Regulatory rules and estimating economic growth: two perspectives on expensing employee stock options

Business Economics, April, 2008 by Cynthia A. Glassman, David N. Beede

Users of government economic statistics may be surprised to learn that not all are direct products of purpose-designed surveys. Financial statements, tax records, administrative regulatory data, and private-industry records are important sources of information. These nonsurvey data sources, which are not designed expressly for the construction of national statistics, vary in their quality and timeliness and are affected by changes in the rules that underlie their primary purposes. Moreover, those data typically have to be adjusted by statistical agencies to reflect the economic concepts being measured (rather than the tax or regulatory concepts on which they rely). Therefore, government economic statistics generally diverge from statistics based on private sector or regulatory agency data, and they are subject to being updated over time as more tax and administrative data become available. A deeper knowledge of the sources of statistical agency data and the adjustments made to those can help data users avoid confusion.

More specifically, the inspiration for this article came from a discovery one of us (Glassman) made shortly after becoming Under Secretary for Economic Affairs at the Department of Commerce, after serving as a Commissioner at the Securities and Exchange Commission (SEC). A SEC Commissioner is a regulator--charged with protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formation. In contrast, the Commerce Under Secretary for Economic Affairs is charged with fostering, promoting, and developing the foreign and domestic commerce--specifically overseeing two of the major statistical agencies--the Census Bureau and the Bureau of Economic Analysis (BEA), among other duties. Not much substantive overlap was expected between the two roles.

However, an issue confronted by SEC commissioners-the expensing of employee stock options-had also been posing challenges to BEA, but from a very different perspective. In particular, coming in as under secretary, it was surprising to learn that decisions made by the SEC regarding the expensing of stock options also affected estimates of gross domestic income (GDI) and gross domestic product (GDP). (2) At the SEC, significant time and effort were spent trying to determine the appropriate way to value the options that were to be expensed, but there was little focus by SEC policy makers on the potential impact of new stock option valuation and expensing rules on the measurement of growth of the economy. However, staff at BEA and Census had been coping with this overlap for many years and had been working with SEC staff on a number of statistical issues.

This paper examines employee stock options from these two very different perspectives. The stage will be set by describing the two perspectives, starting with a short discussion of what the issues regarding stock options were at the SEC and how they were resolved, then switching to the BEA perspective with a brief description of how GDI is estimated. Then the relationship between the two perspectives is described-that is, how changes in accounting and tax rules have caused employee stock options to affect the GDI estimates. The paper concludes by identifying other reporting issues that may also affect, in some way, the National Income and Product Accounts (NIPAs).

Expensing of Stock Options from the Perspective of the SEC

One of the roles of the SEC is to set the standards for the financial reports of public companies filed with the commission. The development of the accounting standards, known as Generally Accepted Accounting Principles, or GAAP, is delegated to the Financial Accounting Standard Board, or FASB. Both the SEC, through the Office of the Chief Accountant, and the FASB had been grappling for years with whether and how employee stock options should be treated as an expense in companies' income statements. Without going into the history of that debate, suffice it to say that a decision was made that after the first quarter of the first fiscal year beginning after June 15, 2006 (December 15, 2006, for smaller filers), public companies had to include the fair value at grant date of employee stock options as a line item expense on their income statements as the options vest. (For more on the history of and the arguments about expensing and valuation of stock options, see Guay, et al., 2003.)

Stock options give employees the right to purchase a specified number of shares of their employer's common stock at a specified price (usually at the market price at the grant date, what is known as "at-the-money") over a specific period of time (typically ten years). Usually, employees cannot exercise their options until they become vested, typically three years after the grant date.

Stock options became an extremely widespread component of compensation in the 1990s, partly as a way to align managers' incentives with shareholders' interests; partly as a way for cash-strapped technology companies to compete for talent; and partly as a rational response by corporations to a $1 million limit on the tax deductibility of executive salaries legislated in 1993-something that Christopher Cox, the SEC chairman has famously suggested "deserves pride of place in the Museum of Unintended Consequences" (Cox, 2006). The popularity of stock options as compensation appears to have waned a bit in recent years for a variety of reasons, likely including the expensing requirement.