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If the force of investor outrage, accounting regulation
and possible legislation in Congress changes the way corporations report
the costs of stock options, the result could be sharp declines in the
stock prices and earnings of hundreds of major companies.
That's because those costs generally are not included in reported earnings,
on which stock prices are based. Earnings look higher than they might
otherwise be, helping to push stock prices up.
This is not really a secret. Companies state the implied cost of stock
options in footnotes to their annual reports. Microsoft Corp., for example,
where many employees have grown wealthy on stock options gains, explains
in its 2001 annual report that if it had charged an expense for stock
options, its reported earnings would have been 91 cents a share instead
of $1.32.
Likewise, Amgen Inc. explains that its earnings would have been 86 cents
a share instead of $1.03; Northrop Grumman Corp. would have reported $4.65
a share instead of $4.80.
The difference was not the result of deception. There are many reasons
options costs haven't been included. But change is coming because of abuses
of the stock options system by many top corporate executives.
Reform should help remove distortions and give investors a clearer picture
of profits and companies' finances. But reform will carry costs and unintentionally
could be anti-entrepreneurial.
Reported earnings for the firms in the Standard & Poor's index of
the 500 major blue-chip companies could decline by 10% on average, estimates
a study by Merrill Lynch Global Research.
Other consequences could crop up, such as a mad flurry of stock buyback
programs to offset the effect of officially counting more shares in the
calculation of earnings per share.
Stock options for broad ranks of employees--a compensation innovation
that has grown in recent years--probably will be cut back.
"Companies will have a disincentive to be generous with stock options,"
says Rep. Brad Sherman (D-Sherman Oaks), a certified public accountant
and a member of the House Banking and Financial Services Committee.
Reform could increase the costs of setting up a business and could slow
the creation of innovative companies, says Brad Jones, founding partner
of Redpoint Ventures, a major backer of high-tech start-ups.
The course of reform is far from certain, as public officials, pension
fund managers and members of Congress grapple with the need to reform
corporate practices and restore confidence in investment markets.
But stock options--which grant the right to buy company stock in the future
at a fixed price--are under fire partly because they were the biggest
source for the explosion in executive compensation in the boom decade
of the 1990s, when average pay soared to $15 million for chief executives
of big U.S. companies.
Retired General Electric Co. Chairman Jack Welch has noted that objections
to high front-office salaries in the 1980s led executives such as himself
to go for stock options--which made them rich beyond their dreams when
U.S. companies grew with the global market and share prices rose in the
stock market. In 2000, his final full year at the helm, Welch's total
compensation, which includes salary, bonus and stock options gains, was
$136 million.
Executive Payoffs
But in the bust that has followed the boom, suspicion is arising that
such outsized rewards were not earned.
"Some option plans were not incentives, but payoffs for executives
at the expense of shareholders," says Frank Glassner, head of Compensation
Design Group, a New York-based consulting firm.
Glassner cites Tyson Foods Inc., which last year took hundreds of thousands
of options that had lost value and replaced them with grants of stock
to executives.
The now-infamous Kenneth L. Lay, former chairman of Enron Corp., had loans
from the company along with stock grants that he could use to repay the
loans, thereby lowering his tax liability and avoiding requirements for
reporting transactions to the Securities and Exchange Commission.
Such loans to executives may be prohibited in legislation the Senate is
likely to pass Monday. Of course, all company loans to employees may be
outlawed.
"Major decisions on company practices are made because of abuses,
and good firms get hurt along with the bad," says Dan Marcus, head
of compensation at Mercer Human Resources Consulting in Los Angeles.
The use of options has grown throughout corporate America and so has the
distortion of reported earnings. Mercer experts calculate that if all
the shares reserved for options were added to common stock outstanding
at the 350 largest firms, average earnings per share could be reduced
by almost 15%. That's about 50% more than the effect would have been five
years ago.
And the effect could be much greater at high-tech firms, which have used
the incentive pay of stock options extensively. Cisco Systems Inc., for
example, could see earnings per share reduced by 67%, according to the
Merrill Lynch study. Dell Computer Corp.'s earnings could fall by 42%,
those of Intel by 25% and earnings of biotech firm Chiron Corp. by 23%.
All the calculations assume no action such as stock buybacks would be
taken to offset the potential effect of calculating per- share earnings
on additional shares.
The routine and extensive use of stock options by some of the most innovative
companies in the nation benefited the economy. The incentives helped to
build Microsoft, where the spectacle of relatively young people retiring
as "Microsoft millionaires" was a mid-1990s advertisement for
options. And options helped Microsoft founder Bill Gates become the richest
man in the world.
The Value of Options
"Company founders, by definition, always have stock at an initial
price," venture capitalist Jones points out. "The real value
of stock options is in their ability to attract those key personnel you
need to help develop the company. Options give them a chance for the big
score they cannot get at big companies," which can offer salary,
security and perks.
But within the next several years, the cost of stock options probably
will be counted as an expense, as wages and salaries are now. The International
Accounting Standards Board, a global professional body, is likely to recommend
this fall that options be expensed.
Support for Reform is Growing.
"I fear that the failure to expense stock option grants has introduced
a significant distortion in reported earnings," said Federal Reserve
Board Chairman Alan Greenspan in a recent speech to bankers.
Distortions have grown along with the increased use of stock options.
For example, companies get tax deductions when employees cash in stock
options.
"But huge tax deductions, with no expense on the other side of that,
doesn't make sense," says Peter G. Peterson, chairman of investment
firm Blackstone Group who is leading an effort by high- level business
people to reform accounting practices and other aspects of the corporate
system.
So companies will have to change their accounting practices. But use of
stock options as incentives for all employees certainly can continue.
Many experts favor lengthening the duration of options, making them exercisable
only after a five-year wait instead of one year or less, which is common.
That way, corporate managers have to work for the long-term development
of the company, not merely for the earnings of the next quarter.
In any event, reformers, members of Congress, company executives and their
employees should keep in mind that the purpose of compensation is to "create
value," says consultant Marcus.
They might look at solid companies such as Worthington Industries Inc.,
a specialty steel producer based in Columbus, Ohio. Worthington has had
profit-sharing plans for all its employees since it opened its doors in
1955. Through a system of incentives and targets, an employee can add
one-third or more to base pay.
The company, which has grown to $1.7 billion in annual sales and 6,800
employees, is continually successful in a tough business.
May the reforms to come produce many more like it.
James Flanigan can be reached at jim.flanigan@latimes.com.
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