Accounting Board Rules Companies Must Expense Options

Despite the technology industry's long campaign against the move, the nation's accounting rulemaker decided Thursday that companies next year must deduct the value of their stock options from their profits.

InformationWeek Staff, Contributor

December 16, 2004

5 Min Read

NEW YORK (AP) -- The nation's accounting rulemaker decided Thursday that companies will have to begin deducting the value of stock options from their profits next year, reining in a cheap way to compensate workers that had been abused by executives and clouded earnings.

The move was cheered by shareholder advocates but scorned by many companies who rely heavily on options to beef up compensation packages.

The Financial Accounting Standards Board's decision calls for public companies to start expensing options beginning with their first fiscal reporting period after June 15, 2005. Private companies and companies that file as small business issuers are not required to comply until after Dec. 15, 2005.

FASB chairman Robert H. Herz said the new rules "provide investors and other users of financial statements with more complete and unbiased financial information.''

Rules for accounting for stock options have pitted the technology industry, which relies on options to attract and retain employees, against some highly influential officials advocating expensing options, including Federal Reserve Chairman Alan Greenspan, Securities and Exchange Commission Chairman William Donaldson, billionaire investor Warren Buffett and the Big Four accounting firms.

Stock options are perks given to employees that allow them to buy shares of their company's stock in the future at a set price. If the stock rises before the options are exercised, the employee can buy the stock at the predetermined, lower price, then sell it at the higher, current price and pocket the difference.

Many employees of companies like Microsoft Corp. and America Online famously became millionaires in the 1990s thanks to stock options.

Under current accounting standards, a company's cost of issuing options only needs to be disclosed in a footnote to its financial statement, not deducted from the income it reports to investors.

The new rules will force companies to subtract the option expense from earnings, which could dramatically knock down profits at some companies.

For instance, Apple Computer Inc. said in its latest annual report that its fiscal 2004 earnings would be cut from 71 cents per share to 44 cents had it expensed its options.

So far, about 850 companies -- including about 120 members of the S&P 500 -- have begun or agreed to begin expensing options, according to research from Bear Stearns.

But the FASB's actions are far from being set in stone considering that Congress has the power to mute its action. A bill passed through the U.S. House of Representatives last summer that would require companies to only expense options granted to their five top executives, though the legislation is currently stalled in the Senate.

Much attention has been paid to the accounting of stock options since the corporate scandals shed some light on this popular pay tool, which is often relied on by companies to reduce compensation expenses, and therefore, boost profitability.

Rampant awards of stock options and their ballooning value made for conflicts of interest among executives.

At companies including fallen giants Enron Corp. and WorldCom, it became apparent that executives manipulated earnings in order to boost their stock prices over short periods of time, and then were quick to cash out of their options before the trouble came to light.

Still, critics of stock-option expensing aren't backing down, keeping up their argument that deducting the option costs from earnings could allow inaccurate information to be entered into financial statements since methods to value the options include some estimates about the future.

And FASB did not specify a particular method of valuing options -- the formulas used to assign costs to the options.

Rick White, chairman of the International Employee Stock Options Coalition, a group that represents companies opposed to the new rules, said the methods of valuing stock options are "so confusing and open to interpretation that they are not even auditable.''

And many companies, particularly in the tech sector, argue the new rules will curtail a key perk that helped startups keep workers loyal and hardworking before the companies began turning profits.

"We need incentives that will help create jobs and foster the development of new products and services,'' said Bruce Hahn, director of public affairs for the Computing Technology Industry Association.

Experts agree that companies will be forced to sharply reduce the number of options they grant, and some question the effect it will have on productivity.

"Basically, there's a bit of a chicken and egg here in terms of if employees are getting fewer options, are they going to be less motivated to improve the performance of their companies and therefore will their stock prices not go up as much as they would have?'' said Ira Kay, practice director for compensation at Watson Wyatt Worldwide, a human-resources consultant based in Washington, D.C.

"I think stock options work, in terms of motivating employees at all levels to do the big and the little things to improve the financial performance of their employers,'' he said.

Advocates of the change, however, maintain that options are an expense of doing business like any other and need to be recognized as such.

Most companies that issue options have to repurchase their own stock at market prices so the extra shares created by the options do not lower their earnings per share, according to J. Edward Ketz, an accounting professor at Penn State University.

"The spending of that precious cash is what in essence makes this whole thing absolutely critical in terms of reporting the truth on what's going on,'' Ketz said.

AP Technology Writer Rachel Konrad in San Jose, Calif., contributed to this report.

Copyright © 2004 The Associated Press. All rights reserved.
The information contained in the AP News report may not be published, broadcast, rewritten or redistributed without the prior written authority of The Associated Press.

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