Herb,
I agree you don't want the politicians meddling too much into accounting practices. Following article is an example of what they are contemplating:
Tech Nightmare: S.1940
[BRIEFING.COM - Gregory A. Jones] While the media was transfixed by the Enron soap opera yesterday, a more important hearing went unnoticed. The Senate Banking Committee was discussing the problems facing corporate accounting, with one idea in particular - mandatory expensing of stock options compensation - gaining widespread support. While this talk is already prompting some analysts to note that reported earnings of many tech companies could be reduced by such a change, an even more ominous cloud is on the tech horizon: S.1940. This Senate bill would not only have the cosmetic effect of reducing reported earnings, it would have the far more serious effect of reducing corporate cash flows.
S.1940 was introduced on February 13 by Senator Carl Levin (D), and has bipartisan co-sponsors, two Democrats: Dick Durbin and Mark Dayton, and two Republicans: John McCain and Peter Fitzgerald. It is awaiting a hearing in the Senate Finance Committee.
One of many likely legislative responses to the Enron collapse, S.1940 attempts to force corporations to declare stock-based compensation as an expense on the income statement. Since the Senate cannot force FASB to adopt such a standard for GAAP, it pursues its ends in a more blunt fashion - companies will suffer tax consequences if they don't submit to the Senate's will (FASB is the Financial Accounting Standards Board, the group that sets GAAP -- generally accepted accounting principles).
Current Affairs
To understand the bill and its impact, you have to first understand the current state of affairs. As we discussed in our first brief about stock-based compensation, corporations are currently permitted to hide stock options expenses in their quarterly GAAP reporting. In a classic example of having their cake and eating it too, however, these companies can deny that options are an expense for the purpose of reporting earnings, but then claim them as an expense when it comes to lining up for a tax deduction.
Under current law, when a non-qualifying stock option (which includes most current options) is exercised by an employee, the employer can claim as a deduction the difference between the cost of the options at the exercise price and what they would fetch at the market price. As we shall see in an upcoming example, these tax deductions can be enormous - sometimes entirely eliminating the tax burden of profitable companies.
The Brave New World?
S.1940 amounts to letting tech companies keep a slice of the cake, but without the "eating it too" part. With just a one sentence amendment to the 1986 tax act, the bill would produce two important changes. The amendment reads thus:
In the case of property transferred in connection with a stock option, the deduction otherwise allowable under paragraph (1) shall not exceed the amount the taxpayer has treated as an expense for the purpose of ascertaining income, profit, or loss in a report or statement to shareholders, partners, or other proprietors (or to beneficiaries).
The first change is on the disclosure front. To qualify for the tax deduction on stock options, a company would have to disclose the expense of the options on their income statement at the time of the grant. Though this does not require a company to declare stock-based compensation as an expense, that would be the effect, as the disclosure of the expense is only cosmetic while the tax deduction is real cash.
The second change is a bit less obvious, but has dramatic financial implications. Because current accounting rules limit the expense that can be claimed at the time of grant to the fair market value of the options (determined by Black-Scholes), the ultimate tax deduction at the time the options are exercised will no longer be unlimited. Under current rules, as the company's share price rises, the tax deduction rises in lock-step. Under this new rule, the tax deduction would rise only to the point of the original expense but no more. So as the stock price rises beyond this point and the options' implicit cost to the company rises, there will be no offsetting tax deduction.
Putting Numbers to the Ideas
How serious is this change? Let's work through the numbers, using Microsoft (MSFT) as an example. In the last three fiscal years, 1999-2001, Microsoft has generated net cash flow from operations well in excess of its net income. This discrepancy is due primarily to huge tax deductions resulting from the exercising of stock options; these deductions were $3.1 bln in 1999, $5.5 bln in 2000, and $2.1 bln in 2001. For the three years combined, Microsoft reported tax obligations of $12.8 bln on its income statement, but recorded $10.7 bln in deductions due to options - a nice way to eliminate over 80% of your tax burden.
Now let's consider how Microsoft would have fared had S.1940 been the law. We can't calculate this precisely, as we would need to know the Black Scholes valuation of all options that were exercised in these years at the times that they were granted. But even without knowing this, we can generate rough estimates that will give a clear picture of the magnitude of the impact.
We do know the strike prices of the options that were exercised in these years (they are listed in the annual 10K filing), the weighted averages were: $6.29 in 1999, $9.54 in 2000, and $11.13 in 2001. Based on these strike prices and typical vesting periods for options, it's a fair guess that most of these options had been granted 4-5 years prior. Using Black Scholes and some very aggressive assumptions (which produce conservative estimates of the tax impact), we can estimate that Microsoft could have expensed these options at the time of the grants at $4, $6, and $7 per share for the three years.
Using those assumptions, we can easily calculate the maximum tax deduction the company could have enjoyed: it would be those prices multiplied by the number of shares exercised (also listed in the 10K), or $700 mln in 1999, $1.2 bln in 2000, and $860 mln in 2001. Using a 35% tax rate, the tax benefit would have been just under $1 bln for the three years combined.
A $1 bln tax break over three years isn't bad, but it pales in comparison to the $10.7 bln break that the company actually received.
It is worth noting that the years 1999-2001 are not representative, as share prices soared just before and during those years, thus dramatically boosting the gap between exercise prices and market prices, and the resulting tax deductions. But this example nevertheless offers a real world look at just how serious the financial consequences of S.1940 could be.
What to Watch
Given the consequences which many tech companies and some non-tech companies would face if S.1940 passes, we doubt that it will pass. This is not a bill likely to win widespread public support given the obscure nature of its contents, but it will encounter the full wrath of many companies that donate huge sums of money to congressional campaigns. After Enron, however, it would be unwise to assume this outcome and investors should therefore watch the bill's progress.
As we noted earlier, it is awaiting a hearing in the Senate Finance Committee. If it manages to make it out of that committee, the level of investor vigilance should increase markedly.
To better understand how this law might affect stocks in your portfolio, you must read the most recent 10K filings with the SEC. This can be done at sec.gov. Just search the document for the word "Scholes" and you'll go right to the discussion of the company's option expenses. There will be a comparison of EPS figures both including and excluding stock-based compensation expenses. This will give you an idea of the "perception" problem. Though disclosure of these expenses will not change the company's operations in any way, there is the possibility that companies whose stated profits are reduced by the need to declare options as an expense could suffer. These fears are probably overstated given that there is only a change in disclosure and not cash flow, but psychology can't be entirely ignored.
The far more important factor is the financial impact of the implicit tax increase in S.1940. To gauge this impact, you will need to look at the company's cash flow statement for a line that reads something like this: "Stock option income tax benefits". The larger this line is relative to net income, the greater the likely impact of this change in tax law. That's a bit of an oversimplification, but this line will at least give you a rough idea of the role that stock options deductions play in generating cash flow for your company.
Greg Jones - gjones@briefing.com |
