Options are nice for recipient, but a cost for the stockholder

April 10, 2002|By JAY HANCOCK

BLACK & Decker Corp. earned $108 million in profit last year in its business of selling power drills, lawn trimmers, pneumatic nailers, door locks, bath faucets and whatnot.

At least that's what its income statement says.

But if you count the expense of valuable stock options given to executives and other employees, the Towson-based company did significantly less well. Black & Decker earned only $91.9 million for the year after subtracting the cost of the options under a common method.

That's almost 15 percent less than the company's reported profit.

And it makes the tool seller's stock seem more expensive, pushing the multiple from a pricey 36 times trailing earnings to an even higher 42.

No wonder corporate America is fighting hard against a new effort to put stock-based pay on the books.

Outrage kicked up by the Enron and Internet-stock collapses seems to have found a remedial outlet in stock-options accounting, which had little to do with those problems but which probably needs fixing anyway.

Stock-options bookkeeping, like opera, is more interesting than you think.

Almost all publicly traded U.S. corporations treat options the way Black & Decker does. Under current rules, these companies can pay large executive salaries without recording the options-related compensation as a cost in their accounts. Instead, they disclose it in a footnote to the financial statements.

It's a beautiful setup.

Stock options are tied to the value of corporate shares. When executives keep options expenses off the books, reported corporate profits rise more than they would otherwise. When profits go up, so does the stock. When the stock goes up, so does the value of the options, so does the size of the executives' pay and so does the magnitude of the cost that is not being reported in the company's income statement.

Whew.

Some analysts have estimated that failing to book options costs in the income ledger inflates the earnings of a typical corporation by about 10 percent.

My favorite part of the debate is how options are treated for tax purposes. While arguing that stock options are not an expense on the income statement, corporations count some types of exercised options as a deductible expense on their tax return, thus lowering their income-tax bills.

I'm not naive enough to expect that generally accepted accounting principles and the corporate tax code are going to be run from the same playbook anytime soon. But at least they should be made roughly parallel by providing for options-cost deductibility on the tax return and the certified financial statement.

Options accounting is controversial for two reasons. First, subject as they are to the stock market, the future and human choice, options are very difficult to value. By definition they are derivative and abstract, as elusive as the electrons in the physicist Heisenberg's famous Uncertainty Principle.

Ultimately, options are worth the difference between the "strike" price and the stock's higher, market price on the day their owner decides to exercise them, but only clairvoyants know when that day will come.

The second difficulty is that options-related corporate costs come home to roost only in a roundabout way. Options don't extract money from the corporate treasury. Rather, by obliging a company to issue new shares on the day of exercise, options dilute the stake of existing shareholders and force the company to sell pieces of itself at a discount.

Black & Decker boss Nolan D. Archibald, whom I called to inform that his company would be an example in this column, argues that, as a noncash event, the issue of options should not count as a cost on the books. In fact, Archibald points out, options yield a cash inflow after exercise-related sales. The company collects cash equal to the option exercise price and adds it to its capital.

The most intriguing argument for keeping options costs off the income sheet is made by James DeLong, a scholar at the Competitive Enterprise Institute. Because more corporate capital value these days is found in employees' brains than in buildings and machinery, DeLong suggests that options designed to retain key talent be treated as a capital item such as investment in a computer, not a direct expense.

Opponents of options expensing portray their rivals as unsophisticated meddlers confused by the Enron mess. That must explain the inclusion in the reform crowd of such rubes as Alan Greenspan, Warren Buffett and the Council of Institutional Investors.

Mercantile Bankshares Corp., one of the most conservative and best-run companies in Maryland, is one of perhaps half a dozen companies in the country that treat stock options as an expense.

Nobody wants to abolish stock options; reformers just want to measure them better. Corporate income statements already include substantial noncash charges in the form of plant and equipment depreciation, which is probably just as imprecise as any options-valuation method being discussed.

And options can be valued, despite their fuzzy abstraction. Fisher Black and Myron Scholes won a Nobel Prize for a pricing model that accounts for options' variables such as expiration date, historic volatility and so forth.

There are good arguments contending that the Black-Scholes formula, used for calculating the options expense now found in corporate footnotes, overstates the cost. But a compromise should be reached on a different model that would put options on the expense ledger and bring some clarity to the debate on executive pay.

The way options are disclosed now, in the footnotes, "it's like a Trivial Pursuit answer, like cocktail-party chat," says Baltimore's Jack Ciesielski, the highly respected publisher of The Analyst's Accounting Observer newsletter. "Companies should recognize what they give up that belongs to shareholders."

And they should recognize it, he says, in the income statement.

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