Britt,
Here's a June 26 article from the WSJ regarding stock options and their effect on reported earnings.
For people not that interested, you can skip to the chart at the bottom of the article.
Changes May Be Coming
For Stock-Option Accounting
By ROGER LOWENSTEIN
In the 1930s, after the stock market had
crashed, public hearings revealed that the
Morgan bank had favored well-known politicians
and other cronies with hot new stock issues at
bargain prices. When the public found out about
this legal-but-undercover-and-excessive lucre, it
was nauseated.
If there is ever an accounting of the current era,
the spotlight, I believe, will shine on the
legal-but-excessive pay pocketed by corporate
kingpins. But no one will be able to say, as in the
'30s, "How could we know?" This time, the tune
will be, "We didn't want to know."
The Financial Accounting Standards Board
fought a long battle to force corporations to
record the expense of stock options but caved in
when high-tech industries persuaded Congress
that without the ability to sanitize their earnings,
Silicon Valley would revert to the stone age. The
FASB, which has yet to regain its respect (lotsa
luck to its new chairman, Edmund Jenkins),
settled on a humorous compromise: Every
company would disclose in a footnote the
earnings it would have reported after deducting
options, but its actual reported earnings-the
number that goes to investors, securities
analysts, Wall Street, the press, the chief
executive's mom and other interested
parties-would be unencumbered.
The issue won't go away because options are
multiplying like rabbits, because the footnotes
(this is their first year) are baring some
interesting numbers and because legislators
turned off by paychecks that are literally
unaccounted -- for are making noise.
Bill Archer, House Ways and Means chairman
and no Trotskyite, flirted with but dropped a
plan to curtail tax deductions for options. A
more-interesting, bipartisan proposal still is
breathing in the Senate. John McCain (R., Ariz.)
and Carl Levin (D., Mich.) have co-sponsored a
bill, which they are hoping to tack on to the
pending tax package, to limit deductions for
options to the amount that companies expensed
on their earnings.
You have to think about this carefully to gather
in the irony. When companies report to the
Internal Revenue Service, they eagerly deduct
the expense of options, thus reducing their taxes.
There are those who maintain that the expense
isn't "real" and that the deduction amounts to a
subsidy-cum-corporate-welfare, but you won't
find anyone at the Business Roundtable taking
that view. "On the tax issue it clearly is a
legitimate expense," Ken Glueck, Oracle's man
on the Potomac, told me.
But the issue of how to treat options in the
earnings statement is, according to the same Mr.
Glueck, "a true conundrum." On form,
companies that are powerfully clear-headed
when a tax deduction is at stake are overcome
by accounting subtleties when it comes to taking
a hit to reported earnings.
Under McCain-Levin, companies could still take
the tax deduction, but only to the extent that they
also took the earnings hit. (The FASB already
encourages companies to record the expense, but
none that I know of do so.) This would be
decision time for CEOs. They would have to
choose between a tax deduction or higher
reported earnings-more bluntly, between hard
cash and accounting fiction.
You'd think that would be a nonissue -- take the
cash, drop the fiction, right? Not so fast.
Companies are apoplectic about McCain-Levin
(and will probably stop it in its tracks).
Preserving the fiction that options don't have a
cost is what the fight over options has always
been about.
For some big companies, such as General
Motors, the effect of expensing options would be
immaterial. For others, like Seagram and MCI
Communications (see chart), it would knock off
more than 5% of earnings. For start-ups like
Netscape it would wipe out current earnings
entirely.
The cry in the Valley is that options are part of
the culture; software geeks get most of their
reward from stock options and wouldn't work
without them. So be it. No one's taking them
away. But as matters stand, the Netscapes of the
world are telling shareholders that their help
largely works for free, which they don't. By
expensing options, they would be saying, "We
have made promises to share a large part of our
future profits with the staff." Which is a fact.
Microsoft, for instance, earned $1 billion in the
first quarter of 1997, yet spent double that on
buying back stock. Despite repurchasing all that
stock, its shares outstanding fell only slightly,
due to its issuance of options. As far as the
income statement is concerned, the quarter's
profits seem to have disappeared. So options
would seem to have some cost.
McCain-Levin has some flaws in the details, but
by proposing to use a company's self-interest as
a hammer to encourage honest reporting, it's the
most intriguing fix on the table. As with
disclosure remedies generally, markets (albeit
better informed ones) would still make the call.
CEOs would be free to decide what markets
valued more-accounting form or real money.
Shareholders would be free to discount, or not to
discount, shares with lower reported earnings. At
the margin, management might cut back on
options -- it would depend on competitive
pressures. But then, cutting the cake between
capital and labor always involves a trade-off. To
argue that telling the truth risks a bad result is
contemptible.
Less Than Meets the Eye
Reduction of reported earnings from including
the cost of stock options on 1996 earnings (1)
Company
Effect
Company
Effect
Netscape
-296%
MCI Comm.
-8.1%
Westinghouse
Electric
-129
Alcoa
-8.2
Reynolds
Metals
-18.3
Georgia-Pacific
-7.6
Seagram (3)
-17.4
United
HealthCare
-7.4
Armco
-14.3
CUC Intl. (2)
-7.3
Unocal
-14.3
Pepsico
-6.9
Genentech
-12.5
Amgen
-6.6
Inland Steel
Industries
-9.3
Avery Dennison
-6.0
(1) This list is selective. Not all companies have
reported. Figures represent change from net or
net primary earning per share. In addition,
companies that reported net losses before
options weren't included.
(2) Year ending Jan. 1997
(3) Period ending June 1996 |
