Regulators Delay Rule on Options

By Kathy M. Kristof and Joseph Menn

Oct. 14, 2004 12 AM PT

Times Staff Writers

Bowing to corporate pressure spearheaded by Silicon Valley, accounting regulators voted Wednesday to delay implementing a rule that would force companies to deduct from their earnings the cost of stock options given to employees.

At the same time, the Financial Accounting Standards Board rejected efforts to change the formula that companies would have to use for valuing options. Technology companies had campaigned for an alternative method to lessen the damage to their bottom lines.

In a 5-2 vote, the FASB agreed to require companies to deduct the value of options from earnings starting June 15, 2005, instead of at the end of this year. The regulatory board proposed the rule change last spring, saying the measure was needed to make corporate financial statements more accurate.

“The good news is that they are doing it. The bad news is that it’s taking longer than we thought,” said Nell Minow, editor at Corporate Library, a corporate governance research firm. “But, given the level of opposition, the delay is not surprising.”

FASB member Edward W. Trott said the accounting panel determined that companies -- grappling with other year-end rule changes demanded by federal laws passed in the aftermath of the Enron scandal -- needed more time to change their options accounting.

“What we did with the effective date was to balance the need of [investors], who have been quite vocal that they would like improved financial statements as quickly as possible, with the practical issue that many companies and their auditors are consumed with finishing the original Sarbanes-Oxley requirements,” Trott said.

Stock options are rights to buy shares at a set price in the future. They are a popular form of compensation, particularly among cash-poor start-ups and technology companies.

Under current rules, the cost of stock options is required to be shown only in the footnotes to a company’s financial statement, rather than in the statement’s main profit and loss section.

About 23% of the companies in the Standard & Poor’s 500 index of large, blue-chip companies are already expensing stock options, according to a study by Bear, Stearns & Co. Ford Motor Co., Bank of America Corp. and General Electric Co. are among the companies that are expensing options or have announced plans to do so.

However, some big high-technology companies such as Intel Corp. and Cisco Systems Inc. are staunch opponents. They complain that the current method for valuing options is inaccurate because it was designed to create a price for options that could be easily bought and sold on an exchange.

Options given to executives are often subject to restrictions that make them not readily salable, so the formula should be changed to discount their value, these companies contend. In addition, they say they are at a disadvantage because tech stocks tend to be volatile -- and under the current formula, volatile stocks are considered more valuable because of the potential for big gains.

Rick White, chief executive of TechNet, a Silicon Valley interest group and a forceful opponent of expensing, said the new rule would have a chilling effect on technology companies.

“The market will probably understand in the short term,” White said. “But every quarter from then on there’s going to be pressure on them to reduce the number of stock options they give out.

“Over time,” he added, “you’re going to see a drastic reduction in the number of stock options given out and the number of rank-and-file employees who are eligible.”

Institutional investors said the FASB rule was sorely needed to make financial statements transparent and comparable.

“It comes down to a few basic principles,” said Ann Yerger, deputy director of the Council of Institutional Investors, a Washington group that represents 140 pension funds.

“We believe that [option] awards are compensation and the value can be reasonably estimated. As such, the cost should be expensed, as all other forms of compensation are,” she said. “Right now, the financial statements of a company that is primarily compensating its employees with cash cannot be compared to a company that is primarily compensating with stock options and that is just ludicrous.”

As for the effect on earnings, a study by Standard & Poor’s estimated that expensing options would reduce the 2004 reported earnings of companies in the S&P; 500 by 5.7% overall.

Some key opponents and trade associations vowed Wednesday to continue fighting. A bill to scuttle the FASB measure passed the House this year, but went nowhere in the Senate.

“We’re still pursuing the legislation route in the Senate,” said Cisco lobbyist John Earnhardt. “And we’re still trying to work with FASB and the SEC. If this is the way it has to go, the valuation [formula] has to be fixed. It’s way, way too high.”

With the main Senate proposal against expensing bottled up in committee, Earnhardt said opponents would try to amend an appropriations bill, probably after the Nov. 2 election.

“There’s a lot of time between now and June 15,” said White of TechNet.

Minow said that even if the technology companies were successful in getting Congress to upend the FASB’s rule, they would face the wrath of increasingly activist shareholders.

“Investors take this very seriously,” Minow said. “The companies that are not persuaded on this issue are going to sell at a very steep discount because of what investors see as a lack of transparency in their financial statements.”

“The market test is always more powerful than any regulation,” she added. “That will ultimately be the deciding factor.”