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Can one good man save accounting?
On one wall of his modest London office, a stone's throw away from St. Paul's Cathedral, Sir David Tweedie proudly displays a front-page article from his hometown newspaper, Edinburgh's The Scotsman. The headline proclaims him "the most hated accountant in Britain."
On one wall of his modest London office, a stone's throw away from St. Paul's Cathedral, Sir David Tweedie proudly displays a front-page article from his hometown newspaper, Edinburgh's The Scotsman. The headline proclaims him "the most hated accountant in Britain."
Britain? Try the world.
Having rescued - or destroyed, depending on who's talking - U.K. bookkeeping nearly single-handedly during the 1990s, Tweedie is now trying to save global accounting from the crisis of confidence that followed the collapse of U.S. energy trading giant Enron Corp. in a miasma of financial irregularities. As head of the International Accounting Standards Board, the industry rulemaker created two years ago to bring consistency to financial reporting, he is on a mission to craft a uniform set of standards that will improve transparency and logic in accounting from Seattle to Seoul to Stuttgart. His proposals are already drawing howls from corporate executives, especially in the U.S.
In a global economy, the plainspoken Scot believes, investors should be able to make apples-to-apples comparisons between companies no matter where they are domiciled. And in an environment where many people suspect that book-cooking is common - 57 percent of Americans said they don't trust corporate executives or brokerage firms to give them honest information, according to a June Wall Street Journal/NBC News poll - Tweedie's effort to make chief executives and their bookkeepers more accountable, so to speak, couldn't be more timely. "Accounting isn't rocket science," he says with characteristic bluntness. "It is simply telling investors what's there, not what you want to be there."
In principle, companies and governments the world over support Tweedie's quest for a consistent set of rules. (No lesser a luminary than former U.S. Federal Reserve Board chairman Paul Volcker gave Tweedie his mandate, in fact.) There's already broad consensus that accounting practices, and the bodies that regulate them, need reform. The U.S. Congress is considering legislation that would overhaul the way American companies do business, and the European Commission voted last month to require that all European Union corporations conform to IASB standards by 2005 rather than follow national guidelines, as many still do.
In fact, thanks to the recent sins of file-shredding multinationals, proponents of reform hint that Tweedie, 58, was put on earth to redeem global capitalism (Global Crossing, WorldCom, Tyco International and Halliburton Co. are just a few of the companies whose stock prices have wilted under intense scrutiny of their books). "Shareholders should pray for his health nightly," says Sarah Teslik, executive director of the Washington-based Council of Institutional Investors, an advocacy group.
Tweedie's crusade would, with key exceptions, bring the world in line with U.S. generally accepted accounting principles, considered the most rigorous global standards. (Any company wanting to list its shares on American exchanges must first produce a set of books that conform to GAAP, as enforced by the Securities and Exchange Commission and the U.S.'s Financial Accounting Standards Board.)
But those key exceptions are already sparking what could be a bitter and prolonged fight. Tweedie is proposing changes to U.S. GAAP that are anathema to many corporations and accountants, particularly Americans. He wants businesses that award stock options as compensation to charge their cost against profits, instead of burying them in annual report footnotes - or, as is common in Europe, not disclosing them at all. He wants to stop companies with huge pension funds from using their plans' investment gains to buttress earnings. He wants insurance companies to mark the value of their policies to market. And he would rewrite the international standards that define and govern off-balance-sheet entities - the vehicles Enron used to inflate profits artificially. These suggestions are drawing a storm of criticism that could derail Tweedie's broader goal of creating a single accounting rule book for the world.
The SEC, which was pivotal in the IASB's creation, is pushing FASB and the IASB to narrow their differences. But if Tweedie insists on his hard-hitting reforms, the U.S. may refuse to follow the IASB's template.
As far as Tweedie is concerned, he holds the moral high ground. Should U.S. lawmakers and legislators reject his international rules, he says, "every time somebody in America says, 'The U.S. has got the best accounting standards in the world,' we'll all jump up and say: 'Yah! Boo! You're a bunch of liars.'"
