Is Apple overstating earnings?

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    Posted: 27 June 2002 02:00 PM

    In a New York Post article spawned by the WorldCom debacle, John Crudele asked Standard & Poors to name five significant companies who they feel are using “creative accounting” to artificially boost their numbers. From the article:

    So which five significant companies overstate profits the most, according to S&P’s calculations?

    The research firms says Raytheon may be reporting profits that are nearly 9,000 percent better than its “core” real numbers. And Perkin-Elmer is 7,274 percent overstated; The Gap, 1,047 percent; Apple Computer, 1,003 percent; and Yahoo! 956 percent.

    He points out that these do not represent outright fraud like the WorldCom case, and that the accounting practices used by these companies are not illegal. In Apple’s case it is apparently due to not counting stock options as a corporate expense.

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    Brian

    It depends on what you look at, obviously,
    But even more it depends on the way that you see

         
  • Posted: 27 June 2002 02:20 PM #1

    Nobody counts options, and that is a debate right now.  But look at the first part again.  *Nobody* counts options, so singling out companies in this way saying they inflate their profits using options as the basis is somewhat pointless.

         
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    Posted: 28 June 2002 08:01 PM #2

    OK, I have to confess that this is an issue that I don’t know a lot about. This is the first time I’ve ventured into this forum, and part of my reason for posting this was to let some of you enlighten me as to the importance of this.

    So, CrazyOne has taught me that nobody counts options and that the issue is being debated. If nobody counts options, then the article was somewhat misleading to a relatively uninformed person like me.

    As I look at it now, I think what’s being said is something like this: It’s coming from the point of view of someone who thinks that stock options should be figured as expenses. If that were to be applied as a required standard, which companies, then, would stand to lose the most from their currently stated earnings?

    If Apple is towards the top of such a list, does it really matter? I guess it all goes back to the question of whether or not options should be counted or not. Does a company with more options out there really face more of a potential downside?

    This question isn’t going to be resolved here, and I don’t intend to start a discussion on it necessarily. Just trying to learn some things.
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    Brian

    It depends on what you look at, obviously,
    But even more it depends on the way that you see

         
  • Posted: 28 June 2002 08:11 PM #3

    Scary

    It is scary to think that options are not counted as expenses.  With the huge number of shares sold by executives exercising their options, and now seeing that these were not counted, for the first time in 20 years I am beginning to loose faith in Apple.

         
  • Posted: 29 June 2002 06:13 AM #4

    Actually, I’m not even sure how a company would book options as an expense, what cost basis they would use, etc.  But there certainly is a debate, a valid one at that, regarding this situation, and it affects a large number of companies, not just Apple.  This guy, it sounds like, is suggesting it affects Apple comparatively more than some other companies due to the amount of exec compensation that is in options.

    Regardless of the validity of this debate, the timing of this is dubious.  While those with some experience will be able to tell the difference, a good portion of the general public would look at this and lump this in with Worldcom, Enron, etc.  It’s not the same.  Worldcom and Enron appear to be out and out fraud.  There’s no fraud in not booking options; it is simply something that has gotten more debatable in recent times with the growth of options as major compensation.

    This is not to say that options being an expense is not a valid point of view.  Indeed I would probably lean that way.  But it is not the same.  And it would not be in Apple’s interest to reconfigure to include options in the calculations unless everyone does it.  So far, everyone is not doing it.

         
  • Posted: 03 July 2002 11:32 PM #5

    [quote author=“CrazyOne”]Actually, I’m not even sure how a company would book options as an expense, what cost basis they would use, etc.  But there certainly is a debate, a valid one at that, regarding this situation, and it affects a large number of companies, not just Apple.  This guy, it sounds like, is suggesting it affects Apple comparatively more than some other companies due to the amount of exec compensation that is in options.

    Regardless of the validity of this debate, the timing of this is dubious.  While those with some experience will be able to tell the difference, a good portion of the general public would look at this and lump this in with Worldcom, Enron, etc.  It’s not the same.  Worldcom and Enron appear to be out and out fraud.  There’s no fraud in not booking options; it is simply something that has gotten more debatable in recent times with the growth of options as major compensation.

    This is not to say that options being an expense is not a valid point of view.  Indeed I would probably lean that way.  But it is not the same.  And it would not be in Apple’s interest to reconfigure to include options in the calculations unless everyone does it.  So far, everyone is not doing it.

