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Pratap Ravindran

MUMBAI, July 18

THE July 14 announcement by Mr Doug Draft, Chairman and Chief Executive Officer of Coca-Cola Company, that the multinational will expense the cost of all stock options it grants during and after the fourth quarter of the current financial year "to ensure that our earnings will more clearly reflect economic reality" seems to have set off a stampede among publicly-traded enterprises in the US towards conservatism in accounting practices.

Parenthetically, media reports notwithstanding, Coca-Cola is not the first American company to switch to the expensing of stock options: Boeing Company and Winn-Dixie Stores have been treating options as an expense for quite some years now. Further, even though AMB Property Corp, a San Francisco-based owner of industrial real estate, had beaten Coca-Cola by a few days to announcing a switch-over to options-as-an-expense accounting policy, the multinational grabbed all the media attention because of its marquee status.... and, of course, because big US companies are vying with each other now in cleaning up their act and Coca-Cola is about as big as they can get.

A day after Coca-Cola broke the ice, as it were, the Washington Post Co and Bank One also announced that they would expense stock options. The Washington Post Co, in its statutory filing, revealed that its 2001 earnings would have been cut by $3.6 million (or 38 cents per diluted share) "had the fair value of options granted after 1995 been recognised as compensation expense".

Interestingly, the value investing icon and ardent advocate of treating options-based compensation as cost, Mr Warren Buffett, is a member of the boards of both Coca-Cola and the Washington Post Co.

Market analysts are now predicting that more and more corporates in the US will participate in a "race to the top", if shareholders endorse the accounting switch-over and boost the stock prices of option-expensing outfits. If the stock prices of these corporates do, in fact, go up, those who have been arguing for quite some years now that the only way of ensuring good corporate governance and honest financial reporting is to make ethics profitable will stand vindicated. But the story is just beginning and there's a long way to go before it ends with a they-lived-happily-thereafter.

Coca-Cola has said that it will adopt the fair value based method of recording stock options as set out in SFAS No 123 (Accounting for Stock-Based Compensation), which it has described as "the preferable accounting method" for employee compensation through the grant of options. "All future employee stock option grants will be expensed over the stock option vesting period based on the fair value at the date the options are granted....."

Coca-Cola has a point. The controversy over the manner in which stock options are (or are not) accounted for is rooted in the fact that there are basically two kinds of plans: non-variable and variable.

Most of the granted options in the US fall in the non-variable plan category which simply means that the number of shares and the purchase price are known on the grant date. Thus, the compensation expense is measured as on the grant date and is equal to the spread (assuming there is one) between the then fair market value of the stock and the exercise price of the option. If the option has no intrinsic value at the date of the grant, no compensation expense is recorded — an accounting method embodied in APB No 25. However, a more rigorous accounting treatment is mandated for variable plans for a variety of reasons.

For one, a typical variable option is subject to what is referred as "performance vesting" which means that the option will be vested only if the corporation's net income during a specified period equals or exceeds pre-determined, reasonable levels. In such instances, the compensation expense is a function of the spread at the time of vesting. If the stock appreciates during the period between the grant and vesting dates, the charge can be pretty hefty.

And then again, in variable plans, the compensation expense attributable to the pre-grant spread is accrued over the vesting period.

The compensation expense caused by post-grant changes in the value of the underlying shares is accrued on a quarterly basis as the stock fluctuates in value.

SFAS 123 irons out the distinction between variable and non-variable plans by measuring compensation on the basis of the fair value of the option itself on the grant date.

The value is determined using the Black-Scholes options pricing model. With the determination of the option value, the charge, based wholly on the number of options that actually vest, is accrued over the vesting period.

Further, under SFAS No 123, if an option that has already vested expires, no downward adjustment is permissible with respect to the previously recorded compensation expenses.

It is, therefore, reasonable to assume that most companies would prefer to go with SFAS 123, which is based on the value of the option at the date it is granted — invariably a manageable figure. The APB 25 charge, based on the spread at the time of vesting, can work out to a pretty hefty one.

Be that as it may, information technology giants in the US are still violently opposed to any change in favour of expensing of options. This is understandable. While Coca-Cola and the Washington Post Co make comparatively limited use of options, Mr Chuck Mulloy, a spokesman for Intel, has summed up the plight of tech firms: "At Intel, all 83,000 employees are eligible for and get stock options. We use it on a much broader basis (than) Coke. It's more culturally integrated in our business...."

Reading between the lines, this means that IT firms know that expensing options will dilute (or "distort," as the IT companies call it) their earnings.

Meanwhile, the International Accounting Standards Board (IASB) has jumped feet first into the fray. Following its July 16 board meeting, the IASB has announced: "In particular, the board will consider whether the International Financial Reporting Standard (IFRS) on share-based payment should require recognition of an expense, based on a fair value measurement method..."

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