Home Health Business Quarterly: Senators take stock of accounting for corporate options
"The stock-option double standard has been a long festering problem in corporate America," according to Sen. Carl M. Levin (D-MI), author of a bipartisan bill that would change how companies account for stock options.
In the wake of the Enron collapse, accounting practices have come under scrutiny, and Levin has found new support for an effort first begun in 1993. The Ending the Double Standard for Options Act (S. 1490), introduced Feb. 13, 2002, aims to amend the Internal Revenue Code so that companies must record stock options as an expense if they also count them as tax deductions.
The bill — cosponsored by Sens. John McCain (R-AZ), Peter Fitzgerald (R-IL), Dick Durbin (D-IL), and Mark Dayton, (D-MN) — doesn’t aim to change accounting standards, just to require companies that take a tax deduction for stock-option compensation as a business expense also show it as an expense on financial statements.
If passed, the Levin-McCain bill could reduce companies’ reported earnings by millions of dollars, in some cases changing profit to loss.
Currently, only two of the 500 companies listed by Standard & Poor record stock-option expenses on both financial statements and tax returns. An analysis by brokerage firm Bear Stearns found that in 2000, the aggregate operating income of those 500 companies dropped about 8% when adjusted for stock-option compensation.
In 1993, when Levin urged the Financial Accounting Standards Board (FASB) to require options to be listed on company financial statements, the FASB merely recommended that they be reported on the bottom line. It still allowed companies to list outstanding options in just a footnote on financial reports.
Enron is one company that took this path. Citizens for Tax Justice analyzed Enron’s public filings, in which the company claimed income of $1.8 billion between 1996 and 2000, but listed options only in a footnote and not with total expenses. The group found the options awarded during those five years were worth almost $600 million, about one-third of the income reported during that time.
"Enron was not acting illegally here, nor were its actions unique," Levin says. The corporation, like many others, followed existing accounting rules in this instance.
The tide may be turning. A survey conducted in September 2001 by the Association for Investment Management and Research found that more than 80% of U.S. financial analysts support charging stock options against earnings on financial statements. Arthur Levitt, who chaired the SEC from 1993 to 2000, says he regrets he didn’t work harder to get stock options treated as expenses. The International Accounting Standards Board, the global equivalent of the FASB, will propose international standards that require options to be expensed at its next meeting.
While critics argue that current accounting practices regarding options distort earnings, companies generally regard options as an incentive they offer employees for future performance. They argue that predicting when options will be exercised and for how much makes it impossible to accurately state outstanding options as an expense. Furthermore, options do show up in earnings per share; outstanding options result in diluted earnings, which are reported.
Many companies use options as a management tool. For example, in 2001, Baxter International Inc., a worldwide medical products and services company, granted stock options to more than 41,000 employees "to further drive alignment of Baxter team member and board of director incentives with shareholder value." The company also changed its long-term incentive compensation program for senior managers and redesigned the compensation plan for its board of directors so that senior managers and board members will receive stock options priced at fair market value the day they’re granted rather than shares of restricted stock.
According to Harry M. Jansen Kraemer Jr., chairman and CEO of Baxter, "These changes serve as a strong statement about the level of excitement that our senior management team and board of directors have about Baxter’s growth prospects and the commitment we all have toward our shareholders."
The FASB has yet to say whether it will set new standards that could change the use of options as compensation.
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