Standard & Poor’s announced this week that it’s taking the revolutionary step of including the expense of employee stock options when it calculates companies’ operating earnings. This is revolutionary because current accounting rules don’t require that options expenses be reported — and only two companies in the S&P 500 opt to do so. For the rest, options expenses are effectively treated as though they were zero.

S&P’s action comes as the result of heightened awareness of options stimulated by such high-profile train wrecks as Enron and Global Crossing, where executives reaped fortunes from their options only to have their companies implode a short time later. But those are only the stuff of sensational headlines: The deeper issue is the concern expressed by Federal Reserve Chairman Alan Greenspan in a speech earlier this month: “I fear that the failure to expense stock option grants has introduced a significant distortion in reported earnings.” S&P suggested this week that its inclusion of options expenses in the future would lower operating earnings overall by up to 10%.

For years Warren Buffett has railed against accounting rules that treat options expenses as zero. In an oft-quoted passage from his 1992 letter to shareholders of Berkshire Hathaway, Buffet wrote, “If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”

Buffett has been vociferously opposed all these years by technology-company executives whose companies issue tons of options, and whose reported profits would be most affected by having to include options expenses. Cypress Semiconductor CEO T. J. Rodgers has argued that options expenses shouldn’t hit earnings because options are nothing more than a matter of dilution: “Shares outstanding, including options, are reported to investors quarterly and also dilute the earnings per share.” Rodgers objects to the prospect of having to “pay for stock options twice, first through the dilution of earnings caused by the share-count increase and then again by the newly mandated expense.” And venture capitalist John Doerr argues that “…options are not a cash expense” because they pay off in the form of stock.

The last time the debate about stock options was taken up by the Financial Accounting Standards Board, the private body that sets generally accepted accounting principles, was in the early 1990s. At that time the FASB wanted to mandate including options expenses in earnings — but pressure from companies that issue options was so intense that, after years of bitter wrangling, new expensing rules were made optional. As FASB put it at the time, “The nature of the debate threatened the future of accounting-standards setting in the private sector…. [L]ogical consideration of issues that usually leads to improvement in financial reporting was no longer present.”

Are options just another business expense that should be reflected in operating earnings? For many years I didn’t think so. But I admit that I’ve been prejudiced on the subject.

I’ve lived in Silicon Valley for years, and I’ve seen first-hand how stock options have motivated hard-working executives, engineers and other employees of high-tech companies to create wealth for themselves and for shareholders at the same time. And I’m well aware of the mistrust and envy of this new wealth — and the power that comes along with it — from the old-line business establishment that’s threatened by the upstart technology sector, and by millions of ordinary people who are angry that they didn’t get a seat on what they think is a gravy train. So I’ve always been very suspicious about attempts to reform option accounting — if the wealth-creation machine ain’t broke, let’s not try to fix it.

But as I’ve done more research in this area with Dr. Reuven Brenner, and I’ve come to the conclusion that granting stock options is indeed an expense, an expense that should be included in companies’ financial statements. Here’s why. It’s really astonishingly simple.

An option is a contract that allows an employee to buy his company’s stock in the future, but at a price locked in at the time the option is granted. If the company’s stock price is $20 when the option is granted, typically the employee would have the right to exercise the option and buy the stock at $20 any time over the next 10 years (usually after having continued to work for the company for a minimum period in order to qualify). If the stock is trading at $50 in five years, the employee might exercise his option. He pays $20 to the company (which the company puts into its treasury), and the company issues shares to him. He turns around and sells his shares in the market at $50, and pockets a profit of $30.

What did it cost the company for the employee to get that profit of $30? Those who oppose options expensing say the cost was zero — the company simply issued some more stock. Sure, that creates dilution, they admit — but no expense.

But just think about this same transaction another way. Suppose the company issued an option that had all the same terms, except that when it was exercised, the company was obliged to pay cash, rather than issue stock. In this example, the employee would exercise the option when the stock was trading at $50, and the company would write him a check for $30. Let’s say that in order to be able to afford to write that check, the company issued stock at the same time, selling it in the market at $50 (keeping the difference of $20 in the company’s treasury).

Clearly this would be an expense of $30. The fact that the company happened to issue stock to pay for it makes no difference to the analysis — companies issue stock all the time to cover a variety of expenses, and those expenses are not exempt from inclusion in income simply because stock was issued.

So if that’s an expense, why isn’t it an expense when the stock is issued directly to the employee? In both cases the employee ends up with $30. In both cases the company had to issue stock. In both cases the stock was sold in the market at $50. In both cases the company treasury ends up with $20.

It walks like a duck. It quacks like a duck. It’s a duck. Options are a business expense, and they should be treated just like any other expense in calculating operating earnings. Period.

It will be interesting to see how investors react when S&P’s widely respected calculations of operating earnings start reflecting this expense. Detailed research that Brenner and I have done suggests that, for many companies, the impact will be far greater than the “up to 10%” that S&P has warned about. Investors aren’t going to like that one bit.

But in the end, honest accounting will help investors make smart decisions about where to put their money. When investors make better decisions, better companies are the result. There may be a painful period of adjustment, but the wealth-creation machine will come out stronger than ever someday as a result.

— This commentary was an Ahead of the Curve column for SmartMoney.com on May 17, 2002. Copyright 2002 Trend Macrolytics. All rights reserved. http://www.trendmacro.com. For information purposes only; not to be deemed to be individualized investment advice with respect to buying or selling specific securities. Derived from sources deemed to be reliable, but we make no warranty as to accuracy. Log off