cluding too many expenses. For example, Cisco Systems wrote off in-
ventories that the firm couldn’t sell and used accounting techniques that
made its acquisitions appear far more favorable than they were. Some
firms advanced pro forma earnings concepts that involved even more
extreme assumptions. Amazon.com declared it was profitable in 2000 on
a pro forma basis if the interest on nearly $2 billion of debt were ignored.
The Employee Stock Option Controversy
One of the most controversial issues is accounting for employee stock
options. Employee stock options give workers a right to buy stock at a
given price if they have worked for the firm a given period of time, usu-
ally five years. The proliferation of stock options given as a part of em-
ployee compensation began after the IRS ruled that payment by options
did not violate the compensation limitations set by Congress.
But options were popular not only because they bypassed restric-
tions on management compensation but also because most stock op-
tions, when granted, did not have to be accounted for as expenses in the
firm’s profit statements. Instead, these options were expensed only if
and when they were exercised.
Although the FASB approved this treatment many years ago, there
were many vociferous critics. Nobody put the case for expensing op-
tions better than Warren Buffett who stated in 1992, well before this issue
took center stage:
If stock options are not a form of compensation, what are they? If com-
pensation is not an expense, what is it? And if expenses shouldn’t go into
the income statement, where in the world should they go?^16
Buffett is perfectly correct. Options should be expensed when is-
sued because earnings should reflect the firm’s best determination of the
“sustainable flow of profits,” profits that could be paid out as dividends
to shareholders. If employees were not issued options, their regular cash
compensation would have to be raised by the value of the options for-
gone. Whether the compensation is paid by cash, options, or candy bars,
it represents an expense to the firm.
When an option is exercised, the firm sells new shares to the option
holder at a discounted price determined by the terms of the option.
These new shares will reduce the per shareearnings and is called the di-
lutionof earnings. Current shareholders are giving up part of the firm’s
104 PART 2 Valuation, Style Investing, and Global Markets
(^16) Berkshire Hathaway 1992 Annual Report.