Updated from 10:12 a.m. EST

For years, the technology industry has politely steered discussions away from its aggressive use of options. Now a rule change proposed Wednesday by an accounting oversight board could require many of the sector's biggest companies to reduce sharply their reported profits and state clearly how much options really cost them.

Under the draft proposal published Wednesday by the Financial Accounting Standards Board, any public company that pays employees this way would be required to estimate the fair-value cost of the options using a pricing model, and then subtract the cost as a business expense on its earnings statements.

Previously the cost of options could be more loosely calculated and needed only be disclosed in footnotes in companies' filings with the Securities and Exchange Commission. For the majority of tech companies, it stayed out of the conventional profit and loss picture.

The upshot is that profits at a representative pool of chip companies would nosedive 37% this year if options were expensed, while software outfits would see their net income plummet 65%, according to respective estimates from SG Cowen and Goldman Sachs.

By contrast, 2004 earnings for the S&P 500 would shrink a relatively paltry 9% if member companies expensed options, according to Standard & Poor's.

The accounting shift would mark another setback for the industry, coming only a year after the leading chip trade group and tech giant Hewlett-Packard ( HPQ) separately counseled investors to expect more-modest long-term returns.

Not only could tech companies see their P&Ls suffer more as a result of the rules change, but the shift would suddenly make them look a lot more expensive than in the past. That could force investors to rethink traditional notions of how much they're willing to pay for their stocks.

For example, the average GAAP price-to-earnings ratio for software makers would jump to 56 from 32 after the accounting rule change, noted Goldman. In the past, a P/E ratio of 30 was a common yardstick of valuation for software stocks.

The accounting proposal comes as industry players have already sought to reduce expectations about their long-term growth outlook. In May 2003 H-P predicted that future tech demand overall will grow at only one or two times gross domestic product, compared to more than four times in the prior three decades. In an increasingly saturated market, the Semiconductor Industry Association, or SIA, said in November 2002 that sales are likely to grow only about half as fast in the future, or around 8% to 10%.

Taking a Bite Out of Profits
Figuring in the expense of employee options
Company 2004 EPS (Estimate) 2004 EPS w/options expense Change
Siebel 0.30 -0.45 -254%
VeriSign 0.58 -0.32 -155
Informatica 0.19 -0.09 -146
Mercury Interactive 1.13 -0.47 -142
Oracle 0.51 0.47 -8
SAP 1.32 1.21 -9
Microsoft 1.19 0.98 -18
Source: Goldman Sachs

Timing-wise, companies could conceivably have to start expensing options in 2005 -- just as the highly cyclical chip industry is expected to enter a downturn. The SIA predicts global semiconductors revenue will shrink 6% in 2005, after three years of growth. In what's already likely to be a lean year for the chip sector, the accounting shift should shave an additional 25% off profits, estimated SG Cowen.

Of course, that outlook assumes companies maintain their current policies on options. But many tech outfits have already pushed through sweeping reforms in their compensation programs, either decreasing options overall or reducing the number of employees eligible for them. Dell ( DELL) and Siebel ( SEBL) have both significantly cut their option grants.

Others have changed the terms of their options. IBM ( IBM) said in February that it will only issue out-of-the-money options for executives, meaning they won't realize any gains until the share price rises at least 10% from the date of the grant.

Standard & Poor's expects so many companies to change their policies soon that it declines to project the impact of expensing options on 2005 earnings. "We expect the overall value of options expense will go down and the number of options granted will also go down. We believe there will be a lot of announcements over the next couple of months" as companies rein in generous options policies, said Howard Silverblatt, editor of S&P quantitative services.

To be sure, the residual financial impact of options is felt long after companies reform their policies. For example, last year Microsoft ( MSFT), the world's largest software maker, made a ground-breaking decision to replace employee stock options with restricted stock. But its earnings outlook is still weighed down by options the company has already granted.

For 2004, Microsoft's earnings would fall 21 cents, or 18%, to 98 cents after accounting for the cost of options.

Meanwhile, Wall Street's reaction to reforms at Microsoft underscore that it's not just corporate policies that matter. Equally important is whether analysts pay any attention. Microsoft's move last year to begin voluntarily expensing options when it reports earnings has been largely ignored, with most analysts leaving the options expense out of their estimates. Thomson First Call has followed their example.

Sanford C. Bernstein analyst Charlie Di Bona wanted Thomson First Call to post Microsoft estimates that include options expensing, but the firm rejected his request. "My feeling is if they are not going to take responsibility for setting the rules themselves, they should at least let the buy-side determine it -- not the sell-side," Di Bona charged. (He has a buy rating on Microsoft; his firm doesn't do investment banking but its parent, Alliance Capital, holds Microsoft shares.)

Right now, those who exclude Microsoft's option expense argue that it makes for an easier apples-to-apples comparison with software vendors that don't expense options.

Until the accounting rule change actually goes into effect, Thomson First Call said it will not break out earnings estimates that include stock options expenses if the majority of sellside analysts don't want to provide them, according to research analyst Ken Perkins.

To be sure, plenty of money managers say they already figure out the impact of options, leading some to argue that the shift to expense options is mostly factored into tech stock prices .

Todd Ahlsten, manager of the Parnassus Equity Income fund, said studying Intel's ( INTC) spending on options-related share buybacks has helped him more accurately estimate the company's discounted cash flows and therefore value the stock. (He doesn't currently hold the stock because he considers the valuation relatively high, but says he likes the company and has owned it in the past).

At Stein Roe Investment Counsel, buyside technology analyst Chuck Jones said he already tracks trends in options issuance and considers what earnings would have been after expensing, also noting how much companies generate in cash flow and what they spend on share buybacks.

In that sense, the focus on options expensing is part of a broad trend toward a more cautious evaluation of tech companies' prospects. "Whereas before we were driven by this vision of unlimited opportunity, now investors in technology still have optimism. But today they are starting to realize it's not unlimited," said Vadim Zlotnikov, chief strategist at Sanford Bernstein.

Dude, Who Took My Profits?
Estimated percent decline in profit at leading chipmakers
Company 2004 2005
Intel 12.3% 10.1%
Texas Instruments 23.5 16.7
Advanced Micro Devices 58.3 38.8
Linear Technology 24.1 18.6
Maxim 33.2 24.1
Analog Devices 39.0 25.8
Source: SG Cowen.
Option expense estimate based on Black Scholes.