A wired, wiry man who says he needs no more than four or five hours' sleep a night, Tweedie has both the temperament and the credentials to carry the banner of ethical business accounting. His values rooted in the stern Presbyterianism of his native soil - he has been an elder of the Church of Scotland for 26 years - he mistrusts extravagance and showiness. He has little patience for pretense of any kind. "Our attitude is, 'Let's show things as they are, and you explain your way out of it, fella," says Tweedie.
Though he loves a good fight, Tweedie is also politically astute, with a talent for making his agenda seem inevitable. His Scottish stubbornness expresses itself mostly in a canny patience. "I don't think he really cares what other people think," says Ron Paterson, a fellow Scots accountant who has known Tweedie for more than 20 years and disagreed with him on numerous professional issues. "I've heard it said of David that he agrees with everybody he meets. He smiles and nods his head and then goes off and does what he intended to do from the very beginning."
What he intends to do now is carry out the IASB's brief - to come up with a single set of high-quality accounting standards that command respect around the globe. Robert Herz's appointment as chairman of FASB last month boosted Tweedie's prospects; Herz served as a member of the IASB board and is an ardent internationalist. "I intend to work very closely with the IASB," he says. "It is important that if possible we arrive at similar places." Adds an SEC official: "Bob has a very good international perspective. Definitely, there's going to be some progress made."
Should Tweedie succeed, companies will be forced to follow far more stringent financial reporting requirements, and investors will gain the ability to study a much broader and more realistic portrait of a company's finances. The result would likely be greater volatility in reported profits, to the consternation of corporate executives, who prefer that they move smoothly and steadily upward. But Tweedie is convinced that investors will become more sophisticated in their analysis of company accounts, thus dampening the impact of share price fluctuations.
He faces furious opposition - mostly from the companies he wants to bring to heel. U.S. and European multinationals have already sent the IASB hundreds of comment letters opposing the options rule change, and lobbyists are crowding the corridors of Washington and Brussels to register their disapproval. Corporate America's influence is already paying dividends; in June Senate Democrats caved in to the pressure and abandoned their efforts to require that options be expensed. Even President George Bush has weighed in, indicating that he thinks stock option accounting is fine as is.
U.S. companies hope that Tweedie will sacrifice his more rigorous proposals - especially the stock option rule - for the sake of getting a consensus. "There are a lot of politics around this issue," says Philip Ameen, General Electric Co.'s comptroller. "I hope [Tweedie] remains as open-minded as he has committed to me and others that he will be." Caroline Graves Hurley, director of tax policy at AeA, a Washington-based trade group that represents high-tech companies, including Intel Corp., Microsoft Corp. and Sun Microsystems, is more blunt. "The U.S. has more experience with stock options than any country in the world," she says. "The rest of the world should follow the U.S. lead."
European executives, whose compensation rarely includes huge stock option packages, nevertheless worry that Tweedie's stubbornness about expensing options could cause an irreparable transatlantic rift. Says Sten Fornell, chief financial officer of Sweden's L.M. Ericsson Telefonaktiebolaget, "We strongly recommend the IASB not go beyond the U.S. GAAP requirements and stay with disclosure rather than income statement treatment." Adds Alan Dangerfield, head of group accounting guidelines at Swiss pharmaceuticals giant Roche Holdings, "If the IASB goes shooting down the expense path and FASB remains intransigent, then convergence takes another step back." And although the European Commission says it believes stock options should be expensed, officials in January urged Tweedie to back off, at least for now.
Tweedie's reforms would hit corporations where it hurts: profits. Bear, Stearns & Co. accounting analyst Patricia McConnell estimates that the combined effect of yanking out pension income and counting the cost of options would reduce earnings at Standard & Poor's 500 companies by 11 percent. In the U.K., pension income alone comprised 5 percent of profits for companies in the FTSE 100 in 2000, according to London-based actuarial consulting firm Lane Clark & Peacock. Though Europe lags behind the U.S. in giving employees options, some European companies would suffer from a change in accounting there as well. According to a 2001 survey by HSBC Bank, if options were charged against earnings, 26 of the 65 largest European companies would see their profits reduced by 5 percent, and 13 would see earnings fall twice that much.
