media should recognize this change.
Second, companies should be required to report not only options grants, but all transactions involving their own stock. In the go-go 90's, many technology companies used options to place bets that their stock would continue to rise. If technology stocks continue to be depressed, these companies will have to buy back their own shares at above-market prices. Shareholders should certainly be able to find out about such commitments.
Third, companies should be required to report within a day or two all insider trades, including option exercises. Current Securities and Exchange Commission rules result in delays that average 25 days. In today's world, there is no excuse for such long reporting delays.
These are all reasonable and relatively simple reforms. The trouble is that companies have long resisted reasonable and simple reforms in options accounting and are now faced with policies that are potentially much more disruptive to current practices.
Executives shot themselves in their footnotes and are now living to regret it.