Stock Option Swings
Elizabeth
MacDonald
06.04.07, 6:03 PM ET
It's been a fact of accounting life for some
time now.
The amount of profits companies report to shareholders is vastly different
from the amount of earnings companies report to the Internal Revenue
Service. And that is often the case with employee stock options. Companies
can deduct the cost of their employee stock options on both their tax
returns and their corporate financial statements. But those amounts can be
vastly different.
And now Congress says it wants to do something about it. Sen. Carl Levin, D-Mich.,
chairman of the Senate's Permanent Subcommittee on Investigations, and Sen.
Norm Coleman, R-Minn., ranking member, will hold a hearing Tuesday that will
delve into whether the IRS and investors should be given different
information about the cost of employee stock options. The differences have
to do with the disparities in stock option bookkeeping treatment under
corporate accounting and tax rules.
"Companies pay their executives with stock options in part because, right
now, those stock options often generate huge tax deductions that are two,
three, even 10 times larger than the stock option expense shown on the
company books," says Levin in a statement.
The statement says that subcommittee staffers examined nine companies who
"claimed stock option tax deductions over five years that exceeded their
stock option expenses by more than $1 billion, or 575%, even after using
tougher new accounting rules to calculate the book expense."
The subcommittee will present IRS data, covering tax returns from December
2004 to June 2005, that shows a massive stock option book-tax gap of $43
billion, which the subcommittee says means that U.S. companies legally
avoided billions of dollars in taxes for that period by claiming $43 billion
more in stock option tax deductions than the stock option compensation
amount shown on their books.
"Those companies did not break the law; they are benefiting from an outdated
and overly generous stock option tax rule that produces tax deductions that
often far exceed the companies' reported expenses," says Levin.
Coleman, in a statement, says he believes "that favorable tax and accounting
rules have caused companies to issue far too many stock options on far too
generous terms, greatly contributing to the meteoric rise in executive pay."
Stock options give employees the right to buy company stock at a set price
for a specified period of time, usually 10 years. According to Forbes,
average pay in 2006 for the chief executive officers at 500 of the largest
U.S. companies was $15.2 million, including an average gain of $7.3 million
from exercised stock options, 48% of the total.
Only within the past year or so have companies been deducting stock option
costs from their earnings; in prior years, they didn't have to subtract that
sum, instead they would bury the amount in a footnote. The expense equaled
the stock options' fair value on the date they were granted.
But on their tax returns, companies can take a tax deduction based on the
stock options' value on the date that it is exercised. Specifically, the
deduction equals the difference between the grant price and their exercise
price. That amount often does not equal the expense shown on a company's
books.
Here's how the math works. Say that Fantasy Systems is trading at $30, and
it issues an option with a $30 strike price to an engineer. Fantasy Systems
subtracts that $30 strike price from its earnings in the year it give the
options. But years later, when the stock is trading at $50, the employee
cashes in the option for a $20 profit. At that time he pays personal income
tax on the $20, and Fantasy gets a $20 tax deduction for that compensation
on its corporate return.
The corporate tax deduction gives a sweet boost to corporate cash flow.
Between 1999 and 2002 the top 10 option addicts on the Nasdaq 10--Microsoft,
Yahoo, Siebel Systems,
Cisco Systems,
Sun Microsystems,
Dell Computer,
Oracle,
Adobe Systems,
Amgen and
Intel---got a combined
$27 billion boost to cash flow from operations from the tax deduction, say
accounting professors Michelle Hanlon of the University of Michigan and
Terrence Shevlin of the University of Washington.
The subcommittee found that moreover, in most cases, the tax deduction
exceeds the book expense that companies report on their filings to the
Securities & Exchange Commission. Indeed, the subcommittee will present new
data from the IRS on the size of the stock option book-tax difference, based
on corporate tax returns filed between Dec. 31, 2004, and June 30, 2005.
Specifically, the IRS data show reported stock option tax deductions were
$43 billion larger than the amounts shown on company books during this time
period. The subcommittee says that the $43 billion difference amounted to
30% of the entire book-tax difference reported by companies. The IRS also
found that 82% of the $43 billion book-tax difference was attributable to
just 250 companies.
To understand how new accounting rules, which require options be deducted
from earnings, would affect the book-tax difference, the subcommittee says
it asked nine corporations to calculate what their financial statement
expense would have been for options exercised between 2002 and 2006, and
compare that expense with their tax deductions.
That analysis showed the tax deductions for the nine companies combined were
over $1 billion, or 575%, larger than their book expense, even under the new
rule.
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