Accountants’ new tool leaves options open

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Did Cisco’s most recent earnings rise by 13.5 per cent or 8 per cent from a year before – or did they fall instead by 10 per cent?

Wall Street, struggling with a controversial new way to account for the earnings, is about to tie itself in knots trying to decide the answer.

The maker of networking equipment was among the most strident opponents of new rules that force companies to deduct the cost of employee stock options from their profits. After a decade-long rear-guard action, mainly from technology companies that have made stock options a way of life, those rules take effect for most US companies at the start of 2006 – though a handful like Cisco, whose financial years do not coincide with the calendar year, have already made the switch.

Using the new rules, Cisco’s profits in its most recent quarter fell by 10 per cent compared with the year before. Based on generally accepted accounting principles (GAAP), these are the figures that accounting rulemakers have decided most accurately reflect corporate performance.

However, few analysts seem prepared to accept this picture at face value.

“Financially, it’s a pretty useless number,” Steve Kamman, an analyst at CIBC who covers Cisco, says of the stock option cost. Based on a number of assumptions that are largely subjective, the valuation is meaningless, he says.

Also, companies like Cisco have argued strongly that the calculation they are forced to make overstates the actual cost of options, since employees are generally not allowed to exercise them for several years.

The companies even dispute whether options represent a true business cost in the traditional sense, since they do not involve any expense to the company itself, only to other shareholders, whose stakes are diluted.

The effects of the transition to the new rules have also complicated the picture and given analysts an excuse to abandon GAAP. For instance, an apples-to-apples comparison that includes option costs for both periods suggests that Cisco’s earnings actually rose by 13 per cent from year to year rather than falling.

Some analysts warn, though, that comparisons like this will make the tech sector in general look healthier than it really is. Many tech companies have cut back on the number of options they issue: that means that option costs have been falling, which in turn adds to earnings growth.

This one-off effect could mislead unwary investors into believing that the higher earnings growth rates are sustainable, says Rick Sherlund, a software analyst at Goldman Sachs.

That has given Wall Street analysts another excuse to fall back on the informal “pro forma” numbers that are widely used to assess corporate performance, but which are frowned on by accounting purists. On this basis – excluding option costs altogether from both periods – Cisco’s earnings rose by 8 per cent. This is the measure that most analysts on Wall Street eventually used for the company.

As a result, the profit numbers that make the headlines and the numbers that investors and analysts actually use when assessing a company are likely to diverge, according to Bob Willens, an accounting analyst at Lehman Brothers.

Politically, most of the big investment banks will feel they have to pay lip service to the new rules and treat the GAAP numbers as paramount, he says – but in private, most investors are already saying they will not use the official figures.

Whether the accounting change will make any difference in the “real world” is equally a subject of some debate on Wall Street.

Stock prices, in theory, should not be affected by the new accounting, says Mr Willens. The numbers have been disclosed in footnotes for a decade, giving investors warning.

But some analysts warn that the magnitude of the costs for some tech companies could affect the way they are viewed in the stock market – particularly if many of their shares are owned by individual investors, who may be more influenced by the headline numbers.

The change could also influence the behaviour of investment funds that use simple mathematical formulae to screen stocks before picking companies to invest in. At the least, the confusion surrounding the transition to the new accounting method could hurt the stocks of companies with big options costs, says Mr Sherlund.

There is one area, though, where the new accounting rules have already had a measurable effect in the real world: the willingness of tech companies to issue stock options. While most say they have not changed their policy, the actual numbers of options being issued has fallen in the run-up to the new rules.

If, as critics claim, US tech companies were far to generous with the stock options they issued during the boom years, the new accounting rules have at least forced a return to economic reality.

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