Board recommends expensing of stock options

Businesses would have to treat stock options as an expense under a proposal from the FASB, which sets U.S. accounting standards. That's not likely to go over well in Silicon Valley.

Declan McCullagh Former Senior Writer
Declan McCullagh is the chief political correspondent for CNET. You can e-mail him or follow him on Twitter as declanm. Declan previously was a reporter for Time and the Washington bureau chief for Wired and wrote the Taking Liberties section and Other People's Money column for CBS News' Web site.
Declan McCullagh
4 min read
American businesses would have to expense stock options under a controversial proposal announced on Wednesday by a private body that is responsible for creating accounting guidelines.

The proposal from the Financial Accounting Standards Board said employee stock options should be included in corporate income statements starting in 2005, a requirement that would sharply cut the reported profits of technology firms. Currently, FASB guidelines require only that stock option grants be disclosed in footnotes.

"We expect the proposal will draw interest from a broad spectrum of respondents, including small and nonpublic companies," FASB Chairman Robert Herz said in a statement. "We welcome all input and have included a wide variety of questions in the exposure draft to elicit comments."

FASB's proposal, which will be open to comment through June, uses a formula that has drawn fire from many technology companies and some members of the U.S. Congress.

Sun Microsystems said on Wednesday that it "believes the use of broad-based stock options plans is indispensable to attracting and retaining the critical talent necessary to motivate the innovation that will help spur our economic recovery."

The National Venture Capital Association lashed out in response to the FASB proposal, saying it "will seriously harm private, emerging-growth companies that are highly dependent on employee stock options to recruit and retain employees."

Taking it to the Hill
While this may seem like an arcane dispute only a tax lawyer could appreciate, 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 July 2002.

When employees cash in stock options, they dilute the value of existing shares, making each one worth a tiny bit less. FASB's proposal requires companies to estimate the value of stock options at the time they were granted, which could mean firms would report reduced profits to shareholders. Such an expensing requirement could mean that start-ups would be less likely to grant options to new employees in the first place.

Tech lobbyists are lending their support to a bill called the Stock Option Accounting Reform Act, which would essentially prevent federal securities regulators from recognizing any FASB decision. It would, however, require the expensing of stock options granted to a company's CEO and four other top executives, if the company had annual revenue of at least $25 million.

Backing the measure are legislators representing Silicon Valley. The legislation has the support of prominent Republicans and House Minority Leader Nancy Pelosi, D-Calif.

Because politicians have been waiting to see what FASB would do, Congress' interest has remained minimal so far. Now that FASB has made its proposal public, its opponents are hoping to round up more supporters on Capitol Hill. "You're going to see renewed momentum for legislation," said Rick White, president of Silicon Valley alliance TechNet. "We're going to get the bill passed in the House. If that happens, there's going to be quite a bit of pressure on the Senate to do something."

While tech titans like Intel, Cisco Systems and Sun strenuously oppose mandatory expensing, some of their peers have agreed to do it. Amazon said in 2002 that it would treat options as an expense, and HP shareholders voted earlier this month to follow suit.

Microsoft announced last July that it would no longer give new employees stock option grants. Rather, it would give them outright grants of stock that would vest over a period of years in much the same way that stock options do.

Ditching GAAP?
In a recent interview with CNET News.com, Cypress Semiconductor CEO T.J. Rodgers said the FASB proposal may cause companies to ditch the board's standards, which include generally accepted accounting principles (GAAP).

"What will happen if we expense stock options is the exodus of every tech company from GAAP accounting to pro forma accounting. They've finally made the product so bad that nobody will use it," Rodgers said.

Complicating the debate is a disagreement over the formula that FASB could use in judging the financial impact of stock options. Two contenders go by the names of Black-Scholes and binomial models, and FASB critics say both are 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.

Stock options give employees the right to buy stock at a certain price and generally are worth something only if the stock increases. For example, if an employee has the right to buy the stock for $10, and the stock is trading at $30, he or she would make a $20 profit on each share before taxes upon selling it. But if share prices fall or remain the same, the options are worthless.

"Neither of these models work for what FASB wants to use them for, and as a result, both substantially overvalue employee stock options," the International Employee Stock Options Coalition, a group of large business and technology trade associations, said on Wednesday. "Both were designed for something entirely different--options freely traded on the open markets--than employee stock options."