How corporate America is being coerced into expensing options.

How corporate America is being coerced into expensing options.

How corporate America is being coerced into expensing options.

Moneybox
Commentary about business and finance.
Aug. 15 2002 6:53 PM

No Options on Options

How corporate America is being coerced into expensing options.

Congress is considering whether to require companies to treat stock options as an expense, a cause that has invited much righteous chin pulling and tut-tutting from outraged members. But this is one area where market forces are already proving far more effective at compelling reform than any bipartisan bill.

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Back in 1994, the Financial Accounting Standards Board was set to require companies to treat the options they doled out as an expense. This was anathema to many firms, especially young technology companies that used options liberally as a compensation and retention tool. Under heavy lobbying from the technology industry, and with the assistance of Democrats like Sen. Joseph Lieberman, Congress effectively killed the measure.

But with the decline of the markets and the rolling scandals, the entire culture of options has come under intense questioning. And while the accounting treatment of stock options wasn't a significant part of the rot at Enron, Global Crossing, or WorldCom, the issue has emerged as a potent symbol.

In the spring, do-gooder institutional investors like the California Public Employees Retirement System and TIAA-CREF began to bang the drum for options expensing. In May, Federal Reserve Chairman Alan Greenspan threw his weight behind expensing. "I fear that the failure to expense stock option grants has introduced a significant distortion in reported earnings," he said. It is a sign of his diminished stature that Greenspan's call was largely ignored and that President Bush openly disagreed with him.

The technology industry continued to resist bitterly, even if the reasoning was occasionally contradictory. Promoters of the status quo tended to argue that: 1) Since markets are perfect and efficient, investors make their own judgments about the cost of options and incorporate the dilution of existing shares that they cause into the price of a stock; and 2) expensing options as a real cost on the income statement would cause companies to reduce their reported earnings sharply, thus triggering sharp falls in stock prices—which would mean the market isn't quite as perfect as all that.

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The move to expense options received a major push this summer from longtime expensing-promoter Warren Buffett. In the late 1990s, Buffett was mocked as a fuddy-duddy who didn't understand technology companies or the way they compensated their employees. Now he's having the last laugh. In mid-July, Coca-Cola, a company in which Buffett has an 8 percent stake, became the first blue chip to announce it would expense options. Next came the Washington Post, another company in the Buffett chaebol.

These were essentially costless moves. Coke and Washington Post don't employ options widely, so expensing them will reduce their earnings by minuscule amounts—by one penny per share in Coke's case. But it created an immense benefit: positive press.

Seeing the reaction, other blue chips with little to lose and much to gain announced their attention to expense options: General Electric, Procter & Gamble, and several other card-carrying members of the business establishment.

In the meantime, embattled companies seeking to regain some of their lost buzz embraced expensing options. Fallen angels like Amazon.com, Disney, and Computer Associates jumped on the bandwagon.  For these companies, which do employ options liberally, expensing was an offering meant to appease the corporate governance spirits. It was a genuinely self-abnegating move, for there's nothing a CEO values more than the profits he can report.

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Last week, the trickle turned into a flood. On Aug. 12, the Financial Services Forum, a group of giant financial services companies, said its 18 publicly held members—among them Citigroup, J.P. Morgan, Goldman Sachs, and Merrill Lynch—would expense options. Since their primary business is peddling stocks and other investment products, supporting an effort designed to increase confidence in stocks was a shrewd marketing move.

In the midst of the rush, a lone, plaintive voice protested. Intel CEO Craig Barrett last week mounted a principled defense in a Wall Street Journal interview, explaining precisely why the chip giant wouldn't be expensing options any time soon.

But such reasoned discourse has been drowned out. Unlike Intel's Barrett, the vast majority of CEOs don't really think for themselves. When American International Group announced it would expense options, its CEO Maurice "Hank" Greenberg said: "The perception out there today, erroneously, is that not expensing stock options is wrong." (A prize to the first reader who correctly calculates the number of double negatives in that sentence.) Nonetheless, he continued, "The perception is more important than the substance."

Declaring your fealty to expensing options now is a little like jumping into a trench long after it has been cleared. It's conspicuous, and you'll get rewarded for it, but it doesn't require a whole lot of bravery. Yesterday alone, at least eight companies announced their intention to expense, including Wal-Mart.  Today, by my count, nearly one-third of the Dow Jones industrial average, and more than 80 companies overall, have come out for expensing options.

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Have we reached the tipping point? Maybe. While 80 is a small number, the expensing cohort includes the massive market leaders in industries such as insurance, retailing, banking, travel, aerospace, and consumer products. And executives instinctively mimic the practices that the leaders in their industry follow. The consultants call it following best practices or benchmarking; I call it imitation.

Other marketplace forces that have nothing to do to with Congress will also compel more companies to start expensing. Two years ago, if you mentioned the term "expense options" to a CNBC anchor, he would have scratched his head. But with the zeal of the converted, talking heads have taken to grilling CEOs about their expensing of options. Earnings reports from Dow Jones and other news services will start to carry disclaimers, or asterisks, as to whether the company is an expenser or not.

This week the Financial Accounting Standards Board said it would propose that companies disclose the values of options each quarter in their SEC filings—instead of once a year in their annual reports. As more companies move to expense options, and as their executives call for uniform standards, FASB could move to require all companies to expense options. It's doubtful Congress would resist again. And one could well imagine the New York Stock Exchange using its listing standards to force its constituents to expense options.

Despite the significant holdouts—Intel, Cisco, and Microsoft—one way or another, options are going to be expensed. Either companies will record them as costs on their income statements or, if they refuse, the press and the market will punish them, effectively counting their options for them. In this new bipolar world, it might be reasonable for investors to value a dollar of earnings reported by a company that expenses options more than a dollar earned by a company that doesn't.

Ultimately, non-expensers may come to be regarded as the smokers of the investment world—marginalized, increasingly shunned, and punished merely for continuing to practice a once-acceptable habit.