The reforms would ripple through Asia, too. Hong Kong, Japan and Singapore are all moving toward requiring their listed companies to use IASB standards, so Asian companies are lobbying Tweedie fiercely on accounting for mergers and for insurance contracts. Japanese insurers have blasted his proposals for booking contracts at market value. In addition, Tweedie is pushing for changes in merger accounting that would force most Japanese companies to write inflated assets off their books - a proposition that incenses Japan Inc.
But the current climate of disenchantment with corporate governance, especially in the U.S., is lending more support to Tweedie's quest. "In my lifetime, American business has never been under such scrutiny. To be blunt, much of it is deserved," lamented Henry Paulson Jr., chairman and chief executive of Goldman Sachs Group, in a well-regarded June speech that endorsed expensing of options. Says Mary Ellen Oliverio, a Pace University accounting professor: "Nobody can trust financial reporting in the U.S. That is a significant issue."
And in May Standard & Poor's unveiled a new calculation of what it calls "core" earnings that essentially ignores GAAP by counting the cost of options against earnings and excluding items such as pension income. Although the move is largely symbolic - the new numbers won't change the agency's bond ratings, for instance - "it indicates which way the wind is blowing," says IASB vice chairman Thomas Jones.
Tweedie says he will stand firm even if the U.S. refuses to back his rules: "It might be controversial, but if it is right, we'll do it." And his track record is such that even his critics believe he could prevail against corporate resistance and political waffling. "It's a tough job, but if anybody can do it, Tweedie can," says Paterson, a former technical director at Ernst & Young's U.K. practice who spent much of the 1990s sparring with Tweedie and dines with him regularly.
Tweedie insists he will create a standard based on principle, not politics. "The American standard is illogical," he says. "Congress can jump up and down all they like. But ultimately, they can't extradite me from Scotland." Besides, he adds, "the best way to win an argument is to begin by being right."
Everything about Tweedie - his NATIONALITY, his professional past, his religion - has prepared him to struggle for the soul of global accounting. The son of a roving Scots mining engineer and a telephone operator, he was born in England but spent much of his childhood in Stirlingshire in central Scotland (where William Wallace, the 13th-century Scottish freedom fighter, also grew up). The Tweedie clan's crest is a bull's head; its motto is "Thol and think," endure and think.
Tweedie's father wanted David to become an accountant - a lofty occupation in Scotland. In fact, throughout the U.K. Scottish bookkeepers are regarded as pillars of moral rectitude. "Straitlaced, Presbyterian and mean," says fellow Scot Paterson, trying to explain why his countrymen make such dedicated number-crunchers. Indeed, bookkeeping in Scotland is considered not so much a profession as an avocation - accountants are trained through the medieval master-apprentice system, rather than in schools. "Maybe it's our puritanical spirit," Tweedie muses. "We don't like these flashy guys that come up with fancy schemes."
As a teenager Tweedie was not interested in accounting. In 1962 he enrolled in the University of Edinburgh's business program, taking his Ph.D. in industrial relations in 1969. The university invited Tweedie to join its faculty, but he felt he wasn't ready to start teaching business without any real-world experience. Tweedie headed to Glasgow for a job at a small accounting firm and found himself drawn to the profession. Tweedie's mentor at the firm, David Flint, was largely responsible for his pupil's conversion. "We would get into these debates over lunch during which he would force us to question the basis of the rules we were studying," Tweedie says.
Tweedie returned to Edinburgh three years later as an accounting lecturer before becoming dean of the social sciences faculty. In 1978 the Institute of Chartered Accountants of Scotland appointed him its technical director. He returned to the private sector in 1982 as national technical partner of what was then Thomson McLintock & Co. In 1987 his firm merged with Peat Marwick Mitchell & Co., and Tweedie was appointed national technical partner of the renamed KPMG Peat Marwick McLintock.