    These are good points. Please remember too that to varying degrees (based on shares vested, etc) unexercised options are counted in diluted share tallies. All exercised options are counted in shares outstanding. While the “cost” of options may not be picked up in the reports on nominal earnings, the effect of options do increase the number of shares counted when earnings per share, the number more closely watched by investors, is computed. More shares means less earning per share.

    So, in effect, options are factored into earnings via the effect on earnings per share that are reported each quarter. This is one reason many companies buy back shares in the open market to keep options from decreasing the earnings per share numbers.

    Options, and their dollar value, are reported in various SEC reports and computed for proxy statement purposes.

    One reason why options are attractive as a form of compensation is because they keep fixed costs down. An executive only makes money on options when the share price exceeds the option price. It’s a way of linking compensation to performance. In other words, if the share price doesn’t move up for the benefit of all shareholders, the executive misses out on a key component of his or her possible compensation.

    Although the company doesn’t declare the profit made by the employee when he or she exercises options as an expense, the employee reports the difference between the current market value for the shares and the lower option price as income and pays taxes on that amount. It’s another reason employees often sell all or a portion of their options when they exercise them. They owe the company for the shares at the option price and the federal and state governments taxes on the difference between the exercise price and the market value as income. Employees do pay income tax on the gain from options.

    I don’t know if it’s still the law, but for a while I believe the government insisted that the taxes be paid at the time the income was created (when the options were exercised) not when the employee sold the shares and received the cash. In either case, the employee owes the company for the shares at the option price when they are exercised. The various taxing agencies take their share of the profits.

    One reason why options are not picked up as an expense is because it would force the company to make a series of complex income and expense transactions for what is now an asset and equity transaction. When shares are exercised the company receives cash for the shares at the exercise price. There’s a pick-up to cash and the second “leg” of the transaction is a pick-up to shareholder’s equity from the increase in cash. It’s not an income and expense transaction. The “expense” appears indirectly as a reduction to cash that might otherwise be received if the shares were sold at market prices and a corresponding decrease to what would have been added to shareholders equity.

    In the same way, if a company sells additional shares at market value, it doesn’t pickup the difference between the market value and the par value (the value assigned to each share at the time a company incorporates) as income, it’s carried on the balance sheet as paid-in-capital in excess of par. It’s not an income and expense transaction. If a company buys back shares it doesn’t book the amount paid for the shares as an expense. It reduces shareholders equity by the same amount as the share buyback decreases cash.  Again, not an income and expense transaction.

    To create an expense item to account for the difference between the market price and the option price, the company would have to book a series of complex income and expense transactions in order to arrive at the same net effect on the balance sheet

    Second, if the difference between the option price and the market value were booked as an expense to the company when the options were exercised, it would make profit and loss statements very uneven, it would only increase the complexity of income statement analysis for investors and analysts because there could be big swings in expenses due to the options exercised in one year versus other years. The “expense” for option exercises would need to be backed out of the numbers to get a comparative look at a company’s performance year over year.

    Third, and the government would have a lot to say about this, if the difference between the exercise price on options and the market value of the shares could be booked as a corporate expense, it would have the net effect of reducing a company’s income tax liability. The government would lose revenue equal to the company’s tax rate on the employee’s gain. Just one more reason the government may not be keen on making that change.

         
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    Posted: 04 July 2002 01:12 AM #6

    The biggest thing about this subject is that Apple is simply playing the same game as every other tech company, and Apple was actually late to table.  Cisco is the king daddy of the stock option compensation game, and Microsoft’s actions dwarf Apple’s puny option granting.

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  • Posted: 06 July 2002 01:21 PM #7

    Editorial Statement

    Just to follow-up in this thread. For anyone to claim that Apple is overstating earnings by following Generally Accepted Accounting Principles (GAAP) as to the manner in which it treats the accounting of stock options is such a disingenuous effort to grab sensational headlines that I think the story writer should spend more time earnestly following the markets and the activities of public traded companies that have announced irregular accounting activities and less time in a effort to “make news”.

    The public ownership of companies and the strength of our free enterprise system are dependent on companies following uniform rules established either by law, regulatory action or set by quasi-public boards comprised by industry professionals.

    To claim that Apple is artificially overstating earnings by following the laws of the land in my mind calls into question the editorial policies of the news organization that printed the story.

    In an environment of fear from the fallout of the 9/11 terrorist attacks on America and the confusion that has been caused by unscrupulous executives who have chosen to thumb their noses at the law at a handful of companies, IMHO news organizations have a responsibility as holders of the public trust to help separate fact from fiction and provide clear and accurate information to readers.

