Aug. 9 (Bloomberg) -- In mid-2005, the Financial Accounting Standards Board, the rule-making body for U.S. accounting, mandated a charge to earnings for the cost of stock-option grants, ending a debate that lasted almost four decades.

More and more companies are doing everything possible under FASB's rules to keep that charge as low as possible, though it can lead to overstating profits and potentially mislead investors.

A key way to lower option values is using an ultra-low assumption for when the option will be exercised. FASB permits a company to assume a term that matches its exercise history.

Between 1993 and mid-2005, companies weren't required to charge their earnings for stock options, though many reported the grant-date fair value anyway. Then the typical effective exercise period used by major companies was about 7 1/2 years.

And today? The effective term, based on my study of 331 option grants with 10-year terms made in 2006 to chief executive officers running U.S. companies with market values of $4 billion or higher, is down to 5.6 years. (Data for this study were supplied by Equilar Inc.)

An executive stock option can only be exercised and not sold during its term. So one could value the option using its entire 10-year term and capture the option's full theoretical value.

Exercising Early

Yet that also implicitly assumes that the executive is a perfectly diversified investor, something most aren't. The bulk of their assets are likely to be in their companies' stock or option shares. So being relatively undiversified, they tend to exercise early, a strategy more familiar to laypersons as ``take the money and run.'' (Tax and personal-spending considerations can also figure in the decision as to when to exercise an option.)

A comparison between the values, using the full 10-year term, and those the companies disclosed in their proxies covering 2006 showed that, on average, the reported figures were 18 percent lower than the full-term values. That's not unreasonable given the degree of non-diversification among executives.

Yet some companies lowered their reported grant-date fair values by far more than 18 percent, and generally did it by assuming that the option would be exercised way early. The result, of course, is a far lower grant-date fair value than a reasonable investor might expect.

Genentech's Levinson

Here's a prime example.

On Sept. 20, 2006, Genentech Inc., the South San Francisco- based biotech company, gave CEO Arthur Levinson a 10-year option covering 500,000 shares with a strike price of $79.17, the stock's closing price on the grant date.

Using a 10-year term assumption and other assumptions supplied by Genentech, the option's grant-date fair value would have been $19.2 million.

I then reduced that figure by the average effective discount of 18 percent among the companies in my study to produce a lower grant-date fair value of $15.7 million.

So, what did Genentech tell its shareholders that Levinson's option was worth? Not $19.2 million; not $15.7 million. It was $12.4 million. That's $6.8 million, or 35 percent, lower than the undiscounted value of $19.2 million.

The prime suspect in this accounting drama is the effective option term that Genentech used with Levinson.

A company isn't required to disclose its Black-Scholes assumptions for each grant it makes in a given year. It is required, in its 10-K filing with the U.S. Securities and Exchange Commission, to disclose its average assumptions for all grants. For all grants, the average effective term in 2006 at Genentech was just 4.6 years, less than half the full 10-year term of the option.

Revise Discount

In thinking about this value gap, one needs to note that Levinson wasn't the only Genentech employee to receive a stock option. Therefore, the aggregate gap for all employees is likely to be quite large.

Did Genentech do something illegal here? Not at all. The company simply followed FASB's rules. If Genentech's stock price growth slows or turns negative in later periods, those same rules could rise up and bite the company, causing it to report higher-than-warranted grant-date fair values.

My conclusion: Charging earnings for the cost of stock options doesn't result in greater transparency or improved ability to compare the financials of companies.

FASB should recognize that using a full 10-year term is unrealistic, and it should mandate a reasonable percentage discount from the full-term option value. That discount should be imposed on every company using 10-year options.

To contact the writer of this column: Graef Crystal in Las Vegas at graefc@bloomberg.net.

Last Updated: August 9, 2007 00:00 EDT