Commentary: Accounting Changes That Keep Investors In The Dark

It has been a rough winter for Wall Street analysts and investors. They have reset their earnings models to factor in the Asian economic crisis and wrestled with gyrating currencies and a market made nervous by Presidential peccadillos. Now, with fourth-quarter earnings reports, comes a new wrinkle: a change in the way that companies must calculate and report earnings per share.

The new Financial Accounting Standards Board methods do bring U.S. accounting standards closer to international ones. And they also shed some light on the dilutive impact of some stock options. But they don't go far enough. The new standards, for example, do not force companies to include all options in their earnings-per-share calculations. And they do not require companies to assign an explicit cost to any options, which many companies continue to view as a magical, free way to pay executives enormous sums. Says Lehman Brothers Inc. accounting expert Robert Willens: "People who would like to see options accounted for officially will be disappointed to find out that this doesn't advance that objective one iota."

"BUYING OPPORTUNITY." One thing the new rules have done is create investor confusion. When Automatic Data Processing Inc. reported second-quarter diluted earnings of 49 cents a share on Jan. 16, it originally seemed to have missed analysts' consensus estimates, which were based on basic earnings-per-share numbers. Comparing the results to diluted earnings per share, though, ADP had matched estimates. "To the extent that someone reads the numbers wrong," says John H. Shaughnessy, chief investment strategist for Advest Inc., "it does provide some buying opportunities."

The new rules are supposed to simplify earnings-per-share calculations. Instead of the primary and fully diluted earnings-per-share reports required since 1969, companies reporting after Dec. 15, 1997, must give two new earnings-per-share numbers: basic, or net income simply divided by the number of shares outstanding, and diluted, which include in-the-money options and convertible securities in the share calculation. The new diluted number is nearly identical to the old fully diluted earnings. But the new basic number, which is--well--basic, can be compared to diluted earnings to provide a clearer picture of what a company's earnings per share would be if it had no options outstanding.

Investors can glean some information about options dilution from the new earnings rules. For example, in Merrill Lynch & Co.'s fourth quarter, primary earnings per share would have been $1.17 and fully diluted earnings $1.17. Using the new rules, Merrill's diluted earnings were still $1.17--but its basic earnings per share were $1.37. So its in-the-money options helped dilute earnings by 20 cents a share, or nearly 15%.

Even that difference, though, does not reflect the total cost of stock options for Merrill. It's only in footnotes to financial statements that companies have to disclose the total earnings-per-share impact of all the options they have issued. At Merrill, the options not included in its 1996 fully diluted earnings would have reduced earnings per share by 2% had they been part of the income statement.

As long as options don't all have to be included in income calculations, they will remain Corporate America's favorite way to pay executives. For example, Walt Disney & Co.'s huge grant of 8 million options awarded to Chief Executive Michael D. Eisner in 1996 never appears as a cost on Disney's income statement--even though the options could eventually cost the company tens of millions. And 1 million of the shares do not even appear in earnings-per-share calculations, because they are still out of the money.

The new rules may get investors to wonder why companies granting options get a free ride in the accounting world--and why investors pay for that ride through dilution. As it is, FASB has made sure there is still some free lunch--at least where executive pay is concerned.

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