Subject: [NEXTEL-1] washingtonpost.com: Executives Resigned To Their Options

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Date: Mon, 02 Jun 2003 00:02:09 -0400

http://www.washingtonpost.com/ac2/wp-dyn/A63328-2003May31?language=printer
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washingtonpost.com

Executives Resigned To Their Options

Change in Accounting Rules Would Cost Some Local Companies

By Jackie Spinner

Washington Post Staff Writer

Monday, June 2, 2003; Page E01

They don't want to say it is inevitable, but corporate leaders at some Washington area companies that offer stock-option packages are resigning themselves to a future when handing out such incentives to employees and executives will cost them -- and at some companies, cost them big.

For credit card issuer Capital One Financial Corp., recognizing options as an expense would have shaved $157 million from its 2002 net income of $899 million. The McLean company makes generous use of options to compensate employees, even going so far as to pay its top two executives only in options. Richard D. Fairbank, chairman and chief executive, and Nigel W. Morris, president and chief operating officer, do not collect any salary or bonus but were granted options on nearly 6 million shares for the past two years. That saved the company the $6.5 million it would have paid them in salary and bonuses. Three other executives receive options in place of half of their cash bonuses.

Under current rules, compensating its executives this way, in essence, costs Capital One nothing.

The private-sector board that writes U.S. accounting rules is considering requiring companies to treat stock options as expenses, a change that would have a broad impact on earnings of Washington area companies. The Financial Accounting Standards Board (FASB), which is debating how to value the options, has said the new rule could be in place sometime next year.

In interviews with some of the largest public companies in the region, the companies defended how they've accounted for options in the past. Some criticized the attempt to change the rule but said they nonetheless would change their accounting if ordered to do so. Some declined to comment on the merits of changing the rule, an effort that has been highly politicized by some members of Congress and that has been a sensitive topic in light of recent corporate scandals.

"If the FASB makes a rule, we'll comply," said Rob Doolittle, spokesman for Falls Church-based defense contractor General Dynamics Corp. "But we'll leave the debate to others."

Tatiana Stead, a spokeswoman for Capital One, said the company wants a new standard that will "achieve comparability for those who follow our financial results." In other words, as long as the new standard applies equally to all of the credit card company's peers, no problem.

Stock options give employees and executives the right to buy shares in their company for a set price in the future. The purchase price is set usually on the day the option is granted, so the executive or the employee holding the option will only profit if the market price of the stock increases. Thus, the incentive to the holder is to create value and make the stock price rise. A standard option grant vests over a number of years, usually four, and expires after 10 years. If the stock price decreases over the life of the option, it expires worthless.

The cost to the company comes when the option is exercised, because the company is selling its stock for less than what it would get if it were selling it on the open market. The company is forfeiting something of value and giving it to an employee. Thus, according to proponents of expensing stock options, they are a real cost to a company's existing shareholders and should be reflected on the income statement -- that part of the financial statement that calculates profit or loss -- when they are granted.

Current accounting rules require only that companies estimate the cost of options in footnotes to their financial statements rather than recognizing them as a cost on their income statements. And for some companies, that has meant the difference between showing a profit or showing a loss. For other already profitable firms, it has saved them millions of dollars in compensation expenses.

For example, if General Dynamics had treated stock option awards to executives and employees as an expense in 2002, its $917 million in reported earnings would have decreased by $28 million. Arlington power company AES Corp., which reported a $3.5 billion loss in 2002, would have lost $148 million more if it had been required to treat options as expenses. And Gannett Co., the McLean-based media company, would have reduced its profit by $52.8 million from $1.2 billion.

Critics of requiring companies to treat options as expenses say it will deter companies from using them, hurting rank-and-file workers and eliminating an incentive high-tech and other start-up companies, in particular, have relied upon to attract employees. They also challenge whether the FASB can come up with a method for valuing stock options that accurately reflects their cost.

"Option-pricing models require highly subjective assumptions, including the expected stock price volatility," said Audrey Schaefer, spokeswoman for Nextel Communications Inc., a wireless phone company based in Reston. "Like many other highly traded technology stocks, ours is volatile, as compared to a Coca Cola, for example, and therefore these formulas become punitive and provide an inaccurate impression of value."

Nextel's reported $1.7 billion in net income available to common shareholders in 2002 would have been reduced to $1.3 billion if the company had been required to treat options as expenses. McLean consulting firm BearingPoint would have taken an even bigger hit. The company's $26.9 million reported loss in 2002 would have more than tripled to $95.4 million if it had deducted the option from its bottom line.

