To Expense or Not to Expense

In the debate over stock options, expensing is picking up steam

Just weeks ago, it looked like the truth-in-accounting brigade was losing the battle to force companies to deduct from earnings the value of stock options granted to executives and employees. Congress sidestepped the issue three times in five months. The Financial Accounting Standards Board (FASB), the group charged with setting accounting rules, didn't want to touch it, either. Even the board of the California Public Employees' Retirement System, the nation's largest public pension fund, shelved a staff recommendation calling on companies to expense options.

But the corporate scandals that have ignited public zeal for accounting reform are suddenly placing stock options in a harsh light. Many experts now conclude that stock option overload contributed to the accounting fiascos at companies such as Enron Corp. and WorldCom Inc. Eager to cash in their options, managers may have resorted to questionable accounting practices and hasty acquisitions to pump up earnings and revenues and boost share prices. Rather than align the interests of shareholders and management, options seem to have done the opposite: transferred vast amounts of wealth to executives, even as outside shareholders have suffered. That's put those who oppose stock options expensing, like John Endean, president of the American Business Conference, a trade group of midsize companies, on the defensive: "Stock options are now seen as the problem rather than the solution," he concedes.

Curbing the use of options by forcing companies to count them as an expense is the reform du jour. Bowing to investor demands for more transparent accounting, Coca-Cola Co. (KO ) on July 14 said it would start expensing options as of this year's fourth quarter. Pushing hard for the change was board member Warren E. Buffett, CEO of Berkshire Hathaway Inc. (BRK.A ), Coke's largest shareholder. The Washington Post Co., where Buffett is also a director, and Bank One quickly followed Coke's lead. And a handful of other blue chips, including Ford (F ), H.J. Heinz (HNZ ), and Gillette (G )--another Buffett company--said they are considering expensing options like they would for any other compensation cost. "It's a new environment today," says Coke Chief Financial Officer Gary P. Fayard. "There's no question that stock options are a form of compensation."

The handful of corporate capitulations emboldened Senate Majority Leader Tom Daschle (D-S.D.) to promise a vote on a measure that would direct the FASB to decide in one year how options should be treated in financial statements.

Even if that fails, options' cost-free status could be upended by reforms across the Atlantic: On July 16, the International Accounting Standards Board (IASB) in London announced it would propose new rules by yearend to require all European Union companies to expense stock options within five years. If the IASB follows through, the U.S. board is likely to renew its long-dormant crusade for stock option expensing, say FASB sources. One reason: Congress is about to place the FASB, which lost a bitter battle over options expensing in 1994, on a more independent footing. Pending legislation would require all public companies to contribute to the FASB's funding, thus freeing it from pleading for funds from companies and accounting firms to which it is then beholden.

Moreover, the FASB, under new Chairman Robert H. Herz--who previously served on the IASB--is publicly committed to harmonizing U.S. and international accounting standards. If the IASB requires stock option expensing, the FASB "will have to act," says Patrick McGurn, vice-president of Institutional Shareholder Services Inc., which advises pension and mutual funds. "Otherwise, the U.S. will be seen as having substandard accounting."

No less than Federal Reserve Chairman Alan Greenspan thinks the momentum for counting options as an expense is unstoppable. "It's going to happen, and quite appropriately so," Greenspan told the Senate Banking Committee on July 16.

Many companies insist the rush to adopt expensing is misguided. The argument: Stock options do not require any actual cash outlays, so should not be counted on the income statement as compensation costs, as are salary or bonuses. Companies warn that expensing options will depress earnings and cause further declines in share prices. And if companies decide to curtail the use of options as a result of having to expense them, they will lose a valuable tool to recruit employees and motivate executives. "When management doesn't have skin in the game, they don't have any interest in what happens to the share price," says Continental Airlines CEO Gordon M. Bethune.

