In the go-go 1990s, companies dispensed stock options to employees like candy. And why not? Under accounting rules, they didn’t have to count them as an expense. It almost seemed like free money.
“You really were hard-pressed, if you were a public company, not to use options,” observed Betsy Field, a Fishers-based consultant for the benefits firm Watson Wyatt Worldwide.
No more. A new accounting rule will require companies to begin recording options as an expense on their financial statements starting mid-year. Suddenly, the bottom lines for a lot of companies will look a lot smaller.
Three cheers, say corporate governance experts, who rightly note that options have a real and substantial cost. Options give holders the right to buy stock in the future at the market price on the day of the grant. Exercising options swells the number of shares outstanding, diluting earnings per share.
How will corporate boards respond? “I do think it will change the way people look at long-term incentive programs,” Field said. “In certain ways, it will require boards to be more thoughtful. I have seen it raise some really good discussions in boardrooms.”
Eli Lilly and Co. is among the first companies to adapt to the new option order. It disclosed deep within its fourthquarter financial report that it plans to decrease the use of stock options while increasing the use of stock grants tied to hitting specified earnings goals.
That approach makes sense, since it strengthens the link between pay and performance, said Corey Rosen, executive director of the National Center for Employee Ownership. One of options’ shortcomings, critics say, is they balloon in value in a bull market, even if a company’s own performance is unexceptional.
For a company like Lilly, weaning itself from relying on stock options is no small feat. The company says that counting options as an expense in 2004 would have reduced the year’s earnings by $260 million, or 14 percent.
The stock grants the company now will favor already had to be expensed. In total, the stock-related compensation Lilly will dole out under its new plan will be worth less than in the past, company spokeswoman Terra Fox said. Even so, because of option expensing and stepped up stock grants, earnings will take a bigger hit-about $280 million in 2005.
Until the Financial Accounting Standards Board adopted the change last year, even many U.S. executives who believed options should be expensed were reluctant to do so, fearing it would make their company look less profitable compared with peers.
Those that voluntarily launched option expensing generally doled out only modest grants anyway. In that group are Simon Property Group Inc. and Duke Realty Corp., which began expensing options in 2002.
That’s not to say the across-the-board mandate won’t bring pain.
Consider a company like Interactive Intelligence Inc., the software maker that eked out earnings of $1 million in 2004, its first annual profit. Expensing stock options would have wiped out the achievement, turning the profit into a loss.
Also on the losing end: rank-and-file employees outside the executive suite. Under pressure to rein in option grants, boards won’t be spreading them as far down the organizational chart as they used to, observers predict.
“The people who will get left behind are the tens of thousands who were able to participate previously,” not the top brass, Ron Dollens, CEO of Guidant Corp., told IBJ in December.
Dollens is such a believer in creating an ownership culture that all 12,000 Guidant employees qualify for option grants. Only a small number of other U.S. companies provide options to every employee. Dollens predicts the practice will disappear when the expensing mandate goes into effect.
Guidant’s board won’t have to make the call. The company last year accepted a $25 billion buyout offer from New Jersey-based Johnson & Johnson. While J&J provides its more than 100,000 employees a rich stew of benefits, it doesn’t provide options to everyone.
The savviest investors already had a sense of how options affected earnings. Companies made disclosures on the subject once a year in filings with the Securities and Exchange Commission.
Now, though, “it will be more difficult to ignore the economic cost of stock options when it is staring at you from the face of an income statement,” Credit Suisse First Boston analyst David Zion said in a report last year.
Even so, many analysts are expected to continue to focus primarily on the profit a company reports before factoring the impact of options.
It’s not that hard habits are hard to break. It’s that companies will have leeway in the approach they use to value options, complicating efforts to compare one company with another.