Originally created 01/15/06

Some unexpected surprises in stock-option costs

NEW YORK - Just because a company has been deducting stock options from earnings for years before new rules forced corporate America to do the same, doesn't mean it will be immune to a big hit to the bottom line.

That's because some companies that initially and voluntarily adopted stock option expensing - a list that includes Costco Wholesale Corp. and Home Depot Inc. - followed different accounting standards than those now being used to calculate such costs.

These new rules could send option expenses at these and other companies ballooning, and for some they could go to levels far exceeding what many investors expect.

Stock options allow employees to buy shares of their company's stock in the future at a set price - and potentially reap big profits if share prices later rise. Corporate executives have long touted options as an important compensation and retention tool, and a way to align employees' and shareholders' interests.

Companies also liked that the cost of stock options haven't diluted earnings. Previously, such expenses were buried in the footnotes of the financial statements, and never had to be acknowledged on the income statement as a cost to earnings.

But after a slew of business scandals, there was great pressure on the Financial Accounting Standards Board, the U.S. accounting rulemaker, to require better options accounting that will help investors more easily gauge their effect on earnings.

Those new rules - known as FAS 123(R) - are finally going into effect after a long battle with opponents who claimed it was impossible to accurately value how much options cost a company.

Companies with fiscal years ending after June, 15, 2005 are now required to subtract option expenses from earnings, just like other salary and benefits costs.

That's put technology companies under close watch. Since they have historically been most reliant on stock options, investors are monitoring how much the rule change will affect their financial health. Same goes with biotech and pharmaceutical companies, which also have been generous with option grants.

But shareholders might want to keep tabs on another group as well: Any company that began deducting costs before the fiscal year beginning December 15, 2003.

Companies in that category have often used what is known as the "prospective method" to determine option costs. They were only required to determine the fair value of options to those granted in the year of adoption and subsequent years, and didn't have to factor in earlier option grants to their cost calculations.

Fast-forward to today, and the new FASB rules require those earlier option costs be included in the cost valuation.

For example, a company could have been granting options every year since 2001, but only started expensing options in 2003. That meant that those options granted in 2001 and 2002 could have been ignored in determining the cost. Now, the company must include the fair value of options granted in those earlier periods.

"You would think this is the last group of companies that you need to concern yourself with when FAS 123(R) goes into effect, as they already expense stock options," said Credit Suisse accounting analyst David Zion. But as he points out, the rule change "may cause their option expense in 2006 to rise above what (investors) have expected them to report."

Among those companies dealing with such an issue is FBL Financial Group Inc., a West Des Moines, Iowa-based insurance and financial services company. In its most recent quarterly report, the company said that it had started expensing options as of Jan. 1, 2003 using the prospective method, but would shift to the "modified prospective method" as of Jan. 1 of this year.

It would not say how much that would change its costs going forward because there are still unknown factors such as when employees would exercise their options and how many would forfeit options. Instead it offered an estimated cost had the new method been in place as of Jan. 1, 2005: profits would have been reduced by 2 cents a share, or $500,000, for the first nine months of last year.

Seattle-based retailer Costco also had used the prospective method since 2003, but said it would shift to the modified prospective method beginning with its fiscal first quarter. The company said that produced an expense of $3.9 million in the first quarter fiscal 2006, and it expects the full-year cost to total around $12.9 million.

Home Depot, which is based in Atlanta, expects its change from the prospective to modified prospective method to reduce earnings by $42 million in 2006

That's not chump change - but at least they are acknowledging that earnings will take a hit. Other companies might not be so forthcoming, which is why investors should be keeping a close watch.


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