In his new job Tweedie grew frustrated with what he felt were the declining standards of his profession. "I hated some of the things we were doing," he recalls. The worst of it, he says, was that investment banking clients would often cite two big auditors that had already signed off on a particular piece of creative financial engineering. "If you're the third accountant, you can't say this isn't an accepted accounting practice," Tweedie says. "You had to accept this wretched thing. The whole process made you feel tainted."
But KPMG also offered Tweedie a powerful megaphone through which to express his views, and he began to use it. "I started going to conferences and saying the whole thing's a shambles, and we should really slash and burn everything," he recalls. In 1990 he got his chance. That year the U.K. created the Accounting Standards Board and charged it with revamping British accounting. The ASB's board of trustees offered Tweedie the chairmanship. As Tweedie recalls, his boss at KPMG told him, "You either take the job or shut up, because you can't keep going around complaining." Tweedie took the job.
When he took over the ASB, the U.K. was being rocked by high-profile corporate collapses - notably that of conglomerate Polly Peck International. Investors blamed shoddy accounting, because companies that had been reporting healthy profits were suddenly declaring bankruptcy. "We were basically going through our own Enron period," says Mary Keegan, current head of the ASB and a former senior partner at PricewaterhouseCoopers. "The board needed a strong leader."
The stakes were high. Not only had British investors completely lost faith in their country's accounting standards, but if the ASB, an industry-financed self-regulatory agency, failed to come up with rules that all British accounting firms could agree on, the government would have likely stepped in and imposed its own. Tweedie and the ASB quickly set about trying to eliminate the loopholes in British bookkeeping. Borrowing heavily from U.S. rules, the ASB reshaped the U.K.'s profit-and-loss statement, created a standard definition for earnings per share and tightened the requirements for acquisition accounting, among a host of other things.
For example, in revamping the P&L statement, Tweedie and the ASB fundamentally overhauled what should be reflected in "above the line" profits - earnings after interest and taxes. Traditionally, that profit number could include income from fairly unusual events, called exceptional items, such as selling an asset. At the same time, one-time events called extraordinary items, such as closing a factory, could be recorded "below the line" - in other words, buried elsewhere in the financial statements. The differences between extraordinary and exceptional items under U.K. accounting rules were hazy at best, and many companies pushed events that drained profits below the line and put those that generated revenues above the line, inflating profits. "Fifty-three percent of our big companies had one of these nonrecurring items every year," Tweedie says. "That wasn't quite what a nonrecurring item is supposed to be."
The ASB redefined extraordinary items so that they could rarely be used and ensured that almost all company profits and losses would be recorded above the line. This, of course, had the dual effect of making profits both more transparent and much more volatile. The restructuring generated waves of controversy, culminating in Tweedie's being crowned the "most hated accountant in Britain." Corporate executives loathed the changes that stripped them of the flexibility they had enjoyed for years, and analysts criticized the ASB for introducing more confusion and volatility into reported profits. One titled a report on the new standard "Tweedie: Descent into Chaos?" and concluded that the new standards would result in an "earnings Babel."
They were wrong. Tweedie persuaded the ASB's member accounting firms to vote yes on his reforms. Thanks to Tweedie, British investors are now vastly better informed than they were a decade ago about the companies they invest in, says Ian Richards, head of corporate governance at London-based investment firm Schroders. In recognition of his pioneering work, Queen Elizabeth II knighted him in June 1994. "He put the U.K.'s standards on the map internationally," says current ASB chairwoman Keegan. "Now the U.S. and U.K. accounting standards are regarded as the best in the world. Ten years ago that would have been unthinkable."
In 1995 Tweedie got into what would become his most infamous row. The ASB published a draft "Statement of Principles for Financial Reporting"; this blueprint for future British financial standards proposed that the U.K. use a market-value approach in measuring assets and liabilities as opposed to historical-cost accounting. "We gave it a good old rubbishing," says Paterson, who was then Ernst & Young's senior technical director. Calling the document "pernicious," "open to abuse" and "fundamentally misguided," Paterson wrote that the ASB framework "strived for an accounting model that we do not believe is desirable, based on principles we do not believe to be workable." Tweedie shot back that Ernst & Young's views "demonstrated all the vision of a mole and all the eloquence of a whoopie cushion."
