No Easy Fix for Stock Options Angst

Amid the controversy about whether companies should treat employee stock options as a normal cost, only about 50 of the nation’s 13,500 publicly traded companies--that’s 0.4%--have announced plans to voluntarily make the switch. And it’s by no means certain that the trickle will become a torrent any time soon.

Standing in the way is the debate raging over the effect the accounting change might have on the companies’ financial results, their stock prices and their employees. One side contends the effect will be hugely negative--lowering corporate earnings and paring the number of options granted to executives and non-management workers. Others speculate that the effect will be minor.

The whole premise behind expensing options is to further clarify a company’s accounting, make its numbers more transparent to the public and thereby boost investors’ confidence, which has been ravaged by corporate scandals.

Executives involved in those scandals were often lavished with options that made them fabulously rich and allegedly prompted the financial abuses that were aimed at keeping the companies’ profits--and stock prices--as high as possible. So options came under assault, and now treating them as a cost to be deducted from earnings is seen as one solution to curbing the abuses.

But some analysts say many investors probably will ignore, or “back out,” the cost when they evaluate a company’s stock on grounds that a company doesn’t immediately pay out cash when it grants options.

Others argue that there are eventual costs. Options increase the potential number of shares a company has outstanding, which could lower its earnings per share that Wall Street and other investors follow so closely. In turn, companies often then spend heavily to buy back their shares on the open market to offset that dilution.

Expensing options will make companies more cautious about how many options they issue, some observers say. But others disagree. “At the end of the day it’s going to be a non-event,” said David Hilal, technology research director at investment firm Friedman, Billings, Ramsey & Co. in Arlington, Va. “I don’t think employees need to be alarmed at the prospect of getting fewer options.”

Practices Unchanged

And despite the turmoil surrounding the issue, companies so far “have not scaled back their use of stock-based compensation” to motivate employees and attract new talent, according to surveys by WorldatWork, a trade group in Scottsdale, Ariz., that tracks worker compensation and benefits.

The debate has “yet to convince a majority of companies to reconsider how they administer their options plans,” the group said.

Even so, the confusion is expected to increase as more companies deliberate whether to expense their options and while the Financial Accounting Standards Board--which sets the rules for corporate accounting and favors expensing options--ponders whether to make the change mandatory.

Many analysts are hard-pressed to think of another issue in recent years that has so divided the sharpest minds in corporate America and on Wall Street.

On one side there are the likes of General Electric Co. and Coca-Cola Co., two multinational behemoths that plan to expense options to boost investor confidence in their accounting. On the other side are Intel Corp., Cisco Systems Inc. and other technology titans that oppose the switch, claiming it would brutally hurt their profits.

Others also oppose the idea, including former American Express Corp. Chairman Harvey Golub, who contends that because options don’t actually cost a company anything initially, there is no reason they should they be deducted from earnings. Another reason: the confusion over how the options should be valued.

Methods Will Differ

Analysts say these factors will limit the practice of expensing options in the immediate future. Investors and employees will be forced to grapple with different options-accounting methods at different firms until the change becomes mandatory, or some trigger prompts most firms to start treating options as a routine expense.

Neither is expected to happen until next year, at the earliest.

Options give holders the right to buy their company’s stock in the future at a set price. The idea is to give employees an incentive to work harder so the stock’s market price climbs higher than the option price. Then the employee can exercise the option, acquire the shares and resell them for a profit.

Companies that issued these incentive options have done so without having to put a precise value on those options and to subtract that cost from their profits. However, under a 1995 ruling by FASB (known as Ruling 123), companies were required to place a “fair value” on the options and arrive at a pro forma, or “as if,” calculation of how that cost would have affected their earnings.

The Numbers Are There

But FASB also required companies to place that data in the footnotes of their financial reports. Investors can see the calculations, but only if they make the effort. Take Cisco, for example. The San Jose-based networking giant last year reported a net loss of $1 billion, but its pro forma loss--that is, after subtracting the cost of its options--shot up to $2.7 billion.

