July 20, 2004 3:14 PM PDT

House says no to expensing options

The U.S. House of Representatives on Tuesday sided with Silicon Valley over Wall Street, voting overwhelmingly to largely preserve the current method of accounting for the cost of stock options.

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What's new:
The House of Representatives approves a bill to keep companies from having to count stock options as an expense--except in the case of the top five executives.

Bottom line:
The vote largely maintains the status quo and should help sooth some nerves in Silicon Valley, where anxiety had been high about a potential sea change in technology companies' financial future. The Senate, though, still has to vote.

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By a 312-to-111 vote, House members approved a bill that mostly maintains the status quo by blocking a recent decision by the Financial Accounting Standards Board to treat stock options as an expense. That proposed change had alarmed many U.S. businesses, especially large technology companies that might be required to report lower profits to investors.

"The notion that stock options are an expense is absolutely absurd," said Rep. David Dreier, R-Calif. Stock options "align the employee interest with the company interest, and that produces a motivated worker," he said.

Rep. Pete Sessions, R-Texas, denounced "inside-the-Beltway accounting technicians" who could harm America's economy by forcing the expensing of stock options. FASB's decision "threatens to destroy broad-based plans and the productivity, innovation and economic growth they currently generate," Sessions said.

The House bill, called the Stock Option Accounting Reform Act, says that only stock options granted to the top five executives must be expensed--and then only if the company's annual revenue is at least $25 million. Its future is uncertain in the Senate, where FASB enjoys broader support from key senators.

Two business coalitions spent the days leading up to the House vote jockeying for political position. On one side are Wall Street investors, including Institutional Shareholder Services, Warren Buffett, the Big Four accounting firms, and federal regulators such as the Securities and Exchange Commission and Federal Reserve Chairman Alan Greenspan. They argue that stock options are an expense like any other form of employee compensation and should be treated the same way.

On the other side: A coalition of U.S. companies led by Autodesk, Genentech, Cisco Systems, Intel, Qualcomm and Sun Microsystems that went so far as to organize a rally in Palo Alto, Calif., last month. Nontechnology companies such as Coors Brewing and Valero Energy also joined the fight to preserve the current accounting methods, under which the number of stock options granted to employees are disclosed in footnotes.

While the House bill was backed by senior members of both major parties, its supporters came largely from the ranks of the GOP. Republicans voted for the measure by a 9-to-1 margin, while Democrats were roughly evenly split between supporting it and opposing it. Of the 111 nay votes, 88 were Democrats.

During Tuesday's debate, some supporters of mandatory expensing said the bill in question must be defeated, because it would merely make the millionaires of Silicon Valley even wealthier. "Let's help the rich get richer," said Rep. Pete Stark, D-Calif., who represents a slice of the Bay Area from Fremont to portions of Oakland. "Let's give more money to the millionaires. We must help those people. That's what this bill today is doing."

Supporters of expensing options suggested that recent corporate scandals, such as Enron, demonstrate that curbs on stock options are necessary to stop executives from taking steps to boost the stock price and cash out. "Expensing is the overwhelming view of financial experts, even before Enron," said Rep. Carolyn Maloney, D-N.Y. Rep. Stark added that the current practice "increases the deficit, falsifies corporate earnings, and it serves the millionaires in this country well."

Legendary investor Warren Buffett, CEO of Berkshire Hathaway, wrote an opinion article for The Washington Post published on July 6 that likens the House bill to "mathematical lunacy," saying: "Give the bill's proponents an A for imagination--and for courting contributors--and a flat-out F for logic."

Stock options have become part of the Silicon Valley culture over the last 20 years. Companies view them as a way to retain loyal employees who will work harder as co-owners of the business, and they dangle the enticing prospect of wealth. One book, published last year, estimated that nonexecutive workers at the top 100 Internet companies made an average of $425,000 in stock option profits between 1994 and 2002.

Stock options permit employees to buy their employer's shares for their market price at the time the option is granted. If the price rises, and employees cash in stock options, the value of existing shares is diluted, and each one is worth a tiny bit less. FASB wants companies to treat exercises of stock options as expenses, which would mean that they would report reduced profits to shareholders.

Silicon Valley lobbyists applauded the vote. "The Republicans and Democrats alike who have joined forces on this critical issue in such a bipartisan fashion deserve our applause and gratitude," said Rick White, CEO of TechNet and chairman of the International Employee Stock Options Coalition. "They recognize the vital role that employee stock options play in fueling innovation and economic growth in this country. We urge the Senate to act soon as well, to keep alive the dream of employee ownership."

Failed amendments
FASB's backers tried repeatedly to steer the House debate in a different direction.

Rep. Maloney, a Democrat who represents part of Manhattan and Queens, tried to add one paragraph saying that the SEC may "establish accounting principles or standards" as necessary to protect investors or that are in the public interest. It failed by a vote of 308-114.

"Simply put, a stock option is either an expense or it is not an expense," Maloney said. "My amendment preserves current law...(It serves) to protect investors, to protect stockholders, to protect the safety and soundness of our largest institutions."

A more radical attempt to replace the entire bill with a substitute came from Rep. Paul Kanjorski of Pennsylvania, who is the top Democrat on a financial markets subcommittee. He proposed that FASB should be allowed to do as it wishes, while requiring the SEC to review any "final standard" for stock options to ensure it followed "the highest quality accounting standards." That amendment failed by a 127-293 vote.

One amendment adopted by voice vote, offered by Rep. Michael Oxley, R-Ohio, clarified that any company that wishes to expense stock options voluntarily may do so.

While many technology titans strenuously oppose mandatory expensing, some of their peers have agreed to do it. Amazon.com said in 2002 that it would treat options as an expense, and Hewlett-Packard shareholders voted this spring to do the same. Microsoft announced last year that it will give new employees actual stock instead of options to buy.

Complicating the debate is a disagreement over whether FASB's Black-Scholes method of evaluating the cost of stock options is the best approach.

Entrepreneurs Ed Keible and Bob Pavey said in an opinion article published on CNET News.com in May that: "The Black-Scholes methodology, often suggested by large company accountants as a way to accurately value public stock, is rigid and arbitrary, and has found no believers among our Silicon Valley peers."

FASB critics say the Black-Scholes option-pricing model is designed to calculate the value of options that are bought and sold in financial markets, not employee stock options.

Employee stock options are different because they can't be sold, are subject to blackout periods that temporarily halt stock trading and only come into the possession of an employee gradually--usually over a four-year period.

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The story left out the cost to the company
Unless I missed it, no mention is made as to how this cost the company. The company must pay the difference between the present value of the stock when the option is exercised and the option price. If the option was $40 and current price is $100, then the company has to come up the $60. To me that's an expense. The question is does the expense hit the books when the option comes in the money (i.e. current value higher than option value) or when the option is exercised.
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