UTStarcom Finds Options Loophole

The company accelerates some options, eliminating the need to count them against earnings.
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Bottom lines under pressure, some companies are finding a release valve in an unexpected place: a hotly contested accounting rule change.

Take

UTStarcom

(UTSI) - Get Report

. As fourth-quarter numbers started rolling in last month, it became clear that the wireless equipment company's anticipated slim profit was shaping up instead as a bulging loss. Indeed, the stock plunged 20% Friday after UTStarcom

warned of a steep shortfall. Unable to salvage the quarter, UTStarcom seems to have looked for ways to boost future profits.

Help came calling in a rule issued by an obscure accounting organization. The Financial Accounting Standards Board

ruled last month that U.S. public companies must start counting the cost of employee stock options against their earnings, starting in June. Fans of the rule, which overcame vocal opposition from some of Silicon Valley's biggest names, say it will give investors a more accurate picture of corporate compensation expense.

What no one counted on, though, was that companies might use the rule to help make their numbers look better. That's just what UTStarcom did last week when it accelerated the vesting period for options on 6.4 million shares of company stock. Of those options, 940,000 are held by six top executives, according to a

Securities and Exchange Commission

filing.

By vesting now, observers say, a company can remove the associated options expense from its income statement -- boosting profits over the life of the option's term. Though that clearly isn't what FASB intended, analysts and investors say you can expect to see more instances of accelerated options vesting in search of profit gains.

"It's silliness," says accounting gadfly Albert Meyer with 2nd Opinion Research. "Companies will simply plug in different assumptions and see which one costs less. It becomes a game."

Long Battle

The FASB has been striving for years to get companies to record the so-called fair value of stock options in quarterly financial reports. Some tech execs, notably

Cisco's

(CSCO) - Get Report

John Chambers, have contended that options expensing would undercut the ownership ethic that has made Silicon Valley the wealth-generating juggernaut it is. On the other side have been companies including

Microsoft

(MSFT) - Get Report

that have backed away from employee stock options, saying they fail to sufficiently align management's interests with shareholders'.

Now, barring any congressional intervention, companies will have to recognize the value of stock options over the life of the vesting period, typically three to five years.

But the reform, which hoped to shine a light on hidden stock compensation costs by treating them as real expenses, is fast becoming something that looks more like a tax code for cunning accountants to run around, say some critics.

Indeed, UTStarcom's posture may soon be adopted by many companies that currently do not account for stock options as a compensation expense. In fact, some 383 companies, or 77% of the S&P 500, currently use the so-called intrinsic method under which no stock-option expense is recognized, according to Credit Suisse First Boston analyst Dave Zion.

Among the early leaders in the early-vesting game are hospital operator

HCA

(HCA) - Get Report

. On Dec. 16, the day FASB wrote its final version of the rule, HCA made options on 19.1 million shares immediately exercisable. The company boasted that the accelerated option vesting will save $83 million in future compensation expenses.

A UTStarcom representative said the company was in a quiet period and declined to offer any cost-savings estimates on its accelerated vesting. The company posted preliminary fourth-quarter results Thursday, showing an estimated net loss of as much as 45 cents a share due to a whopping 16% sale shortfall.

UTStarcom makes cell phones and networking gear primarily for developing regions like China. Lately, the company has been looking for ways to expand its business beyond China, where it had pioneered a short-range wireless phone system but now faces increasing challenges from conventional cell phone services.

On a conference call with analysts Thursday, CFO Mike Sophie acknowledged that the company is in a difficult transition period. Yet while dropping its sales target for the first quarter ending in March, the company guided for a stronger profit -- about 22 cents per share. Some analysts had been looking for a dime a share.

Though the company offered no detailed explanation for its optimism, CFO Sophie listed a few factors, including changes in stock compensation costs. He said he would discuss the matter in more detail during a Feb. 8 fourth-quarter earnings report and call.

Cutbacks

In annual reports, companies are required to show the impact of stock option expenses as if they were charged to earnings. CSFB analyst Zion estimates that total 2003 earnings for the S&P 500 would have been cut by 8% if the FASB rule was applied.

But stock compensation costs ran a little higher for UTStarcom. In 2003, UTStarcom would have had to subtract $27 million, or 26 cents a share. That's a 13% cut.

Though early, 2005 doesn't exactly look like a year of fat profits for UTStarcom. So it's probably no coincidence that the company removed some looming compensation costs by giving six executives immediate exercise rights on their options to shave a few critical pennies of expenses.

"It's so farsical that it's mindboggling," says accounting critic Meyer, referring to companies' actions in general and not UTStarcom's move in particular. "FASB writes a rule that tries to address the true economic substance of stock options, and companies treat it like a tax loophole."

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