Stock Options Charade: High Cost Gets Buried in the
Footnotes
By Loren Steffy
Stock Options Charade: High Cost Gets Buried in the Footnotes
San Diego, March 14 (Bloomberg) -- Qualcomm Inc., whose
wireless communications systems have made it a stock market
darling, earned a record $200.9 million for its fiscal year ending
September 3 -- or at least that's what the company reported to
shareholders and the public.
Qualcomm told a different story on page 72 of the annual
report it filed with the U.S. Securities and Exchange Commission
almost two months later. In a footnote, the company said earnings
would have been cut by 26 percent to $149.1 million if it had
counted as compensation expense the cost of stock options paid to
most of its 7,000 employees.
The San Diego-based company isn't the only one that boosts
its profit by refusing to include options as an expense right
along with salaries, office furniture, and electric bills.
All companies among the 10 whose shares were the best
performers in the Standard & Poor's 500 Index last year --
Qualcomm, Nextel Communications Inc. and LSI Logic Corp. were
numbers one, two, and three -- excluded the cost of options. If
those 10 companies had booked options as an expense, they would
have had their profits reduced -- or losses increased -- by as
much as 139 percent, according to annual reports they filed with
the SEC.
``From a financial accounting perspective, it's just
silliness,' says Ernest Ten Eyck, a former SEC assistant chief
accountant who now runs his own investigative accounting firm in
King of Prussia, Pa. Companies treat options as a no-cost way of
compensating employees, creating what Ten Eyck calls ``cashless
enterprises.'
Compromise
Since 1996, the Financial Accounting Standards Board -- the
independent group that sets reporting procedures for U.S.
corporations -- has required footnotes in companies' annual
reports listing ``pro forma' earnings that state how much profit
would have been if an expense for options were deducted. FASB had
proposed inclusion of the cost on the income statement but backed
off under a rain of protest from option-happy corporations and
their employees.
Companies determine the cost of options in their footnotes by
using the Black-Scholes method. That's the same option-pricing
tool many companies use to set the value of options granted to
executives. While hypothetical, it gives investors an idea of how
much companies are relying on options as part of employees' pay.
Now, with a few years of the pro forma footnotes in hand,
investors are beginning to get a grasp of the consequences.
``For the first time, we've got enough data to figure out
what the costs are,' says Kevin Murphy, a finance professor at
the University of Southern California's Marshall School of
Business.
Real Money
At Microsoft Corp., where all 35,000 full-time employees are
eligible for options, reported earnings in the past three fiscal
years would have been slashed by $1.66 billion, or 11 percent, if
the dominant producer of personal computer software had counted
the options it granted as an expense, according to its SEC
filings. Microsoft declined to comment.
For many companies, there is a widening gap between the
results reported in end-of-the-year press releases and what's
disclosed in the footnotes of annual reports, which can be
hundreds of pages long.
Qualcomm's SEC filings, for instance, show that the gap
between reported and pro forma results was $51.8 million for its
past fiscal year and $50.8 million in the previous year --compared
with $18.7 million in fiscal 1997. Qualcomm treasurer Richard
Grannis says the pro forma results are a tool for shareholders.
``They do not have significance for us, but investors should
decide what they mean,' he says.
Recruiting Cost
Among the top 10 S&P 500 companies last year, Network
Appliance posted one of the widest gaps between reported and pro
forma results. Its net income of $35.6 million for the year ended
April 30 would have been cut by 66 percent, to $12.2 million,
according to its SEC filing.
The Sunnyvale, Calif.-based company, which makes computers
that store files and deliver files over computer networks, needs
options to attract the best employees, spokesman Adam Trunkey
says. ``It's a very powerful recruiting tool,' he says. ``In
Silicon Valley, options are an important part of the compensation
package.'
All the more reason, critics say, that such compensation
should show up on the income statement.
Issuing all of this stock can create what is in effect a
double cost. To prevent the shares created by the exercise of
options from diluting their per-share earnings, companies spend
billions to buy back already-issued shares.
Grant and Buy
Dell Computer Corp., the biggest direct seller of personal
computers, for example, says in its footnote that record fiscal
1998 earnings of $1.46 billion would have been cut by $136
million, or about 9 percent, if it had accounted for the cost of
options. During the same year, the Round Rock, Texas-based company
paid $1.5 billion to buy back 149 million shares of its stock.
Dell spokesman T. R. Reid says the company's option and
buyback programs are the best way to retain employees without
diluting the value of the company's stock. ``The actual cost is
very small,' he says. ``We use part of our consistently strong
cash flow to repurchase stock -- over time making the use of
options in compensation nondilutive.'
While companies refuse to reduce their earnings by including
the cost of options, they are quick to use an options-related tax
break to increase their profits. U.S. tax law allows companies to
deduct as a corporate expense the capital gains taxes paid by
their employees when they exercise their options.
