Posted on Wed, Dec. 15, 2004
Valley firms react to new rules on options
CHANGES IN HOW THEY HANDLE ISSUES AIMED AT REDUCING IMPACT ON PROFITS
By Mark Schwanhausser
Mercury News
siliconvalley.com
With new stock-option accounting rules expected to be released as early as today, technology companies across Silicon Valley are changing how they handle stock options to reduce the rules' impact on their reported profits.
Companies typically have made accounting alterations with little or no explanation, often disclosing them deep in the footnotes of financial statements. While these moves are within the rules, two tactics in particular are drawing fire and raising concerns among investors, the Securities and Exchange Commission and an auditing oversight board.
Many companies, including scores in Silicon Valley, are changing how they value options, resulting in less-expensive accounting charges. And a handful of companies are accelerating ``underwater'' options, effectively wiping them off the books before the rules take effect in June. (Options for which the purchase price is higher than the current stock price are said to be underwater.)
``It's simply for accounting dress-up,'' said Todd Fernandez, a senior research analyst for Glass, Lewis, which advises CalPERS and other institutional investors. ``You're taking something that is a detriment to shareholders, and you're doing it simply so your profitability looks better going forward.''
Even critics acknowledge, however, that these tactics are not necessarily signs of abuse -- and that they are scrutinized by auditors. The accounting board has encouraged companies to be more exacting in determining the variables used in their calculations. Companies are taking a closer look at when employees exercise options. And even rule-makers were divided on whether companies should be given a break for options that are unlikely to be cashed in.
Since 1995, companies have been allowed to estimate the cost of options in financial footnotes, rather than subtracting them from profits. That choice will end soon.
Final rules expected
The Financial Accounting Standards Board is expected to issue final rules this week that will require companies to ``expense'' the stock options that have become a standard part of Silicon Valley pay packages. Barring intervention from Congress or the SEC, public companies must start complying with the rules starting June 15. Start-ups and private companies would have until Dec. 15, 2005.
The battle over stock-option accounting rules has pitted investors and businesses for decades. As investors see it, current accounting rules contributed to the tech-stock bust by permitting companies to overstate their profits.
The powerful tech industry -- led by Cisco Systems, Intel and Sun Microsystems -- continues to lead the battle to block the rules.
Chief among the industry's complaints: There's no acceptable method to estimate the cost of stock options.
Though the tech industry has vowed to continue the fight in Washington, scores of companies already are changing their stock-option accounting practices.
Two out of three of Silicon Valley's largest companies have reduced their estimate for how much their stock price will fluctuate in the future, according to research compiled for the Mercury News by Equilar, an independent provider of information on executive compensation. This number generally drives calculations of the cost of options.
Siebel Systems, DSP Group, Covad Communications, Foundry Networks and Juniper Networks made the biggest changes in estimating how much their stock price would fluctuate -- ranging from 43 percent to 36 percent, according to Equilar's survey of 93 of the valley's biggest 150 companies.
Nearly one-third of the companies, including Cisco, also are assuming that workers will exercise their options sooner. That assumption also can shrink the impact on profits.
The accounting board has been encouraging companies to fine-tune the variables they use when valuing options. For example, the board says relying on short-term historical price fluctuations is not the best indicator of what will happen over the long term.
San Jose's Brocade Communications Systems, however, reduced its expected volatility to 57.5 percent, down from 81.6 percent, for the 12-month period ended Jan. 31 by basing its estimate on volatility over the previous 12 months.
But by looking back four years, Glass, Lewis estimated volatility at 98.8 percent.
``If we were to use a longer period of time, it would include a period of time in the stock market better known as the `bubble' that we do not believe is a reasonable indication of our future stock price volatility,'' Brocade spokeswoman Leslie Davis wrote in an e-mail.
A handful of companies have accelerated the vesting of ``underwater'' options, allowing them to recognize the cost in financial footnotes rather than subtract them from profits when the new rules take effect.
The accounting board was divided on this issue. As some board members saw it, companies shouldn't be forced to expense options that are deeply underwater and are unlikely to ever be cashed in. But investors worry that companies will accelerate options that are nearly in the money, handing a windfall to workers.
Accelerated vesting
Glass, Lewis has taken aim at health services giant McKesson, which applied this tactic to all options that could be exercised for $28.20 or more. That accounted for ``substantially all'' of the San Francisco-based company's unvested options, according to a one-sentence disclosure in a financial filing for the year ended March 31.
By June, however, McKesson's stock had popped up to $35, enabling many workers to cash in for a profit, and its stock closed at $32.46 Tuesday. The tactic allowed McKesson to report $117 million in option expenses in footnotes -- the equivalent of 54 percent of its profits in 2004, Glass, Lewis said.
Alarmed that companies might be quietly employing this tactic, the SEC issued a policy statement last week indicating that disclosure was necessary and should detail why the company did it.
McKesson officials did not return phone calls Tuesday.
The problem with all these tactics, investors say, is that companies don't disclose enough information to determine whether they're making reasonable adjustments. In some cases, companies are making changes that point to contradictory trends.
``If it's a better number, no one has any objections,'' said Rebecca McEnally, senior director of the CFA Institute's Center for Financial Market Integrity. ``It's just that some of the numbers don't seem consistent with what companies have said in the past.''
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