Options: Cutting Through the Thicket

First, the good news. With investors railing against overly generous employee stock-option programs, some 270 companies -- many of them well-known -- have promised to include the cost of options in their bottom lines. Every week, more companies are coming aboard. The bad news? Corporations may choose from among any of four methods to calculate these costs, undermining "the comparability and usefulness of financial statements in the near future," says David Bianco, valuations and accounting analyst at UBS Warburg.

Accounting's rulemaking body, the Financial Accounting Standards Board (FASB), has promised to clear up the confusion next year, when it plans to issue yet another accounting standard. FASB has vowed to require companies to put the cost of options on the income statement -- right now, it's required only in the footnotes -- despite opposition from many of the high-tech companies that have awarded generous options packages in the past.

No matter what happens, there are plenty of reasons to pay attention to options, since they can transfer wealth from shareholders to employees. That's why in this installment of The Fine Print, a series that shows investors how to dissect corporate financial statements, we're examining the state of options disclosure.

A few basics: Stock options give their holders the right to buy a certain number of company shares, generally at the price that prevails on the day the options are granted. In the standard employee option, that right usually extends for 10 years. Say an employee has an option to buy a share for $10 when it's trading at $50. To exercise the option, the employee pays the company $10 a share for the stock. Then the employee can hold it or sell it for $50, pocketing $40.

While the employee makes out well, other shareholders do not. Exercised options turn into stock, which increases the shares outstanding. With earnings spread over more shares, the earnings per share decline, reducing each stockholder's slice of the pie. Companies with rapidly rising earnings might avoid this problem. More often, corporations buy back stock on the open market to avoid increasing the share pool. If the company spends $50 for a share it sells to an employee for $10, there's a cash drain. The impact doesn't show up in the earnings statement, but it hurts the cash account. "There's a cost to issuing options," says Charles Mulford, director of the DuPree Financial Analysis Lab at Georgia Institute of Technology.


When you read an income statement, it's not obvious which of the four options-accounting methods was used. That's because, instead of breaking out stock options as a separate line on the income statement, companies often lump them into broad categories, such as "Selling, General & Administrative Expenses," says Janet Pegg, accounting analyst at Bear Stearns (BSC) As a result, investors must look in the footnotes to the financial statements for information to determine which method was used.

In the footnotes, companies reveal important details about their options programs -- for an overview, see BusinessWeek's Apr. 15, 2002, issue. Now, a new table in the quarterly report restates the bottom line for the cost of options. This makes it easier to compare the results of companies that follow different methods of options accounting.

-- The old method. Like many other high-tech companies, Siebel Systems (SEBL) a San Mateo (Calif.) provider of business software, sticks to the long-standing practice of disclosing the options expense in the footnotes, without bringing anything into the income statement. How can you tell if a company is doing this?

Look at Siebel's income statement for the quarter ended Mar. 31. There, the software maker reports a $4.6 million profit. However, the table in the footnotes (table 1) tells a different story. It shows that if Siebel's options had been expensed, the company would instead have had a $303 million "pro forma" loss. According to this table, Siebel included only $505,000 of its options expense in the income statement, just 0.16% of the total cost. The $505,000 covers special categories of options, mainly issued by companies it acquired.

Siebel's table covers more ground than most others. It breaks down the options expense to reveal how much is related to "in-the-money" options -- those that could be exercised profitably now -- as well as options that have been canceled or are "out-of-the-money" or cannot be cashed in now for a profit.

-- The "prospective" method. Unlike the old method, the prospective approach plugs the options expense into the income statement. But it doesn't factor in all the expense. Companies using this method, such as banking giant Citigroup (C), must expense options granted from the year they make the accounting switch forward. But they can ignore past grants that, after all, have a cost.

Look at the options table in Citigroup's first-quarter financial statement (table 2). The first line shows that the bank reported $13 million of stock options expense on the income statement. The second number, $94 million, is pro forma -- or what the stock options expense would have been if past options grants were also counted. With only 14% of its expense on the books, Citi's net income was $4.1 billion -- or almost 2% more than it would have been with the full options expense deducted.

That understatement won't last forever. Indeed, over time, more and more of the outstanding grants will be included in the income statement, says David Zion, accounting analyst at Credit Suisse First Boston (CSR) Why? Because eventually, the past grants that the prospective method ignores will drop out of the picture. Meanwhile, grants issued from this year forward will be included in the bottom line.

To see why it's only a matter of time before all outstanding grants are accounted for, consider a company that issues a new options package today. When a company grants new options, it values them using an options pricing formula that incorporates factors including the stock's volatility and expected dividend. The company then spreads that expense over the years in which the options "vest" -- or become eligible to be redeemed for stock. Thus, a $100 million grant issued today that vests after four years creates $25 million of options expense in each of the next four years.

Because the prospective method ignores past grants, it requires the company in the above example to book only $25 million of options expense today. However, next year, another $25 million will go into the expense ledger -- plus a portion of any new grants made. As a result, Citigroup estimates that by 2005, its annual earnings per share will fall by 6 cents per diluted share because of the new options accounting rules.

-- The "modified prospective" method. This one goes a step further by plugging the entire options expense -- including past grants -- into the income statement right away. In the first quarter, insurer Chubb recognized $15.8 million of options expense, a sum that matches the full options expense disclosed in its footnotes (Table 3). As a result, Chubb's reported income of $224.6 million is the same as its pro forma income. Still, in the first quarter of last year, Chubb recorded just a portion of its options expense. So when comparing this year's results with the past, look at the pro forma results instead of what's on the income statement.

-- The "restatement" method. Like the previous method, this one recognizes the full options expense at once. But it's even better: It restates past results, too. Only a few companies, such as Wal-Mart Stores and SBC Communications (SBC), have taken this approach, says Bear Stearns. Even here, though, you have to look in the footnotes -- if only to confirm that the restatement method was indeed used.

So until FASB comes up with one method that puts all the options expense on the income statement, look in the footnotes. Otherwise, you might miss something important -- such as a profit that turns into a loss once the options cost is included. By Anne Tergesen

American Apparel's Future

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