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Expensing stock options: the rule is final; Or is it? Most companies following new accounting rules since June 15 have begun to expense stock options. But others--including private and smaller public companies--insist the struggle to reject or modify the accounting is not over.

It's happening. After a struggle of more than 10 years, Financial Accounting Standard No. 123(R) is going into effect. Since June 15, certain public companies have been accounting for share-based payment transactions--including employee stock option compensation--as an expense, often against their will and better judgment.

The arguments are widely known. Investors, analysts and the Financial Accounting Standards Board (FASB) tend to agree that stock option compensation is worth something and therefore should have an effect on a company's bottom line. On the other hand, many companies argue that the value of stock compensation cannot be computed with reasonable accuracy and therefore should be relegated to the footnotes of financial statements.

Right or wrong, accurate or fudged, fair or not, 123(R) must be implemented now by large public companies whose fiscal years began after June 15, and soon by private companies and smaller public companies whose fiscal years begin after December 15. All have a choice of prospective or retrospective recognition, and any company can start as soon as it wants.

Corporations have responded in a number of ways, and some insist that the struggle isn't over. Even as they begin to comply with the new rules, they are hoping, and even pressing, for a reprieve. Some have, in a sense, given in. Dell Inc., Aetna Inc., Pfizer Inc., McDonald's Corp., Time Warner Inc., ExxonMobil Corp. and Microsoft Corp. are among the companies that have either stopped granting stock options to employees or have cut back to offer them only to top executives.

Many companies, however, would rather suffer the hit to profits than lose an invaluable employee incentive. And, in some cases, the stakes are high. Intel Corp. plans to apply prospective recognition beginning in fiscal 2006. It doesn't expect the first report to look pretty. The company's 10-Q for the period ending April 2 reported a $333 million drop in pro forma net income, which went from $2.178 billion to $1.845 billion.

Qualcomm Inc. expects to get hit hard, too. Bill Keitel, executive vice president and CFO, says that according to the theoretical expense reported in the company's financial footnotes, earnings per share (EPS) in future statements could drop by 13 percent. Yet, dropping options isn't an option, since 99 percent of Qualcomm's employees have received or are receiving stock options as compensation, and not without reason.

"We really think the shareholder benefits greatly," Keitel says. "With an equity incentive program, we attract better people, and our retention rate is the envy of many. It affects how employees think, day in and day out. The fact that they have these stock options affects how they work," he says. "It helps people think longer term and in terms of growing our cash flow."

So, although Keitel doesn't like the new rule, Qualcomm will continue to use stock options as an inspirational carrot. The options issued each year constitute less than 2 percent of outstanding stock, he says, "a small amount of dilution in exchange for attracting and motivating people."

But that doesn't mean he isn't worried. He's going to be monitoring shareholder response to the inevitable dip in profits. Savvy investors will know what's going on because they've been following the pro forma effect of 123(R) as it was disclosed in footnotes. Others, however, might balk at the apparent drop in company performance.

Keitel's problem with the new rule is three-fold. First, there's the blow to profits. Second, there's the burden of calculating the fair value of stock options that are issued today but not redeemable for many years into the future. And third, all that calculation doesn't lead to an accurate answer because nobody knows when or whether the options will be exercised or what stock will be worth at that time.

Like many corporate officers in his shoes, Keitel holds out hope for a proposal that Cisco Systems Inc. has tendered to the Securities and Exchange Commission (SEC). The proposal is for a derivative instrument--a socalled "Employee Stock Option Reference Security" (ESORS)--designed to mimic the value of stock options issued to employees. These instruments would have a fixed term, an exercise price equal to the price of common stock, and an exercise date well into the future.

As the theory goes, once tossed to the winds of the open market, these securities will find their natural price. That price, by definition, will be the fair market value of employee stock options. The proposal may have piqued a few eyebrows, but it hasn't sent anyone into back flips. It would be nice if the instruments worked, but the many restrictions on their use and availability only to institutional investors could skew the price toward the cheap. Some say it's just a trick to minimize the reported value of options in question.

If the market can't establish a fair value, companies have to calculate an estimate in what they determine to be the most appropriate way, which boils down to either of two models: Black-Scholes or the binomial lattice. No one seems especially excited about either.

The Procter & Gamble Co. is going with the binomial lattice model. Mick Homan, director of corporate accounting, says it fits the P & G situation better. "At the end of the day, it allows you to plug in more assumptions," Homan says. "To us, it seemed to be a more robust method of estimating the cost, with its ability to factor in company- and employee-specific data."

P & G plans to retroactively restate its financial statements so that pro forma numbers will be built in to the company's financial history, minimizing the perceived impact of putting stock comp on the books.

Qualcomm has opted for Black-Scholes, explaining that the binomial lattice model is just a more complicated version of the same thing. Even so, Keitel says, Black-Scholes was designed for derivatives that are short-dated, transferable and hedgeable--three adjectives that do not apply to employee stock option grants. He'd rather use the value of an instrument that's actually traded on the open market.

