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Microsoft may see earnings cut

"If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?"

Warren Buffett, head of Berkshire Hathaway

Many large US companies, including Microsoft Corp, Yahoo Inc and Starbucks Corp, would have their profits slashed or erased under a Senate bill that would make them count the cost of granting employee stock options as an expense in company earnings.

If the proposed legislation had been in effect in 2000 -- when the biggest US firms granted US$162 billion of options, up threefold from 1997 -- Yahoo would have reported a loss of US$1.26 billion instead of a US$70.8 million profit. Earnings at Microsoft and Starbucks would have been 31 percent and 22 percent less, respectively, in fiscal 2001.

Michigan Democrat Carl Levin and Arizona Republican John McCain said that their bill would end a "double standard" that lets companies get a tax deduction when employees exercise stock options without having to count the options as an expense on their income statements.

"It's a good idea -- it fosters transparency," said Louis Kokernak, senior equity strategist with Martin Capital Advisors in Austin, Texas. Stock "is another form of compensation, so it's fair game."

Congress is moving forward with proposals to make accounting and corporate finance more transparent in addition to changing tax, banking and criminal laws in response to Enron Corp's bankruptcy filing. "It is our intention to pass whatever new laws are needed before the end of this year," Senate Majority Leader Tom Daschle said Feb. 14.

The proposed options bill "would be intensely fought," said C. Clinton Stretch, a partner at Deloitte & Touche LLP. "There's just a tremendous number of companies that have stock option programs."

The Financial Accounting Standards Board, an independent group that sets the rules for US companies, tried in the early 1990s to make companies expense stock options as they grew in popularity as a form of compensation. Opposition from Congress and industry lobbyists forced the group to back off.

Since 1996, FASB has instead required companies to list in a footnote to their annual reports how much their profit would have been if an expense for options were deducted. The group still recommends that companies regularly subtract the costs from net income. Of the 500 biggest firms, only two -- Boeing Co and Winn- Dixie Stores Inc -- actually do.

Stealth compensation

Levin said stock options have become a form of "stealth"compensation, allowing companies to ignore a cost and to benefit from billions in tax breaks. When an employee cashes in an option, the employer receives a tax deduction based on the difference between the option's exercise price and the market value of the stock.

In the year ended June 30, that tax benefit was worth US$2.07 billion to Microsoft, or 28 percent of the biggest software maker's net income, according to its annual filing with the Securities and Exchange Commission. A spokeswoman for Microsoft, which had net income of US$9.42 billion in that fiscal year, declined to comment.

Cisco Systems Inc, the largest maker of equipment to link computers, listed its benefit as US$1.4 billion in the year through July. Charles Schwab Corp, the biggest discount brokerage firm, had a US$330 million tax benefit from stock compensation plans in fiscal 2000, 46 percent of its net income.

If the value were fully expensed, earnings for the Standard & Poor's 500 Index would have fallen 12 percent in 2000 instead of rising 1 percent, according to a report by Credit Suisse First Boston.

Merrill Lynch & Co analyst Steven Milunovich estimates that losing the benefit would cut technology companies' cash flow an average of 50 percent. The profit growth of companies in the Standard & Poor's 500 Index for the three period through mid-2000 would have been 9 percent annually instead of 11 percent annually, according to analysts at Bear, Stearns & Co.

More than 80 percent of financial analysts and fund managers say stock options are compensation and should be recognized as an expense, according to a survey conducted in November by the Association for Investment Management and Research.

Companies argue that the value of options is hypothetical, based on the Black-Scholes option-pricing method.

Investors would have to rely on a fictional measure that might misstate the options' true value, said Caroline Graves Hurley, director of tax policy at the American Electronics Association.

The group represents 3,500 companies, including Dell Computer Corp, Intel Corp and Microsoft. It helped defeat a similar bill in 1997.

"This has been talked about for years and years," said James Schneider, Dell's chief financial officer. "The question is how you actually booked this into your P&L," or profit-and-loss account.

Technology lobbyists argue companies would award fewer stock options under the plan, making it harder for companies early in their growth cycle to compete for workers with more established rivals that can afford higher cash salaries.

Reducing stock-based compensation may also make employees less responsive to investors, said Ray Hirsch, head of technology stock investing at American Express Financial Advisors.

"I kind of like it the way it is," he said. "It puts employees in the same box with the shareholder."

Warren Buffett called current accounting "Alice-in-Wonderland" stuff in his annual letter to shareholders three years ago. Buffett typically eliminates option plans when his Berkshire Hathaway Inc acquires another company.

"If compensation isn't an expense, what is it?" Buffett asked in the letter.

"And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?"
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