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All Things Considered


Efforts to reform how stock options are counted in company balance sheets

03/06/2002

NPR: All Things Considered

Copyright 2002 National Public Radio, Inc. All Rights Reserved.

ROBERT SIEGEL, host: Lost causes have found new life in Washington after the wreckage of Enron. This story is about another accounting issue that springs obliquely from the Enron bankruptcy: stock options. Last week in Senate hearings, California Democrat Barbara Boxer was grilling the ex-CEO of Enron, Jeffrey Skilling. At issue: Enron's use of partnerships and perhaps its own stock to take debts off the corporate balance sheet and make the company look more profitable. Senator Boxer read from Enron VP Sherron Watkins' famous memo of warning. She cited what Watkins claimed was an absolute verity of accounting.

Senator BARBARA BOXER (Democrat, California): She says it in a sentence. `My understanding as an accountant,' she says, `is that a company could never use its own stock to generate a gain or avoid a loss on its income statement.' Is that true? SIEGEL: To which Jeffrey Skilling replied that `never' is not absolutely correct.

Mr. JEFFREY K. SKILLING (Former Enron CEO): There are cases where you can use equity to impact your income statement. And the most egregious, or the one that's used by every corporation in the world, is executive stock options. And essentially what you do is you issue stock options to reduce compensation expense and, therefore, increase your profitability.

SIEGEL: How companies account for stock options became an issue in Washington 10 years ago. Now, thanks to Enron, it's back.

For a primer on how stock options work, we called upon Steven Huddart, who teaches accounting at Penn State.

Mr. Steven Huddart (Penn State): Well, a typical stock option would allow an employee to purchase stock from the company at a fixed price some time in the future. And that's advantageous to the employee whenever that future stock price is above the price that's specified in the contract, which is sometimes called the exercise price and sometimes called the strike price.

SIEGEL: So if I were the CEO of a company that gave me the right to buy 100,000 shares at $30 per share and I could do it after five years and at that time a share was going for $40, I'd make a lot of money.

Mr. HUDDART: And on every one of those 100,000 shares, I'd capture a benefit before taxes of $10. So that would be $1 million.

SIEGEL: And when I, still as the hypothetical CEO, exercise my option, I pay income tax on that money and the company claims a deduction on its tax return, but not on its corporate earnings statement. As Steven Huddart explains, in an annual report, stock options, unlike salaries, do not count as expenses to be subtracted from earnings.

Mr. HUDDART: If you were to think of two companies that were identical except for their compensation policy, where one company chose to compensate in the form of salary, say, and the other used stock-based compensation, the reported income of the company that used salary compensation would be lower than the income of the company that compensated with stock options.

SIEGEL: Because it would have to deduct those costs of salaries, whereas the stock options wouldn't be deducted.

Mr. HUDDART: That's right. That's correct.

SIEGEL: In the early 1990s, an independent agency, the Financial Accounting Standards Board, or FASB, wanted to change that. It wanted to require companies to enter the cost of stock options on their balance sheets. So did Senator Carl Levin, a Michigan Democrat. In the early 1990s, Levin and his staffer, Elise Bean, were concerned about the growing gap between the pay for CEOs and the pay for average workers.

Ms. ELISE BEAN (Staffer for Senator Carl Levin): And what we found out is the single most important factor was stock options. Back when we started 10 years ago, CEO pay was hundred times average worker pay; now it's over 500 times.

SIEGEL: So Levin held hearings. He wanted to know why FASB hadn't implemented its plan to require that stock options appear as expenses against corporate earnings. Elise Bean says they found out why pretty soon: opposition from corporate executives was intense.

Ms. BEAN: I remember one day back in 1994, 100 CEOs flew in to Washington to lobby members of Congress on this very important issue. And, of course, it was important to them because this was their personal pay. This is how they were making their millions as CEOs.

SIEGEL: At that time, Arthur Levitt had just become chairman of the Securities and Exchange Commission. He says he spent as much as a third of his time being lobbied on this issue by executives.

Mr. ARTHUR LEVITT (Former Chairman, Securities and Exchange Commission): As a matter of fact, one senior executive of a major company at the end of a half an hour's dialogue in which he became increasingly animated, finally exploded by saying that, `If you allow this to happen, it will be the end of capitalism.'

SIEGEL: In 1994 in Silicon Valley, where stock options were widely used to attract top talent to risky start-ups and where they were often available to many employees, not just top executives, thousands turned out for a rally against the proposed change in FASB's accounting rules.

