LONDON, 30 September — Equity markets are currently obsessed with the issue of accurate reporting of employee stock option schemes. In the US, most of the attention is focused on the influence of employee stock options on corporate profits as well as the impact of pension plans on the earnings situation. Investors are furiously debating questions relating to the size of past and future company profits and the scope that firms have to dress these profits up.
The debate could go even further: Investors could, for example, ask what portion of research and development costs can be capitalized as an asset on the balance sheet and how much should be written off directly as an expense via the income statement.
However, with this question as with so many other accounting issues there is a fair amount of room for interpretation, which inevitably leads to variations in the way earnings are presented.
The subject of employee stock option schemes is not as new as one might suppose. As far back as 1972 the accounting authorities in the United States decided that employee options did not have to be accounted for as an expense provided that they did not have any intrinsic value (Accounting Principle Board (APB) Opinion 25). In 1993 the matter was taken up once again, though pressure exerted mainly by the technology industry and the US Congress prevented any clear new ruling. December 1995 saw then the introduction of Financial Accounting Standard (FAS) Statement 23. From this point on, companies had to report the cost of options in the notes to their financial statements.
In the recent past, developments have come thick and fast. In July 2000 the International Accounting Standards Board (IASB) published an initial public discussion paper. Just one year later the IASB managed to push through a ruling that stock based compensation should be recorded in the accounts as an expense. At the beginning of this year, Senators John McCain and Carl Levin presented their bill “Ending Double Standards for Stock Options”, which proposed that companies should only be able to deduct employee stock options from their tax liability if the costs were accounted for as an expenses.
In February 2002, the influential technology lobby once again tried to have this ruling thrown out. The lobby will probably find it harder and harder to make its case as time goes on, firstly because of the great public interest in the issue, and secondly because companies have indeed started to account for these costs as expenses. Blue-chip companies such as Bayer AG, which prepares its accounts in accordance with US GAAP, are already now expensing their employee stock options in the accounts.
In the US, companies such as Coca-Cola and the Washington Post are set to follow suit for the first time in the third quarter of this year. Even one of the most well know “new economy” stocks, amazon.com, has decided to do the same. The IASB will meet again in the fourth quarter to discuss worldwide convergence on the use of the fair value method for employee stock option schemes. A final draft is expected in the first quarter of 2003 and a ruling, which may well be adopted by the US, too, will probably come into force on Jan. 1, 2004.
In the US, accounting standards for employee stock option schemes are governed by FAS Statements 123, which was introduced in 1995.
The most significant form of employee equity participation scheme is the stock option plan. FAS 123 stipulated two methods for recording such plans in the accounts: The fair value method and the intrinsic value method — described in APB Opinion 25 — is also permitted. So what do the two methods look like in detail, and what influence do they have on corporate earnings?
With the fair value method, stock options have to be valued at the time they are issued using an appropriate option-pricing model. Normally the Black-Scholes option-pricing model is favored; this is based on the share price, the option strike price, the volatility of the share, the expected dividend yield, the option’s term to maturity and the risk-free interest rate.
The resulting option price is written off over the life of the option and charged to personnel expense. This means that there is a direct impact on the income statement. Consequently, the company’s operating profit and net profit is reduced by the vale of the options that have been issued.
A very simple rule applies to the intrinsic value method. Only the difference between the share price on the day of issue and the exercise price of the option on maturity has to be accounted for as an expense in the income statement. Since the option’s exercise price is normally higher than the share price on the day of issue, the result is normally less than zero. And since the intrinsic value of the option is zero, nothing has to be charged as an expense. There is therefore, no impact on the company’s operating or net profit. The only requirement is that the difference between the fair value method and the intrinsic value method has to be reported in the notes to the balance sheet.
Public pressure on companies to use the fair value method is increasing steadily. We can, therefore, expect to see reductions — in some cases significant ones — in future earnings at both the sector and individual stock level, though not all companies and sectors will be affected to the same extent. As a consequence there will be some major shifts in the relative valuations of sectors and of individual shares with these sectors, and these shifts will have a significant influence on investments decisions. We believe that in the months to come investors will take this issue more and more into account when selecting preferred sectors and companies.
In order to make meaningful decisions, each individual company has to be subjected to analysis. Owing to the wealth of information available, for the purposes of this report we have focused on the companies in the S & P 500.
The relevant information for past years can be found in the “Form 10-K” which companies have to file with the US Securities and Exchange Commission (SEC). Form 10-K is more of less equivalent to a company’s annual reporting, but with an extremely detailed set of appendices. Among other things, a 10-K also shows the impact of employee stock options on earnings. It thus provides a figure for actual earnings as well as one for pro forma earnings. If we aggregate all the individual data at the sector level, we can see the impact for each industry.
In order to be able to come to some conclusions about 2002 as well, we have assumed that companies will maintain their options-issuing activity at the 2001 level and have taken the consensus earnings estimates for 2002 as the actual earnings figures.
(This is Part I of a two-part series)
(The information contained herein is for information only and should not be construed as an offer or a solicitation to purchase, subscribe, sell or redeem any investments. While Clariden Bank uses reasonable efforts to obtain information from sources, which it believes to be reliable, Clariden Bank makes no representation or warranty as to the accuracy, reliability or completeness of the information)