Tougher Accounting Rule Expected for Stock Options

In a ruling that could change the way many Americans are paid, the nation’s top accounting authority is expected to decree as early as today that companies must treat employee stock options as business expenses when they are issued.

The Financial Accounting Standards Board ruling would be a defeat for Silicon Valley technology firms that have lobbied passionately against having to “expense” options by deducting their value from earnings in public financial reports.

Right now, companies can pay employees with stock options -- a sort of IOU on future growth -- without draining cash or depressing reported profits the way that ordinary salaries do. Options have been a cheap means for cash-poor, high-growth companies to attract and retain top employees.

Critics contend that the way options have been accounted for on income statements is fundamentally dishonest and can no longer be tolerated in the wake of the Enron Corp. and WorldCom Inc. accounting scandals, among others.

As billionaire investor Warren E. Buffett, long an advocate of options reform, put it in a 1999 commentary: “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?”

The ruling would be one of the most important U.S. bookkeeping changes since 1974, when Congress passed the Employee Retirement Income Security Act, forcing corporations to back up their pension obligations with cash instead of just promises.

Before being adopted, however, the accounting board’s action would have to go through a public comment period of 90 days or more, FASB spokeswoman Sheryl Thompson said, and probably would not take effect until 2005.

An option is a contract allowing the holder to buy stock at a specified price for a specified time period, typically 10 years for employee options. If the stock soars, options can create instant millionaires. That was a common phenomenon in Silicon Valley during the 1990s stock market boom, and helped inflate California’s income tax revenue collections.

But options cut both ways: When the tech-stock bubble burst, many holders saw their nest eggs built with stock options shrink or even disappear. And the state government suddenly saw a decline in tax collections, contributing to the budget crisis.

The granting of lucrative options has also been a theme in the criticism of runaway compensation packages for chief executives, many of whom derive more of their income from options than from salaries.

For corporations, stock options were never exactly “free money.” At some level, investors have understood that when a company awards options and its share price rises, it eventually must redeem the options either by issuing new shares -- which dilutes the ownership stake of existing investors -- or by repurchasing stock in the open market, which drains cash from the corporate treasury.

But as long as companies didn’t have to recognize options as an immediate expense, the awards functioned as a “buy now, pay later” compensation plan.

“It’s a tremendous tool for recruiting, motivating and incenting employees,” said Kim Gibbons, a spokeswoman for San Jose-based Cisco Systems Inc. At Cisco, which opposes the FASB ruling, all employees get stock options, Gibbons said, and 80% of them are held by workers below the rank of vice president.

If forced to expense options, some companies said, they simply wouldn’t provide options to as many employees as now receive them.

Expensing options “would vastly curtail the capability of small firms to offer stock options as an employee recruitment, retention and incentive tool,” Karen Kerrigan, chair of a small-business advocacy group, said in remarks to a House committee this month.

David M. Blitzer, chief strategist for Standard & Poor’s, estimated that the rule change would cut reported earnings for S&P; 500 companies, the nation’s biggest and best-known firms, by 6% or 7%. The biggest effect would be on technology firms, he said, followed by financial services companies.

It is uncertain whether a drop in reported profits would hurt companies’ shares in the stock market. Blitzer thinks it could, but others on Wall Street believe that the market has had plenty of time to prepare itself.

“For a lot of our member companies, it’s a big yawn,” said Colleen Sayther, president of Financial Executives International in New York, an association of corporate financial officers.

Over the last two years, about 500 U.S. companies, including General Electric Co., Eastman Kodak Co. and Coca-Cola Co., have voluntarily begun treating stock options as an expense. That trend is continuing: On Monday, retail giant Circuit City Stores Inc. said it had begun to count options costs against earnings.

A number of these companies are now issuing stock to employees in place of options, with some strings attached.

Companies that haven’t begun expensing options are facing increasing pressure from shareholder activists to do so. Just last week, shareholders of PeopleSoft Inc. overrode the objections of company management and voted in favor of expensing options. Hewlett-Packard Co. shareholders staged a similar uprising in a nonbinding vote a week earlier.

Silicon Valley’s opposition to the idea hasn’t softened despite the decision by software titan Microsoft Corp. in July to count existing options as expenses while also abandoning the practice of handing out new options.

For firms such as Cisco Systems that historically have relied heavily on options, the switch to expensing would have a profound effect: In its most recent quarterly financial statements, Cisco said that accounting for stock option costs under the most common method would have slashed reported earnings for the six months ended Jan. 24 from $1.81 billion to $1.17 billion, a 35% reduction.

Silicon Valley has no intention of accepting the FASB ruling without a fight. A delegation of technology executives plans to descend on Washington on Wednesday to lobby for a House bill that would sharply scale back the FASB’s ruling.

The legislation, written by Rep. Richard H. Baker (R-La.), would require firms to expense stock options for their top five executives only. The bill, endorsed by Sen. Barbara Boxer (D-Calif.), also would create a new method of figuring an option’s cost that some critics believe would produce a misleadingly low value.

One Republican congressional source said many legislators were reluctant to challenge the FASB, which was established 30 years ago as a politically independent body, albeit one that is bankrolled by the accounting industry.

Tech companies that oppose expensing options contend that the most commonly proposed method for estimating those costs, the Black-Scholes model, is inherently flawed.

The companies say they can’t accurately estimate option values because there is no way to know when employees might exercise their stock purchase rights. In addition, these firms say, if a company’s stock price falls, an option might never provide a real benefit to the employee -- or impose a genuine cost on the company.

“We think the valuation methods are the Achilles’ heel of the FASB,” said Jeff Peck, lead consultant to the International Employee Stock Options Coalition, a Washington-based group that represents opponents of the FASB rule change.

Corporate governance activist Nell Minow, editor of the Corporate Library Inc., said that even an imprecise estimate would be better than the current practice of valuing options at zero. “It’s hard to believe the disaster scenarios from Silicon Valley,” Minow added. “Somehow, Coca-Cola and Microsoft have managed to do the right thing without the roof falling in.”

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Staff writer Tom Petruno in Los Angeles contributed to this report. Mulligan reported from New York, Kristof from Los Angeles and Yue Jones from San Francisco.