The ability to issue stock options was one of the reasons BearingPoint Inc., formerly KPMG Consulting Inc., went public 2001. John A. Schneidawind, a spokesman for BearingPoint, said the systems integration and business consulting firm had suffered an exodus of employees to firms that did offer options and it had a hard time getting people in without them.

"We wanted to use stock options as a retention tool," he said. "It's still a weapon against companies that are not offering them."

Schneidawind declined to comment on how a new accounting rule would affect the firm.

"We can't speculate on what we will or will not do without something solid to go on from FASB," he said.

Capital One's Stead said the company would "consider many factors" in reassessing its compensation program if it is forced to treat options as an expense, including "the format of incentive awards for our employees."

Some companies are considering issuing restricted stock grants rather than options if the proposed accounting rule change is adopted. Restricted stock, which is counted as an expense under current accounting rules, is subject to limitations on when it can be sold.

Marriott International Inc. already has decided to limit its use of stock options, it announced before its May shareholders' meeting. In a filing with the Securities and Exchange Commission, the company said restricted stock awards will replace annual option awards granted to the majority of senior management.

In 2002, the company recognized $9 million in expenses for deferred and restricted stock awards. Had it been required to treat options the same way, Marriott would have recognized $55 million more, reducing its reported profit from $277 million to $222 million.

Marriott spokesman Tom Marder declined to comment, referring instead to the company's proxy, in which it outlined its objection to a shareholder proposal requiring Marriott to establish a policy to treat options as expenses.

The company cited industry practice -- the majority of companies do not treat options as expenses -- as one of the main reasons it did not want to adopt a new policy. It also noted that the information is available to shareholders in the financial statements.

"We believe that this accounting treatment both adequately informs shareholders of the financial impact of stock options and makes it easier to compare our financial performance to that of other companies," it said.

Shareholders overwhelmingly defeated the resolution by more than 67 percent.

Jim Spellane, a spokesman for the International Brotherhood of Electrical Workers' pension fund, which proposed the resolution, said companies have relied far too much on options to compensate top executives.

Booking the expense "is a way of being honest," he said. "It gives a truer picture of what the company's finances are. It's an issue of fairness."

Critics such as the electrical workers' union have said the potential riches of options gave some corporate executives the incentive to use deceptive accounting practices to boost their companies' profits and stock prices during the stock bubble of the 1990s. Some also point out that companies now get to deduct the cost of options from their taxable income when they are exercised, seemingly a double standard.

Capital One, for example, recognized $22 million in tax benefits from the exercise of stock options by its employees during 2002. General Dynamics had tax benefits of $25 million in 2001, and MedImmune Inc., a biotechnology firm headquartered in Gaithersburg, recognized a tax benefit of $14,804 in 2001, down from $24,505 in 2000 and $111,720 in 1999.

Although MedImmune's tax benefit was relatively minor, the impact of treating stock options as expenses is a significant issue for the company. MedImmune reported a $1 billion loss in 2002 but would have lost $19.2 million more if it had booked the options as a cost.

"The company's perspective is that stock options have been a very valuable part of the compensation package," said Gregory S. Patrick, chief financial officer for MedImmune.

But how to account for them is an issue "that has been taken out of our hands," he said. "The FASB has signaled very clearly that stock options are a form of compensation. The FASB has taken the position that they are going to be required to be expensed. We'll have to do that whether we like it or not."

Several executives said a new accounting rule would not necessarily be the death of options in the region, something lobbying groups opposed to the FASB effort have said would be the result.

"That may be overblown," said Wayne M. Rehberger, chief financial officer of XO Communications Inc., a telecommunications firm based in Reston. "I personally never took a job because I got stock options. Stock options are one lever in a series of levers to pull when you're trying to recruit people. Will it affect how extensively you use them? Maybe."

Rehberger said XO, which emerged from bankruptcy protection in January, is a good example in the difficulty in valuing options.

Like most companies, XO used the Black-Scholes option-pricing model to value its shares. That model relies on a number of assumptions to predict the future value of the company's stock.

In 2002, the company reported a loss of $804 million. If it had treated stock options as an expense, that number would have risen to $3.4 billion. But the assumptions the company used to value the options didn't count on bankruptcy. XO filed for bankruptcy last year and emerged earlier this year as effectively a new company; all of its former stock was rendered worthless.

"It shows how silly Black-Scholes is," Rehberger said.

Earlier this year, the company redistributed stock options under the reorganization plan approved by the bankruptcy court. In the first quarter, it reported a $21.4 million loss. Had it been required to treat the options as expenses, its losses would have risen to $24.5 million.

Its stock-option expenses, Rehberger said, are now "immaterial."

© 2003 The Washington Post Company

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