Stock options are compensation. (Sound Off).

Accounting treatment for stock options needs to change. In our post-Enron world, investors believe that the reported earnings they have relied on to make decisions are highly inflated. One key accounting practice we can apply to restore some of that lost investor confidence and make earnings information more reliable is to report stock options as compensation.

POLITICAL PRESSURE

In 1993, FASB issued an exposure draft which sought to recognize the fair market value of employee stock options as a regular compensation expense. To estimate the fair market value of options, companies could use an option-pricing model such as the Black-Scholes, which is widely used to price stock options sold in open markets. However, the exposure draft faced strong opposition because it would deflate companies' bottom line.

Companies, especially high-tech, argued that recording employee stock options as a compensation expense would lower their reported earnings and would put them at a competitive disadvantage in the race to raise capital. The impact was especially significant for smaller, financially weak high-tech companies that used stock options to attract employees at lower salaries.

Perhaps it was this industry pressure that motivated Sen. Joseph Lieberman in late-1993 to sponsor a bill that would have required the SEC to make it unacceptable to recognize employee stock options as compensation expense. The bill failed, but its introduction and other pressure compelled FASB to abandon its proposed standard.

CURRENT STANDARD--SFAS NO. 123

FASB finally issued Statement of Financial Accounting Standard No 123, Accounting for Stock-Based compensation in 1995. SFAS 123 recommends, but does not require, that companies treat the fair market value of employee stock options as compensation expense. Very few companies do.

Instead, they use the other option, the intrinsic value approach, which recognizes as compensation expense only the amount in excess of the market price over the exercise price on the grant date.

Companies choose this approach because stock option compensation does not reduce a company's reported earnings. Here's how it works: A company usually sets the exercise price equal to the market price of the stock on the grant date, so no compensation expense from stock options is reported. With the intrinsic value approach, the company then discloses the pro forma net income and earnings per share according to the preferred method of SFAS 123 in a footnote.

Kathleen Pender, a San Francisco Chronicle columnist, analyzed 2001 reported net income of the Bay Area's largest 25 companies along with what those companies would have reported if they had deducted the fair market value of employee stock options.

Seven of the 25 companies would have reported a loss instead of a profit. For many of the companies, there would have been a dramatic shift in the bottom line. For example, Intel's profit would have dropped from $1.3 billion to $254 million; and Cisco's loss would have increased from $1 billion to $2.7 billion. No wonder investors are skeptical of reported earnings.

YOU CAN HAVE YOUR CAKE AND EAT IT TOO

When employees exercise stock options, a company is entitled to a compensation expense deduction equal to the difference between the exercise and market price. This is done in spite of the fact that the company never spent any cash and never deducted the employee stock options as an expense for financial reporting purpose. Many large corporations have avoided federal income taxes in recent years due to this deduction.

THAT AIN'T ALL

Distortion of earnings under the intrinsic value approach is only one issue related to not expensing stock options using the fair market approach.

Since the intrinsic value approach has no effect on the bottom line, there have been lavish stock-option grants to top executives and directors. This has contributed to a culture of greed leading to many undesirable consequences. Enron emphasized stock price growth at any cost. Oracle's CEO exercised stock options shortly before the company issued an earnings' warning last year.

Employee stock options also dilute the ownership of current stockholders. It transfers wealth from existing stockholders because the company could have sold the shares at a higher market price instead of a cut-rate exercise price.

Requiring companies to expense employee stock option at fair market value would solve many of these problems as companies would be more selective in granting stock options. But above all, it will help restore investor confidence in reported earnings.

M. Zafar Iqbal, CPA, Ph.D, is an accounting professor at Cal Poly State University, San Luis Obispo and a member of CalCPA's Global Opportunities Committee and a California CPA Education Foundation trustee. He can be reached at [e-mail].