    IMHO the New York Post story only adds to confusion by purposely selecting a high-profile company such as Apple and arbitrarily creating a short list of corporate names to mention as possibly overstating earnings without providing in-depth information as to the criteria or methods used to make the allegation nor reference to any clear-cut standard by which the calculations of overstatements are made.

    If one were to look closely at Apple’s employee stock option program, one would find that due to the recent drops in the company’s share price, many of the options granted to employees have no value at this time.

    Options are a way to compensate employees for excellent work that contributes to an increase in the stock price for the betterment of all shareholders. It’s a practice that has been in place for decades.

    Let’s take a look at the flip side of this issue. Case in point: Dell Computer. Over the past several months Dell has been aggressively repurchasing its own shares by using billions of dollars of the company’s cash resources. Has anyone claimed that Dell should treat the share repurchases as an expense even though the repurchases have removed $2 to $3 billion from Dell’s balance sheet? Of course not.

    Dell has chosen to use its substantial cash position to reduce the number of outstanding shares and help prop up its earnings per share growth at a very challenging time in the PC industry. Has anyone claimed that Dell is artificially increasing its earnings per share by buying back shares and thus reducing the number of shares counted in the earning per share calculations? Of course not.  It’s a standard corporate practice that many companies have chosen to follow at a time of low stock prices.

    Please note that Apple has not chosen to use its cash to buy back shares. The reason? In publicly stated comments by Apple executives the company is preserving its hefty cash balance in part to alleviate the concerns of risk-averse education buyers about Apple’s financial position following several years of challenging times.

    When options are excercised Apple recieves cash equal to the market price of the shares on the day the options were granted. The cash is added to the company’s balance sheet and increases the company’s already hefty cash holdings. The employee profits on the difference between the option price and the excercise price, the same benefit received by any shareholder who purchased shares the same day the employee received his or her options.

    Apple, like most large, publicly traded companies uses stock options as a way to reward employees for hard work while reducing fixed costs. Apple employees benefit from stock options only when all shareholders reap the benefits of a higher stock price. Is there something wrong with Apple using standard corporate practices to compensate employees and work for the benefit of all shareholders? Of course not. Is there something wrong with what Dell has done to maintain earnings per share growth even though it has removed billions of dollars from Dell’s balance sheet? No. But after reading the above-mentioned New York Post story that mentioned Apple I have the impression that the writer believes that Apple has somehow abused established corporate practices or done something irregular.

    If a handful of Dell executives exercise stock options to reap the benefits of a higher stock price aided in part by the massive stock buyback, I would expect an analogous New York Post column to read:

    “Dell Spends Billions to Help Enrich a Handful of Employees”


    A quick read of the daily financial news stories indicates that many investors are scared and confused. Investor confidence is needed now more than ever to help restore economic health and American prosperity. I believe there is more than enough news to report to help investors make wise decisions and help restore confidence in our free enterprise system. IMHO this is not the time for “make news” stories that only add to public confusion.

    Robert

         
  • Posted: 23 July 2002 10:46 AM #8

    1. Is salary counted as an expense?
      Is a salary bonus counted as an expense?
      Isn’t an employee stock option a form of potential or actual employee compensation an expense (deducted from an asset of the company - i.e. stock)?

      Of course.

      Do companies “earn” cash from issuing stock?  Yes.  Do companies earn cash from issuing stock options? No. But,  as the “price of an asset equals the present value of it’s future cash flows” it becomes clear that the difference between passing out stock options and issuing stock does affect future cash flow.

      In so far as companies hide (or shade) the difference - everything; from open market stock price, to the capital value of the company on the open market, to the ability of a company to borrow money from banks for future production or expansion, is affected.

      It didn’t seem to matter in the days of “irrational exuberance” but now that the party is over institutional investors, pension funds, banks,  suppliers and individual investors will be taking a closer look at the companies they do business with.

         
  • Posted: 23 July 2002 11:44 AM #9

    The Coca-Cola Company last week decided they would be booking stock option compensation as expense.  I expect others will follow, slowly but surely.

         
  • Posted: 24 July 2002 10:51 PM #10

    [quote author=“Anonymous”]1. Is salary counted as an expense?
      Is a salary bonus counted as an expense?
      Isn’t an employee stock option a form of potential or actual employee compensation an expense (deducted from an asset of the company - i.e. stock)?

      Of course.

    No. Stock options are not “deducted” in any way from an asset of the company. Stock options are usually new shares issued upon excercise of the options.The company receives cash equal to the option price. The employee gains on the difference between the option price and the excercise price. The employee pays taxes on the gain because it is considered income to the employee.

