& cplSiteName &

Chambers Attacks Accounting Plans

Light Reading
News Analysis
Light Reading
4/29/2003

LAS VEGAS -- Networld+Interop -- Cisco Systems Inc. (Nasdaq: CSCO) CEO John Chambers used part of his opening keynote address here to launch a passionate attack on proposed changes in accounting rules concerning stock options.

Chambers said that the changes, proposed by the Financial Accounting Standards Board (FASB), could have a devastating impact on the hightech community in the U.S., forcing some companies to move operations overseas.

Chambers' rant came at the end of a speech which up until then had been reminscent of previous performances. There'd been the usual breast-beating about Cisco's financial performance and its latest products. And he'd even demonstrated a few products launched at the show, including a wireless IP phone (see Cisco Launches WLAN Phones).

Towards the end of his keynote, however, Chambers got on his soapbox over the FASB's proposal to require companies to expense stock options granted to employees as part of their compensation -- a proposal that won unanimous support from the independent standards authority in a vote last month.

Under current U.S. accounting rules, companies are not required to book the cost of options to executives and workers. But they are expected to tell investors what impact the value of outstanding options would have on their bottom line in footnotes to their financial statements.

FASB’s decision to expense options, which is supported by many in Congress, came in response to outrage over top executives from Enron, WorldCom Inc. (OTC: WCOEQ), and Global Crossing Holdings Ltd. who reaped billions of dollars in cash when they sold their stock options before their companies plunged into bankruptcy.

In his speech, Chambers spoke out against this rationale.

“Expensing stock options will have no impact on senior management compensation,” he said. “To implement something like this without careful economic study would be a mistake.”

He said that the action would result in more job loss in the U.S., as companies would be forced to look overseas for cheaper labor. He warned that this trend in the U.S. technology community would be devastating.

“When engineers leave, it’s not long before companies follow,” he added. “I guess you can tell that I’m passionate about this topic.”

This is not Cisco’s first time publicly speaking out against the plan. The company has taken a leadership role lobbying against FASB’s plans on Capitol Hill.

The reason that Chambers and his counterparts at companies like Intel Corp. (Nasdaq: INTC) and Dell Computer Corp. (Nasdaq: DELL) are so opposed to this plan is because it will significantly cut into the companies’ stated profits by raising overall operational costs. Cisco and these other tech companies have built their businesses by offering executives and employees options as part of their compensation. This has allowed these companies to pay out less in actual cash compensation and make up for it in company equity.

“Expensing options goes against Cisco’s general philosophy and business model, which is to pay low real compensation and incent employees with options to work as a team,” says Alex Henderson, an analyst with Salomon Smith Barney. “But the truth is that the way they have accounted for it has been a little misleading to overall cash flow.”

If forced in 2001 to expense options, Cisco’s after-tax net income would have been reduced by $1.5 billion. Henderson adds that this new accounting method would likely reduce Cisco’s quarterly cash flow, which is about $1 billion to $1.3 billion a quarter, by at least a third.

“That’s pretty big hunk of change,” he says. But Henderson and other analysts say that the changes, if they actually happen, will likely have little impact on how the company’s stock is viewed. Other analysts agree.

“It will have zero impact on the company and its operations,” says Stephen Kamman, an analyst with CIBC World Markets. “We aren’t stupid. We can still look at the cash that is being generated through revenues to work out what is going on.”

Cisco ends its fiscal third quarter of 2003 tomorrow. Its revenues are expected to be down slightly -- between 2 percent and 4 percent.

— Marguerite Reardon, Senior Editor, Light Reading

(50)  | 
Comment  | 
Print  | 
Newest First  |  Oldest First  |  Threaded View        ADD A COMMENT
Page 1 / 5   >   >>
rjmcmahon
rjmcmahon
12/5/2012 | 12:09:12 AM
re: Chambers Attacks Accounting Plans
Can someone reconcile the different perspectives for me? Confused. Thanks in advance.

Exec: "[Expensing stock options] would result in more job loss in the U.S., as companies would be forced to look overseas for cheaper labor. [Exec] warned that this trend in the U.S. technology community would be devastating."

