Accounting tactics hide option cost

Accelerated vesting, other steps beat new regulations' deadline

September 02, 2006|By Mark Schwanhausser | Mark Schwanhausser,San Jose Mercury News

SAN JOSE, Calif. -- Rushing to beat new accounting rules for stock options, some 900 companies used a controversial tactic to erase an estimated $8 billion in options costs that would have dented their profits for years.

"You can argue about the merits and the pros and cons of it, but at the end of the day, it creates apples-to-oranges comparisons," Bear Stearns analyst Chris Senyek said.

"We want investors to be able to make apples-to-apples comparisons when they value companies and their earnings streams," Senyek said.

Starting with their 2006 fiscal year, companies must subtract the cost of stock options from profits as employees attain the right to cash in their options, a process known as "vesting" that typically stretches over four years.

But a Bear Stearns report issued Thursday demonstrates that companies commonly accelerated the vesting schedule so employees could exercise their options in 2005. That essentially wiped the options off the books before the new accounting rules took effect.

The tactic was especially popular in the tech sector. A third of the companies that accelerated vesting were in the information technology sector, Bear Stearns said.

More than 30 of those companies, in California's high-tech Silicon Valley, used the tactic to dodge an estimated $1.4 billion in costs, the Bear Stearns report said.

Sun Microsystems Inc., which helped lead the fight on Capitol Hill to block the new accounting rules requiring the expensing of options, dodged $400 million in expenses. That was second in the nation only to Round Rock, Texas-based Dell Inc., which avoided $591 million in expenses.

Other Silicon Valley companies that ranked among the top 15 were Flextronics International Ltd., $157 million; Juniper Networks Inc., $153 million; and Applied Materials Inc., $138 million.

When it became clear that the new accounting rules could not be derailed, companies employed a variety of tactics to reduce the amount they would have to subtract from profits. Some slowed the flow of options. Some honed the numbers that were plugged into the formula used to value the options. And some began buying back stock to minimize the amount that options would dilute earnings.

But the practice of accelerating options is arguably the most contentious tactic.

Many experts say the practice is acceptable if the options are priced so high that it's unlikely that employees would ever get a chance to cash in the options. That is a common problem for Silicon Valley workers holding "underwater" options that were priced before stock prices plummeted during the tech bust.

"We're speaking mainly of options issued during the dot-com bubble," said Todd Fernandez, a senior research analyst for Glass Lewis, a San Francisco-based corporate governance advisory firm. "It's not reasonable for companies to recognize the expense when the stock was at $500 and now it's at $5."

Still, Fernandez and others worry that companies are temporarily understating their compensation expenses, creating an unpleasant surprise for investors when the benefits of the tactic run out. "What should worry investors is that in the future those costs are going to increase," Fernandez said.

Corporate governance experts also object that many companies included options that were close to being profitable or already were profitable. That, they say, was an accounting-driven giveaway.

A total of 146 companies nationwide accelerated vesting on in-the-money options, according to Bear Stearns.

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