Companies Prepare to Expense Stock Options

Since 1993, the Financial Accounting Standards Board has been working to require public companies to recognize the potential impact of stock options on their income statements. Now, it is getting its wish.

Companies whose 2005 fiscal year ends on Dec. 31 will be required to start expensing options in 2006. This means that companies will have to start making a provision for the impact of stock options on their income statements.

For most companies, that means they will report a lower net income figure. For years, companies have only had to report how many options they've granted and their likely impact in a pro forma statement in a 10-K filing footnote.

Stock options give executives and other employees the right to purchase the company's stock, at a specified price, at some point in the future. Often the options "vest," or become available for purchase, over a specified time period, such as three or four years.

Companies feeling the impact most severely are technology firms, which have traditionally used options as a significant form of compensation. In fact, a coalition of tech firms has fought the proposed expensing for years. The companies' most recent lobbying effort resulted in the U.S. House of Representatives passing a bill, 312-111, last year to block expensing. The bill, called the Stock Option Accounting Reform Act, has gone nowhere in the Senate. (For more, see this story.)

Companies have been preparing to implement the new accounting standard by reducing the number of options available, thereby reducing the potential impact to the bottom line. One technique has been the move from options to restricted stock.

A recent PriceWaterhouseCoopers study (as reported by Dow Jones News Service) found that the number of stock options being offered has fallen sharply since 2003. Only 79 percent of the 131 multinational companies surveyed granted options. Every one of these companies offered options in 2003. The study also found that 51 percent of companies now offer employee stock-purchase plans, compared with 72 percent in 2002.

Companies also have been accelerating the schedules under which options "vest," or become eligible for employees to buy stocks. In an April 2005 study, Bear Stearns reported that 102 companies, with a median market capitalization of $626 million, had accelerated vesting.

Some companies, such as Sun Microsystems, are up front about the purpose of accelerating. In an SEC filing in 2004, Sun reported that the change could help it avoid taking a $400 million pretax charge to net income. "The purpose of the acceleration is to enable the company to avoid recognizing compensation expense associated with these options in future periods," the filing reads.

The vast majority of companies are choosing to accelerate the vesting of "out-of-the-money" options, meaning the options' purchase price is above the company stock's market price at the time of acceleration. Since the options are "under water," the company avoids booking a charge against earnings and removes the options from being a potential liability. Bear Stearns' study showed that only 12 of the 102 companies accelerated both in-the-money and out-of-the-money options. Of the accelerating companies, 36 percent were in technology.

In recent years, companies have been presenting a pro forma version of the anticipated impact in Footnote 1 of their 10-K filings. The contrast between "traditional" companies and tech companies is stark. For example, General Electric reported 2004 earnings of $16.6 billion. If the new regulation had been in force, its options expense would have been $245 million, meaning that its net income, with an adjustment, would have been $16.4 billion. Intel, by contrast, reported net income of $7.5 billion in 2004. If the new regulation had been in force, its options expense would have been $1.3 billion, reducing its net income to $6.2 billion.

Since expensing of options on the income statement will result in lower net income, how analysts account for the impact is somewhat uncertain. The Wall Street Journal reported that Thomson Financial, which publishes the First Call consensus of corporate earnings expectations, will feature two average estimates for some companies: "One that includes analysts' forecast of companies' earnings per share, including stock-option expenses, and another that doesn't include costs stemming from stock-based compensation."

The Journal reported that organizations such as Zacks Investment Research, Reuters Estimates and Thomson typically collect and report estimates, using the approach employed by the majority of analysts covering the company.

Thomson told the Journal that the most prominent "'EPS consensus'" number will be the one used by most analysts covering the company." The Journal reported that Merrill Lynch & Co. and UBS AG say their analysts will include options expense in net income estimates.

Executive Compensation Figures

Christopher Cox, the new chairman of the Securities and Exchange Commission, has identified executive pay as one of his priorities. In public comments, Cox has said the SEC will either revise existing rules or issue new rules on executive compensation disclosure. Cox told Nightly Business Report that shareholders should "have one number that the different kinds of executive compensation add up to a number that's comparable, executive-to-executive and company-to-company, and at the same time that this information is provided in a timely way before, rather than after, the fact."

Cox said that the requirement to disclose all compensation is more important than the detailed proxy tables the SEC now requires. "All compensation must be disclosed," he said.

Cox has created a special team of SEC investigators to determine how companies disguise executive pay and bonuses. An SEC spokesman told TheCorporateCounsel.net that "executive compensation can be opaque and this is what the commission aims to find out about."

Ronald Mueller, a partner at Gibson Dunn & Crutcher, told Compliance Week he expects to see a requirement that compensation committees add discussions of current year compensation. He also said it could be difficult to arrive at one number for compensation, "because so much of pay is often in multi-year packages."

SEC Oversight

Although the SEC oversees the operation of public companies, it is not setting an example. Congress' Government Accountability Office found "ineffective management controls" at the agency itself, according to a report issued in October. The report built on a study released in May that cited other SEC weaknesses.

According to the new report, SEC officials underestimated by $48.7 million the cost of building its new Washington headquarters and remodeling its New York City and Boston offices. New Commissioner Cox wrote to the GAO that he is "determined to put these budgeting errors and omissions behind us." He referred to changes in the project that will save $4 million in the Boston office.

Copyright © 2008 Donald W. Reynolds National Center for Business Journalism