Ten years ago, the biggest gap in GAAP (Generally Accepted Accounting Principles) was the treatment of goodwill. In making acquisitions, companies were forced to expense the amount they paid over book value. This write-off was ludicrous since goodwill is an appreciating asset. So long as people focused on the income statement, quality companies with goodwill amortization were targets for undervaluation — and for us, targets of opportunity. In time, reality won out and goodwill was no longer treated as an expense.

Five years ago, the biggest flaw in our accounting rules was in the treatment of company stock options. Here, a legitimate expense was ignored in determining earnings per share. Stock options are capitalism's most popular 'heads you win, tails you break-even' proposition. As an employee or, in particular, as an executive of a company, you can benefit from a rise in your company's stock price without risking any loss from its decline. As a shareholder in a company, however, the equation isn't so favorable. For one thing, if the stock you own declines in price, you lose money; for another, those options given to employees and execs are worth something, and that something comes out of your pocket.

Companies have been required to account for the impact of options, but in a manner which hasn't much help investors. For example, five years ago, Cisco issued 295 million options to its employees (8 million to its top six execs) which represented about 4% of the shares outstanding. On its income statement, Cisco accounted for the additional shares (which will be issued when the options are exercized) by increasing the number of "fully-diluted" shares, earnings per share were reduced accordingly.

Sounds fair? Not really. The problem was that these options, when properly valued, reduced earnings by a great deal more than 4%. Based on the widely used Black-Scholes model, the value of the options granted were $5 billion, more than the entire earnings for that year!

Why, then, didn't the FASB (Financial Accounting Standards Board) require more accurate accounting? For one thing, GAAP accounting uses rules which try to maintain consistency and objectivity in financial disclosures. Black-Scholes is consistent; as for its objectivity, that could be argued either way. The fact that its valuations are inaccurate, based as they are on uncertain future events, doesn't undermine its usefulness. GAAP accounting is already inaccurate, given its reliance on historical valuations for assets. (An alternative, more realistic approach to option valuation is discussed in Options — Special Report.)

Returning to the underlying question, perhaps the best reason why this country's public companies have accounted for options as they have is the obvious reason. As The Economist noted, "The main argument advanced for not putting options into the profit-and-loss account is perfectly simple: to do so would cost American companies too much."

This "let's not recognize an expense because it's big" shell game has finally been exposed. Beginning in July of this year, companies must treat options as a legitimate employee expense, an approach which would have been put in place more than a decade ago but for the avalanche of lobbying money, particularly from the high-tech industry. Congress saw the light and pressured the FASB to overturn itself, contributing in part to the tech-stock bubble of the late 1990s. Certainly, when it comes to accounting, no bad deed goes unrewarded.

Today, the biggest accounting problem is with pensions. Most companies' pensions are underfunded — worse, the assumptions behind the obligations are flawed. Companies are permitted to assume whatever return on pension assets they feel is justified, and not surprisingly, they seem willing to err on the high side (thereby reducing the annual cost on their income statements). Although the assumed return on assets has come down, there are some enormous risks for some old-line companies. General Motors, to highlight an extreme example, is underfunded by more than $100/share; further, if they assumed a 6% return on assets instead of their current assumptions, their earnings would be reduced by about $3.50/share — to put this in perspective, the consensus earning per share for 2005 is a bit over $5.00.

When we analyze a stock, our focus is on the cash flows and our interest is in the true economics of the underlying business, not the creativities of the accounting business. We agree with John Maynard Keynes who said that he'd "rather be vaguely right than precisely wrong." From our perspective, the more people who are distracted by the irrelevant or the misleading, the better our opportunities. Two things are certain: anything can happen to stocks in the short run, but in the long run, the market does a pretty impressive job of separating the contenders from the pretenders.

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