How Expensive Will Expensing Options Be?

A talk with accounting expert Pat McConnell on the impact of stock options on earnings

The nation's accounting rulemaker, the Financial Accounting Standards Board, has unveiled a long-awaited plan to require companies to treat stock options as an expense on income statements -- just as they would any other form of compensation. Many tech companies that rely heavily on stock options have criticized the move. But while a similar plan was shot down a decade ago, the fallout from recent accounting scandals is expected to help this one prevail. BusinessWeek Personal Finance Editor Anne Tergesen asked Bear, Stearns's (BSC ) accounting and tax policy analyst, Pat McConnell, what investors need to know about the proposed change that's scheduled to take effect on Dec. 15.

How much of a hit will earnings take?

If options had been expensed in 2001 and 2002, the [Standard & Poor's 500-stock index] operating earnings would have been almost 20% lower. In 2003, there would have been an 8% reduction. This year we estimate options will clip the bottom line by just 3%. And in 2005 the impact will be even smaller.

What accounts for this trend?

You had very highly valued grants -- made from 1997 through 2000 -- flowing through income just as earnings were depressed by the recession in 2000, 2001, and to some extent in 2002. But as the S&P 500's earnings have risen, [the value of] stock options as a percentage of that number has declined.

The number of options granted has fallen because options are often given as bonuses, and when earnings are down, bonuses fall, too. Also, in anticipation of FASB's move to require expensing, some companies have begun to reduce grants.

Do you think the new rule will improve earnings quality?

Absolutely. It brings earnings closer to economic reality because an element of compensation was missing before. Still, FASB may want to consider requiring companies to restate 2003 and 2004 earnings to include stock options expense -- which the proposal does not do.

So 2005 earnings will include stock options expense while those from previous years will not?

Yes. But the footnotes to the financial statements tell you what net income would have been in previous years if stock options had been deducted. So it's easy to look in the footnotes to put those years on a comparable basis.

The new rule will also reduce operating cash flow at some companies. Why?

When employees exercise options, the company receives a tax deduction. This benefit has been counted as an improvement to cash flow from operations. Under the new rule, though, in some cases only part of the tax benefit will go into operating cash flow. Specifically, if a stock's market price on the option's exercise date is higher than the cost the company recognized plus the price the employee paid for the share, the tax benefit on that excess goes into cash flow from "financing."

What's the rationale for the change?

There has been a tremendous amount of controversy over whether that tax benefit should be included as an operating or financing cash benefit. Many people believe it's financing because companies often use the tax benefit -- along with the proceeds of employees exercising options -- to buy back their stock. Buybacks are classified in the financing section of the cash-flow statement.

Can you provide an example of a company that may report lower operating cash flow because of this change?

If the new rule had been in effect in 2003, Yahoo! (YHOO ) would have reported 14% less in its operating cash flow.

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