(Soundbite of music from 1994 rally)

Unidentified Woman: The accounting, in this instance, has a face. This is not about debits, it's about dreams. It's not about credits, it's about the quality of our lives. And it's not about accounting, period. It's about people, you, me and all of us who stand to lose...

Unidentified Man: ...from Connecticut. ...(Unintelligible) change the accounting rules, which will wipe out half of the earnings from Silicon Valley companies with no benefit to anyone else, just hurt Silicon Valley.

(Soundbite of applause)

SIEGEL: Senator Carl Levin's effort flopped. The Financial Accounting Standards Board came up with a compromise that the Senate overwhelmingly endorsed. Companies could either enter the cost of stock options as an expense, or they could add a footnote to their earnings statements spelling out the impact of options on the value of their stock. Hardly any companies chose to expense their stock options voluntarily. Boeing was a very rare exception. Just about everyone else used the footnote method. So in 1997, now joined by Republican Senator John McCain, Senator Levin tried again. Levin staffer Elise Bean recalls the sorry fate of that bill.

Ms. BEAN: It was not considered in committee, no hearings were held, no action was taken on the bill.

SIEGEL: So now it's 2002.

Ms. BEAN: And we have Enron, and Enron was reported to be the seventh-largest corporation in the United States, highly profitable, highly successful on the stock market. Now we don't know the facts entirely because we haven't gotten their tax returns yet. But apparently, $600 million in stock option deductions were used to essentially eliminate the payment of any corporate income tax.

SIEGEL: This time, Elise Bean and Senator Levin are using the tax argument on behalf of their bill.

Ms. BEAN: Should very wealthy corporations be paying their fair share of taxes? The companies need to be consistent. Either it's an expense or it isn't. But what we have now is a double standard where they tell their investors one thing and they tell Uncle Sam the opposite and take advantage of a tax subsidy.

Mr. WILLIAM ARCHEY (AEA): I don't agree with that, because I don't think that this issue has ever been based on the companies aren't paying enough taxes.

SIEGEL: William Archey says it's really all about the balance sheets. He runs AEA, which used to be the American Electronics Association, and he says the Levin-McCain bill would hurt his association's member businesses in several ways.

Mr. ARCHEY: It's, first of all, going to represent a massive tax increase. The second is it's going to put into some doubt whether or not companies, given the accounting changes and the tax changes, whether or not companies are going to be able to afford to provide stock options to all employees. And then the third is I'm not sure that investors are going to benefit at all by it, because the current rules require a fair amount of reporting on what those stock options cost to companies.

SIEGEL: By the current rules, William Archey means the footnote, which he says works.

Mr. ARCHEY: 'Cause the footnote describes an awful lot of what you're worried about not being seen. It has got a load of information.

SIEGEL: Well, a Levin staffer now says the version of the bill that's going to be, she hopes, considered this year will say, `You can continue to do the footnote. No problem.'

Mr. ARCHEY: Right. But you also will not get the tax deduction.

SIEGEL: You won't get the tax deduction.

Mr. ARCHEY: Right. So the Hobson's choice is not terrific.

SIEGEL: While businesses' arguments have held sway in the past, Federal Reserve Chairman Alan Greenspan said last week that expensing stock option costs would help restore confidence after the Enron disaster. Arthur Levitt, the former SEC chairman, recalls the executive who forecast the end of capitalism if stock options were counted in the balance sheet.

Mr. LEVITT: Even I, when I was in the community, got caught up in the hyperbole of events being so significant that we would never recover. Well, I think we have a very resourceful and resilient business community. And if we decide to account for stock options in the way that I think is in the public interest, I do not believe for a moment that it will be the end of capitalism, nor do I believe it will have a significant negative impact on America's corporations.

SIEGEL: The one time this issue came to a vote on the Senate floor, fewer than 10 senators voted for stock option reform. But William Archey, speaking for many high-tech corporations, fears that could change in the current atmosphere.

Mr. ARCHEY: There is an attitude in Washington right now of `We must do something.' And what we're worried about is they're going to do something they shouldn't do without benefiting the body politic, let alone the companies.

SIEGEL: Because of Enron?

Mr. ARCHEY: Because of Enron.


Steven Huddart
Smeal College of Business, Penn State University, University Park, PA 16802-3603 USA
(814) 863-0048
huddart@psu.edu
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