Consider the Options.

Changing the way stock options are accounted for wouldn't just take a heavy bite out of corporate earnings; it could eliminate the benefit altogether.

When is an option not an option?

If you think this is a trick question, think again. The answer can be found, literally, in tens of thousands of financial statements filed by public companies. That's where information, sometimes in the form of footnotes in small print, detail the actual costs of stock options.

To date, because of an apparent bookkeeping maneuver that allows executives and other workers to be given stock options without such options being accounted for as employee expenses, investors don't have to concern themselves with their actual costs. As a result, a company's earnings are much larger than would otherwise be reported. Were it not for this accounting practice, company stock options would probably not be considered an option at all.

Unless a change is made to accounting rules, stockholders need not be alarmed. So far, such a change does not appear to be in the cards. Although the Financial Accounting Standards Board did take steps several years ago to prohibit the maneuver, the move was shot down following intense lobbying efforts by members of corporate America. So, for now, stock prices won't have to factor in the true costs of options.

But what about the management team? If there were a change in this accounting wizardry--and one can never say never--wouldn't the new rules affect the ability to recruit and retain the best and the brightest? And if so, what happens then? And is it even possible to plan for such a time?

The answer, at least in theory, is a resounding yes, according to experts who have studied the matter. A true accounting of employee options would greatly diminish a company's ability to dangle such incentives in front of talent. There's simply no substitute.

"It'd be a huge, wrenching change," says Alan Johnson of Johnson & Associates, a New York-based consulting firm that specializes in compensation matters. "If there were such an accounting change, companies would use fewer options, at least initially.

"But our betting is that it'll be a cold day in hell before FASB takes this on. Both FASB and the Securities and Exchange Commission caved in three years ago when it was up for review," says Johnson. "It's just too unpopular. Although investors have enough information to figure it out already, people are terrified of explaining anything to Wall Street."

Refueling the Debate

The debate arose anew last summer when analysts at Bear Stearns & Co. issued a closely read report examining the effect on earnings at companies in the Standard & Poor's 500 stock index if employee stock options were accounted for as an expense.

The findings were illuminating: "Since employee stock options are a form of compensation expense, including their value in the financial statements would negatively impact a company's operating income as well as net income and earnings per share."

By how much? Well, the charge against earnings amounted to six percent last year and four percent in 1998. In fact, in 122 companies, the decline in diluted earnings per share was 10 percent or more, according to the report. Not surprisingly, technology companies felt the impact the most, with 42 experiencing double-digit declines.

"There's no question that some sectors, such as high-tech, that use options the most would then incur the highest charges (to their books) if there were any changes in the accounting rules," says Carol Bowie, director of publications at Executive Compensation Advisory Services in Alexandria, Va.

"But there's also a school of thought that says if earnings changes were required tomorrow for stock option grants," she continues, "the stock market would adjust for that and the end result would be no different.

In any event, here are a few examples found by Bear Stearns: Yahoo, the popular Internet portal, reported 1999 operating income of $154 million, but that would have been transformed into an operating loss of $374 million if stock options had been accounted for as an expense.

Similarly, Broadcom's 1999 operating profit of $143 million would have become an operating loss of $172 million, while HBOC McKesson, the big wholesaler, would have posted an operating loss of $34 million instead of an operating profit of $137 million.

In general, the overall effect options have on corporate earnings is negative, according to the Bear Stearns report. The S&P's three-year compound annual earnings growth shrank from 11 percent to 9 percent when options were considered as a cost.

And the S&P's compound annual growth in operating income subsided from a three-year rate of 12 percent to just 10 percent when the favorable accounting treatment of options is eliminated, according to the Bear Stearns report, issued last August.

With many of the most notable examples culled from the ranks of the volatile high-tech sector, Pat McConnell, a senior managing director and head of the accounting and tax group in equity research at Bear Stearns, suggests that some companies might do better repricing options.

"It seems to me that if a company's stock is volatile but a company finds it necessary to reprice options frequently, they'd be better off adapting an alternative-valuing their options using repricing at the date of grant and charging them as an expense," McConnell says.

