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Expensing Options Could Hurt Earnings

Expensing options could be expensive. While fund industry leaders are calling for uniform expensing of options, some fear such action could drag corporate earnings down by 23% or more. And with the markets as ugly as they have been, now is not a good time to risk further losses, opponents to regulation say.

The Investment Company Institute (ICI) recently called upon the Financial Accounting Standards Board to adopt a standard for expensing options. Commonly reported items, such as earnings per share, will take on greater meaning under a uniform system, the ICI claims. The institute further reasons that options should be treated the same as other forms of compensation.

Jack Brennan, chairman of the Vanguard Group of Valley Forge, Pa., meanwhile, issued a letter to the heads of all of the companies in which Vanguard holds 3% or more of their stock, asking them to expense their stock options.

An option, the right to buy or sell a stock at a specific price and by a specific date, is not currently required to be recorded as an expense on a company's balance sheet. However, options are, as their name implies, just an option to buy. There is no guarantee the holder will purchase the security. So, while some companies have developed their own methods for recording options on their expense sheets, many other companies don't, instead footnoting them on their earnings statements.

The mutual fund industry, which invests nearly $4 trillion in equity and fixed-income securities issued by U.S. corporations, according to the ICI, could be heavily affected by a change in the regulation.

Supporters of regulation claim that expensing options is key in maintaining investor confidence, amid a market plagued by corporate scandals. "Our main point is to have a standard method of accounting for these options and ensure uniformity as to how they are valued in order to provide meaningful comparisons," said Chris Wloszczyna, a spokesman for the ICI.

However, recording these options on the balance sheet will hurt many stocks that are already aching. Howard Silverblatt, an editor at Standard & Poor's quantitative services division in New York, said that expensing options would have cut $51 billion off of earnings for the entire S&P 500 index last year, reducing the earnings of the corporations in the index by a whopping 23%.

"It's a pretty complicated issue, but the truth is, they're hard to expense," said Jeremy Lopez, a semiconductor stock analyst with Morningstar of Chicago, noting that several variables need to be taken into account.

"Unless you're going to go ahead and restate all the previous earnings, making historical comparisons will be incredibly complicated, because it [becomes] an apples-to-oranges comparison," which would make "past numbers useless," Lopez said. This will make it nearly impossible for mutual fund portfolio managers, analysts and investors to determine how well or poorly any given company is performing.

Further Tech Beating

But besides muddying comparisons, Lopez said the already downtrodden tech sector could take yet another blow if expensing options is mandated. "They were the heaviest issuers [of stock options] during the tech bubble," he said. "The earnings are going to take a significant hit if they're going to use the Black-Scholes method," a formula he is not in favor of implementing. The Black-Scholes method is a formula that values publicly traded options and attempts to capture the value of the option in the open market, he said. Many companies that currently expense options employ this method.

In addition, the change in accounting practices could also change the P/E ratios of a number of companies dramatically, because the earnings number could drop if the expensing of options was required.

Still, a lot of options were granted during the height of the tech boom. Because their value has dropped so precipitously, they obviously would not be exercised in today's market. "No one is going to exercise those options," Lopez said.

Herein lies the difficulty in regulating the expensing of options: "The true value or true cost is somewhere in between the Black-Scholes method and the camp that says options are already accounted for in the diluted EPS figures," Lopez said. To his mind, neither approach is exactly right, and the industry still "needs to find a method."

Jack Bogle, founder and former chairman of Vanguard, says that companies are already changing philosophy and expensing options. He noted recent moves by Coca-Cola and the Washington Post company.

"I think the marketplace is speaking. Investors are speaking." And it is Bogle's contention that the companies are listening. He expects options will be regulated because of the public sentiment pushing for this move.

"Options are an honest-to-god expense," he said. Options can be valued as the money companies have to spend "to buy back shares so they have them for the optionees," Bogle said.

Expensing options may seem utopian to naysayers, but Bogle insists "the day will come when there is a standard."

Nonetheless, the issue is one that requires a lot of consideration from a number of sources and is far from a sure thing.

"The challenge is to determine a methodology to make certain assumptions of options usage. That's the complication. Its not only near-term options, it's also long-term. There needs to be uniform standards," said Geoffrey Bobroff, a mutual fund consultant based in East Greenwich, R.I.

Multiple Shocks'

Bobroff said the issue surrounding these changes boils down to whether the "whole system could take multiple shocks better than we ultimately think." He said the investment management industry needs to be careful about how it handles the growing sentiment for expensing options, but also said they need to be regulated by calendar year 2003. "It needs to be thoughtfully dealt with, but we can't study it to death."