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New Rule: Apple, Others Required to Expense Options

TMO Reports - New Rule: Apple, Others Required to Expense Options

by , 6:00 PM EST, December 16th, 2004

The Financial Accounting Standards Board (FASB) has issued a ruling that will require Apple Computer, among other companies, to begin deducting the value of stock options from profits, starting in 2005. The ruling ends years of debate over the issue, and will dramatically change the way many companies, especially tech companies, compensate employees and executives, and account for that compensation.

The ruling effects the first annual report that public companies make after June 15th, 2005. For Apple, this would be the fiscal 2006, which begins in October, 2005.

Fair-Value vs. Intrinsic Value

At the root of the issue is the fair-value of expensing options vs. the intrinsic value method, which Apple has heretofore used. The intrinsic value method accounts for options by taking the difference between the market price of the stock and the exercise price at which the employee may buy that stock. Under this accounting procedure, compensation expenses are not recognized in Apple's consolidated statements of operations.

The fair-value method attempts to reflect what the options would cost to buy if they were available on the traded market, and count that price as an expense.

The difference in reported profits could be profound for many companies, including Apple. On December 3rd, The Mac Observer reported that Apple's annual report said that its 2004 profits would have been cut some 38%, from US71 cents to 44 cents per share, had it been required to use the fair-value method of accounting.

Resistance

Apple has been among those companies arguing against the fair-value method of expensing options. In March of 2003, then Apple chief financial officer Fred Anderson defended his company's practice by saying, "Option pricing in a real market reflects a broad range of subjective factors that are subject to constant change. The markets for traded options do not rely solely on blind adherence to the results of complex mathematical models as suggested by the FASB's position."

That argument has also been used by other companies as the debate has raged back and forth during the past few years. The Wall Street Journal notes that on the side of changing to the fair-value method lies such business leaders as Federal Reserve Chairman Alan Greenspan, Securities and Exchange Commission Chairman William Donaldson, billionaire investor Warren Buffett and the Big Four accounting firms.

At the same time, Apple has also said in the past that it was unfair for the company to start expensing its options when most of the competition was not doing so. Very few companies have voluntarily agreed to do so, but the long-awaited ruling from the FASB puts all companies on an equal footing.

The concerns

The concern of many companies that have resisted the move to expensing options, especially startups and tech companies, is that they will be unable to retain employees, or to motivate their employees to work long hours if they can not give them valuable options.

At the same time, while the intrinsic value method of accounting leaves profit numbers subject to manipulation, the same can be said of the fair-value method, which relies on some prognostication on future stock prices. That prognostication is subject to both a subjective outlook and deliberate efforts to manipulate the numbers.

To make this matter a bit trickier, today's ruling from the FASB did not include any specific formulas or rules on how to expense the options. This is something that many critics (i.e. those tech companies resisting the change) have tried to leverage as a reason not to change the status quo.

On the other side of the debate lie shareholder advocates and the economic luminaries noted above. Their point is that options represent a legitimate cost of doing business for those companies that use them, and that this expense must be reported to shareholders. Otherwise, they argue, profits are being unfairly reported.

Going forward

The ruling should bring some reassurance to the markets, which will now know that companies are playing by roughly the same rules. At the same time, the lack of specifics in the FASB ruling will likely mean that it will take years to work out the kinks.

An Apple spokesperson did not respond to repeated phone calls and e-mail from The Mac Observer for comment on the FASB decision.

Brad Gibson contributed to this article.


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