GB791 Unit 8 Comment Letter Analysis Example

What the Letters Said and What Their Writers Stood to Lose: A Unit 8 Comment Letter Analysis on Stock Option Expensing

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Purdue University Global

GB791: Advanced Topics in Accounting

Unit 8 Comment Letter Analysis

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[Date]

The forty-letter pilot set and its counts are a composite built to illustrate the coding method; the standard setting history and the studies cited are real.

The Rule's Path

In June 1993, the Financial Accounting Standards Board issued an exposure draft proposing that companies recognize compensation cost for employee stock options, measured at fair value on the grant date and expensed over the vesting period. Under the existing rule, APB Opinion 25, options granted at the market price had an intrinsic value of zero and so produced no expense.

Opposition was immediate and intense. Companies, particularly in technology, argued that the proposal would depress reported earnings and harm their ability to attract talent. In May 1994, the Senate passed a nonbinding resolution urging the Board not to adopt the proposal, and bills were introduced that would have overridden it. In December 1994 the Board retreated, and Statement 123, issued in October 1995, encouraged the fair value method but allowed companies to continue using the intrinsic value method if they disclosed in the notes what earnings would have been under fair value (Financial Accounting Standards Board, 1995). Nearly all companies chose disclosure. Expensing became mandatory only with Statement 123(R) in December 2004, after Enron and WorldCom had changed the climate for standard setting, and it applied to most public companies from 2006.

The Method

The analysis is designed for the full public record of comment letters on the 1993 exposure draft. For this unit, a pilot set of forty letters was coded to test the coding frame. The pilot is a composite built for the exercise, and the counts below illustrate how the method works rather than report findings.

Each letter was coded on four dimensions. Respondent type: issuer, audit firm, investor or analyst, academic, or other. Position: oppose, support or mixed. Stated arguments: each distinct argument the letter made, coded into categories such as measurement unreliability, harm to capital raising, harm to employee ownership, and the conceptual claim that options are not an expense. Disclosed stake: any information in the letter, or available about the writer, about how the rule would affect the writer, for example the size of option grants to the issuer's executives.

The Pilot Results

In the pilot set, thirty-one letters opposed the proposal, six supported it and three took mixed positions. Issuers wrote most of the opposing letters, and technology issuers wrote most of those. The supporting letters came mainly from investors, analysts and academics. Audit firms divided, generally accepting the concept of expensing while questioning whether the models could measure options reliably.

Among opposing letters, the most common argument was measurement: that the Black-Scholes model and similar methods, built for short-lived traded options, could not reliably value long-lived, nontransferable employee options. The second most common was harm to capital raising, the claim that lower reported earnings would raise the cost of equity for young companies. Fewer letters made the conceptual claim that options are not a cost to the company at all.

Testing the Arguments Against the Stakes

The coding frame allows a comparison that a reading of the letters alone does not: whether the arguments writers made were the ones their circumstances would predict.

Watts and Zimmerman (1978) provide the theoretical frame. Studying lobbying on an earlier FASB proposal on general price level accounting, they argued that managers lobby on accounting standards according to how the standards affect their own wealth, through compensation tied to reported earnings, through political costs and through contracts. Their framework predicts that managers whose pay depends heavily on options, and whose companies would show the largest earnings reductions, will oppose expensing most strongly, regardless of the arguments they present.

Dechow et al. (1996) tested that prediction on the options controversy itself. They examined firms that lobbied against the 1993 exposure draft and compared their characteristics with those of other firms. They found that opposition was associated with higher levels of executive compensation from options, and not with the characteristics that the capital-raising argument would imply, such as a greater need for outside financing. Their interpretation was that the stated concern about capital raising served the interests of executives whose pay would be reported as an expense.

The letters argued about measurement and capital, but the companies that wrote them were distinguished most by how much their executives were paid in options.

Reading the Pilot Through the Frames

The pilot set is consistent with that interpretation, though it cannot test it. Opposing letters from issuers whose executives held large option grants more often led with the capital-raising argument, while audit firms, which had no compensation at stake, more often confined themselves to measurement. Supporting letters from investors argued that excluding a real cost made earnings less comparable across companies. One investor letter quoted Warren Buffett's question from his 1992 letter to shareholders: if options are not a form of compensation, what are they?

The measurement argument deserves separate treatment, because it was partly correct. Employee options do differ from traded options, and valuing them requires assumptions about early exercise and forfeiture. But Statement 123(R) eventually addressed those problems with adjustments rather than by abandoning fair value, which suggests the measurement difficulty was a reason to refine the method, not to avoid recognition.

What the Analysis Shows About Who Pushed Back

On the evidence of the published studies and the pattern in the pilot, the Board was pushed back in 1994 by issuers whose executives had the most to lose, and by members of Congress responding to them, rather than by a broad judgment that the measurement problems were insurmountable. The arguments in the letters were genuine and some had merit, but they were not independent of the writers' interests. The full analysis would test this on the complete set of letters, with each issuer's option compensation linked from proxy statements.

Why the Episode Still Matters

The options controversy is now a standard case in accounting courses because it shows the limits of an independent standard setter. The Board had the authority to issue the 1993 proposal, but it did not have the political room to finish it until a decade later, when the scandals had made opposition harder. The comment letters record the arguments; the Senate resolution records the power behind them.

A Limit of Comment Letter Research

Comment letters record only the views of those who chose to write. Firms that favored expensing, or were indifferent, had little reason to spend effort on a letter, and the record therefore overstates opposition. Lobbying also took place in meetings and through Congress, outside the letter file. A comment letter analysis shows who argued in public and what they said, which is valuable, but it is one channel among several through which the Board was pressed.

References

Dechow, P. M., Hutton, A. P., & Sloan, R. G. (1996). Economic consequences of accounting for stock-based compensation. Journal of Accounting Research, 34(Suppl.), 1-20. https://doi.org/10.2307/2491422

Financial Accounting Standards Board. (1995). Accounting for stock-based compensation (Statement of Financial Accounting Standards No. 123).

Watts, R. L., & Zimmerman, J. L. (1978). Towards a positive theory of the determination of accounting standards. The Accounting Review, 53(1), 112-134.