How Wall Street Analysts Will Treat Stock Option Expensing

It is the eve of stock-option expensing. The Financial Accounting Standards Board’s now-infamous FAS 123R requires that most public companies begin accounting for the costs of stock-based compensation as of their first fiscal year that begins after June 15. For companies with a calendar year-end, that won't be until the March 31, 2006, quarter.

But at least 26 companies will kick off this exercise next month, since they have a fiscal year ending June 30. That’s according to corporate communications firm Financial Dynamics, which cites Microsoft, Procter & Gamble and Newscorp as some of the first companies to begin expensing stock-based compensation under the new standard. Cisco Systems, one of the most vocal opponents of the new requirement, has a fiscal year that ends July 31.

Altogether, at least 76 companies will begin expensing options before the end of the calendar year, including Monsanto, Walgreen, and investment banks Bear Stearns and Morgan Stanley.

Hardesty

And while executives at many public companies have been exploring option expense reduction techniques—like shortening option lives, shifting to restricted stock, and minimizing volatility (see extensive related coverage in box at right)—they’re now starting to look at impact odds. “This issue is what keeps CFOs up at night because there are a lot of variables on how to implement the rules and a lot of ways to get it wrong,” says David Hardesty, author of Share-Based Payments: An Analysis of FASB Statement 123(R). In fact, much of the anxiety may be due to the fact that the average investor is generally unaware of what is about to happen, and what it means. “While most Americans who invest in the stock market will not understand these rules because they are technical,” says Hardesty, “they should understand that this change in the rules could affect stock prices.”

A Consistent Approach

One of the biggest questions facing Wall Street, investors and corporate management is how companies—and the Wall Street analysts who follow them—are going to account for the expense in their earnings estimates filed with First Call. This is a critical question.

First of all, analysts and the companies must be on the same page so investors understand whether a published earnings number met, exceeded or missed consensus analyst estimates, which in turn will have a big impact on the stock's subsequent performance.

Also, it is necessary to make realistic comparisons for earnings, margins and other metrics within the same industry. But those judgments won’t be easy in some cases. For example, will companies go back and restate prior years numbers so investors can do apples-with-apples comparisons?

"Not only is there the issue of comparability of analysts' estimates between those that include the expense versus those that do not, there is the potential for unduly negative comparisons when a company reports GAAP EPS, and the First Call mean estimate excludes the expense," notes Financial Dynamics in a recent report. "We can envision media headlines that cite an earnings miss when, in reality, the First Call estimate overstates actual earnings."

McCoun

For its part, Financial Dynamics recommends that companies consider following FAS 123R as soon as possible. In addition, the firm recommends that companies break out the amount of the expense in the text of the earnings release, and consider adding a supplemental table showing the impact of the expense on earnings. They also say companies should then include the expense in analysts' First Call estimates.

“Our suggestion is for the company and the analysts to agree on a consistent approach and have the estimate showing the impact of the expense,” says Gordon McCoun, senior manager director for Financial Dynamics.

Company-By-Company Basis

How the analysts will actually behave, of course, is the big question.

Unfortunately, most of the major investment banks approached by Compliance Week wouldn’t provide details of how they plan to apply the new rules. A spokesperson for Bear Stearns, for example, says simply in an email response: “We began requiring our analysts to present an EPS [earnings per share] number with stock option expense deducted in the winter of [2002-2003]. We are going to require them to continue presenting such a number.”

A Merrill Lynch spokesperson provides more insight, noting that currently its research analysts make individual judgments on a company-by-company basis as to whether option expensing is reflected, “depending on what is most useful for investors and for valuation for each company.” She adds that option expense in GAAP EPS will be reflected in analysis from the time when a company voluntarily expenses or when option expensing becomes mandatory for companies covered.

According to some experts, it is possible that companies might look back and provide new sets of numbers for prior years so that Wall Street and investors can make year-over-year and quarter-over-quarter comparisons. These are not technically restatements.

Of course, companies are allowed to provide additional information and earnings numbers excluding the effect of options, just as they have in the past provided numbers excluding “one-time” events like write-offs. As a result, it’s likely that some analysts will provide estimates that exclude options, and others will them. According to David Dropsey, a research analyst for Thomson Financial, First Call plans to treat the issue on a company-by-company basis.

Of course, this could become confusing when a company releases its results, especially since many investors like to make snap judgments about whether a company hit the consensus estimate or not. “The investment community and the media must be diligent enough to read the footnotes, or double-check with us before breaking a story to make sure the analysts are on the same page,” Dropsey insists.

But, what if analysts covering the same company have different policies as to whether or not to include the option expense in their estimates? The answer is rather simple: majority rules.

For example, if 10 analysts follow a particular company and, say, six include the option expense, then the consensus figure only includes the option expense, and vice versa. The minority group’s estimates will be provided in a lightly shaded gray area but will not be calculated in the consensus figure.

The reality, though, is that most analysts follow the company’s lead and guidance, Dropsey notes. “Analysts can’t produce a [forecast] number without help from the company,” he explains. “At the end of the quarter, analysts don’t want a big beat or miss. They want to be right on the money so they are in line with their target stock price.”