Jan 30th, 2007 by Martin Lee
A major accounting change, which was to be implemented by January 1, 1993, requires that businesses recognize their present-value liability for post-retirement health benefits.
For some reason, these were not required to be recorded on the books previously even though pensions to be paid in the future (something similar) were.
By ignoring the built-up of such liabilities, some companies had left themselves vulnerable to open-ended liabilities in the future.
The result of this new rule will many companies to record a huge balance-sheet liability (and a consequent reduction in net worth).
Warren Buffett tends to avoid companies with significant post-retirement liabilities when he is making his acquisitions.
Despite the accounting rule change for health benefits, no such change was required for stock options.
Stocks options were still illogically treated for in the accounts.
Some people have argued that “out-of-the-money” options (those with an exercise price equal to or above the current market price) have no value when they are issued.
Others have said that options should not be viewed as a cost because they “aren’t dollars out of a company’s coffers.”
Warren Buffett sees these as flawed as they would open up possibilites for companies to instantly improve their reported profits.
For example, they could now eliminate the cost of insurance by paying with it using options.
As long as something of value changes hand (and not just when cash changes hands), there will be a cost involved.
The arguement that options should not be recognised in the accounts because it is difficult to value them is also not right.
Currently, estimates are being used in accouting anyway. Examples include depreciation of a plane, a bank’s annual loan loss charge and losses of property-casualty ompanies.
“If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”