Copyright 2002 The Chronicle Publishing Co.  

The San Francisco Chronicle
JULY 9, 2002, TUESDAY, FINAL EDITION
SECTION: BUSINESS; Pg. B1; NET WORTH

LENGTH: 1463 words

HEADLINE: Support grows for expensing options

BYLINE: Kathleen Pender

BODY:
AMB Property Corp., a San Francisco real estate investment trust, has voluntarily begun deducting employee stock options as a compensation expense on its income statement.

AMB is believed to be the first company to take this step since Enron and WorldCom imploded under accounting scandals and reheated the long-simmering debate over stock option accounting.

So far, only two companies in the Standard & Poor's 500 index -- Boeing and Winn-Dixie -- expense options. AMB is not in the S&P 500, although its market value, at $2.5 billion, is bigger than Winn-Dixie's.

Most public companies disclose the estimated value of employee stock options granted each year in a footnote to financial statements but do not deduct an option expense. As a result, the earnings they report to shareholders are higher than they would be if they deducted options.

However, companies get a tax deduction when their employees exercise nonqualified stock options, the most popular kind.

This favorable accounting treatment, along with a booming stock market, made stock options the compensation of choice at many companies in the late 1990s. Some say the craze went too far and encouraged executives to do whatever it took to keep their stock prices up, even if it meant cooking the books.

A growing chorus of financial luminaries -- including Federal Reserve Chairman Alan Greenspan, billionaire Warren Buffett and former Securities and Exchange Commission Chairman Arthur Levitt -- would like to see mandatory expensing of stock options.

Public companies, led by the tech lobby, have defeated previous attempts to require stock option expensing. But they may not be as successful this time, if companies like AMB continue to break ranks.

An informal Web survey, done in May by the National Association of Stock Plan Professionals, suggests other companies may follow suit.

The survey asked: "Is your company/audit committee, etc. considering adoption of SFAS (Statement of Financial Accounting Standard) 123, providing for a 'fair value' charge for stock option grants?"

Out of 240 anonymous responses, 12 said they had already decided to adopt SFAS 123, which requires companies to expense stock options, and 39 said they were considering it. The rest were not considering it.

Obviously, the companies most likely to expense stock options are those with the least to lose.

When AMB went public in 1997, it gave options to all employees. Since then, it gives them only to officers, who make up about one-third of its workforce.

Even so, AMB estimates that its options expense this year will be only $900,000, or about 1 cent per share. Last year, it earned $1.47 per share. (AMB reported second-quarter earnings Monday of $26.7 million, or 31 cents per share, after taking a charge of roughly $200,000 for stock options).

By comparison, if Siebel Systems had expensed options last year, it would have reported a $467 million loss instead of a $255 million profit. Intel's profit would have shrunk to $254 million from $1.3 billion. Yahoo's loss would have grown to $983 million from $93 million, according to the company's 10-K reports.

Hamid Moghadam, chief executive officer of AMB, says his firm is expensing options "because it's the right thing to do." AMB has a history of being out front on issues favored by shareholder rights groups.

For example, its directors all stand for re-election each year, its board has a majority of nonemployee directors and its charter forbids repricing options.

About two years ago, AMB began emphasizing earnings per share in its press releases and analyst communications at a time when its competitors were touting funds from operations, or FFO, the REIT-equivalent of pro forma.

Many shareholder groups and compensation consultants say that if companies are forced to expense options, they would use them more wisely and judiciously than they have in the recent past.

"You might see some retrenchment in the frequency and size of large option grants," said Martin Katz, a principal with Mercer Human Resource Consulting. Compensation committees "don't want an option grant out there that brings embarrassment to the company."

The typical option plan gives an employee the right to buy company stock at a certain price, known as the strike price, at any time for 10 years. The strike price is usually the market price on the date of grant. Options typically vest, or become available, over three to five years.

If the stock prices rises even 1 cent above the strike price, the option has value, assuming it has vested. If an executive has enough stock options, even a small rise in the stock price can translate into a huge payoff.

Many experts say that if companies had to expense options, they could be more creative in designing compensation plans more closely tied to above-average, long-term performance.

For example, an option plan could be indexed to a peer group and/or the overall market. Under this scenario, options could be exercised only if a company's stock price outperformed some benchmark by a certain margin.

That way, "you won't be rewarded if your entire industry is skyrocketing and you're skyrocketing less," says Sara Teslik, executive director of the Council of Institutional Investors.

Or, options could be granted with a strike price that is above the market price on date of grant. That way, the option wouldn't have value until the company's stock price rose by a significant margin.

Companies can award indexed or performance-based options today, but they have to expense them. So most don't.

"When you add a performance contingency, you go from fixed to variable accounting. Variable accounting requires expensing," says Katz.

Some companies, like Boeing, have already taken that leap.

Instead of getting stock options, Boeing's top 2,000 or so employees get performance shares, which are units that can be converted to common stock if Boeing's share price reaches certain targets.

Each year, managers receive a block of performance shares. If, at any time in the next five years, the stock price reaches and maintains -- for 20 trading days -- a price that is 61 percent higher than the stock price on the date of grant, then one-fourth of the performance shares awarded are convertible to common stock.

The remaining performance shares are convertible at successively higher stock prices, culminating in a price roughly twice what it was on the grant date.

Performance shares not converted to common stock within five years expire worthless. However, the board's compensation committee could allow conversion if the company's total return during the five years exceeds the total return of the S&P 500.

Because it's a variable plan tied to a particular target share price, Boeing must deduct performance shares on its income statement. The cost is based on the maximum potential payout, spread over five years.

Boeing also awards stock options to nonexecutive employees, but the option plan is much smaller than the performance-share program.

To get the best accounting treatment for its performance shares, Boeing adopted SFAS 123. As a result, it can spread the expense out over five years.

If it had not adopted SFAS 123, Boeing would have had to deduct the expense only when the target price was hit and the shares were converted. This would have produced huge, largely unpredictable hits to earnings and would have vastly increased earnings volatility.

Because it adopted SFAS 123, Boeing also had to expense stock options.

Boeing took a $227 million charge for performance shares in 2001 (even though no shares were converted that year because Boeing's stock price tumbled) and a $79 million charge for stock options. Net income was $2.8 billion.

Although Boeing's plan is not without flaws, "it's certainly better than most of the option plans out there," says Teslik.

To encourage long-term performance, board consultant Joe Goodwin says he would like to see options that couldn't be exercised until an employee left the company -- or even 12 months after departure.

The main argument against expensing are: If companies had to expense options, they might stop giving options to rank-and-file employees. There is no good way to value options when they're granted because nobody knows what they'll be worth when exercised. The United States should wait until foreign stock exchanges and regulators, which are also working on option issues, come up with an international standard.

These are all valid arguments, but the time for change has come. And the United States, if it wants to retain its tenuous position as the world's accounting leader, should take up the charge.



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