Stock Option Accounting Is Tricky (Kerry Lee Watkins Commentary)

Want to know the true cost companies are really spending on stock options? Get out a magnifying glass. To get the true number, one must examine the footnotes.

The collapse of the likes of Enron and Global Crossing has brought into question numerous accounting issues. One cooking on the front burner is stock-option accounting. Companies such as the two previously mentioned generously handed out options to top executives, some of whom sold large amounts of stock before the business failed.

A quick review: options give the holder the right to buy shares in the future at a specific price. For example, an executive might be awarded options to buy 100,000 shares of XYZ Corp. at $50 per share, which is known as the exercise price. If the share price rises above the $50, the executive can use the options to buy the stock and sell the shares immediately, pocketing the difference.

Unlike cash compensation, options do not appear as an expense on a company’s income statement. Under current U.S. Generally Accepted Accounting Principles, employee stock options are valued on the date they are granted, so as long as companies fix an option’s exercise price at the prevailing market price on the date of grant, no expense is booked on the income statement. This is because basically the option is worthless at that time since the exercise price and market price are the same.

The option accounting issue currently has the attention of some on Capitol Hill as well as many in the investment and accounting communities. A bipartisan group of five senators has proposed a bill that would change the way stock options are accounted for on corporate income statements. Legendary investor Warren Buffet and Fed Chairman Alan Greenspan have spoken recently in support of expensing options.

The practice of granting options in lieu of salary has been used immensely by technology companies. Supporters of the proposed changes suggest that current policy has enabled tech companies to significantly overstate their earnings in recent years. A change like the proposed law could reduce corporate earnings, over all, by almost 10 percent, and some tech companies could takes hits as large as 60 percent, analyst say. Had the proposed new changes been in place in 2000, Cisco’s operating earnings would have been reduced by 40 percent and Lucent’s down 32 percent.

Critics of the proposed changes argue that stock options have been an essential part of creating the U.S. economy’s superior performance during the past 10 years. The growing use of stock-based incentive compensation, linking interests of employees and shareholders, has been a healthy development, getting employees to think more like owners.

The biggest problem with making companies take a charge for using options lies in determining how much the charge should be. Measuring the worth of an option is not an exact science and many corporate leaders argue that the fair value of employee options cannot accurately be determined.

The disillusionment of investors with Wall Street strategists, research analysts and now auditors is nothing new. What is new is that they seem to be disenchanted with corporate America.

A number of accounting practices such as pension accounting, off-balance sheet financing, and compensation practices in addition to options issues are being questioned, and the icons of American business are now under the microscope. Some of the most beloved companies in the world have come under the gun recently.

Investors always knew the stock market was volatile, but at least they trusted the numbers upon which it was valued. Now many are questioning that basic assumption. Is this the fall out from the bear market and the bursting of the tech bubble that will soon be forgotten? Or could it produce a change in attitude with profound implications for valuations going forward? We’ll just have to wait and see, but for now, keep that magnifying glass handy.

(Kerry Lee Watkins, CFA, is senior vice president and equity portfolio manager at Garner Asset Management Co. LP, a registered investment advisor in Fayetteville.)