How would you like to be able to chow down on other people's cake, but be able to tell them with a straight face that you're doing it for their own good? It's as if you can prove your parents wrong by not only eating your cake but having it, too.
Welcome to a quirk in the accounting rules that has allowed more than 200 U.S. companies to give executives (and regular employees) billions of dollars of free cake -- all in the name of fattening future profits and share prices. They can report higher profits tomorrow by giving gifts at shareholders' expense today.
Yes, I know this doesn't make sense. But it's an unintended consequence of the new rule that requires companies to treat the value of employee stock options as a business expense. Unless the Securities and Exchange Commission changes its mind -- which could happen -- the new rules will go into effect for companies' upcoming fiscal years. For most companies, this means calendar year 2006.
Under the new rule, companies have to subtract the value of employee stock options from reported profits. Hundreds of companies -- including my employer, The Washington Post Co. -- already do this voluntarily. But until now, companies have been able to bury the charge in their footnotes rather than including it in the profit-and-loss statement.
One piece of background before we proceed. Companies don't merely value the options they grant each year and subtract the sum from reported profits -- that would be too simple. Instead, they report the charge gradually, as employees gain the right to cash in those options. Say you got options valued at $60,000 when they were granted, but you can't cash them in for three years -- the so-called vesting period. Your company would charge its profits $20,000 a year for three years, not $60,000 this year.
Under the new rules, companies have to charge their profits not only for fiscal 2006 options, but for earlier options that haven't yet vested. So if a firm declares its old options to be vested before it has to start counting options as an expense, its future reported income will be higher than it would be if the options continued to vest on schedule. This is bizarre and counterintuitive -- but true.
As a result, at least 212 companies have accelerated vesting in the past year, according to Jack Ciesielski, editor of the Analyst's Accounting Observer. (That was the count in May -- he hasn't yet updated for June.) Ciesielski has given this strategy a wonderful name: "vest fleece." Vest fleecing, he says, is "a use of management's time and shareholders' funds to do only one thing -- keep investors in the dark about the way management pays itself." By his count, companies valued these options at about $2.6 billion when they were given as gifts to executives and other options holders.
More than 20 percent of the total is from just two companies: Viacom ($277 million) and Sun Microsystems ($260 million). Both firms argue that the options involved were granted when their stock prices were much higher than now and were worth little or nothing when companies decided to let employees exercise them ahead of schedule. Thus, stockholders didn't give away anything of real value. Viacom spokesman Carl Folta said the firm accelerated only options exercisable at prices way above today's -- and precluded top officers from taking quick profits on the accelerated options if Viacom's stock soars.
I'm all in favor of employees getting what they can from employers -- heck, I've been an employee all my life. But it strikes me as more than a little strange for executives to have their employer give them something of value and for them to pocket the gift (whatever its actual value) in the name of helping shareholders.
In fact, all this options-expensing maneuvering may be over nothing. Back in 1996, when the Financial Accounting Standards Board began requiring companies to report the value of options in their footnotes, options lovers claimed it would drive stock prices down. It didn't. A recent study by the pro-option National Center for Employee Ownership concluded that treating options as an expense probably won't matter much. "Expensing could well turn out to be the Y2K problem of equity compensation: much feared, but with little impact," said Executive Director Corey Rosen.
Now a touch of irony. President Bush's proposed SEC chairman, Rep. Christopher Cox, Republican of California, is tight with Silicon Valley, which hates the idea of expensing options. If Cox gets options-expensing reversed, companies will have given away cake to top executives (and tiny cupcakes to other employees) to no purpose at all. Yummy.
Sloan is Newsweek's Wall Street editor. His e-mail address is firstname.lastname@example.org.