Stock options that US corporations grant employees as compensation should be counted as expenses in earnings statements and their value should be tied to the performance of the company relative to its competitors, Federal Reserve Board Chairman Alan Greenspan said.
"The failure to expense stock option grants has introduced a significant distortion in reported earnings," Greenspan told a Federal Reserve Bank of Atlanta conference on financial markets.
"Capital employed on the basis of misinformation is likely to be capital misused."
Greenspan, who has voiced concern about the issue for years, has pushed for a change in options accounting three times in as many months. That puts him in conflict with President George W. Bush, Securities and Exchange Commission Chairman Harvey Pitt, Treasury Secretary Paul O'Neill, and most corporate executives.
Stock options allow executives to buy shares of their companies in the future, often at prices well below their value at the time. Current US accounting rules require only the disclosure of the options' value in footnotes to company financial statements, allowing companies to avoid reducing reported earnings.
Any change likely would have a big impact on earnings. Of the 30 members of the Dow Jones Industrial Average, only Boeing Co.
put any value on its options when calculating earnings during fiscal 2001. If all the Dow industrials had done so, their total net income would have been 9.5 percent lower. Two companies, Eastman Kodak Co and Hewlett-Packard Co, would have shown losses rather than profits.
"The seemingly narrow accounting matter of option expensing is, in fact, critically important for the accurate representation of corporate performance," Greenspan said. "To assume that option grants are not an expense is to assume that the real resources that contributed to the creation of the value of the output were free."
When executives exercise their options, often years after they were granted, it dilutes the pool of existing shares, making each worth less. "Surely the existing shareholders who granted options to employees do not consider the potential dilution of their share in the market capitalization of their corporation as having no cost to them," Greenspan said.
Investors shouldn't worry that share prices might fall if options expensing depressed earnings because "expensing is only a bookkeeping transaction," he said. "Nothing real is changed in the actual operations or cash flow of the corporation."
If lower reported earnings dissuade investors, "it means only that they were less informed than they should have been about the true input cost of creating corporate revenues," Greenspan said.
The Fed chairman's position puts him at odds with Pitt and O'Neill, the former chairman of Alcoa Inc and a former board member of Kodak and Lucent. O'Neill said yesterday that while there should be "much fuller disclosure" of options, he opposes expensing because a company that expensed options now might have its earnings artificially inflated in the future if its stock price doesn't rise and the options aren't exercised.
A bill introduced in the Senate by Michigan Democrat Carl Levin and Arizona Republican John McCain would require the stock option tax deduction to mirror the stock option expense on the company's income statement. If a company doesn't report a stock option expense, then it couldn't take a tax deduction.
Greenspan said regulators, such as the Financial Standards Accounting Board, were better equipped to deal with the issue than Congress. The issue "does not lend itself to hard-wired legislation, which makes flexibility of rule-making difficult," he said.
The London-based International Accounting Standards Board plans to publish a draft rule requiring companies to deduct the estimated cost of employee stock options from earnings. A proposal similar to that made by FASB in the US was abandoned in the mid- 1990s because of opposition in Congress.
Enron Corp, which in December filed the biggest bankruptcy in US history, has rekindled concern that earnings statements don't always accurately reflect a company's financial health.
If options accounting distorts earnings, it may lead investors to buy stocks in companies that aren't adding to the country's growth potential. "That would be an issue of national concern," said Greenspan, who raised the issue at a 1999 Fed conference in Jackson Hole, Wyoming.
Decisions not to count options as an expense may have contributed to a surge in technology stocks during the late 1990s because "substantial capital arguably was wasted on a number of enterprises whose prospects appeared more promising than they turned out to be," he said. "at least some of the unsustainable euphoria that surrounded dotcom investing at its peak may have been exacerbated by questionable reported earnings."
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