Options expenses and earnings management 

by Bruce Meyerson
Associated Press

Now that companies are required to start deducting the expense of employee stock options from their profits, you’d think the math involved would be a simple matter of subtraction.

It turns out the new rules are so loose that companies are tweaking mathematical assumptions in a way that cuts their options expense by tens and hundreds of millions of dollars, judging from this year’s annual reports.

These assumptions are essential to calculating options expenses. What may come as a surprise is just how much latitude the formulas recommended by the Financial Accounting Standards Board and the Securities and Exchange Commission give to companies in estimating the value of options grants to employees.

Two big variables stand out: predictions of how long employees will wait to exercise their options and convert them to stock, and calculations of the price volatility that would be associated with those options if they were publicly traded. Lower numbers for either projection will reduce the estimated value of an option and the resulting expense a company has to report.

It is entirely possible that companies are fine‑tuning their assumptions appropriately since the SEC and FASB only began clarifying many specifics of the new rules a little more than a year ago. Still, the timing of these revised estimates are unsettling even if they merely underscore the ease with which the new calculations can be manipulated.

Consider Google Inc. Despite the sharp swings that send its shares soaring or slumping on any given day, Google nearly halved its volatility assumption for 2005 from the rate it used in 2004, according to its annual report. Using the new estimate, Google calculated that the average value of an employee option granted last year was $78.58. But had it kept the  volatility rate unchanged from 2004, that fair value–and the expense to be deducted from earnings–would have soared to roughly $130 per option.

Either way, the impact on Google’s profits is tiny because most of the non‑cash compensation it has paid employees since going public in 2004 has been with stock awards rather than options. But it’s easy to see how a reduced volatility assumption would add up to big savings for technology companies that grant hundreds of thousands of options to top executives.

Broadcom Corp., a chipmaker whose shares have traded between $20 and $50 in the last 52 weeks, sharply reduced its assumptions for both volatility and the “expected life” of an option before it’s exercised by an employee. Taken together, these revised assumptions may understate Broadcom’s 2005 options expense by $182 million, according to calculations by Gradient Analytics Inc., an accounting research firm.

It’s true that Broadcom’s daily swings eased some last year. And the lower estimate may be partly explained by a switch to “implied” volatility from a measurement based on historic trading data, an approach recommended by the SEC and FASB. Implied volatility is derived from the current price of publicly traded options, providing a reflection of the market’s expectations for the future rather than past behavior.

One possible concern raised by Gradient is that when the volatility of a company’s stock and options decrease, it’s generally accompanied by an increase in the assumption for an option’s expected life, not the simultaneous decrease shown by Broadcom.

The conventional wisdom here is that when a stock is more volatile, there are greater odds of a rapid rise that will motivate employees to exercise their options and lock in those gains. With a less volatile stock, they’re likely to hold their options longer because they have less money at risk.

William Ruehle, Broadcom’s chief financial officer, doesn’t dispute that logic, but says his company’s revised assumption for the life of an option is based on the actual investment behavior of his employees. A steady rise in the stock in the past two years has prompted more employees toexercise their options, he said.

“That’s just plain, actual experience–nothing magical or esoteric, just plain methodology,” said Ruehle. “If you look at prior years, that was when the market was melting down and most of the options were under water. And when they’re under water, most people aren’t going to exercise.”

While a recent uptick in volatility could mean a bigger expense calculation for options granted during 2006, Ruehle said Broadcom will stick with implied volatility, ensuring the consistency mandated by the SEC and FASB.

That approach should offer greater clarity from year to year than another allowed by regulators in which a blend of implied and historic data is used to estimate volatility. Companies that have adopted this approach include CBS Corp., discount broker E‑Trade Financial Corp., sunglasses designer Oakley Inc., off‑price retailer TJX Cos., and software maker BEA Systems Inc.

Since the companies don’t offer specifics on how they blended the volatility data for 2005, it may be unclear whether they alter the mix in subsequent years. While ongoing data collection may justify some tweaks, this lack of transparency could invite opportunistic adjustments designed to reduce options expenses.

There’s no logical way to rid accounting of assumptions, so it shouldn’t be a shocker that the adoption of options expensing won’t bring a cut‑and‑dried consistency to profit reports. That said, it’ll be crucial to keep an eye on what companies ask us to assume.