Options Expensing Will Pinch Cash Flow

Many investors have written off the looming hit to earnings that's coming this year as companies phase in the new rules on stock options expensing, but they may be ignoring another source of damage that will play out in the transition.

The rule change will also take a toll on operating cash flow, which may come as a surprise, because many analysts consider cash flow sacrosanct, since they believe it is harder to fudge than earnings.

To understand why operating cash flow may dwindle as the new options expensing rules get phased in, you have to take a step into the mind-boggling world of accounting rules. Here's a simplified version of what's about to play out, and seven companies that may well rue the day options expensing began.

As things stand now, when employees exercise stock options, companies grab a tax benefit based on the difference between what their workers paid for the options, and the price of the stock when the options are exercised.

The difference -- a cost to the company -- is a kind of compensation expense. So it can be used to reduce taxable income.

Under prior accounting rules, all the cash saved by using this tax benefit went right into operating cash flow -- a common cash flow metric that many investors follow to gauge the strength of a business. Under the new rules, a good part of the tax benefit will migrate to financing cash flow -- automatically reducing operating cash flow, points out Patrick Dorsey, the director of stock research at Morningstar, who originally put this issue on my radar screen.

By how much?

It's hard to know for sure, says Marc Siegel, an accounting expert who has been following this issue at the Center for Financial Research & Analysis. But basically, the impact will come whenever companies underestimate expenses related to employee options when they are granted. Under the rules change, the unforeseen tax benefit companies enjoy later on because of this error will move from operating cash flow to cash flow from financing, says Siegel.

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Brush is an award-winning New York-based financial writer. At the time of publication, Brush had no positions in any of the securities mentioned in this column, but he does do occasional consulting work for Edgar Online. In addition to writing for RealMoney, Brush has a weekly market column on MSN Money called Company Focus. He has covered business and investing for The New York Times, Money magazine and the Economist Group. He studied at Columbia Business School in the Knight-Bagehot Fellowship program and the Johns Hopkins School of Advanced International Studies. He is the author of Lessons From the Front Line, a book that offers insights on investing and the markets based on the experiences of professional money managers.

Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.

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