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Cisco Leads Fight for Options

In an ongoing battle against expensing stock options, Cisco Systems Inc. (Nasdaq: CSCO), Qualcomm Inc. (Nasdaq: QCOM), and Genentech Inc. have given accounting regulators an alternative method for valuing options.

The method the companies presented to the Financial Accounting Standards Board is aimed at lowering the value of stock options if they are forced to treat them as expenses on their balance sheets.

Some background: Accountants and companies worldwide have been struggling for the past decade with whether options should be included in company accounts and, if so, what value should be put on them.

Those against options expensing say that it would lower their reported earnings, which would, in turn, lower stock values.

In the past, Cisco has argued that if stock options were expensed, it would drag on corporate earnings and companies would stop issuing options. That expense -- and failure to offer options as an incentive -- would force more companies to find cheaper labor in other countries (see Cisco Renews Options Parade).

Large options grants are often viewed as dilutive to shareholder earnings potential, because those options will increase a company's share count and they dilute corporate earnings. Cisco, interestingly, manages its options grants by using its cash to buy back billions of dollars of its own shares (see Cisco's Chambers Gets More Options).

The FASB says it will release a final standard for requiring companies to expense options by the end of the year. This standard will include how to value options.

It should be noted that hundreds of companies, notably Microsoft Corp. (Nasdaq: MSFT), now voluntarily expense options.

But Cisco, Qualcomm, and other companies would rather see a world where expensing options doesn't actually cost money. The technology companies’ options valuation plan differs in several ways from the current FASB proposal. First, it would allow companies to decrease the value of their options by taking into account the fact that -- unlike common shares -- employees can't sell their options to other people.

Additionally, the technology companies’ plan discusses whether valuing stock options by using movements in a stock index such as the S&P 500 would accurately reflect the cost of options held by an employee.

Cisco and its pals that presented the plan to FASB are members of the International Employee Stock Options Coalition (IESOC). The coalition is now backing a bill that would require companies to expense options for their five highest-paid executives. The coalition is pushing for this bill because its objective is to allow companies to have the broadest-based stock options plan for employees.

Kim Boylan, an attorney with Latham & Watkins, says the three technology companies’ valuation plan would be easier to implement than the FASB proposal. Boylan, by the way, is a consultant to Cisco and the IESOC. Of course, not everyone agrees with Boylan's description of Cisco's accounting proposal.

“Anytime that value is moved out of the corporation, it should be reflected immediately on the balance sheet,” says Nell Minow, an editor at The Corporate Library, an independent investment research firm. “We do that for everything else, so there is no reason not to do it for stock options.

“Why are the tech companies lobbying so aggressively against expensing stock options? Because right now it’s free money for them and they don’t want to give that up.”

— Joanna Sabatini, Reporter, Light Reading

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paolo.franzoi 12/5/2012 | 1:16:42 AM
re: Cisco Leads Fight for Options
The reason to count them:

When they are exercised, they dilute the owners (shareholders) value as new shares are created out of thin air. Thus, EPS and EPS growth are challenged for those companies with option pools outstanding if they issue. The only effective way to account for this is to have the company accrue the cost of issuing the option when its issued.

The reason not to count them:

At the end of the day, counting them means only executive teams will receive options in public companies. This is not a big deal except in areas like California.

seven
whyiswhy 12/5/2012 | 1:16:42 AM
re: Cisco Leads Fight for Options In their rabid march to crush anything remotely democratic and egalitarian, the neocons have foisted the "expense options" parade to the FASB...an appointed board. Notable the companies leading the chage against expensing are California based...they recognize the knife against the Democratic dominated money engine's throat.

Expensing also reduces the taxes companies pay to the government....their earnings are reduced. It's detrimental to the government and the companies.

This will kill technology development in this country...and leave us with the old established companies like Standard oil and Coke....and less competition. That will take any growth the market might have had and throw it in the trash.

Neocon: Stupid, just stupid.

-Why
ironman 12/5/2012 | 1:16:42 AM
re: Cisco Leads Fight for Options There is nothing free on stock options, regardless in whatever way they are accounted or not accounted for. When options are exercised they're counted. I fail to see what the big issue is with not counting something (options) that really doesn't need to be counted. As there is no value until it's exercised and too my knowledge most employee (not VP) options fall well below the radar of impact to the companies bottom line.

IM
whyiswhy 12/5/2012 | 1:16:41 AM
re: Cisco Leads Fight for Options Brooks:

"The reason to count them:

When they are exercised, they dilute the owners (shareholders) value as new shares are created out of thin air. Thus, EPS and EPS growth are challenged for those companies with option pools outstanding if they issue. The only effective way to account for this is to have the company accrue the cost of issuing the option when its issued."

WRONG! Those options are NOT created out of thin air! The board creates an option pool, and the shares are issued from the pool. The existance and size and status of the pool is public information available to investors before they buy the stock. If the pool is created after they buy, the board has made the decision that the dilution is in the best interests of the company. That's the market. An investor selling a big block of shares drops the price per share due to supply and demand. Same thing. Exactly.

"The reason not to count them:

At the end of the day, counting them means only executive teams will receive options in public companies. This is not a big deal except in areas like California.

seven"

It's a big deal everywhere, as Bush would say: "the haves and the have mores are (his) base".

The demographics are such that most enlightened companies with employee stock options DO exist in CA. And they are overwhelmingly the largest sponsors of the Democratic party.

And now you know the real story here....

-Why
whyiswhy 12/5/2012 | 1:16:41 AM
re: Cisco Leads Fight for Options Iron:

The impact was huge in the Clinton years....options being exercised in CA and elsewhere literally paid off the national debt.