Of course, this would automatically require a company to book its options as an expense, thanks to recent changes in accounting rules. But this approach also allows them to more easily adjust the price of the options to reflect the stock price in the open marketplace. By doing so, a company more easily uses an option as a recruiting and retention tool. After all, rare is the company that can easily attract or keep valued personnel if its stock price is less than the strike price of its options. Repricing, in such an instance, becomes desirable.

"Variable options, when linked to performance measures, are a better motivator than fixed options. But if you have options that are variable-they don't vest at exercise price or a number isn't known until a target is hit-they also receive onerous accounting treatment under the current rules," she explains.

In effect, a change in the FASB rule 123 would require all stock options to be treated as variable options. Like Johnson, McConnell doesn't anticipate a shift for the next few years. But she believes a change is needed because it would require accounting that permits better valuations.

"If the intrinsic value was eliminated," she says, "if a company could use only the fair value, it'd make for a level playing field. ...Right now, there's actually a disincentive to grant options- that are linked to the performance of a company."

Carol Bowie agrees: "There's no question that some options are eye-popping," she says. "And if the rules were changed, investors would be upset. It certainly would have an effect on how liberally a company uses options if it has to watch the earnings."

Options Still Rare

Of course, not everyone in corporate America is granted stock options, anyway. A recent survey published by the U.S. Bureau of Labor Statistics found that, in fact, most employees in private industry aren't granted stock options. Just 1.7 percent of all private-industry workers received stock options in 1999.

Not surprisingly, executives were about three times as likely to get stock options than were other employees--4.6 percent compared with 1.6 percent, respectively. The share of nonexecutive employees offered stock options ranged from 0.7 percent for those earning less than $35,000 to 12.9 percent for those earning $75,000 or more.

What's more, the likelihood that employees received options ranged, by industry, from 0.2 percent in nondurable manufacturing industries to 5.3 percent in durable manufacturing, and by geographic region, from 1.1 percent in the Northeast to 2.1 percent in the West, the BLS found.

The study also noted that 22.1 percent of publicly traded companies offered stock options, compared with 2.34 percent for all private establishments. Among publicly held companies, the percentage ranged from 33.9 among finance, insurance and real estate firms to just 5.5 percent among services firms.

"Whatever you say about options, right now they're the perfect tool, from a company's point of view," says Executive Compensation's Bowie. "There's no charge and there's no payoff unless the stock price goes up. It remains a powerful tool and there's no way they'll stop using them."

For the moment, the accounting rules also provide another type of benefit. As Bear Stearns' McConnell pointed out in an earlier report last July, most companies don't record compensation expense on their income statements when granting options to employees.

But when an employee exercises an option, the employer can deduct the compensation expense on its tax return, which lowers its tax bill. "This tax benefit has no impact on reported income, but may improve earnings per share and cash flow," according to the report.

McConnell notes that the income tax benefit accounted for more than 10 percent of cash flow from operations for seven of the largest companies in the Nasdaq 100 index, including Cisco Systems, JDS Uniphase, Altera and Xilinx.

In effect, there seem to be many overwhelming reasons why corporate America would like to see the current accounting treatment for stock options left in place. And given industry's success in forestalling any changes of late, compensation experts agree further change is unlikely right now.

"Executives who deal with Wall Street say any change in the way they report their earnings would change their stock price dramatically, even if investors have enough information to figure it out," says Johnson & Associates' Alan Johnson.

So where does all this leave corporate executives? For now, they can sit tight. If a change in the accounting rules is unlikely, the management team probably doesn't have to start planning for life after stock options.

On the other hand, the very fact that the issue is being discussed at all suggests it would be prudent to at least consider the possibility that accounting rules might one day be modified. After all, the rules regarding variable pricing were tightened recently under revised FASB rulings.

To an extent, such a scenario resembles the recent past when many options were under water for a spell. While the stock-market drop mainly affected high-tech companies, particularly dotcoms, the phenomenon suggests others could find themselves without options as a sufficient motivator.

"The conventional wisdom is that the whole issue (of accounting changes) has been put to bed," says Bowie. "But we may be at a crossroads as to how companies are going to do now that they can't rely on stock options as they once did. It's just been so powerful and valuable over the last decade. But the future could be less certain."