Analyst: "It will have zero impact on the company and its operations," says Stephen Kamman, an analyst with CIBC World Markets. "We aren't stupid. We can still look at the cash that is being generated through revenues to work out what is going on."
bmckee
bmckee
12/5/2012 | 12:09:10 AM
re: Chambers Attacks Accounting Plans
Under current accounting regs, companies pay a large part of compensation expenses with stock options... and they immediately declare that expense as a tax deduction.

However, they are not required to report this expense as a hit against earnings to the public (except as a footnote... unreconciled against reported earnings).

This has the effect of inflating the "P" in the P/E calculation. (In some cases: MSFT, CSCO, YHOO, etc., etc., by QUITE a lot.)

(Most people are not aware of the fact that - in some recent years for example - after factoring in the compensation expense / stock dilution effect, HP actually posted larger profits than MSFT....)

So, in essence, they have their cake and eat it too: they keep the tax deduction, and get to ignore the expense when they show their face to the public.

Of course, to the extent those options are later converted into stock when they vest, the stock holdings of existing shareholders gets diluted... this is the old, old game called 'stock watering'.

From the point-of-view of existing shareholders, those options grants are a very REAL expense, when all those new shares come onto the market to dilute their percentage of ownership.

The main argument for options grants is that they incentivize workers... (everybody wants to get rich, and that's a GOOD thing.)

The problem is: the best academic evidence seems to indicate that options grants provide the WRONG sort of 'incentive' compared to actual share ownership.

If companies only wanted to tie employees' performance to that of the company, all they need to do is issue restricted stock ('letter stock') to them. (That, too, is an 'expense' for the company, and gains them the tax deduction... but it MUST also be reported to the public as an expense on the earnings reports, unlike options.)

If employees are issued shares of stock, then their own well-being is directly tied to the company's performance.

If the stock drops in value, they have a strong incentive to work harder/smarter to get the value back up. If the price rises, they profit.

But, if they have been issued options (most of which traditionally go to upper-management), and the company's share prices fall... then they can just walk away from the 'under-water' options (or get the company to re-price them for another bite at the apple). They don't have the same type of incentive to work for steady, long-term, stable growth.

What they mostly DO have, is an incentive to 'goose-up' the company's reported earnings... to get the stock price up (even if only temporarily) so they can cash out their options for a profit.

(And, of course, because they don't have to clearly report to the public the company's actual expenses... they have a means to help 'goose' that price up.)

This sham (and tax dodge) may still be useful in pulling the wool over the public's eyes... but most analysts are well on to it, and include the effect of stock watering in their models.
skeptic
skeptic
12/5/2012 | 12:09:09 AM
re: Chambers Attacks Accounting Plans
Can someone reconcile the different perspectives for me? Confused. Thanks in advance.
----------------

Exec:
The exec is concerned about employee retention
and running the business in a successful way.
The exec sees stock options as a cheap way to
do that compared to any other method (the
most likely other methods being higher salaries
or cash bonuses).

Analyst:

Contratry to what he says, He and his friends
ARE stupid. They don't understand the businesses
they cover and to make up for that, they use
simplisitic models to evaluate companies. And
if say a set of people wants to discourage a
particular behavior (employee stock options),
their models are changed and the companies cease
the activity. And the goal of the people who
want this change is to end employee stock-options.

They talk about executive stock options, but
I'll believe they are serious about that issue
about the same time I see the pay-level for CEOs
fall.

The real problem in all this is that the model
proposed for valuation of stock options against
earnings is fatally flawed. A set of people want
to value the options as if they were futures
contracts traded on an exchange. Which would
be fine if options instantly vested, but they
dont.

