Firms' abuse of stock options draws new scrutiny

Back in February, Senators Carl Levin (D) of Michigan, John McCain (R) of Arizona, and three other senators introduced legislation that would "plug a corporate tax loophole."

The bill, stirred up by the Enron scandal, would require corporations to expense on their shareholders' earnings statements the stock options issued to executives if the firms claim tax deductions for the options.

That bill is now before the Senate Finance Committee.

During the 1990s golden age of the high-tech industry, options made instant millionaires of hundreds of executives at dotcoms, and at high-tech, telecommunications, and other firms. With stock prices rising rapidly, the executives would frequently "exercise" their options – buying stock from their company at the price when the options were first issued.

"Stock options are a stealth form of compensation because they do not, under current accounting rules, have to be shown as an expense on the corporate books," Senator Levin stated. "The result is a misleading picture of a company's finances."

In other words, companies told Uncle Sam one thing and stockholders something else. The assumption is that this enabled Enron and other companies to fool investors about the true value of their companies.

Some business-school researchers say the options issue isn't so simple.

First, they note, it was Congress itself that in the early 1990s blocked the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission from requiring companies to report options as expenses in their income statements.

Such senators as Barbara Boxer (D) of California and Joseph Lieberman (D) of Connecticut used tough tactics to protect executive options.

"Congress is being very disingenuous," charged a professor.

Second, while the FASB, the private group that sets accounting standards, ruled in 1995 that companies must disclose what the net income and earnings per share would have been if the fair value of employee stock options had been charged as a compensation expense, they only had to do so in a footnote in their annual report.

The ruling did recommend that companies charge as an expense – in their regular financial statements – the fair value of an option over the period it takes for the options to be vested with the executive, say, five years.

Two of 500 companies in the Standard and Poor's 500 Index – Boeing and Winn-Dixie – actually did so. The rest did not, apparently fearing it would hurt their stock price.

An FASB spokeswoman, Sheryl Thompson, says the board will not take up its ruling again – that "the ball has been moved down the field" – presumably into the hands of Congress.

Third, the academics say, investors and their Wall Street advisers can read footnotes as well as basic financial statements. So stock prices already reflect the fact that options, when exercised, dilute the value of a company's stock. (The earnings of the company are spread over many more shares.)

"Though accounting numbers are not getting it quite right, the stock market is getting it approximately right," says S.P. Kothari, an expert at Massachusetts Institute of Technology's Sloan School of Business.

Mr. Kothari bases his opinion on a study of 400 stocks over the past five years. But the study doesn't indicate whether improperly reported options distort stock prices of individual companies.

Certainly the stock dilution can be large. A report last summer by Bear Stearns & Co., a Wall Street investment firm, found that if stock options were taken into account, aggregate earnings per share for the S&P 500 in 2000 would fall about 9 percent. Aggregate operating income would fall 8 percent.

Those are far from small numbers. And in some industrial sectors, adjusted earnings would be dramatically lower than pro forma earnings. The worst, communications equipment, was down 170 percent. Think Nortel Networks.

One author of that Bear Stearns report, Pat McConnell, suspects that investors in some industries, such as specialty retailers, are not sufficiently aware of the dilution of their shares.

The number of options outstanding is huge. In 2000, companies that made up the S&P 500 had 6.5 billion outstanding, up 32 percent from 1999.

MIT's Kothari says the Levin bill will not affect the stock market. But it may influence corporate boards in their decision to award options to executives if these are expensed on the books.

Some corporations "have been rather careless about issuing options," he maintains.

They may have been too generous. Options give executives an incentive to make their companies thrive – and thus boost their stock prices. But it's suspected that some executives seek short-term easy gains at the expense of long-term prosperity.

Any effort to change options accounting will face a fight. Last week, business groups in Washington formed a coalition to preserve and protect stock options.