Magazine article Strategic Finance

The Stock Options Accounting Subterfuge: Stock Options Are Employee Compensation. Why Then Aren't These Costs Recognized on Income Statements? (Financial Reporting)

Magazine article Strategic Finance

The Stock Options Accounting Subterfuge: Stock Options Are Employee Compensation. Why Then Aren't These Costs Recognized on Income Statements? (Financial Reporting)

Article excerpt

Everywhere, people are talking about accounting.

We can't remember another time when there's been more discourse about the lack of quality and transparency in corporate financial reporting than today. And it isn't only the usual crowd of investors, legislators, regulators, journalists, lobbyists, bankers, accountants, and corporate financial managers. Even Jay Lena is satirizing accountants.

The clamor for change continues to get louder. Investors are hammering stocks of companies whose earnings are suspect. Yet when it comes to stock options, an increasingly popular form of employee compensation, companies still let this cost go unrecognized, and thereby distort their financial statements. It's a serious problem for anyone who believes in the integrity of our capital markets and the efficiency of capital allocation.

But you can't lay total blame on accounting rule makers for the stock options accounting subterfuge that companies continue to finesse.

A GAP IN GAAP

For the last decade the Financial Accounting Standards Board (FASB) has tried to issue accounting rules for stock options that would help make financial statements more transparent but has been stymied politically. As a result, the FASB issued a compromise: Statement of Financial Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based Compensation." Unfortunately, this scaled-back standard only recommends, but doesn't require, that companies charge the fair value of options as a compensation expense to operating income. And few companies do. Instead, they follow SFAS No. 123's alternative of disclosing in a footnote what net income would have been if the value of employee stock options had been booked as a compensation expense. If companies were compelled to recognize this expense, it would be quite noticeable: Net income of nearly one-quarter of the companies in the S&P 500 would have been at least 10% less if stock options were accounted for as an expense in 1999, according to a study by Pat McConn ell, an accounting and tax analyst with Bear Stearns & Co.

On the accounting merits, the FASB always had a strong case for fair value accounting of employee stock options. Stopped short of its broad goal for SFAS No. 123, the FASB subsequently chose a clever--but not ironclad--approach to regain some ground by issuing FASB Interpretation No. 44, "Accounting for Certain Transactions Involving Stock Compensation--an Interpretation of APB Opinion No. 25" (FIN No.44). FIN No.44, which took effect in July 2000, improves the accuracy of financial statements.

Under FIN No. 44, companies have to expense options that are re-priced. As companies' stock prices fall from previous highs, firms face difficult choices under FIN No. 44. Re-pricing options to a lower exercise price results in lower earnings, while failure to re-price could lead to the loss of talented employees. Opponents of FIN No. 44 argue that lower earnings will damage growth-oriented industries, making capital harder to get. Moreover, without re-pricing, employees will move to new firms where they will get new options.

But where there's a will there's a way. FIN No. 44 has loopholes. Some companies whose share prices have sunk are now exploiting these loopholes. By canceling underwater options whose exercise price is well above the company's stock price, then re-pricing and re-granting those options to be effective more than six months later, these firms are able to defeat the intent of FIN 44: They avoid all compensation expense recognition for the re-priced options.

RE-PRICING UNDERWATER OPTIONS

As options fall far out of the money where their exercise price is way above the underlying stock price, their ability to motivate employees declines. Companies with options like these that are deeply underwater may not be able to retain their best employees. So previously awarded employee stock options are commonly modified when a company's stock has been depressed. …

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