Expensing Options: More Detours

The SEC may allow companies to pick their method of valuing options, delaying much-needed reform and making earnings comparisons even tougher

By Robert D. Hof

Here we go again. Any day now, the Securities & Exchange Commission is expected to put off the day of reckoning for many public companies that were prepared to start counting employee stock options as an expense come June 15, 2005. Already, the Financial Accounting Standards Board has given private businesses a six-month reprieve, to Dec. 15. Now, it looks as though the SEC will give larger, public outfits -- whose fiscal year closes at the end of December -- until Jan. 1, 2006, to start expensing, too.

Trouble is, regulators have been putting off expensing reforms for more than a decade. With these new delays, it could be several more years before the promised benefits of expensing options -- clearer, less opaque earnings statements -- finally get to investors. If they arrive at all, that is. Attorney William D. Sherman, co-chairman of Morrison & Foerster's public company group, fears the drive for expensing may be losing momentum. Says Sherman: "There's now a meaningful chance expensing could get delayed indefinitely."


  Most observers aren't that pessimistic. For years, companies have been allowed to leave the cost of options off their income statement, boosting their reported earnings. At the same time, they take a tax break for the phantom expenses. They also spend billions in cash on buybacks to fund options grants, diluting the value of their stock.

In truth, a temporary delay could be justified -- and prove to be constructive. Companies have been struggling mightily to conform with disclosure requirements mandated by the new Sarbanes-Oxley law, causing delays in financial statements. Sources say the SEC realized that companies had too little time following the just-ended proxy season to get all their options ducks in a row by June 15.

Fair enough. The bigger problem, that the SEC seems to be wavering on the key issue of how to value options, could cause even longer delays in real reform. On Mar. 29, it issued a bulletin suggesting that companies will be able to choose from a variety of methods for valuing options. Valuation ranks as the biggest concern of corporations. All this time, they could have been researching the best ways to value options instead of fighting what their own investors want. Now, unfortunately, this research process gets pushed into the future again.


  The traditional expensing method, called Black-Scholes, was devised for freely traded options, not employee stock options. The results may well inflate the true value of employee options, which aren't traded and vest over a number of years. That's why FASB instead suggested an alternate method, called binomial lattice. But that, too, has been criticized as valuing options too highly, thus unduly hitting the bottom line.

Now, it looks like companies will be freer to choose from among many valuation alternatives without fear that the SEC will crack down on their choices if the decision later turns out to be imperfect. No wonder opponents of options expensing are smiling, if cautiously. "The SEC's allowing latitude on valuation is a good step in the right direction," says Mark Heesen, president of the National Venture Capital Assn.

Providing such flexibility could prove to be a shrewd move over the long run. Some experts doubt the SEC will allow companies to tinker with the numbers any way they wish without clearly disclosing what they're doing. "The SEC has been clear there has to be a lot of transparency," says Fred E. Whittlesey, a senior vice-president at Aon Consulting/Radford Surveys, a compensation-consulting firm. "It can't be a black box."


  Moreover, it appears unlikely the SEC will accept an extensive menu of options-valuation methods forever. Instead, says Whittlesey, it likely will study what best practices emerge and, within a couple of years, issue more definitive rules.

Still, that's a long time. In the interim, it may take a degree in forensic accounting to compare earnings by companies, even in the same industry. One perverse outcome of an options-expensing smorgasbord could be that analysts start comparing pro-forma earnings of companies they cover, as they did during the tech boom years, in order to level the playing field. That's a fuzzy measurement that's open to potential abuse.

And what about smaller businesses looking for guidance from larger outfits? Delays for large public companies also delay the emergence of best valuation practices. "We were supposed to try to learn from what the big companies do," says Heesen. So an SEC delay on expensing for large companies "could be a detriment," he adds.


  There's a better solution, at least from investors' point of view: The SEC should just designate what it believes to be the most promising method and require all companies to use it. A wide variety of outfits, from IBM (IBM ) and Microsoft (MSFT ) to Amazon (AMZN ) and Netflix (NFLX ), have already expensed options and started to explore potentially better alternatives such as restricted stock. There's no evidence their stock prices have suffered as a result.

In fact, study after study indicates that investors will take the earnings hit -- a noncash expense, by the way -- in stride and won't penalize companies whose earnings take a paper hit. Most prefer a fair game over inflated scores.

"If you had one formula, it would be easy to make comparisons," says Corey Rosen, executive director of the National Center for Employee Ownership. "The more complicated it is, the less transparency there will be." If the chosen method proves to be off, it will become apparent quickly enough and can be changed -- again, for all companies at once.


  Let's just hope tech companies don't use the interim to keep trying to fight expensing. If they accept expensing as inevitable and in the spirit of better corporate accounting, they'll have more time to come up with best practices that benefit everyone. "The longer people have to get used to this, the less scary it will become," predicts Rosen.

Scary or not, expensing is something companies should get used to sooner rather than later.

Hof is Silicon Valley bureau chief for BusinessWeek

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