The Ernst & Young attack forced Tweedie to table the draft statement temporarily, but he didn't give up. "He laid low for a few years, waited until everybody else got bored with it and got it through anyway," Paterson recalls with a laugh. The majority of the ASB voted in favor of a watered-down version of Tweedie's blueprint. Simply getting the guidelines passed was an achievement in itself.
His remake of British financial reporting complete, Tweedie spent the latter half of the 1990s addressing areas that he felt global standards setters had neglected. Pension accounting topped his list. "British pension accounting was hopeless, absolutely hopeless," he says. For the most part, U.K. investors had no means of determining the financial status of a British company's pension plan, which in effect made it an off-balance-sheet liability that might amount to hundreds of millions of pounds. Tweedie set about changing that. He looked at U.S. pension rules and was largely unimpressed. Although FASB forced companies to disclose the status of their pension plans, they were free to bury the data in the fine print.
Moreover, FASB allows companies to use smoothing mechanisms, such as a five-year moving average, to calculate the value of assets used to cover pension liabilities. The logic: Because pension funds are long-term investments, short-term market fluctuations are irrelevant. Tweedie did not agree.
The ASB devised a new rule, Financial Reporting Standard 17, requiring British companies to disclose the status of their pension funds at the front of their annual reports - and using market, not smoothed, valuations. Oddly, the rule didn't cause much of an uproar when it was introduced. But as companies have begun to implement it - the rule becomes fully effective in 2003 - its consequences have become plain. A host of large British companies, including upscale retailer Marks & Spencer, the U.K. arm of Ernst & Young and chemicals manufacturer Imperial Chemical Industries, have revealed big unfunded liabilities in their pension funds. That by itself has had no effect on corporate earnings in the short term and deflated share prices only temporarily, but the deficits have weakened corporate balance sheets.
As a result, some companies have closed their defined benefit plans to new employees, accelerating the growth of defined contribution plans in the U.K. Others are shifting their pension fund investments out of equities and into bonds, a more predictable asset class.
"Now they're calling me the man who wrecked pensions," says Tweedie cheerfully. He is completely convinced he did the right thing. In fact, he intends to reform the IASB's pension rules to make it look more like the British standard. "There isn't a lot of sympathy at the board for smoothing. Boy, that'll be a contentious fight," says Tweedie with relish, anticipating the coming war with U.S. companies.
As his ten-year tenure at the ASB began winding down in 1999, Tweedie contemplated a return to academia. Around the same time, though, the International Accounting Standards Board was beginning to take shape. The IASB traces its roots to 1972, when its precursor, the International Accounting Standards Committee, was formed. The IASC's purpose was to create accounting rules that countries the world over could use, particularly emerging markets lacking standards of their own. The group's initial members were representatives of the accounting boards in Australia, Canada, France, Germany, Ireland, Japan, Mexico, the Netherlands, the U.K. and the U.S. Other countries gained entry later. But "the IASC really had little or no authority," says Pace University's Oliverio. "The rules it produced were just kind of sitting there for anybody who wanted to use them."
As the 1990s began and business globalized, it became clear that a unified set of accounting standards was desirable. Australia, Canada, New Zealand, the U.K. and the U.S. created a working group, headed by Tweedie, to join forces with the IASC informally and discuss some of the thornier financial reporting issues, such as derivatives, to which the IASC hadn't paid much attention. But it wasn't until the Asian financial crisis hit in 1997 that the need for uniform, high-quality global standards became urgent. As Tweedie remembers, "You'd have a company in Korea doing pretty well, good accounts, and then poof! It's gone."
