Many large U.S. companies are already expensing stock options, but most are waiting for the regulatory mandate.
The summer stampede to announce stock option expensing has slowed to a saunter. Among the S&P 500, only two organizations -- Boeing and Winn-Dixie Stores -- treated stock options as an expense before July. By October 15, 112 major U.S.-based companies had announced their intention to begin expensing options. However, after the rush of late summer, many companies flatly announced that they will not treat options as an expense until they are forced to do so. They may not have to wait long.
For the most part, the expensing of stock options has been adopted where it is least needed (see Companies Expensing Options, below). Experts agree that expensing will have the smallest effect on earnings in the energy, consumer staples and financial services industries. It will hit hardest in the IT, consumer discretionary, telecom and materials industries -- and most of these companies refuse to jump on the bandwagon. The high-tech industry is continuing its long fight to block any congressional or regulatory attempt to make expensing mandatory.
Chicago-based Bank One Corp. and the media giant Washington Post Co. were among the first businesses to announce that they would adopt expensing. Bank One treated options as an expense in its second-quarter earnings statement, released in mid-July. "We did it for the simple fact that we think it's accurate, fair and reasonable, and we just want to get this thing behind us and move on as a company, recognizing reality," says Jamie Dimon, chairman and CEO of Bank One. "The most important thing for shareholders is that they know the facts as best as we know them."
Companies Expensing OptionsMore than 100 companies have announced that they will account for stock options as an expense, including those listed below.
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The Washington Post Co. decided to treat options as an expense early in 2002, reports Jay Morse, CFO. "We did so because we believe that this is a form of compensation which should be recorded as a cost," he says. "Although we did not publicly announce our intention to do so until July, we had in fact already gotten our letter of concurrence with the change from our independent audit firm."
For the six months ended June 30, 2002, Bank One's expensing affected net income by $8 million and fully diluted earnings per share by $0.01. The company estimates that the impact on net income and EPS for the full year will be $28 million and $0.02, respectively. At the Washington Post, "the change has as yet had no impact on our reported results for two reasons," Morse reports. "First, we have issued no options as yet this year. And second, we intend to follow the guidelines of FAS 123, which apply the new method on a prospective basis."
Merrill Lynch estimates that if all companies in the S&P 500 had accounted for options using FAS 123, their aggregate earnings per share would have declined by 21 percent in 2001 and 10 percent in 2002, assuming all other factors remained unchanged. Merrill Lynch also developed industry-specific estimates, which range from a 2 percent drop in EPS for utilities to a 70 percent decline for IT businesses.
Because the effect on earnings could be so huge, controversy surrounds the decision of how to value options. When Coca-Cola announced that it would adopt expensing, it also stated that it had devised a unique procedure for valuation, using a bank bidding process, with the bids averaged to determine the value of the stock. Bank One selected the FAS 123 fair value method. Under the terms of Bank One's stock option plan, up to 2 percent of the outstanding common shares are authorized for issuance per year, or 24 million shares in 2002, and unused awards may be carried over to future years. The company will continue to account for options granted prior to Jan. 1, 2002, under APB 25.
Morse doesn't think the finance function at the Washington Post will find the choice of an expensing method burdensome. "We will probably use Black-Scholes [Option Pricing Model], although we will certainly consider other acceptable options if offered by the FASB," he says. "Since we already have actuaries who value the stock for disclosure purposes in the footnotes, we intend to continue this same process to arrive at the cost to be recorded."
Although the immediate investor response to expensing has been lukewarm, pressure continues to build for mandatory expensing, particularly from institutional investors. The U.S. Congress has sidestepped the issue, so the best bet for mandatory expensing now lies with the International Accounting Standards Board. The IASB issued a discussion paper on expensing in July 2000 and has been working steadily toward an international standard since then. Regulatory accounting bodies around the world, including the FASB, are waiting for the IASB to act.
In September 2001, the IASB concluded that companies should recognize stock option expenses in their financial statements and use a fair-value method. An IASB exposure draft on expensing is expected by the end of this year, followed by a three- to four-month comment period and finalization by the end of 2003. The FASB would then determine whether to adopt the IASB standard. Businesses based in countries that adhere to IASB standards would begin expensing in 2004; all companies listed in the European Union must adopt IASB standards by 2005.
With global standards nearing completion, many foreign companies have decided not to adopt expensing until the IASB acts. In Europe, where stock option plans have proliferated in recent years, guidance remains scarce because governments are reluctant to issue expensing rules that would put companies within their borders at a competitive disadvantage.
Daniel L. McConaughy, Ph.D., partner in charge of valuation services for Los Angeles-based Valuation Advisors LLC, says, "Both the IASB and the FASB are serious about the accounting for the economic impact of these transactions, which sometimes is large, and they will adopt new rules for expensing options. Along with adopting new rules, there needs to be an education process so that investors understand the numbers and the cash-flow impacts of these transactions."
Dimon says that Bank One's shareholders and analysts "have been pleased by the disclosure" that occurred with expensing. Morse reports that the response from the Washington Post's shareholders and analysts "has been very favorable, virtually united in support." But most of the companies that have decided to treat options as an expense have been rewarded only briefly in the markets. Generally, their stock prices rise on the day they announce their decision, but prices drop soon after.
As companies turn to expensing, with or without legal or regulatory mandates, more questions may arise from shareholders about the real return that can be expected from stock options. "Options are not free. Check out the Chicago Board Options Exchange," McConaughy notes. "The issuance of options is expensive to the shareholders of the company."
How much shareholders are willing to pay to reward key employees will become the larger issue once expensing is common. In the meantime, CFOs should understand that shifting to stock option expensing is no longer a question of if, but of when.
Resources on Expensing Stock OptionsFASB. At its August meetings, the FASB addressed issues related to the transition and disclosure provisions of FAS 123. These decisions and other materials related to expensing are posted at www.fasb.org [1]. IASB. The International Accounting Standards Board's discussion paper "Accounting for Share-Based Payment" can be ordered at www.iasc.org.uk [2]. Standard & Poor's. S&P maintains an up-to-date list of companies that have announced they will treat stock options as an expense, available at www.spglobal.com [3]. |
Links:
[1] http://www.fasb.org
[2] http://www.iasc.org.uk
[3] http://www.spglobal.com