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New rules on stock options, put in place to uncover the true cost of paying executives and other employees with options, have created new ways for companies to manipulate their reported profits.
Look at semiconductor maker Broadcom (BRCM, news, msgs). Its reported options expense fell by more than $200 million between 2004 and 2005, even though the company issued 36.1 million stock options last year compared with 19.9 million in 2004. A big reason for the expense drop: The company changed assumptions for how volatile its stock price would be and for how long those options would be in force.
"The whole process is fraught with inconsistencies and opportunities for manipulation," says Albert Meyer, an accounting expert who manages money at Bastiat Capital of Plano, Texas.
Companies have always had to account for their outstanding stock options. But for years they were allowed to book the "intrinsic value" of options -- essentially the value of an option if it had to be exercised right away. Since the strike prices on many options are at or above the current stock price, a lot of options look worthless, meaning they have an intrinsic value of zero. So the real cost of options has gone understated for years.
Thanks to new rules drawn up in 1995 but put in place only this year, companies are required to give a fuller picture of their options costs. Their accountants use mathematical models to produce a "fair value" for options.
The models leave several variables in the hands of the companies, though. How volatile will the company's stock be? How fast will it rise? When will employees cash in their options, if at all?
The use of options models is not new. For a decade, companies have reported the cost of options in footnotes. But those calculations weren't part of their financial results. Now that they are, many companies are changing their assumptions in ways that improve their financial results.
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The numbers game
Companies issue options to employees to reward and motivate. If employees work well enough to move a company's stock price, they share in the gains by cashing in those options. When the employees exercise the options, it creates new shares traded in the stock market. To prevent that greater number of shares from depressing the value of other shares outstanding, companies typically buy back their stock. That costs money.The question: What is the current cost of those options? Under the new rules, companies assign a value to the options they issue each year, based on how many options were issued, how their stock price will perform and the expected lifespan of the options.
Companies have lots of discretion in answering those questions. They can value newly issued options based on how volatile their stock has been recently or how volatile it was several years ago. They can easily shorten the assumed lifespan of the options, which reduces the estimated cost of employee stock options.
Back in 2002 and 2003, Broadcom assumed its stock had a volatility of 70% when it came time to estimate the expense of employee options. (Here's how that number works: If a company expects compounded annual returns of 10% over five years and claims a volatility of 30%, it means the stock could be up 40% or decline 20%.) But as the time approached when Broadcom would actually have to book an options expense, its volatility estimates declined sharply.
Broadcom's assumed volatility dropped to 64% in 2004, then to 40% in 2005 and to 35% in the first quarter of this year. At the same time, Broadcom revised down the estimated average lifetime of options to 3.2 years in 2005, from 4.73 years in 2004 and four years in both 2002 and 2003. That also reduces the estimated options expense, because when options have a shorter lifespan, there's less time available for employees to cash them in.
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