How should companies account for the costs of the options they give employees? It seems like an arcane bookkeeping question. But the stakes are huge: If the estimated cost of options were taken as an expense against earnings in 2000, the net profits of Standard & Poor's 500-stock index companies would have been 9% lower than they reported, according to Bear, Stearns & Co.
Enron's collapse has brought the issue to a head by exposing the incentives executives have to inflate earnings in order to profit from huge options grants. And critics say one reason grants have become so big is that companies can give them to executives cost free. To reduce that risk, Senators Carl Levin (D-Mich.) and John McCain (R-Ariz.) say that if businesses want to keep getting a tax deduction for options' costs--as they do now--they should also start counting the expense against earnings.
Business is going to war against the idea. Backed by lawmakers such as Senator Joseph I. Lieberman (D-Conn.), groups ranging from the U.S. Chamber of Commerce to Silicon Valley trade group TechNet are battling to preserve current rules. Today, companies do not have to deduct the cost of options from their income statements. Thus, options related expenses never appear on their bottom line. Corporations only include a footnote in their annual report that estimates the future value of options when they are granted.
CEOs say such disclosure is enough. They argue that options are not really a cost, since no cash ever goes from a business to a worker. "There's no logic to expensing stock options," says Kim K. Polese, chairman of software management company Marimba Inc. (MRBA ) They also say that estimates used for the footnotes are little more than guesswork. So including those numbers as an expense in the profit-and-loss statement would just confuse investors.
But options do have a real financial impact on a company when exercised. Here's why: Say the strike price of an option is $20 and the market price of the stock when the option is cashed is $100. In effect, the company gives the worker stock for $20 that it could sell for $100. The $80 difference is a real expense, since it would otherwise go into the corporate coffers.
Treasury Secretary Paul H. O'Neill has a better idea: "The cost of stock options ought to be charged toearnings when the options are exercised," O'Neill told BusinessWeek on Mar. 15. "You gave people a ticket to grab the brass ring. When it gets turned inyour shareholdersought to see the consequences on the bottom line."
O'Neill says he is speaking for himself and not the Administration. But his idea has strong support. It is being studied by the International Accounting Standards Board--a London group developing global disclosure rules. Adds Tim Lucas, research director of the Financial Accounting Standards Board: "It would solve a lot of problems."
Of course, companies complain that it would force them to take a big hit to earnings when lots of options are exercised. To avoid this, they could estimate options' costs over their lifetime, making adjustments each year, says Mark Rubenstein, a finance professor at the University of California at Berkeley. Or they could report costs gradually as employees become eligible to cash in options.
The tech industry and its suppliers are unconvinced. Kim Boylan, a partner in the Washington law firm Mayer, Brown, Rowe & Maw, calls it "a wildly bad idea." Her objection: "You are bringing the stock price into the [income] statement."
If that makes a business uncomfortable, perhaps it is because the shift would highlight just how much companies spend when they fork over oodles of options to their execs. True, properly accounting for options is not easy. But ignoring their costs is hardly the right solution. The point of disclosure is to provide the best information possible about a company's financial position. As options have become a bigger part of that picture, huge costs are being masked that investors should see.
By Howard Gleckman