"Every quarter I put my name on my SEC report and say, 'This is all accurate.' Now I have to sign off on a theoretical expense that never gets trued up and isn't comparable between companies. I want integrity behind that number, and I think Cisco's come up with the best idea as to how we might be able to do it."

Approval of Cisco's ESORS idea straddles the spiked and wobbly fence between accountancy and politics. Opponents of 123(R) have not hesitated to apply political pressure to the issue. Back in the mid-1990s, the Senate passed a nonbinding resolution asking FASB to drop the project. In 2004, the House passed a bill that would have seriously weakened the impact of the rule.


Since the resignation of SEC Chairman William Donaldson and the appointment of Rep. Christopher Cox (R-Calif.) to succeed him, opponents are hoping that new leadership might turn things around. Maybe they can get the Cisco plan approved. Maybe they can get implementation delayed. Maybe they can get the rule relaxed a bit. And maybe they can get the whole thing shot down dead.

However, if they were listening to Cox's statement to the Senate Banking Committee at his confirmation hearing in late July, their hopes may be dashed. Cox pledged "continuity, clarity and consistency in the commission's rule-making and enforcement responsibilities."

James F. Reda, managing director of New York City executive compensation consultancy James F. Reda & Associates LLC, is seeing movement away from the use of stock options.

"Companies are waiting until the last minute to start booking stock option expense," he says. "Until then, they are doing two things: They're accelerating the vesting term of underwater options [options that won't be exercised because their underlying stock has declined in value] because they don't have to take a hit for that. And they're moving away from stock options and into performance shares."


Performance shares, Reda says, are especially interesting to more mature companies, but he's also advising emerging and high-growth companies to move in that direction. Even though performance shares must be expensed, their value doesn't hit the bottom line until they are granted. Until then, he says, they are more effective inspiration for top corporate officers who understand the underlying economics of companies, their goals and what targets are reasonable in a given industry.

On the other hand, Reda says, if a company moves to performance shares and then the stock comp rule gets changed or delayed, the company will have booked an expense without need. "It's not a done deal," Reda says of 123(R). "There's a lot of stuff going on."

Kim Boylan, a partner with the Washington, D.C., office of law firm Latham & Watkins, says that private companies may be the most adversely affected--not by the expensing as much as by the burden of accounting.


"Private and small public companies will start implementing 123(R) at the same time, for calendar years starting after December 15," Boylan says. "That means they'll be looking for the same consultants at the same time ... and that's problematic because private companies won't have the resources and can't get consultants to pay attention and help them value [stock options]." Also, there are still significant issues on how private companies should value these things. "How do you determine the expected life of an option or stock that doesn't trade and for options that can't be exercised until and unless the company goes public?"

On top of that, Boylan says, "even if companies come up with a number, how are they going to convince auditors that it's an appropriate number?"

Mark Heesen, president of the National Venture Capital Association, feels the pain of the nation's privately held companies. He understands FASB's pronouncement on expensing stock option compensation, but he doesn't see how private companies are going to comply. Few have the resources of an Intel or a P & G, yet their computations will be more difficult. If they dare issue options on stock that has yet to be issued, they're in for an algebraic nightmare of unknowns.

"How are we going to come up with a value for these options?" Heesen asks. "How do we value options for a totally new company, like eBay was, or Google? How do we value an option when there aren't any comparables? How do we value them when you can only compare them to the public companies? Is that a valid comparison? Or do you go out and find other private companies? If so, how do you do that?" These are fundamental issues that FASB has not addressed, he argues.

Heesen says that boards of directors of private companies should be able to decide how their options are valued. If they can come up with a number that they believe is reasonable and auditable, he says, auditors should accept the number as reasonable even if they would have come up with a different number under a different model.

In early July, Heesen met with representatives from FASB and the American Institute of Certified Public Accountants (AICPA) and says he was heartened to find FASB "fairly receptive" to the plight of private companies. FASB plans to discuss it further with its implementation group, which consists of preparers, auditors and users.

In addition, Heesen noted the frustration of being shuttled from one regulatory body to another, each denying jurisdiction over private companies. "The SEC told us to go to FASB, the AICPA told us they need direction from FASB, and FASB told us the SEC needs to be part of the process and that the AICPA should have everything they need to implement expensing for private companies," Heesen says. He asks, "Who's driving this bus?"

Who indeed? Financial executives may be asking themselves, "Where is this bus going, anyway?" "And when, oh when, will we ever get there?"

Glenn Cheney ( is a freelance writer based in Hanover, Conn., who frequently writes on accounting and financial reporting subjects.


* FASB No. 123(R) has gone into effect, although many companies still argue that the value of stock options cannot be computed with reasonable accuracy, and should remain in footnotes to financial statements.

* Qualcomm's CFO has three issues with the new rules: the blow to profits, calculating the fair value and confusion surrounding whether the calculation is accurate.

* With the appointment of a new SEC Chairman, opponents of the new rule hope for a reversal.

* Many executive compensation consultants are seeing a move from stock options to performance shares.
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Title Annotation:stock options
Author:Cheney, Glenn
Publication:Financial Executive
Geographic Code:1USA
Date:Sep 1, 2005
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