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Let your stomach rule your head

There comes a time in every business period when a financial director has to do things simply because they feel right, and not because the financial jargon or technical complexities say otherwise.

Speaking at the CIMA annual conference in mid-November the chief auditor at Unilever, James Duckworth, provided a powerful analysis of how Unilever manages risk. In particular he talked about the system they have of top down/bottom up in assessing where risks lie in the business.

Managers are quizzed on what risks their divisions face and how important these risks are. Duckworth argued that at times this should not be reduced to an analytical process alone. Managers, he suggested, should not always state clinically how serious a particular risk might be. They should say how their stomachs felt when standing up and saying how dangerous a future risk might be.

There’s a lot to be said for gut feel versus corporate systems when assessing challenging issues. One area which will benefit from such an approach is the question of accounting for share-based payments, share options to you and me. The American corporate sector has never liked the idea of accounting for them. So much so that when in 1994 the American standard-setters, the FASB, put forward proposals for showing options as an expense, corporate America put together some £70m as a fighting fund to get the idea over-turned.

It may seem bizarre but that is how accounting standards excite Americans. There were even demonstrations in the street. It’s hard to imagine a society where financial directors exhort their colleagues to take to the streets to demonstrate about accounting standards. But America can be a very strange place sometimes.

But they have not all taken leave of their senses. The great investment guru Warren Buffett came up with the definitive comment on stock options almost ten years ago and you do wonder why anyone has been arguing over the rights and wrongs of expensing them ever since. What he said was simple.

“If options aren’t a form of compensation, what are they?”, was his first question. “If compensation isn’t an expense, what is it?”, was his second.

“And if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”, was his third. QED, as the Romans used to say.

But still the arguments run on. The International Accounting Standards Board (IASB) now has its proposals, ED2, out for comment until March 2003, with an intention of having a final standard out by the end of the year.

The intention of FASB in America is to follow suit, but with some trepidation in case another campaign swings into action.

You can argue all manner of different issues as to the calculation of the value of options. The point is the Buffett point. Does explaining why you should not account for share options as an expense make you feel great in the stomach? Or does the queasy feeling that it really is an untenable argument come over you?

One of the factors which might determine your gut feel is whether you work for a technology company. Then your gut feel may be bad but explaining that changes have to be made to the rest of the board of directors, the analysts and the investors might make you feel a lot worse. Yahoo, the internet company, has, on its last figures, an astonishing $409,556 per employee undisclosed as stock options. Explaining that this is now going to have to be taken as a hit on earnings would not be the average FD’s most enjoyable moment.

One of the other problems is that share options were seen as a good thing.

They made people feel good throughout the company. They increased all those corporate objectives like loyalty and high morale. But the reality is that this never happened. There are companies, particularly in the UK, where company-wide share option schemes have worked well. But generally it has been the fat cats who got fatter. The figures for America show that 75% of all options go to people classified as being among the top five executives at their company. The next 50 executives in the pecking order scooped 15%. And the rest of the employees accounted for the final 10%.

We are now in an era when being seen to be bending not just the rules but investors’ credulity is not good from the corporate governance point of view. The gut feel is that Buffett has prevailed. Time to move on.

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