I think that some people could live with expensing
options if the method used actually reflected
the real cost to the company. But the current
proposals don't do that.

lite-brite
lite-brite
12/5/2012 | 12:09:08 AM
re: Chambers Attacks Accounting Plans
And did you notice the options meted out to the lower level employee never reach an exercisable level?
l-b
(a lower-level employee:-(
porn starr
porn starr
12/5/2012 | 12:09:07 AM
re: Chambers Attacks Accounting Plans
I'm not sure all the analysts are so clever. They praise Cisco for repurchasing stock, claiming it's a good use of cash. But the buyback program, necessitated by the dilutive options plan, is sucking out almost half of the company's free cash flow.
skeptic
skeptic
12/5/2012 | 12:09:06 AM
re: Chambers Attacks Accounting Plans
This has the effect of inflating the "P" in the P/E calculation. (In some cases: MSFT, CSCO, YHOO, etc., etc., by QUITE a lot.)
------------
This is simply not true. The actual expense
involved in stock options and its effect on
earnings is not a simple calculation, despite
the efforts of ignorant people to pretend that
it is.

If stock options were six-month futures contracts
with no vesting period, you could calcuate their
value against earnings. But they are NOT. The
options often vest over a period of years and
have exercise windows beyond that. By forcing
the company to expense them immediatly, the
earnings of the company will be influenced
downward in an artifical way.

If we applied these wonderful formulas to cisco
and MSFT in lets say 1998-2001, their earnings
would be depressed artifically by a cost that
never actually occured because most of the options
issued then are underwater (or without value).
You would have artifically made Cisco and MSFT
look worse than HP, in spite of the fact that
that in the end (after several years) their
true earnings were higher.
---------
From the point-of-view of existing shareholders, those options grants are a very REAL expense, when all those new shares come onto the market to dilute their percentage of ownership.
---------
As far as I know, none of the expensing formulas
proposed basis the cost of options against
earnings based on dilution effects.

And if your aim is to account for all dilution
effects, how about accouting against earnings
for other dilution effects....such as issuing
"convertables" or other instruments which
have dilution effects.

But thats never going to happen. Somehow,
dilution of stock is only an issue when employees
get stock options.
-----------------
If employees are issued shares of stock, then their own well-being is directly tied to the company's performance.
-----------------
I can tell you from personal experience with
both stock options and restricted shares that
neither provided any more motivation than the
other.

In either case, I care about what I can sell
the entity for (option or stock) at the end of
the holding period.

But I think what your really suggesting is
the Enron-style invest-in-the-company idea where
employees are forced to invest their own
money. The problem is that Enron totally
discredited such schemes. They don't work
because upper management will never be treated
the same way as lower-ranked workers.

----------------------
But, if they have been issued options (most of which traditionally go to upper-management), and the company's share prices fall... then they can just walk away from the 'under-water' options (or get the company to re-price them for another bite at the apple). They don't have the same type of incentive to work for steady, long-term, stable growth.
----------------
I can tell you that your understanding is wrong
on most counts. Companies can no longer easily
re-price stock options. And as far as "walking
away" from them, the whole point of stock options
is the long-term retention of the employee. An
employee that walks away from worthless stock
options is an employee that
----------
What they mostly DO have, is an incentive to 'goose-up' the company's reported earnings... to get the stock price up (even if only temporarily) so they can cash out their options for a profit.
==========

From my experience, there are three things
required to "goose-up" earnings:

- A crooked CEO
- A crooked BOD that has issued the CEO short-term
stock options and allows executives to exercise
without restriction
- A crooked financial industry that can't see
through "goosed-up" books.

We have reached a point where we are blaming
stock options for the criminal actions of
executives and BODs. But what you have to
understand is that if the entities at those
levels are dishonest, they will steal the
money of the company one way or the other.

The reason we have stock options is that
if you move back to a system without them,
what you will end up with are companies
with unaccountable CEO's and BODs effectively
controlled by upper management who will ignore
the stock price as long as their cash flows
are large enough.















rjmcmahon
rjmcmahon
12/5/2012 | 12:09:06 AM
re: Chambers Attacks Accounting Plans
They use simplisitic models to evaluate companies

Are you referring to the Capital Asset Pricing Model (CAPM)?
skeptic
skeptic
12/5/2012 | 12:09:05 AM
re: Chambers Attacks Accounting Plans
I'm not sure all the analysts are so clever. They praise Cisco for repurchasing stock, claiming it's a good use of cash. But the buyback program, necessitated by the dilutive options plan, is sucking out almost half of the company's free cash flow.
-------------------
Buyback programs have nothing to do with
options and they are certainly not necessitated
by options plans.

