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Study on impact of expensing stock options

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01 Dec 2005

Standard & Poor's has published a report of the impact of expensing stock options on the S&P 500 companies.

FAS 123(R) requires expensing of stock options (mandatory for most SEC registrants in 2006). IFRS 2 is nearly identical to FAS 123(R). S&P found:

  • Option expense will reduce S&P 500 earnings by 4.2%. Information Technology is affected the most, reducing earnings by 18%.... P/E ratios for all sectors will be increased, but will remain below historical averages.
  • The impact of option expensing on the Standard & Poor's 500 will be noticeable, but in an environment of record earnings, high margins and historically low operating price-to-earnings ratios, the index is in its best position in decades to absorb the additional expense.
S&P takes issue with those companies that try to emphasise earnings before deducting stock option expense and with those analysts who ignore option expensing. The report emphasises that:

Standard & Poor's will include and report option expense in all of its earnings values, across all of its business lines. This includes Operating, As Reported and Core, and applies to its analytical work in the S&P Domestic Indices, Stock Reports, as well as its forward estimates. It includes all of its electronic products.... The investment community benefits when it has clear and consistent information and analyses. A consistent earnings methodology that builds on accepted accounting standards and procedures is a vital component of investing. By supporting this definition, Standard & Poor's is contributing to a more reliable investment environment.

The current debate as to the presentation by companies of earnings that exclude option expense, generally being referred to as non-GAAP earnings, speaks to the heart of corporate governance. Additionally, many equity analysts are being encouraged to base their estimates on non-GAAP earnings. While we do not expect a repeat of the EBBS (Earnings Before Bad Stuff) pro-forma earnings of 2001, the ability to compare issues and sectors depends on an accepted set of accounting rules observed by all. In order to make informed investment decisions, the investing community requires data that conform to accepted accounting procedures. Of even more concern is the impact that such alternative presentation and calculations could have on the reduced level of faith and trust investors put into company reporting. The corporate governance events of the last two-years have eroded the trust of many investors, trust that will take years to earn back. In an era of instant access and carefully scripted investor releases, trust is now a major issue.

Click to download The Impact of Option Expensing on S&P 500 Earnings (PDF 399k). Please note that the report remains copyright Standard & Poor's, all rights reserved, and is posted here with the kind permission of S&P.

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