Options Expensing Ripe for Abuse

Troy Wolverton
TheStreet.com Staff Reporter
6/29/2004

Opponents of a proposed accounting change contend expensing options will end up overstating costs, leading to unfairly depressed earnings results. Ironically, a number of accounting experts worry about the exact opposite -- that some companies are grossly underestimating the value of options and thus artificially inflating their earnings.

This is not just a theoretical concern. Although U.S. companies currently don't have to include options expense in their income statements, they do have to estimate their value. Those costs -- included in footnotes in financial reports -- often appear to be dramatically understated, accounting experts say.

"What we see are companies selecting methodologies and assumptions [to value options] which vary widely," said Greg Taxin, CEO of proxy advisor Glass Lewis. "The people who are probably underestimating the cost the most are the same people who haven't yet started to expense them."

Firms Glass Lewis claims are guilty of low-balling the cost of their options include eBay (EBAY:Nasdaq) , Maxim Integrated Products (MXIM:Nasdaq) , Checkpoint Systems (CKP:NYSE) and Gymboree (GYMB:Nasdaq)

eBay represents perhaps the starkest case. In arguing against the company's plan to increase its options pool last year, Glass Lewis projected that eBay would award $1 billion worth of options in 2003.

But eBay estimated that its 2003 options grants were worth less than half of Glass Lewis' projection. Why the huge discrepancy? Taxin noted that eBay used numbers for shelf-life and risk-free interest rates that were much lower than what Glass Lewis used. Based on its estimates of those values -- and eBay's actual options grants last year -- Glass Lewis now thinks that eBay's options grants were actually worth nearly $700 million last year, or about 57% higher than eBay's own estimate.

eBay representatives did not return calls seeking comment.

Accounting Theory and Practice

The issue of how companies value options is important, because a proposed accounting rule by the Financial Accounting Standards Board, or FASB, would require all publicly traded companies to recognize options costs next year. Although the fate of that proposal is uncertain, most observers think companies will soon have to recognize at least some options costs.

Underestimating Options?

Company *Options Granted (mln) Avg. value per option (Co. estimate) Gross Grant Value** (Co. estimate) Avg. value per option (Glass Lewis estimate) Gross Grant Value ** (GL estimate) % Difference Between firm and Glass Lewis Estimates

Maxim 19.432732 $10.25 $199.19 20.38 $396.04 98.8%

Gymboree 1.432 6.16 8.82 8.43 12.07 36.2

Checkpoint 0.9385 3.13 2.94 6.99 6.56 123

eBay 26.694 16.31 435.38 25.55 682.03 56.7

*Most recent fiscal year. ** In millions. Sources: Glass Lewis and companies' annual reports.

Technology companies in particular could take a huge hit to earnings if forced to recognize options expenses. For instance, according to its own estimates, PeopleSoft (PSFT:Nasdaq) last year would have posted a loss of $75.5 million, or 22 cents per share, instead of a profit of $85.0 million, or 25 cents per share, if it had included options costs.

At Yahoo! (YHOO:Nasdaq) , expensing stock options would have slashed net income 85% in 2003, while earnings would have been down about 18% at chip-giant Intel (INTC:Nasdaq) .

But those figures assume the companies' estimates are accurate. When companies determine the cost of options, they essentially are making a projection of the future value of options they grant in a particular time period. They can use a number of methods to forecast that value, most notably the Black Scholes formula and the so-called binomial method. These formulas determine the value of options by factoring in a number of variables, including the current price of the underlying stock, the exercise price of the options, the stock's expected volatility, risk-free interest rates and the options' projected shelf life.

While some of those variables are difficult to tweak -- companies have to use their real stock price and the real exercise price in their options calculations, for instance -- others are much more flexible. Firms have wide latitude in estimating future volatility, for example, or in projecting how long their employees will hold on to their options before exercising them. With both variables, lower numbers lead to reduced estimates of options costs.

"Arguably all companies will have an incentive to underestimate" if forced to expense options costs, said Lucian Bebchuk, a professor of law, economics and finance at Harvard Law School. "The evidence is strong that, in general, management always errs on the side of lower numbers where discretion is available."

Indeed, public companies have a poor track record with estimates. Many companies have chronically underfunded their pension plans by assuming the most optimistic returns. Others have overstated their ability to collect on accounts receivable by understating the percentage of customers who will default.

FASB, which regulates the accounting industry, is aware that companies will have flexibility in determining their options costs under its expensing proposal. But that flexibility recognizes the reality that companies are different and each will be able to come up with an options value that is unique to their characteristics, said FASB board member Michael Crooch.

"There are judgments in the inputs to this," Crooch said. "But I believe that managements are in the business of trying to do the right thing. [About] 99.9% of managements are trying to report the results of their operations as best they can."

But some experts question whether certain companies are truly trying to come up with the most reasonable estimate of options costs -- or whether they are trying to come up with a number that reflects best on their income statement.

In a report last month, independent accounting analyst Jack Ciesielski took a close look at the underlying assumptions S&P 500 companies used in determining options costs.

According to Ciesielski, 53 companies lowered estimates of both future volatility of their stocks and the expected shelf life of their options in 2003 vs. the values they used in 2002, including Apple Computer (AAPL:Nasdaq) , Monster Worldwide (MNST:Nasdaq) , Adobe (ADBE:Nasdaq) , ADC Telecommunications (ADCT:Nasdaq) and Lexmark (LXK:NYSE) .

Lowering both of those values at once is an apparent contradiction, Ciesielski wrote.

Generally, if a stock is less volatile, options holders will have to hang on to their shares longer before they can exercise them. Likewise, as a stock becomes more volatile, options will have a greater likelihood of being in the money and options holders will have more opportunities to exercise their shares.

Representatives for those companies did not respond to inquiries about the assumptions they used in calculating their options.

Companies that lower their assumptions on volatility or options shelf life could honestly believe that those values are going down, Ciesielski said. But they could also be trying to illegitimately minimize their options costs.

"Stock option compensation has been controversial because firms don't like to disclose compensation," Ciesielski wrote. "It's only right to view assertions about the compensation with a large dose of skepticism."

Watching the Watchdogs

Regardless of the incentives and corporate America's spotty track record, at least some in the accounting community believe companies will try to be honest about their options estimates -- or will be forced to.

Auditors could keep firms in line if they "feel that the assumptions are getting outside of what's reasonable," suggested Chuck Mulford, a professor of accounting at the Georgia Institute of Technology. "That's one governor on assumptions."

Likewise, FASB's Crooch thinks that with all the intense scrutiny on corporate governance and accounting following the corporate scandals of recent years, companies will do their best to give the most accurate numbers.

From a practical perspective, options cost -- accurate or not -- may end up being overlooked by analysts and investors. Just as many focus on EBITDA, or earnings before interest, taxes, depreciation and amortization, they are likely to exclude options expenses from their earnings estimates.

"Because this is a noncash expense, most people are going to pro forma it out in their analysis," said Jeff Brotman, a professor of accounting at the University of Pennsylvania's law school.

That is, of course, until some company -- or companies -- takes advantage of the gray areas of options expensing and Wall Street's curious leniency when it comes to accounting matters.

Last updated: June 04
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