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How Stock Options Become an Accounting Trick
By Jim Jubak
MSN Money Markets Editor
03/06/2002 12:08 PM EST
It's certainly good news for investors that bellwether companies such as General Electric (GE:NYSE - news - commentary - research - analysis), IBM (IBM:NSYE - news - commentary - research - analysis) and American International Group (AIG:NSYE - news - commentary - research - analysis) have announced that they will release more detailed information on their financials.
The changes will include more detail on the performance of individual business units, gains and losses from the sale of assets, and off balance sheet partnerships. It's unlikely that the extra information will be enough to enable investors to easily understand these three companies -- the authors today of truly inscrutable financial statements -- but it's a start.
Unfortunately, no CEO is volunteering to take on the biggest accounting issue hanging over U.S. companies and their stocks right now. Today's accounting rules for stock options make up the most powerful tool available for manipulating earnings. Stock options accounting is the 800-pound gorilla lurking in every discussion of accounting reform taking place right now: Everyone knows the issue is too big to ignore, but everyone worries that a serious fix would take down the entire technology sector -- and perhaps more.
That's not to say that absolutely no one is talking about it. Jeffrey Skilling, former CEO of Enron, brought up the topic at his recent appearance before the Senate Commerce Committee. Taunted by California Democratic Sen. Barbara Boxer for defending the right of a CEO to use his company's stock to improve his company's reported earnings, Skilling shot back that companies do it all the time. "You issue stock options to reduce compensation expense and therefore increase your profitability."
The rejoinder was particularly effective because Skilling, and everyone else in the room, knew that Boxer represents Silicon Valley, which lives and dies on stock options. In the mid-1990s, Boxer worked hard to kill accounting rules that would have ended the ability of companies to inflate their earnings through the use of stock options.
That battle went like this: Stock options clearly have value. Companies offer them to valued employees instead of cash compensation or as an extra reward for special achievement. Options are dangled in front of CEOs and other managers to motivate them to reach certain revenue or earnings targets. And financial analysts have even invented ways to value these options in the publicly traded market for options, where investors who want to hedge or leverage positions in a stock can buy the right to buy or sell shares at specific prices in the future.
But according to current accounting rules, companies that issue millions of shares of options each year don't have to charge a dime in cost against earnings. In 1993 the Financial Accounting Standards Board proposed rules -- pages and pages of them -- on how companies should value the options at the time they were issued and how they should subtract them from earnings.
After a bitter fight that included high-level congressional lobbying against the rules, the Financial Accounting Standards Board withdrew a key part of its proposal. Companies would not have to deduct the cost of options from their reported earnings unless they wanted to do so. Instead, they could provide a footnote to their financials stating what earnings per share would have been if the cost of options (calculated using the widely accepted Black-Scholes method for valuing options) had been deducted from earnings. And that's where investors can find the number today -- if they care to search for it.
Small Print, Big Numbers
That fine print hides some big numbers. In 2000 Intel (INTC:Nasdaq - news - commentary - research - analysis), for example, reported earnings of $1.73 a share. Pro forma earnings after deducting for the cost of options came to $1.40 a share, according to the company's 10-K filed with the Securities and Exchange Commission. At Cisco Systems (CSCO:Nasdaq - news - commentary - research - analysis), another big user of options, charging the cost of options against earnings would have increased the loss per share in the fiscal year that ended in July 2001 to 38 cents from the reported 14 cents. At eBay (EBAY:Nasdaq - news - commentary - research - analysis), including the cost of options would have reduced earnings for 2000 from a reported profit of 19 cents a share to a loss of 36 cents a share. And at Microsoft (MSFT:Nasdaq - news - commentary - research - analysis), accounting for the cost of options would have resulted in earnings of 91 cents a share for the year ended June 2001, instead of the reported $1.32 a share. You'll find these numbers in the footnotes to a company's financial statements in its annual 10-K.
The reductions in earnings per share at these technology companies -- 20% at Intel, for example -- are dwarfed by the drop in earnings per share at new technology companies that had to reprice options after their stocks tanked in 2000. Some of these companies had to issue huge numbers of new options in 2001 -- or still face the necessity of doing so in 2002 -- because options issued in 1999 and 2000 were so far underwater that they were valueless to the employees they were designed to compensate and motivate. Brocade Communications Systems (BRCD:Nasdaq - news - commentary - research - analysis), for example, issued 20 million options in April 2001 to workers whose existing options were underwater. For the fiscal year that ended in October 2001, Brocade reported earnings per share of 1 cent. By including the cost of options, that figure transforms into a pro forma loss of $2.68 a share.