In 1999 the body that oversaw the IASC declared that the committee lacked the independence and the transparent decision making to produce a highly regarded set of global standards. Instead, it called for the creation of a new, 14-member board composed of accounting professionals from around the world - the IASB. In May 2000 the IASC appointed 19 trustees to oversee the restructured organization and named Paul Volcker their chairman. He and the trustees set about looking for 14 full-time IASB members and for someone to lead them.
"As soon as I became chairman, everybody called me and said, 'You've got to get David Tweedie to run this board,'" Volcker recalls. "'He's the only guy who can do the job. He's respected by the French, the Germans, the Swiss.' I had never heard of him before." When he finally did meet Tweedie, Volcker was impressed. "He's able to command respect and articulate issues in ways that aren't commonplace in the accounting profession, or any other profession for that matter," says the ex-central banker. And given global fears of American domination of the IASB, and with Volcker already installed as chairman of the board of trustees that oversees the accounting group, naming an American to run the IASB simply wasn't an option. "David was a suitably neutral candidate," says vice chairman Jones, himself a Brit.
When Volcker offered Tweedie the job, he weighed the idea for a month before accepting. A university had offered him a vice chancellorship, and he was tempted to take it. He conferred with Edmund Jenkins, then chairman of FASB, before agreeing to take on the world. "He wanted to be sure that the new board would have the continued support of FASB, because that meant the IASB had a good shot of being successful," Jenkins says. "I assured him it would." Ultimately, the chance to shape international accounting standards won Tweedie over. "It was an opportunity I couldn't walk away from," he says.
Tweedie keeps a flat in London and commutes home every weekend to North Berwick, just outside Edinburgh, where he and his wife, Janice, have a house overlooking the Firth of Forth. Their two sons are grown up; for relaxation Tweedie hikes. In fact, he spends his May vacations tramping in the Scottish highlands. A naval history buff, he says the historical figure he admires most is 18th-century British Navy legend Admiral Lord Nelson. "He did things that were beyond convention," Tweedie says. "And he had the courage of his convictions."
Tweedie now faces a broad cultural conundrum. He must reconcile the fundamentally different approaches to accounting rules that Europeans and Americans take - approaches rooted in their very history and political structure. Largely as a result of the litigiousness of U.S. society, Washington has produced highly prescriptive, detailed rules. Europeans, on the other hand, favor regulations that are more general and principle-based. For example, FASB's rule on leasing runs more than 400 pages; the international standard is about 25.
Tweedie falls firmly into the European camp. "Put simply, detailed guidance may obscure rather than highlight the underlying principles," Tweedie told the U.S. Senate Committee on Banking, Housing and Urban Affairs in February. Says an EC official: "We in Europe don't have that tradition of detail. We leave room for professional judgment. We believe that is a better system." So the EC won't accept standards that it regards as top-heavy with detail, while the U.S., with its cadres of lawyers, demands rules that provide clear guidance. "The trick is to find the right place to draw the line," says former FASB chairman Jenkins.
Still, Enron's collapse has cast doubt on U.S. rules, and SEC chairman Harvey Pitt has declared that the agency favors a shift toward principle-based standards. But bridging the transatlantic divide will be difficult. For one thing, American accountants would have to be retrained to form their own opinions. And these days there's a fundamental skepticism about whether such opinions can be unbiased. "I wish we lived in a world where we had professionals making judgments that could be respected," GE comptroller Ameen says. "That's not the world we live in now."
Five Americans, two Brits and members from Australia, Canada, France, Germany, Japan, South Africa and Switzerland serve on the IASB. The board members were chosen not because of the countries they represent but because of their expertise in national and global accounting. To assemble its rule book, the IASB is examining standards from all over the world, cherry-picking from various countries, writing its own rules where none exist and junking current ones that it feels are inadequate. The IASB inherited 34 global standards from the IASC; in May it issued revisions to 12 of them. Although the board doesn't have a deadline for unifying standards, the recent EC decision that all EU countries must follow the same rules by 2005 has provided a loose timetable. Tweedie's term runs for five years ending in 2006 and is renewable once.
