Uncovering the Billion-Dollar Secret

My last article focused on the unreported costs of stock options. After it was published, I received several emails. Some were supportive, and some disagreed with me. All were informative. Without rehashing the long list of arguments (they are well-chronicled in the articles listed below), I want to provide my general accounting philosophy: When faced with the choice between two or more accounting options, companies should obviously opt for the choice that provides the greatest clarity to the investor. In the case of stock options accounting, that means providing a best estimate on the expected costs of employee stock option programs -- including the effect of these compensation costs on the company's bottom line (net income).

In this article, we explore the big picture of stock option accounting. Who is responsible for determining accounting practices? What are they doing about stock option accounting? And how can investors find the true compensation costs of stock options on a company's financial statements?

First, let's clarify the complex landscape of stock option accounting jargon.

The Securities and Exchange Commission (SEC) governs financial reporting and accounting policies. However, they have traditionally relied on the private sector to develop their own standards. The Financial Accounting Standards Board (FASB) is the link between the SEC and the private sector.

Made up of seven members, the FASB establishes Generally Accepted Accounting Principles (GAAP). The SEC recognizes FASB and GAAP as the authority on financial accounting policy. There are two main FASB statements relating to stock option expensing: Accounting Principles Board Opinion 25 (APB 25) and the Statement of Financial Accounting Standards 123 (SFAS 123).

The two statements allow for very different treatments of stock options: SFAS 123 requires companies to recognize the fair value of stock options on their financial statements; APB 25 (with some exceptional cases) does not. Since SFAS 123 is not required practice, most companies use APB 25 accounting because it allows them to avoid treating options as a compensation cost -- and therefore enables them to report higher net income (see my first article for a discussion of other ramifications).

For many years, the FASB has attempted to make SFAS 123 part of GAAP. Aggressive lobbying by tech industry heavyweights such as Cisco and Intel has led to significant roadblocks (our legislators are good at passing laws that inhibit implementation of accounting reforms). Still some companies, such as Microsoft and Netflix (NASDAQ:NFLX), have voluntarily adopted SFAS 123.

What's the difference?
The tech industry has the most to lose over changes in stock options accounting. From their early days as cash poor, revenue poor innovators, they have used stock options as a key component of their compensation structure. Options became an expected and especially lucrative component of employee rewards, and companies continued the practice even after they transitioned into mature, revenue-producing entities. Because option compensation has become so ubiquitous, the effects of options charges on net income can be significant (18% to 45% in the examples below). The following chart displays net income before and after application of SFAS 123 for selected companies (numbers in millions of dollars):

* In July 2003, Microsoft adopted the SFAS 123 standards. Microsoft numbers are for fiscal 2002 (pre-adoption). Where can we find these numbers?
Companies that still use APB 25 accounting now include SFAS 123 accounting in their footnotes. Search through the company's SEC 10-K filing for the words "pro forma" (pro forma is fancy speak for "as if"). We are looking for a chart displaying the pro forma net income. The chart will be preceded by a statement on SFAS 123 (usually with a plethora of excuses on why SFAS 123 is so useless) and will include reported net income, compensation expenses (net of tax), the pro forma net income, reported earnings per share numbers, and pro forma earnings per share. The company will also disclose the formula inputs they used in valuing options (historical volatility and expected life are key inputs). Here is an example from Cisco's 2004 10-K:

What's next?
Barring legislative action, SFAS 123 will be required accounting practice beginning in the third quarter of 2005. At that time, companies must restate their past financial results in accordance with the new accounting principles. This means "pro forma" numbers will replace "as reported" numbers -- and lead to a largely negative impact on earnings. Valuations based on these numbers will be redefined -- either through higher P/E multiples or through declines in the stock price.

Companies that address this issue early place themselves and their investors in an advantageous position. Since they will have already divulged their true costs, they won't take the large hits affecting the rest of the industry once SFAS 123 becomes mandatory. In addition, companies that voluntarily adopt SFAS 123 choose the interests of their shareholders over their reported bottom line. Companies that value their shareholders are less likely to provide negative surprises down the road. And that's good for investors.

For related Fool content, read:

• The Billion-Dollar Secret
• Stock Options' Perverse Incentives
• The Best Stock Options Model

Jim believes in the importance of balanced experience. So he has (temporarily) departed from the liberal confines of San Francisco to the conservative streets of Tucson, Ariz. There, he hopes to find out what drives the other 51% of the population -- insights are appreciated (email him)! Jim doesn't own any of the stocks discussed in this article. The Motley Fool has a disclosure policy.