Turning Assets Into Liabilities

I for one have heard the protestations from Silicon Valley and elsewhere about the massive wealth-destruction that would ensue were companies forced to expense stock options enough times that I'm tempted to throw the equivalent of a three-year-old's tantrum if I hear it again.

Nevertheless, let's review the bidding on this score:  High-growth (most decisively including high-tech) companies love to compensate executives and employees with stock options because of several magical financial properties they currently enjoy, not least being while they are indisputably of value to the recipients, they are not treated as an expense to the company.  Warren Buffett, among others, has mocked this state of affairs with the rhetorical question, "If compensation is not an expense, what is?; and if an expense doesn't belong on the income statement, where would you have it go?"

Defenders of the status quo argue not from principled opposition to this logic—they may silently concede it's unassailable—but from a fearful self-interest.  To state the obvious, recognizing an expense for stock options (bypassing the thorny issue of how to calculate their value) would decrease reported profitability of many firms, some by drastic amounts.  Wall Street would immediately pummel the suddenly less-profitable stocks, the companies' cost of capital would go up, employees would desert as their options became worthless, and why not just invite the Chinese to take over the entire high-tech sector and be done with it?

The illogic of this position is of course that Wall Street already does recognize the cost of stock options:  But it does not recognize that cost on the P&L, rather (and far more logically) it recognizes that cost in terms of implicit dilution of the stock.  (This is what the phrase, "fully diluted earnings" means.)

What has this to do with law firms?  Consider a firm that converts from a traditional general partnership to LLP status.  This commentator argues that there will ensue a change in the accounting treatment of what we might call "unpaid-out profit," and that the consequence will confound banks, sully the firm's reputation for profitability, and generally cause mischief.  The issue is this:  In a general partnership, earnings owed to partners are treated as reserves of the partnership (perhaps in a partner's current account, but an asset nonetheless).  But, in an LLP, that same money is treated as a liability of the LLP to the partner.  Voila:  Net capital is slashed at a stroke.

Not so fast.  Unless financial innumeracy is even more rampant than I sometimes fear, this change is both transparent and utterly immaterial.

If you find yourself in a loan conversation with a banker adopting the commenter's view, a word of advice:  Short his firm's stock.