The unveiling of a plan to require companies to recognize stock-option compensation given to executives and employees as an expense on their income statements isn’t likely to have a major impact on most companies’ bottom lines, analysts say, but it may have profound ramifications for earnings in the technology sector.
Last Wednesday’s proposal from the Financial Accounting Standards Board (FASB), a private rule-making body for financial accounting and reporting, requires companies to record the cost of the options in their profit-and-loss statements. Previously, firms were only required to disclose the cost in the footnotes to their financial statements.
Interested parties will have 90 days to comment on the rule, which would take effect in 2005.
For the majority of companies, expensing looks like a non-issue.
About a third of the companies in the Standard & Poor’s 500-stock index have already started expensing stock options, or plan to at some point in the future, according Standard & Poor’s, and options expensing is expected to cut earnings for companies in the S&P 500 index by about 7 percent.
“From an investment point of view this is much ado about nothing,” said Tom Taulli, a business professor at the University of Southern California and an expert on stock options. “Analysts have been looking at balance sheets and income statements and they have been adjusting for stock options for years,” he added.
But in the technology sector, where options have frequently been used to pay employees, analysts see some substantial earnings problems.
A report by investment bank Bear Stearns shows that net income in 2003 for the 100 biggest companies trading on the Nasdaq market would have dropped 44 percent in 2003 if the firms had been required to treat options as expenses.
Another research report, this time from Goldman Sachs software analyst Rick Sherlund, shows earnings for a selection of software companies reduced by a median of 46 percent if options are expensed. Similarly, SG Cowen semiconductor analyst Jack Romaine said expensing options would cause a median net income decline of 45 percent in 2003 in the semiconductor space.
“Were software companies to expense employee stock options, we think that investors would have a very different picture of profitability within the software industry,” Sherlund wrote in his report, noting that the full impact of options expensing has on share prices has yet to be fully realized.
However, Sherlund also points out that many of the companies in his study have taken steps to reduce their exposure to stock options, either by decreasing the number of employees eligible for options or by decreasing the size of the options given. “Thus although the impact on the software industry is significant, we would expect that actions taken this year will mitigate the impact going forward,” he said.
Indeed, technology companies are increasingly turning to other compensation methods, such as restricted stocks or cash bonuses, to avoid getting caught out by stock option accounting regulation according to Bill Coleman, a former compensation consultant who is now senior vice president of Salary.com, a company that researches human resource trends.
“Stock options drove the whole tech boom because companies could use a free, unexpensed incentive,” Coleman said. “But today executives are stepping back and asking what sort of compensation makes the best sense for the company, and in many cases that’s not stock options.”
The widely anticipated FASB plan has caused a furor in the accounting industry and on Wall Street and comes after a decade of debate between the FASB accounting board and corporate America, particularly the technology sector, which has steadfastly opposed expensing stock options.
Critics of the plan to count options as expenses say methods used for calculating the cost of the options are far from precise and argue that expensing stock options stifles economic growth and will drive high-tech start-ups overseas.
But despite the opposition, high-tech bigwigs like Dell and Yahoo! have already cut back on options and replaced them with other forms of compensation. Microsoft has abandoned them altogether, and many more technology firms are likely to follow suit, Coleman said.
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Some blue-chip technology names that are among the largest users of equity-based compensation, like Cisco Systems and Intel, have been lobbying hard on Capitol Hill to block changes to stock option accounting.
Bipartisan legislation gaining strength in the House would limit required expensing of options to those owned by the top five executives in a corporation. It also would prevent a new FASB mandate from taking effect until an economic impact study is done.
But given the corporate shenanigans of the Enron and WorldCom era, Jan Koors, a compensation expert at compensation consulting firm Pearl Meyer & Partners, is skeptical that the expensing opponents will prevail.
FASB tried to force companies to expense stock options a decade ago, only to be derailed by an intense lobbying effort that persuaded Congress to block the change in 1995. “I don’t think there’s an appetite out there to back down again this time,” Koors said.
Koors also thinks companies will continue to grant stock options. Options allow workers to buy an employer's shares at a fixed price and then sell them at a profit if the company's stock rises.
“If the reason you grant stock options is because you think philosophically it’s important for employees to have a stake in a company, I think you’re continue to grant them,” said Koors. “The fact that it results in an expense doesn’t really matter.”
The Associated Press contributed to this report