Although international standards existed under the IASC, the IASB's rules have more heft. The International Organization of Securities Commissions, of which the SEC is a member, says that if the IASB produces a comprehensive set of international standards, it will recommend that they be endorsed for cross-border capital-raising and listing purposes in all global markets.
But Tweedie's specific proposals mean that getting those endorsements will be an uphill battle. Take his suggestions for pension accounting. Under current U.S. standards companies must include pension costs or income in their profit calculations. The bull market of the 1990s swelled corporate pension funds, and profits were a prime beneficiary. Bear Stearns estimates that in 2000, pension income accounted for 1.4 percent of the aggregate operating income of the S&P 500. And thanks to smoothing, GE, for example, was able to book pension income last year - to the tune of 13.7 percent of the company's $13.1 billion in net income.
Under Tweedie's plan the income statement would be divided into at least two columns: The first would cover operating earnings, and the second finance charges. In that formulation pension investment returns would be included in the finance column, and the only pension-related number that companies could include in operating earnings would be the service cost - the increase in pension benefits owed employees because they worked another year.
FASB, too, is in the early stages of work on a reconfigured balance sheet, in close consultation with the IASB. "I could see pension income as an item that ultimately might not get mushed into the bottom line," says chairman Herz. Ultimately, FASB and the IASB would cooperate on the revision, he says.
But the idea of taking pension gains out of profits rubs many executives the wrong way. "What the user is supposed to do with that is unclear to me," says GE's Ameen. "I don't think the market pays a lot of attention to pension earnings. I don't think investors are giving us a 30 multiple because of $1 billion in pension earnings."
Much as companies may oppose changing their pension accounting, Tweedie's biggest challenge will be pushing through reform of stock option accounting. Analysts and investors overwhelmingly support expensing options. In a September survey conducted by the Association for Investment Management and Research, an independent trade organization of portfolio managers and analysts, more than 80 percent of respondents said options should be recognized as an expense. Institutional investors such as TIAA-CREF and the State of Wisconsin Investment Board are pushing for the change as well.
The issue is fairly straightforward: Tweedie and the IASB believe that because stock options are compensation, they should be treated as such. And compensation is a cost that should take a bite out of earnings. Business executives argue that options already cut into earnings. "When we give stock options, we recognize that we are diluting our ownership," says Howard Cox, general partner of Waltham, Massachusetts-based venture capital firm Greylock and chairman of the National Venture Capital Association. "We are not handing them out like candy."
Forcing U.S. companies to charge options against profits, Cox and others argue, would deter companies from offering them. And that, they say, would devastate the engine that drove the American economy in the 1990s and stifle innovation. "If options had to be expensed, it would have a catastrophic effect on the formation of new high-growth technology companies," says Cox.
Options give their holders the ability to buy shares in the future at a specific price, called the strike price - typically, the stock's price on the day the option is granted. If the stock price rises above the strike price, the option holder can buy the stock at the strike price, sell the shares immediately and keep the difference.
Under GAAP, U.S. companies have two choices in treating options: They can use their "intrinsic" value on the day they are granted - the difference between the market price and the strike price - and charge the difference against earnings, or they can calculate the fair value of the options starting on the day they are granted using an option-pricing mechanism such as the Black-Scholes model. Of course, since the difference between the market price and the strike price is zero, most companies opt to use intrinsic value. Those companies are required to disclose in a footnote what the hit against earnings would have been had they used the fair-value approach. In practice, only two companies in the S&P 500 use fair value, Boeing Co. and Winn-Dixie Stores, says Bear Stearns accounting analyst McConnell.
FASB devised the muddled standard - FAS No. 123 - in 1995, after a ferocious lobbying campaign by U.S. businesses. In fact, FAS No. 123 closely resembles the old rule it was meant to replace. "Using a 1972 accounting model is nonsensical," says Elizabeth Fender, a director of governance at TIAA-CREF.
