American companies with fiscal years ending December 31, 2005 will start expensing their stock options in 2006. This newly required reporting is expected to drop company net income figures noticeably.
The Financial Accounting Standards Board (FASB) has been working to require American public companies to account for the impact of stock options in their financial statements since 1993, according to Business Journalism. Up to now, companies have only been required to report the number of options granted and their potential impact on their financials in a pro forma statement in a 10-K filing footnote.
“As the requirement to expense becomes more of a reality… and they face that these costs have to go into the income statement, companies should make sure all corners are tucked in nicely,” said Robert Howell, a visiting professor at Dartmouth College’s Tuck School of Business, speaking to the Seattle Post-Intelligencer.
Companies, especially tech firms, have fought this change in their accounting for years. The House of Representatives passed a bill titled the Stock Option Accounting Reform Act last year, 312-111, to block options expensing, but the legislation has stalled in the Senate.
Business Journalism reports that a recent PricewaterhouseCoopers study found that only 79 percent of the 131 multinational companies participating in the survey granted options. This number has not grown as all of these companies offered options in 2003. Seventy-two percent of surveyed companies offered stock-purchase plans in 2002 and now only 51 percent offer these plans.
In preparation for the expensing requirement, companies have either reduced the number of options available or converted existing options to restricted stock. Companies have also sped up their vesting schedules. Business Journalism reports that a study by Bear Stearns found that 102 companies with a median capitalization of $626 million had implemented accelerated vesting. Tech companies accounted for 36 percent of the accelerating companies.
Sun Microsystems has accelerated its vesting schedule to avoid a $400 million pretax charge to net income and stated so in a 2004 SEC filing, Business Journalism reports. The statement in their filing read, “The purpose of the acceleration is to enable the company to avoid recognizing compensation expense associated with these options in future periods.”
According to Business Journalism, in another tactic to avoid expenses to their income statements, companies are accelerating only “out-of-the-money” options that are “underwater” already to avoid booking charges against income. Those options can also be removed from being potential liabilities according to Business Journalism. The Bear Stearns study found that only 12 of the 102 surveyed companies were accelerating both “in-the-money” and “out-of-the-money” options.
The contrasting sector effect of this new expensing requirement is shockingly apparent in this example between General Electric and Intel according to Business Journalism. GE reported earnings of $16.6 billion in 2004 and under the new accounting rule, their earnings would have come in at $16.4 billion. Intel on the other hand, reported $7.5 billion in 2004 earnings and would have reported $1.3 billion under the new requirement. The option expense for GE was $245 million while Intel's bottom line would suffer with an option expense of $6.2 billion.
CFO reports that the Council of Institutional Investors encouraged companies providing financial forecasts and investment bank research departments to create a single policy to report net earnings with stock option-related costs. CFO reports that Ted White, the council’s deputy director, wrote in letters to the heads of 31 research houses, “There should be no doubt regarding the desire of long-term investors to have the cost of employee options represented in financial statements and earnings statements.”
The Wall Street Journal reports that Thomson Financial First Call will report parallel forecasts, one estimate including option expenses and another excluding option costs. CFO reports that Standard and Poor’s (S&P) will include option expenses in calculating earnings for its S&P 500 and other U.S. indices. S&P says this reporting will decrease earnings by 4.2 percent for the S&P 500 in 2005 and a staggering 18 percent decrease for information technology sector companies.
“The ability to compare costs across company and sector levels is vital to the investment community. A consistent earnings methodology that builds upon accepted accounting standards and procedures is a vital component of investing," S&P equity analyst Howard Silverblatt said in a prepared statement reported in CFO. "By including option expense in operating and as-reported earnings, Standard & Poor’s is contributing to a more transparent and informed investment environment.”