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The Wall Street Journal: 'Goodwill' Is Not an Option | Cypress Semiconductor

The Wall Street Journal: 'Goodwill' Is Not an Option

Last Updated: 
May 24, 2012

How can Alan Greenspan, Warren Buffet, General Electric, Coca Cola and now Ernst and Young all be wrong? They all support the expensing of stock options. Of course, Mr. Greenspan never ran a public company, let alone one from Silicon Valley; and Mr. Buffet, GE and Coca Cola can afford to make the grandiose gesture because they don't even give stock options to rank-and-file employees. Ernst & Young should just change the name of the firm to "Not Arthur Anderson", and leave Silicon Valley alone.

Yet, it may be strategically advantageous to give in to option expensing now -- the big win might be to kill or reform GAAP accounting.

In Silicon Valley, employees typically hold options totaling 20% of their company's outstanding shares. Non-executive employees typically hold more than half of those options (at our company, the non-executive ownership is 80%). The Silicon Valley culture opts for employee ownership -- and that more humanistic management system also produces demonstrably better economic results.

The penalty for giving out too many stock options is dilution. Despite silly claims to the contrary, there is clear visibility and full accountability for option abuse built into the current accounting method. Since shareholders approve option plans, there is also built-in control.

The Financial Accounting Standards Board's proposed new edict (FAS 123) treats stock options more punitively than any other form of compensation. While options sold to investors are accounted for as either an expense for debt service or as dilution, options sold to employees are counted as both an expense and as dilution.

It gets worse. Using Siebel Systems as a case study, Duquesne University researchers, Bill Carlson and Conway Lackman, recently documented how FAS 123 turns profits into losses. Instead of making 49 cents a share on a pro forma basis in 2001, Siebel would have lost $1.02 per share. Which is more reliable, an accounting system that proportionately reduces earnings per share in line with options granted or one that turns real profits into paper losses?

FASB ended the usefulness of GAAP accounting for many companies in 2001 when they banned pooling accounting for acquisitions in favor of purchase accounting. Consider the absurd results: Now, when company A acquires company B for a price greater than the book value of company B's tangible assets, the difference must be put on the acquirer's balance sheet as "goodwill."

Forget that the new phony "asset" has no tangible backing whatsoever or that the goodwill could have been frozen on the balance sheet during a period of "irrational exuberance" in the market. Before June 2001, FASB also had mandated straight-line amortization of the goodwill asset, creating fictional quarterly losses.

In addition to distorting the balance sheet with hollow assets, the goodwill gaffe also damaged the basic integrity of GAAP accounting by decoupling earnings from cash flow. If a company earns $10 million in cash but writes off $10 million in goodwill, its earnings will be zero, but its cash flow will still reflect the $10 million truly earned.

That's when the analysts stepped in and started "correcting" GAAP earnings -- the birth of so-called pro forma accounting, which is now used by 74% of our industry, according to a PricewaterhouseCoopers study. The Thomson First Call Web site reports analysts' earnings estimates for most companies in pro forma terms only. The only mention of GAAP earnings is in a disclaimer footnote.

The passing of the new accounting rule would create a whole new group of companies whose earnings will be misrepresented by GAAP accounting. The new rule would cut Cisco Systems' and Intel's GAAP earnings by more than half, while their actual cash earnings would remain unchanged. Intel has already announced it will not expense stock options.

That's only a taste of what's to come. If the new rule gets into place, more disgruntled companies will face the choice between issuing distorted earnings reports or using pro forma accounting. The analysts will have no choice but to use pro forma accounting if they want to provide economically meaningful analyses. As Robert Willens, an accounting expert from Lehman Brothers says, "I don't know anyone who uses GAAP net income anymore for anything." In business terms, FASB is losing market share because of its poor product.

In other words, we need a pro forma accounting standards board, chartered to specify how to make clear, consistent corrections to the GAAP statements to remove the phony assets from our balance sheets and the unwarranted charges to earnings from our income statements. Alternatively, if FASB would listen to its customers, GAAP could be restored to its pre-2001 level of usefulness, with pooling of interests accounting restored and option accounting left as is.