Buyback programs are total stupidity because
they never really work. All they do is prop
up trading volume for a short while, but they
never typically increase stock price over the
long run.

Cisco's market cap is so large that even huge
buyback programs are going to have little
effect on P/E or price.

The money spent on buyback programs would be
much better spent as dividends. But the tax
code has certain people convinced that dividends
are "wasted money" compared to buybacks. Even
though the reverse is almost always true.

opticalphaggot
opticalphaggot
12/5/2012 | 12:08:59 AM
re: Chambers Attacks Accounting Plans
Nice to know that if Cisco accounted for options, it would wipe out mostly all it's profits for the past few years. Accounting rules changed? Oh where oh where will the industry go? Time to brush up on those resumes Light Reading boyz, your clock has been ticking for a while now. The only reason Cisco can get away with this is, like Microsoft, they are such a large Enron-size company, that a collapse would cause immediate damage to both the idiot barometers you all know as the stock market indices. Read 8 billion shares outstanding. Who is buying this worthless toilet paper? Answer: your 401K and pension plans. Oops!
laserbrain
laserbrain
12/5/2012 | 12:08:58 AM
re: Chambers Attacks Accounting Plans

>This has the effect of inflating the "P" in the P/E calculation. (In some cases: MSFT, CSCO, YHOO, etc., etc., by QUITE a lot.)
----
Umm, no, earnings are the denominator.

>So, in essence, they have their cake and eat it too: they keep the tax deduction, and get to ignore the expense when they show their face to the public.
---
This is populist misconception. However neither is in fact true. There is no cash compensation to employees, therefore the "expense" is indirect if at all. It certainly isn't operating expense. It is more meaningful to report earnings as they relfect operations. So the companies are being most clear with the current model. Reporting option grants as expenses actually negatively distorts the true picture. Plus the individual employee pays taxes on any gains. So taxes get paid either way.


> Of course, to the extent those options are later converted into stock when they vest, the stock holdings of existing shareholders gets diluted... this is the old, old game called 'stock watering'.
---
This of course is why the MSFTs and CSCOs have massive stock buyback programs. These buybacks are indeed meaningful to report to investors.


> The problem is: the best academic evidence seems to indicate that options grants provide the WRONG sort of 'incentive' compared to actual share ownership.
---
That's not only unfounded, it's crazy. I can look at a hundred people sitting in my building, bustin' ass to make a great product and a great company and it's all founded on options equity. Its a MARVELOUS tool. If a CEO commits fraud to goose a stock, he should go to jail. But don't throw the golden goose out with the bathwater. (or something like that)


>If employees are issued shares of stock, then their own well-being is directly tied to the company's performance.
---
Sure, I'd take stock too. But giving actual stock is akin to cash, so it doesn't really help the employee willing to risk foregoing real compensation in exchange for potential upside. Or the company that needs to use that carrot for lack of cash. Stock as a compensation tool doesn't replace options.

>This sham (and tax dodge) may still be useful in pulling the wool over the public's eyes... but most analysts are well on to it, and include the effect of stock watering in their models.
---
More populist tripe. More tax money was generated in California and Federally when people were exercising options like they were on fire. What happened when the options are underwater? Tax revenues plummetted! More taxes get paid by the exercising of options that thru any corporate income tax.

Bottom line is the world needs more options and companies like Cisco should be encouraged to grant them not punnished.
Page 1 / 5   >   >>
Featured Video
Upcoming Live Events
October 22, 2019, Los Angeles, CA
November 5, 2019, London, England
November 7, 2019, London, UK
November 14, 2019, Maritim Hotel, Berlin
December 3-5, 2019, Vienna, Austria
December 3, 2019, New York, New York
March 16-18, 2020, Embassy Suites, Denver, Colorado
May 18-20, 2020, Irving Convention Center, Dallas, TX
All Upcoming Live Events
Partner Perspectives - content from our sponsors
Sports Venues: Where 5G Brings a Truly Immersive Experience
By Peter Linder, 5G Evangelist, North America, Ericsson
Multiband Microwave Provides High Capacity & High Reliability for 5G Transport
By Don Frey, Principal Analyst, Transport & Routing, Ovum
All Partner Perspectives