But this is all just part of the way that options accounting distorts corporate earnings. The bigger problem -- and the much more lucrative side of options as far as corporate cash flow is concerned -- becomes evident when a company that has issued options to its employees goes to pay its tax bill. At this point a company gets to deduct the difference between the cost of the options at the exercise price and their market price.
For example, let's take a company whose employees exercised a million options in 2000. Those options had an initial average strike price of $80 a share. The initial Black-Scholes value of those options (taking into account such factors as the volatility of the stock, the time until the option expires, and the relationship between the price of shares and the price at which the option allows the option holder to buy shares) was roughly $20 a share. But the stock has moved up in price since the options were granted, and as the stock soared in price, the right to buy shares at $80 became increasingly valuable. By 2000, those options using the same Black-Scholes valuation method were worth $40 each. The company would, therefore, have been able to take a $40 million tax deduction for the "cost" of those options -- even though the initial "cost" was just $20 million. The higher the stock had climbed in price, the bigger the tax deduction would have been.
Have you noticed what's really so lucrative about this kind of tax accounting? The tax deduction expands along with any climb in the value of the stock. And it's not limited by the initial Black-Scholes cost of the option.
Juicy Tax Break
The resulting tax break can be very juicy indeed -- although it's not easy to find in a company's financial statements. You'll see it, though, if you go to the corporate cash flow statement and look for a line with a name like "Tax benefit from employee stock plans." That's how the figures are labeled in Intel's 2000 10-K, for example. That year, Intel's total tax break from options came to $887 million. At Cisco the total for fiscal 2001 came to $1.4 billion. At eBay it came to a comparatively paltry $37 million. And at Microsoft, a princely $2.1 billion in fiscal 2001.
In most years, I'd give any effort to reform this set of accounting and tax rules no chance at all. Lined up against reform you'll find the same powerful coalition of technology companies and politicians that killed tighter rules back in the mid-1990s. These folks are motivated to defend the status quo with energy and cash, and they have a lot of the latter. Reform, on the other hand, lacks a natural and energized constituency. You may be outraged that Intel can claim $1.73 a share in earnings when it really made $1.40, and that the company is getting a $900 million tax break from the U.S. Treasury to boot. But if you're an Intel shareholder directly or through a mutual fund, do you really want to see Intel's shares take another hit in exchange for accounting accuracy? Personally I believe that the long-term benefits to the capital markets of honest numbers are worth the short-term pain to individual stocks, but as an Intel shareholder I have to admit that I feel ambivalent about any call for reform, even my own.
However, thanks to the Enron fraud and scandal, this isn't a normal year, and the proponents of options accounting reform have come up with an ingenious strategy. (Especially ingenious because the Senate can't force the Financial Accounting Standards Board to adopt any specific accounting rules.) As written into Senate Bill 1940, it would offer companies a choice between keeping some of their tax breaks and giving up their accounting freebie. Companies that included the cost of options in their reported earnings numbers would, under the terms of the bill, still get to claim a tax deduction for the full cost of the option. Companies that didn't include the cost of options in their reported earnings wouldn't be entitled to a tax deduction at all. And all deductions would be limited to the original Black-Scholes value of the option -- no more sky's-the-limit deductions if the stock price soared like a rocket.
The bill's backers -- on the Democratic side of the aisle, Sens. Carl Levin, Richard Durbin and Mark Dayton, and on the Republican side, John McCain and Peter Fitzgerald -- still face a tough fight even to get this legislation out of the Senate Finance Committee. And I suspect that the legislation has even less chance of success in the House of Representatives.
But the Enron scandal, and the other investigations into the activities of companies such as Global Crossing (GBLXQ.OB:OCT BB - news - commentary - research - analysis), could produce a surprise with the potential to create enough investor anger to push proposals like this into law. Watch the progress of SB 1940 carefully. If it gets out of committee, this bill could make technology investors even more nervous than they are now. |
