The Problem with Stock Options Accounting

As I wrote a few weeks ago, in my review of Yahoo!’s 3rd quarter, changes in stock options accounting made Yahoo!’s quarter seem worse than it was.  In an aside in that post, I also mentioned my criticisms of the current “fair value” accounting for stock options.

In a recent articleon MoneyCentral, “A tricky new way companies inflate profits”, Company Focus columnist Michael Brush made a complementary critique.  The substitle of his article is “Companies can now manipulate their reported profits by changing the way they value stock options” and he writes:

Look at semiconductor maker Broadcom.  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.

“Volatility” refers to how up and down a stock is.  The more a stock goes up and down in wild swings the more valuable options are.  Similarly, the longer the term on your option, the more valuable it is.  Think about it: would you rather be able to purchase a stock at a set price for the next 1 year or 5 years?  The extra 4 years gives the stock a chance to run quite a bit more and make the opton that much more attractive to excercise. 

So by manipulating their assumptions about volatility and how long their options will be in force companies can change the so called “fair value” of their options compensation. 

More from Brush:

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.  But ast 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 4 years in both 2002 ad 2003. 

How big an impact do changes like these have on reported expenses?  Based on the increase in the number of options granted in 2005 to 24.1 million from 14.1 million the year before alone, Broadcom should have recognized an increase in its options expense of $149 million last year, calculates David Zion, an analyst with Credit Suisse.  That’s a significant 35% of operating income.

Broadcom was able to wipe out that increase – and more.  By adjusting down volatility assumptions, Broadcom was able to lop $118 million off its options expense, according to Zion,.  Reducing the expected lifetime of the options helped the company save another $65 million in options expenses.  The total savings from those two changes: $183 million.

Note: Brush got one of the numbers for Broadcom’s 2005 options issuance wrong, as he says they issued 36.1 million options in one place and 24.1 million in another.  But the main point still stands.

As you can see, this isn’t minor stuff.  35% of operating income is enough to change the company from being a good value to being way too expensive.  That’s why, as I argued last time, you just can’t look at income statements anymore.  Its not a cash but an accounting number.  You just have to account for options by recognizing the dilution, which isn’t hard to do. 

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