Senate bill could stymie stock options

Legislation meant to "plug a corporate tax loophole"--which lets companies claim large tax deductions without declaring the cost as an expense--could put a huge crimp in tech earnings.

Dawn Kawamoto
Dawn Kawamoto Former Staff writer, CNET News
Dawn Kawamoto covered enterprise security and financial news relating to technology for CNET News.
5 min read
A congressional bill introduced Wednesday could dampen the technology industry's widespread reliance on stock options.

Sen. Carl Levin, D-Mich., introduced Senate Bill 1940 to "plug a corporate tax loophole" that allows companies to claim large tax deductions without declaring the cost as an expense on earnings statements. Co-sponsors of the bill, which must first get approval from the Senate Committee on Finance as well as the House of Representatives and ultimately the president, include Sen. John McCain, R-Ariz.; Sen. Peter Fitzgerald, R-Ill.; Sen. Dick Durbin, D-Ill.; and Sen. Mark Dayton, D-Minn.

Supporters say the bill, if passed, would require companies to make accounting changes that would result in clearer annual earnings reports. Currently, companies are allowed to claim a tax break on their stock options but do not have to charge them against earnings as part of their compensation expenses. The bill would require them to charge options against earnings.

"Stock options are a stealth form of compensation because they do not, under current accounting rules, have to be shown as an expense on the corporate books even though they're treated as an expense to get a tax deduction," Levin said in a statement. "The result is a misleading picture of a company's finances."

Compensation experts say that many companies in the technology sector--by far the most generous industry when it comes to doling out options to workers--would end up showing big losses if the bill were passed into law.

"I think this will demolish earnings of tech companies, and they're already having a difficult time," said Steven Hall, managing director of compensation consultants Pearl Meyer & Partners. "This could definitely cause them to reduce the options they grant."

For example, Microsoft would have posted $5 billion in net profits last year if it accounted for the stock options-based compensation in its actual earnings, as opposed to the $7.3 billion it reported without having to account for the options. The figure comes from footnotes in Microsoft's annual filing--data that the Securities and Exchange Commission began requiring in 1996 despite opposition from tech lobbyists.

Similarly, Apple would have generated a hefty $396 million net loss had it accounted for stock options, compared with its reported $25 million net loss. Applied Materials would have generated a net profit of nearly $291 million, compared with the reported $508 million, according to footnotes in those companies' annual SEC filings.

Enron heightens urgency Congress has long considered legislation to change the way stock options affect a company's bottom line and reduce the number of options that companies award to workers. Stock options allow employees to purchase a company's stock at a set price for a specified period of time, such as five or 10 years. When the stock price increases, the potential profit to the employee increases.

But stock option reform has taken on new urgency since the Enron bankruptcy and demise. The Houston-based energy giant reportedly failed to pay any U.S. taxes four out of the past five years--during which time it earned $1.8 billion--in part due to $600 million in stock option tax deductions that were never reported as an expense on its financial statements.

Levin and the bill's other sponsors say that Enron stockholders would have learned the company's income was one-third less than the $1.8 billion it disclosed had the company been forced to report this deduction.

"Enron was not acting illegally here, nor were its actions unique," Levin said. "It took advantage of the tax provisions--which we hope to change in our bill--that allow a company to claim a stock option expense on its tax return even if the company never lists that expense on the company books. These tax provisions incomprehensibly and indefensibly allow companies to tell Uncle Sam one thing and their stockholders something else."

It's unlikely opponents in Silicon Valley will be able to stall the bill, which enjoys support in both parties of the Senate. The tech sector has had mixed success in thwarting such legislation in the past.

The last major battle took place in 1996, when the Financial Accounting Standards board began requiring companies to at least footnote in their annual report what their earnings would have been had they charged their options against their compensation expenses. The tech industry lobbied against the requirement.

Tech lobbyists are not likely to get help opposing the newest bill from public policy groups and trade organizations, including the Council of Institutional Investors. Members of the influential organization, including pension fund managers and portfolio mangers of mutual funds, will vote in March to determine whether a policy change is needed.

"Option grants out of control"
"The feeling is that maybe the earlier efforts aren't working," said Peg O'Hara, a spokeswoman for the council. "The disclosure by companies doesn't seem to be working. The size of option grants have gotten out of control, and a standard valuation method for the options is needed. There's a sense that if a company is not willing to take the expense off their bottom line, then maybe they shouldn't grant them."

The Association for Investment Management and Research is also considering whether to endorse the bill. The trade group for financial analysts, portfolio managers and investment advisers recently surveyed nearly 2,000 of its members, and 80 percent said stock options are compensation and should be recognized as an expense on income statements rather than as a footnote, according to the survey.

The organization also found that 81 percent of its survey participants use information about stock options when evaluating a company's performance and assessing its value.

The International Accounting Standards Board is also soliciting comments from its members on developing a global accounting standard for treatment of stock options as compensation. The comment process is anticipated to last for several months.

The organization found that few countries have standards for accounting for stock options. But those that have reviewed the issue have concluded that stock options should be counted as an expense in companies' income statements.

It's difficult to overstate the sweeping changes that a stock options bill would have on American companies and the national economy. If all of the Standard & Poor's 500 index companies accounted for options as an expense, earnings would have plunged 9 percent in 2000, according to the most recent data by investment banking firm Bear Stearns.

The tech sector would have done substantially worse. The PC networking sector would have seen its earnings lowered by 89 percent. The communications industry--not including Nortel--would have suffered a 32 percent drop. Computer software and services would have seen its earnings lowered by 30 percent, according to Bear Stearns.

"The more volatile the market and more options granted, the greater the impact to earnings," said David Zion, an accounting analyst with Bear Stearns.