GE, Coke and the others that plan to switch will move the cost of their options from those footnotes directly to their profit-and-loss statements. General Motors Corp., the nation’s largest auto maker, said last week that it’s planning to expense options too.

But corporate America is hardly jumping on a bandwagon. Here’s why:

* Large technology companies oppose expensing options, with bellwethers Cisco and Intel reiterating their opposition last week. A few tech companies, such as Amazon.com, are planning to switch, but the biggest tech firms rely most heavily on handing out options as incentives--and thus claim to have the most to lose if they must subtract the options’ cost from profits.

If Cisco or another Silicon Valley power were to voluntarily make the shift, “that would be a watershed event for the community” and probably would prompt most others to follow, said Robert Willens, a tax and accounting analyst at Lehman Bros. “But I don’t see any of them breaking ranks.”

* FASB acknowledges it wouldn’t be able to force all companies to expense options until next year at the earliest, after it has studied public comment and otherwise deliberated on the matter. That’s far too slow a pace, some critics say, especially as the political climate is ripe for quicker action.

* The confusion over how to properly value options makes some companies hesitant about taking the step. Although they’ll all have to adopt FASB’s Ruling 123 that requires they put a “fair value” on options, companies are doing so in different ways. Some are employing mathematical models already used to value options traded in the markets. Others aren’t--Coke is soliciting bids from Wall Street firms to calculate its cost.

* FASB is weighing other changes that could muddle the picture. For instance, companies that voluntarily switch to formal expensing wouldn’t just begin treating options as a cost, but also might have to expense their options retroactive to 1995 and restate earnings for years since then. For companies with lots of options, that would make their past performance look much worse and jeopardize their stock prices, even though the change wouldn’t involve a cash drain on the firms, analysts said.

“I was shocked” by that proposal, Willens said. “Any form of retroactivity will bring this voluntary adoption, I believe, to a screeching halt.” And as FASB is encouraging firms to expense options, that move “seems counterproductive on their part.”

Long-Term Data

The seven-member FASB board, at a hearing last week, considered that formula and other ways that options could be expensed, but no decision will be made before the board meets again Wednesday, said Patrick Durbin, a FASB project manager.

But he said the idea of requiring companies to expense options retroactively is meant to help the public compare how options would have affected a company’s profit over time, and not just in the current year, so they can make more educated decisions about its financial health.

“We’re not interested in creating a penalty, if you will, for companies who are voluntarily adopting” the treatment of options as a cost, Durbin said.

As the debate goes on, the list of companies deciding to expense options probably will grow as another means of regaining investors’ trust, predicted David Blitzer, a managing director at Standard & Poor’s Corp. “I’m not sure they’ll do it within the next few months, but most will migrate to it,” he said.

“More and more companies outside technology will start expensing options, and that will put pressure on the tech companies” to follow suit, largely because institutional investors--which are providing the capital for all these companies to grow--will look more favorably on companies that treat options as a cost, Blitzer said.

And Blitzer sees all the confusion over options as overblown. Investors already have myriad factors they use to calculate before buying or selling a stock, and expensing options is one more variable.

“The different treatment of options is going to be another tool in a long, long list of situations where there are two, four, 10 ways to do things” in evaluating companies and their stocks, he said. “Yes, there will be some arguments” about the options’ cost and impact on corporate profits, “but it can be done.”

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Options Costs: The First Wave

Most companies that have announced plans to begin expensing the cost of stock options estimate that the effect in 2003 will be small compared with expected earnings per share. A sampling:

Est. 2003 cost per Current estimate

Company share to expense options of 2003 EPS*

Citigroup 3 cents $3.64

Computer Associates 2 cents 0.29

Fannie Mae 2 to 3 cents 7.00

General Motors 15 cents 6.22

Pogo Producing 2 cents 1.61

Scotts Co. 6 cents 3.60

Temple-Inland “not material” 4.07

Tupperware “minimal” 1.83

* Analysts’ consensus estimate of operating earnings per share

Sources: Times research, Reuters, Bloomberg News