Where to Look
Cisco Systems Inc., for example, got an $837 million boost in
the year ending July 31 by using this tax benefit. The amount
represented 40 percent of its $2.1 billion in net income.
Shareholders didn't find that huge number in Cisco's year-end
earnings announcement. They had to look in the cash flow tables in
Cisco's full annual report under ``tax benefits from employee
stock options.'
In a footnote in the same annual report, the No. 1 maker of
computer network equipment says earnings would have been $498
million, or 24 percent, less if it had charged options granted
during the year as an expense.
For Sun Microsystems, the tax benefit from options in the
year ending last June 30 was $222.4 million -- or about 22 percent
of its $1.03 billion in net income. In its obligatory footnote,
Sun, one of the largest makers of computers that run Internet
sites, says the year's earnings would have been reduced by $130.1
million if it had booked the options granted as compensation.
Railroads and Oil
Computer and telecommunications companies have the most to
gain by ignoring the cost of their options. But other companies
benefit too. Burlington Northern Santa Fe Corp., the number two
U.S. railroad, and Phillips Petroleum Co., the sixth-biggest U.S.
oil company, each would have reported 1998 earnings cut by about 3
percent if they had accounted for the expense. The companies
haven't filed their 1999 reports to the SEC yet.
Not every company ducks the question, however. Aircraft maker
Boeing Co. is one of the few S&P 500 companies to have adopted
FASB's stricter reporting requirements. It changed its accounting
in 1998 to record a compensation cost for options -- a move that
lowered net income by $109 million that year, according to its SEC
filing.
The practice of burying option costs has drawn fire from
investors such as Warren Buffett, who typically eliminates option
plans when his Berkshire Hathaway acquires another company, as it
did with insurer General Re Corp. in 1998.
The Real Thing
Berkshire replaced General Re's stock-option plan with a cash
plan. That raised the company's compensation expense by $63
million. In a letter to shareholders, Buffett said the move means
managers now get their payoff from the business performance they
deliver rather than a rising stock price.
``In effect, accounting principles offer management a choice:
Pay employees in one form and count the cost, or pay them in
another form and ignore the cost,' Buffett said in his letter to
shareholders last year. ``Small wonder then that the use of
options has mushroomed.' While options can motivate top managers,
they often are ``inordinately expensive for shareholders,' he
said.
The controversy over the cost of options dates to the early
1990s, when start-up computer companies began lavishing options on
employees to lure them away from larger competitors. The Financial
Accounting Standards Board called for a revamping of options
accounting, arguing that since options had become a routine piece
of compensation, they should be considered an expense in the same
way salaries and bonuses are.
Protests
FASB's proposal sparked an outcry from companies. Silicon
Valley workers staged a protest. FASB was bombarded with almost
1,800 letters denouncing the idea -- one of the biggest responses
it had ever received for a proposed accounting change. Congress
called for hearings.
The accounting chiefs, fearing Congressional intervention
could undermine their standards-setting authority, agreed to a
compromise: Companies could continue to ignore the cost of options
in their earnings statements as long as they disclosed the expense
in the footnotes.
While the board has no plans to reopen the issue, members
aren't happy with the outcome, FASB spokeswoman Deborah Harrington
says. ``It's not giving shareholders the exact amount of
information they should be getting,' she says.
There's a dissenting view from Goldman, Sachs & Co. analyst
Gabrielle Napolitano. She argued in a report in 1998 that adopting
FASB's proposal would run the risk of overstating options-related
expenses. Napolitano said current methods for valuing options fail
to account for those that expire without being exercised.
Not Always Material
Also, while companies value options in figuring executive
compensation, the methods used are designed to calculate the value
to an employee, not the cost to the company. What's more, while
the earnings of some technology companies could be materially
reduced by adopting FASB's proposal, Napolitano found that the
average impact to earnings for the S&P 500 in 1997 would have been
less than 1 percent.
Murphy of USC, who was an early proponent of using options to
tie executive pay to a company's performance, now believes that
many companies award options indiscriminately -- in part because
they don't have to pay for them. ``It makes executives believe
that the options are free,' he says.
If companies had to deal with the costs up front, there's no
doubt they would reconsider their stock-option plans, Murphy says.
He points out that many companies changed or eliminated retirement
plans after new accounting rules in 1993 made them a reported
expense.
``Once they started having to put it on the books, they
figured out how expensive they were,' he says. Once companies
realized the true cost of options, he adds, ``these broad-based
plans would dry up overnight.'
Companies with the 10 best-performing stocks in the S&P 500
in 1999 would have all had lower earnings had options been taken
into account. Figures are in millions.
Net Income `Pro Forma' Percent Change
Yahoo!** 26 -10 139
Network Appliance 36 12 66
Qualcomm 201 149 26
Teradyne** 102 78 24
Oracle Corp. 814 657 19
Sun Microsystems 1,031 901 13
LSI Logic** D132 -186 41
Nortel Networks D1,282 -1,399 9
National Semiconductor D1,010 -1,069 6 |