    The dilution of earnings per share from more shares outstanding due to options will be refelected in the company’s earnings per share tally. That is how this “expense” is already indirectly reflected on a company’s books in that the additional paid-in-capital is below what it might theoretically have been if the same shares were floated at market prices with the company collecting the full sum from the shares. To book the difference between the option price and the excercise price as an “expense” would overturn conventional accounting and force complex entires to get at the same net numbers.

    If corproations could do this - book the difference between the option price and the excercise price as an expense for tax purposes - it would reduce corproate tax liabilities. Becuase employees pay income tax on the difference between the option price and the excercise price but the company does not book the difference as an expense, the government gains a one-sided income tax advantage. One more reason the government would be hesitiant to endorse this change. The net effect of allowing companies to book employee option gains as an expense would be a drop in corporate income taxes.

    Further, because the excercise of options occurs at different times at different levels of frequency at different companies, it makes treating the employee’s gain on excercised options as an expense problematic for comparisons of companies in the same industries over the same periods of time. Analsyts and investors would need to back out this expense from comparisons in order to get at comparable corporate numbers.

    For example, if employees at computer company “A” regularly excercise the same number of options each quarter with a similar option price the expense would be regular in terms of its effect on corporate earnings.

    But if employees at computer company “B” only infrequently excercise options, in the periods when no options are excercised company “B” will report lower expenses than company “A”. In the periods when company “B”‘s employees excercise a lot of options, its earnings will look much worse than company “A”‘s even though they may have sold the same number of computers and made similar profits.

         
  • Posted: 24 July 2002 11:16 PM #11

    [quote author=“CrazyOne”]The Coca-Cola Company last week decided they would be booking stock option compensation as expense.  I expect others will follow, slowly but surely.

    Is Coca-Cola going to single-handedly rewrite IRS code and gain the benefit of lower taxes based on stock option “expense” or is it an accounting expense divorced from its tax accounting?

    Is the government going to permit Coca-Cola to pay lower taxes from this “expense” by itself or has the government decided to give large corporations one more huge tax break to the exclusion of small businesses that don’t have the luxury of this “expense” to reduce their taxes?

         
  • Posted: 25 July 2002 05:56 AM #12

    Who knows?  There was an interesting long piece on Marketplace http://www.marketplace.org/ yesterday that talked about both sides.  How do you value the options?  At what point in time?  For how long?  And, of course, you bring up the tax bit.  Presumably the tax liability doesn’t change, but I don’t remember if that bit was discussed on the radio show.

    Things are happening, though.  TIAA-CREF apparently sent letters to a bunch of large companies saying they will favor those who include the expense of options.  And add Amazon.com to the list of high-profile companies saying they will do it.  (These bits are according to the same Marketplace radio show yesterday.)

         
  • Posted: 25 July 2002 01:12 PM #13

    Stock Option Expense

    Thanks CrazyOne for the Marketplace.org radio link. Excellent commentary.
    Say what you want DawnTrader, but in the Marketplace.org Archives there were a couple of radio pieces on stock options through which I heard and learned that the International Accounting Standards Board in London has just voted to require all companies within it’s jurisdiction to treat the employee stock option as an expense!

    How it all comes out in the wash will be interesting.

         
  • Posted: 25 July 2002 02:35 PM #14

    Re: Stock Option Expense

    [quote author=“Anonymous”]Thanks CrazyOne for the Marketplace.org radio link. Excellent commentary.
    Say what you want DawnTrader, but in the Marketplace.org Archives there were a couple of radio pieces on stock options through which I heard and learned that the International Accounting Standards Board in London has just voted to require all companies within it’s jurisdiction to treat the employee stock option as an expense!

    How it all comes out in the wash will be interesting.

    Hey, I did not say I was categorically opposed to the idea of treating the difference between the option price and the exercise price as a corporate expense. What I am saying is that if the various accounting regulatory boards choose this option there should be uniform guidelines for the manner in which the expense is determined and the manner in which it is booked. Confusion helps no one.

    Personally, I would prefer that the expense formula for options be established for accounting purposes at the time the options are granted and/or vested rather than at the time they are exercised in order to provide more accurate information to investors, if the manner in which options are treated is changed for accounting purposes.

         
  • Posted: 11 August 2002 12:15 PM #15

    The debate on this issue continues with many high tech firms choosing not to expense the “cost” of options. Companies are citing the difficulty in determining the value of unexercised options as one reason for not choosing to expense this cost.  The value of options fluctuates with the rise and fall of stock prices.