Remember the Clinton years, when we had a surplus budget, and the rest of the world was more or less on our side, and we didn't send 1000+ poor young American kids over to the Middle East to get killed only to turn over the place to Al-Queda?

And we weren't offshoring and we had full employment?

-Why
deauxfaux 12/5/2012 | 1:16:40 AM
re: Cisco Leads Fight for Options There is an underlying premise in all of these arguments for expensing options that one can accurately determine the value of the option. The Black Scholes model determines the price of an option based on two key factors: duration of the option contract and the volatility of the underlying security (the actual share price).

So for "large cap" companies like Cisco that exhibit strong form market efficiency in their stock price, Black Scholes is a good predictor of option value. Nevertheless, there are problems. Problem 1) The value of the option changes every day. Should this be reflected in the P&L every day? every week? I'll bet every one of you had the problem of "underwater" options at some point. Since they start out with some value and decline toward zero, should we increase earnings to compensate?!?!Problem 2) Options are granted, but typically vest over years. So do you make guesses about the length of time that an employee will actually "stick around" or do you just "expense 'em all" even though the employee won't own them for several years and couldn't do anything with them (no liquidity kills the value of the Black Scholes model because of the "no arbitrage assumption". Problem 3) When an option holder actually sells the option, he/she doesn't sell it to the company, he sells it to the market. P&L expenses have to affect the company's cash position and the sale of an option doesn't cost the company cash.

In the case of a private (startup) company where there is no good way of establishing an underlying security price (the VCs only guess every year or two) Black Scholes doesn't work at all. There is no way to price the option.

At the end of the day, the real issue is dilution. So report the EPS numbers on their most conservative basis; earnings divided by the total number of shares (including options) if there is income, and just shares in the denominator for a loss.

Wait....thats how we do it already. This subject is just a work of fiction by accounting priests being reported by mindless LR writers.
jtm 12/5/2012 | 1:16:38 AM
re: Cisco Leads Fight for Options You forgot to factor in whyiswhy's extra chromosome, uber neocon conspiracy against the enlightened democratic supporting CA-based companies...

b_40 12/5/2012 | 1:16:37 AM
re: Cisco Leads Fight for Options >There is no way to price the option.

So humor an accounting-challenged engineering grunt for a moment. The value of stock options to the engineer, and the cost to the company, would seem to be established when the employee exercises his options.

Why is it inconceivable to register a compensation expense at the time the employee exercises?

>... So report the EPS numbers..

The obvious problem is that a company can create the illusion that it is a profitable ongoing enterprise by feeding off of itself, paying its expenses with its equity. This illusion of profitability holds its market cap aloft, feeding the cycle temporarily, until the whole thing comes crashing down at some point.

The reason we don't like this idea is that we believe ourselves to be benefitting from this ruse. In the short term, this may be true, but in the long term (think a "career-span"), I doubt it.
laserbrain2 12/5/2012 | 1:16:36 AM
re: Cisco Leads Fight for Options Amazing how your vitriol for Bush clouds your vision for your own party's policies.

Here's a quote from your buddy John "protect us to death" Edwards: "Everyone knows the right thing to do. The Federal Accounting Standards Board has now said it plans to require expensing of options. Politics should not get in the way of this decision... we [need to] clean up options accounting"

The fact is that during this election, bashing corporate America is fashionable and populist. It plays well in Michigan and Ohio. We hear it from both sides. That, of course, is why everyone should vote libertarian. www.lp.org

My personal feeling is that accounting for options is inevitable and while I don't see it ending innovation per se, it is a sad passing. The 25-year Silicon Valley gravy train has left the station for most low-level engineers. For the talented and ambitious, the train has plenty of seats. (We're more hampered by crazy taxes like AMT.) Options will be replaced by some other compensation strucutre and people will be compensated for their work, but they won't see a 100x home run like if you happened to land at Cisco in the mid-90s. The right-place-right-time guy is SOL.

The outsourcing argument is the same. The only viable argument about protecting jobs here is a sentimental one. For the economy it's a good thing, but it just ain't gonna be like it used to.

Sad but probably the right thing to do.
deauxfaux 12/5/2012 | 1:16:35 AM
re: Cisco Leads Fight for Options Good questions

1) Could you report the expense at the time the employee excercises? This probably brings the least amount of distortion into the picture, but has a limitation. If we think of total profit as a pie, all the excercise of the option does is change the size of each individual slice, not the whole pie. Since the transaction occurs between the option holder and a new equity holder (shareholder), no money goes into, or out of, the company's bank account.

2) So the EPS number really does tell all, it measures the effect of dilution because it includes the overhang effect of options. Negative earnings can't be made into a positive EPS number. If a company an operating profit of $1M and 1 share but issued 999,999 options, the EPS would be $1/shr. However, lets say that the same company lost $1M. By the accounting rules, you DON'T count in the options. So the EPS is -$1,000,000/shr.

Every accounting method in use today has distortions. The operative question is really "what distortions do the least damage?" Considering the number of top flight people in technology, and the absolute dependance on attracting/retaining these people, I would err on the side of keeping the status quo. The new distortions introduced by expensing options just don't add enough clarity to make it worthwhile.

So lets take a more Machiavellian view. The same big fund managers with Harvard MBAs that are telling you that companies need to improve the clarity of their statements are also the SAME knuckleheads that tell you in their fund prospectus' that "you should pay us big fees, becuase we're Harvard MBAs that can find value in the market." The reality is that they just want to find a scapegoat for their crummy returns.

Hope this helps
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