Ingram: A bandwagon worth jumping on
16:41 EDT Thursday, August 15, 2002
These are strange times in the business world, with companies going bankrupt right and left, and a wave of multibillion-dollar accounting scandals. But even in that context, something unusual is going on: Growing numbers of corporations are changing the way they report their results — a change that makes their performance look worse — without being required to by regulators or lawmakers. They are expensing stock options.
About 10 years ago, the Financial Accounting Standards Board (FASB) — the rule-setting body for U.S. companies — tried to change the way stock options were treated, by requiring corporations to treat them as an expense. Business groups howled in protest, saying this would impose unreasonable costs, depress their earnings, and cause investors to dump their shares. As a result, FASB eventually watered down its proposal.
Companies argued that expensing stock options was unrealistic, since no money changes hands on the issuance of these phantom shares — or rather, the right to purchase and sell shares at some future price. Only when the shares are sold is there a cost, the theory goes, and that is balanced by the benefit of receiving payment for them, and also by the (presumably) superior performance of the executives who were awarded them.
The counter-argument is that options are a form of expense even if no money changes hands, since awarding them both dilutes the holdings of existing shareholders (when the shares are sold) and takes the place of a regular share issue — which would bring in real cash. If companies such as WorldCom and Nortel Networks had issued stock for cash instead of options, for example, both would be better off. Companies also spend billions buying back stock to counteract the dilutive effect of options.
As recently as three months ago, only two members of the Standard & Poor's 500 index recorded stock options as an expense on their balance sheet: airplane maker Boeing Corp. and the Winn-Dixie chain. Then, a trickle of companies started doing so, with one of the first being Toronto-Dominion Bank — and now, the trickle has become a flood. Coca-Cola said it would, then General Electric, then General Motors, and this week, 18 financial firms said they would, including Citigroup and Morgan Stanley.
The main impetus for this has been the fact that investors are looking for companies that have nothing to hide — and, rightly or wrongly, the perception is that those who refuse to expense options are trying to inflate their results (since not expensing options tends to boost earnings). The trend has been accelerated by comments from market gurus such as billionaire investor Warren Buffett and Fed chairman Alan Greenspan.
"Reporting stock options as expenses is a sensible and positive step toward a clearer and more precise accounting of a company's worth," Mr. Greenspan said in a recent statement. "The failure to expense stock option grants has introduced a significant distortion in reported earnings." Mr. Buffett, meanwhile, wrote in an op-ed piece in the New York Times that "flagrant deceptions" have occurred with respect to options, something that "dwarfs the lies of Enron and WorldCom."
The result is that hundreds of major U.S. companies have decided to make the change, even though they are not yet legally required to do so. Is it because some companies believe they can win 'brownie points'? Perhaps. Despite the fact that expensing options depresses earnings, the shares of many companies that have made the change have risen in value, according to Fortune magazine. Is it because some companies see rule changes coming eventually, and want to get it out of the way now? Possibly.
Whatever the reason, the fact remains that this relatively substantial — and formerly contentious — policy change has started to become an industry standard without any of the rule changes that are usually required to get companies to alter the way they do things. The more blue-chip companies that expense options, the more those that don't will look less attractive to investors.
Everything isn't quite that rosy right now, obviously. Most tech companies — including Intel, Microsoft and Cisco — have refused to jump on the bandwagon, arguing that it would hit their profits too hard. In the case of some companies, such as Dell Computer and Cisco, their profits would be decimated, falling by 70 per cent or more. Some argue that expensing options is a fad, and doesn't make things any clearer.
It is true that the process of expensing options is not without its hurdles — the most common method of arriving at a current price, the Black-Scholes equation, has some problems. However, companies routinely estimate the value of things, such as goodwill or the 'real' value of assets such as factories or equipment. It may not be easy, but a consensus seems to be emerging that expensing options is the way things should be done, and if enough companies go along, then it will become the norm.
Copyright © 2002 The Globe and Mail
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