Indeed, corporate governance watchdogs believe the generous accounting treatment afforded by the current rules encourages companies to use stock options as a primary form of compensation. Many blame the stock options that Enron executives received for the company's collapse, saying that overreliance on options encouraged management to embrace dubious accounting practices that inflated earnings and sent the stock price soaring. Needless to say, lots of corporate executives disagree. "Enron's collapse had nothing to do with stock options," declares John Doerr, a partner at Menlo Park, California-based venture capital firm Kleiner Perkins Caufield & Byers. "We had a long and hard debate about this in 1995. I think we got it right."
FASB itself, though, wasn't satisfied with its work. "The Board chose a disclosure-based solution for stock employee compensation to bring closure to the divisive debate on this issue - not because it believes the solution is the best way to improve financial accounting and reporting," FASB says in FAS No. 123.
European standards for share options are less clear than America's. "There are virtually no accounting standards in Europe for share-based payment," says Kimberly Crook, the IASB project director who oversees the reform effort. Disclosure requirements vary from jurisdiction to jurisdiction. Some companies in Germany, for example, use GAAP as a guide, and most European corporations do not charge options against earnings because they don't have to.
But Denmark, Germany and the U.K. recently began considering rules that would treat options as an expense. That movement, Tweedie and others say, is what forced the IASB to take up the issue. "Outside the U.S. there are no standards anywhere else in the world on this," says James Leisenring, an American who serves on the IASB board and is its liaison to FASB. "People in the U.S. have to understand that." Retorts trade group lobbyist Hurley, "Just because the rest of the world hasn't figured out the entrepreneurial spirit of the U.S. doesn't mean that the U.S. should be punished for it."
Although industry groups remain committed to battling the IASB on share options, the board appears determined. "I think that in fact it is going to end going the IASB's way," says Richard Baron, deputy director of policy at the Institute of Directors, a business lobby based in London. "They've invested enough political capital that they're going to stick with it, and we are probably going to be reduced to discussing how we value these things."
Yet even if Tweedie and the IASB stick to their guns, the European Union has an out; it can void any rule that would put European companies at a "competitive disadvantage" to those in other markets. If FASB rejects the IASB standard on stock options, the EU could opt out, too. European companies like DaimlerChrysler, Pirelli and F. Hoffmann-La Roche are already sounding that argument in their comment letters to the IASB on stock options. "I don't blame them," says an EC official. Another scenario: If the U.S. rejects the new options rules and Europe accepts, the EU could accuse the U.S. of predatory accounting practices in a complaint to the World Trade Organization.
But if the IASB leads the way on stock options, it will put great pressure on FASB to follow suit. "Given FASB's pledge to support convergence, it would be incumbent upon the board to at least consider putting the issue on its agenda," says former FASB chairman Jenkins. Current chairman Herz says he thinks options should be expensed - though he's not sure how their value should be calculated.
Another potential area of conflict for Tweedie is the standard governing when "special purpose entities" - off-balance-sheet vehicles that essentially isolate certain assets from the financial results of the companies that own them - must be included on balance sheets. Needless to say, Enron's collapse turned the spotlight on that accounting rule: The company used a number of SPEs to hide massive losses from investors.
In June FASB said it would produce for comment a new rule that among other things would require that outside investors own at least 10 percent of an SPE for a company to keep it off the balance sheet - up from a current 3 percent. If the outside investment falls below that "bright line," the company would have to bring the results of the SPE onto its balance sheet. At the same time, the proposal would give companies and their accountants leeway to rebut the 10 percent minimum using criteria set by FASB.
The IASB, too, is poring over its SPE standard - though some believe that the international rule is already superior to its U.S. counterpart, in that it doesn't use a "bright line" approach. Instead, the rule states that if a company has operating control of an SPE, the entity must be included on the balance sheet. Nevertheless, the IASB is revisiting its SPE rule and will meet with FASB and other national accounting boards in August to try to work toward convergence.
Tweedie knows that no matter how good his global standards are, it will ultimately be up to accounting firms, investment banks, corporate boards and enforcement agencies to enforce them. "If we write good rules and people follow them, we'll get investor confidence back," says Tweedie. The latter is a big if. But a victory by Tweedie would make him, to shareholders at least, the most beloved accountant in the world.