Updated from March 30 The Financial Accounting Standards Board returns this week to a battlefield where it was vanquished and left for dead 10 years ago, hoping to revive support for a proposal that would put the cost of stock options in the plain sight of investors on corporate earnings statements. The new proposal, expected as early as Tuesday, is a blow to Silicon Valley, which has fought such regulations for years while continuing its practice of awarding generous options to employees and, especially, top executives. The new rule from the nation's lead accounting body would force that practice into the open, with unforeseen and potentially far-reaching implications on corporate practices and share prices. (On Wednesday, FASB formally
released a draft of the new rule, which is now opened for public comment. The accounting group expects to issue a final rule this fall.) Granted, public companies already disclose the hypothetical cost of options expensing in the footnotes of quarterly reports filed with the Securities and Exchange Commission. Furthermore, the FASB proposal is widely anticipated and many firms have already adjusted their accounting in anticipation. On Monday, for example, Circuit City ( CC) announced it will expense stock options beginning with its fourth-quarter report this week. "It will not very likely have an effect on stock prices at this point," Meir Statman, chair of the finance department at Santa Clara University, said of the FASB ruling. Under efficient markets theory -- which postulates that current prices accurately reflect the knowledge and expectations of all investors -- expensing options should be a nonissue because the information is already available, agreed Ken Broad, a portfolio manager at Transamerica Investment Management. "But that begs the question why the tech industry has fought tooth and nail against it," said Broad, who believes expensing options will ultimately produce a gradual decline in tech industry shares. Of course, the market does not always value stocks in a rational way. "Stocks will probably trade on price-to-earning ratios and the last headline and which broker screams the loudest," said David Blitzer, chief economist at Standard & Poor's. "That's what they'll trade on the day after the FASB" rules go into effect.
For most companies, the impact of the rule has already been factored in, Blitzer said, suggesting the only real casualties are likely to be the handful of companies which, after expensing options, see quarterly profits turn into losses. Still, the new rule on options expensing is likely to push cash flow trends to the fore. "It's not so much that companies will be providing brand new information, but I believe it will significantly raise people's awareness of the fact that cash flows that normally accrue to shareholders or bondholders or go towards capital spending are in fact committed to offsetting dilution," said Vadim Zlotnikov, chief strategist at Sanford Bernstein. (Employee exercising of stock options increases a firm's total shares outstanding; companies often buy back shares to offset such dilution, but that absorbs money that otherwise could have been used to pay a dividend or be reinvested in the company's core business.) Noting that corporate cash balances as a percentage of assets are the highest they've been since World War II, Zlotnikov predicted "the use of corporate cash flows and the disciplined use of cash flow" will be the "single most important controversy" over the next few years. Todd Ahlsten, manager of the ( PRBLX) Parnassus Equity Income fund, said his firm already pays careful attention to whether a given company's stock buyback plan actually reduces its net shares outstanding, or merely offsets the dilution from generous stock options grants. For example, Parnassus found that Intel ( INTC) bought back a net $16.9 billion in stock between 1999 and 2003, equivalent to 9.3% of the company based on the current share count. Yet the company's shares outstanding declined only 2.7% because it had to pay up to offset options dilution. The issue of expensing options has come to the forefront in recent years following the accounting scandals at Enron, Worldcom and other companies. Many governance critics have blamed stock options for the aggressive or illegal accounting that precipitated such fiascos. Because options only have value if a firm's stock rises and have a limited shelf life, governance experts argue their use encourages executives to take short-sighted, risky, and sometimes illicit steps to boost share prices.
U.S. companies are currently allowed to choose whether or not to include options expenses in their income statements. Many firms have chosen to exclude such costs, arguing they are a noncash expense that muddles true results. Meanwhile, most technology industry executives have argued that stock options are all but essential to their survival, providing a crucial means to compensate and motivate workers inexpensively. Intense lobbying by Silicon Valley helped defeat a requirement to expense options a decade ago, and the high-tech industry hopes history will repeat itself. There is growing support in Congress for a bill that would block FASB's latest proposal, The Washington Post reported Monday evening. Still, most observers believe the momentum for options expensing is unstoppable. In anticipation of FASB's proposal, many companies have already changed their accounting and options practices. Most famously, Microsoft ( MSFT) and Amazon.com ( AMZN) have voluntarily moved to expense options. Shareholders at Hewlett-Packard ( HPQ) and PeopleSoft ( PSFT) recently supported similar, albeit nonbinding, proposals. Meanwhile, other tech companies that have not yet adopted options expensing are already taking steps to rein in their options programs. Some 73% of respondents to a 2003 survey of technology company executives by Deloitte & Touche said they are cutting back on their options grants, something Dell ( DELL), Yahoo! ( YHOO) and Intel, for instance, have already pledged to do. Additionally, 83% of respondents to the survey from public companies said they were exploring alternatives to options, such as restricted stock grants, which are actual shares (vs. options to buy shares) that vest over time.
"We're big fans of restricted stock," said Ahlsten. "When we talk to executives, we want to see them hold at least one year of salary in restricted stock and only be able to sell a third in one year. We just think there has to be more alignment between shareholder returns and compensation." While some have argued that options expensing will have little effect on tech industry shares, Broad disagrees. After logistics company C.H. Robinson Worldwide ( CHRW) began using restricted stock instead of options, analysts began writing about how the company's operating costs were going up and its margins declining, Broad recalled. The value of the company's compensation expenses remained the same or even declined; the only difference was how it was reporting those expenses. Technology companies may face similar share pressure once they are forced to expense options. "The fact that
options expense will be on the income statement will make it that much more transparent," Broad said. "Overall, you'll see pressure on multiples." Of course, technology companies could attempt to go the route they've gone with other noncash charges, arguing that analysts and investors should ignore them. Although Microsoft expenses stock options and includes restricted stock charges in its income statement, sell-side analysts exclude those costs from their estimates, Broad noted. There's also the prospect that companies will try to "game" the system. Although FASB plans to force companies to expense options, it does not plan to dictate the method by which companies calculate their expenses. The two leading formulas -- the Black Scholes method and the binomial method -- can lead to two different calculations of expense, even when using similar variables, noted one accounting expert, who asked not to be named. Companies can also lower their options expense by making different assumptions about how long employees will hold them or how much their stock price will change over time, or by reducing the shelf life of options and how many they grant. "I certainly think that companies will review the inputs under the new standard and the flexibility the new standard allows to reduce" reported options costs, the accounting expert said. Indeed, perhaps the only certainty in the wake of FASB's ruling is that calculators all over America will be getting a workout in the coming weeks and months.