That's a debatable point, of course. What's more critical is to restore investor confidence--and expensing stock options will go a long way toward the goal, says Buffett. For years, Buffett has been one of the leading voices, along with a handful of institutional investors, supporting expensing of options. Other companies that follow Coke's lead, says Buffett, will "develop a reputation for being believable, for not hyping things, and will be valued more than those whose CEO is flim-flamming [investors]."

No doubt, deducting the cost of stock options on the income statement will reduce earnings. On average, estimates Standard & Poor's, expensing options would have trimmed the S&P 500-stock index's 2001 earnings-per share of $24.69 by 24.5%, and it would cut this year's estimated EPS of $35.47 by 17%. That means stocks will look more expensive.

For Silicon Valley, whose entrepreneurial culture is highly dependent on employee ownership, the cost of expensing stock options could be particularly steep. Cash-poor startups use the lure of options--with the possibility of big riches down the road--to attract top engineers and software writers. "Without options, it's going to be hard to recruit new talent," says Mark Heesen, president of the National Venture Capital Assn. What's more, morale and even productivity could decline. If forced to expense options, tech execs warn, they will no longer dole them out to everyone from the mail sorter to the chief programmer. "The options that are going to go away are those that go to rank-and-file employees," warns Alfred P. West, Jr., CEO of Oaks (Pa.) asset manager SEI Investments.

While CEOs like to note that more than 90% of those getting options are the foot soldiers in their companies, 80% of the value goes to the most senior executives. "It's true that a lot more people are getting stock options today, but most of the benefit is going to managers," says Corey Rosen, executive director of the National Center for Employee Ownership, an independent think tank.

Along with employee morale, the federal budget deficit could take a hit. Mark Zandi, chief economist at consulting firm Economy.com, says that if the value of options offered and exercised shrinks by, say, 25%, individual income tax payments from stock options would drop by about $15 billion. This would be significant in light of the $165 billion budget deficit, but modest in the context of $2 trillion in tax revenues.

Still, such prominent critics of the existing treatment of options as Alan Greenspan point out that it allows companies to reap a double bonus. Not only do they avoid expensing the costs of options, they also can deduct from taxes the difference between the issue price and the exercise price. Microsoft Corp. (MSFT ), for example, showed a $2 billion benefit in 2000 from the tax deduction, while its net income was $2.2 billion higher by not having to expense options, according to a report by Credit Suisse First Boston.

Because companies can take a tax deduction and still not expense options, many doled out stock options willy-nilly. "Not expensing [options] has been an important source of the distortion of executive pay," says Kenneth Bertsch, director of corporate governance at teachers' retirement fund TIAA-CREF. Indeed, roughly three-fourths of executive compensation now comes in the form of options.

To many corporate governance experts, less-hyped earnings figures will boost confidence and bring back rattled investors. That's why companies like Coke are reacting by giving the market what it seems to be demanding: more transparency. If Coke had expensed options in 2001, earnings-per-share would have dropped by only 9 cents, to $1.51 from $1.60. Because Coke is not a big issuer of options, it's relatively easy for the soft-drink company to look bold and make the switch. Indeed, stock option grants represent only about 1.8% of Coke's 2.5 billion shares outstanding.

Other consumer goods, manufacturing, and retail companies, hoping for a reward from investors, may follow Coke's lead. "It gives the company a good image in the investment community," says Tim Drake, senior equity analyst for Banc One Investment Management, which owns 8.4 million Coke shares. Coke's share price rose 95 cents, to close at $52, on July 15, after its announcement. "Companies that convince their investors that they're committed to clear, candid, and conservative accounting are going to win the race for capital," says Nell Minow, a corporate governance activist.

Until recently, that race was won by the companies that boosted earnings at any cost, even if it meant exaggerating revenues, hiding losses, and fraudulently listing everyday expenses as capital expenditures. The new winners will be the companies that play by the rules.

By Amy Borrus and Paula Dwyer in Washington, with Dean Foust in Atlanta, Louis Lavelle in New York, and bureau reports

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