Rogue Missives Friday, July 18, 1997

Accounting for Stock Options:
Fictitious Earnings?
-- Louis Corrigan  (RgeSeymour)

Ask any roomful of investors what most influences stock prices, and aside from the two guys obsessed with Greenspan's next move, the rest will say corporate profits. With apologies to the Fed chairman, the majority would be correct. Yet we're often made aware of the way earnings get massaged by management to satisfy the Street's expectations. Play with the numbers too much, and you end up in the hoosegow. Play with them just enough, and you click off the predictable quarterly growth of a COCA-COLA <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: KO)") else Response.Write("(NYSE: KO)") end if %>, regardless of whether sales in Brazil had any fizz or not.

A Dynamic Worth Considering

Earnings are everything, the solid reality of the bottom line that we use in our financial models to determine a company's value. Yet they are also mere fictions, tales that we've all agreed to believe as long as they follow certain widely accepted conventions. Lest you mistake this for just a strained analogy, those conventions are known as the Generally Accepted Accounting Principles (GAAP), and they are put in place by the Financial Accounting Standards Board (FASB), which the Securities and Exchange Commission (SEC) more or less defers to on these matters. The FASB has the power to change our very understanding of corporate earnings. Indeed, they may have already done so thanks to the added corporate disclosure required by recent rule changes regarding the treatment of stock options.

Stock options are the bete noir of corporate America. Hardly a week goes by that we don't hear of yet another top executive who's made off like a high-class bandit despite stringing together a series of lackluster results. Then again, options seem quintessentially American, aligning management and sometimes even employees with shareholders while rewarding risk-taking and stellar performance with mind-boggling riches. It seems thoroughly appropriate, even good, that Seattle should be teeming with MICROSOFT <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MSFT)") else Response.Write("(Nasdaq: MSFT)") end if %> millionaires. Only in America.

Most folks aren't opposed to options per se but to the way corporate boards dish them out as if no one has to pay for them. Of course, that is one huge reason why compensation packages are chock full of such generous options awards: the company doesn't have to pay for them, at least not up front. Options are tickets to ride, not cash, so they don't get subtracted from a firm's income. Since companies need cash to build the business, better to hand out stubs now, cash later, if at all. Better yet, companies actually profit from these non-payment payments by expensing the costs to gain lucrative tax advantages. The confusing result may not make much sense, but it's the way things have worked for a while now. At the center of the confusion is the simple question: How should we calculate earnings?

Part 2: A Virtual Example

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