Cognos Inc. reported a profit of $19.4-million (U.S.) in fiscal 2002, based on U.S. accounting standards. The company's chief executive officer said Cognos had a "great" fourth quarter, and its earnings handily beat analysts' expectations.
There was a catch, but one only sophisticated analysts and investors could appreciate. It was the cost of the technology company's employee stock options.
If Ottawa-based Cognos had included its options cost as a business expense on its income statement — an accounting treatment that was not required — its 2002 profit would have been wiped out, and Cognos would have lost $6.1-million in the year ended Feb. 28.
Canadian accounting rules have not required companies to disclose the costs of their stock options — although that is changing this year — but a large number have already revealed the information because they also report under U.S. accounting principles.
A Globe and Mail analysis shows that Cognos is hardly unique. A number of Canada's best-known companies have large stock option expenses, especially in relation to the size of their profits.
Hummingbird Ltd.'s $3.7-million profit in 2001 would have become a $12.3-million loss if the cost of stock options were included in the Toronto company's calculation.
ATI Technologies Inc. of Markham, Ont., would have seen its 2001 loss soar to $31.2-million from $17.1-million with option costs. Celestica Inc. of Toronto lost $51.3-million last year, which would have almost doubled to $97.1-million including option costs. Waterloo, Ont.-based Research In Motion Ltd.'s loss of $7.6-million last year would have more than doubled to $19.4-million including options.
Two companies in particular had enormously high options costs in 2001. Nortel Networks Corp. of Brampton, Ont., issued stock options valued by the company at $1.7-billion, while JDS Uniphase Corp. of San Jose, Calif., and Ottawa had option costs worth more than $440-million.
These sort of huge expense levels are changing the way shareholders think about options. For many years, stock options were widely popular with both company executives and their shareholders. Shareholders believed executives with options had more incentive to work to increase the company's share price, thus aligning their interests with those of shareholders.
But more recently, as stock prices have fallen and scandals have swept through corporation boardrooms, conventional wisdom has been questioned. Many investors are growing skeptical that stock options have worked as intended in theory, and they are especially concerned that the cost of options is not reflected on income statements.
"I think initially it started off as a good thing," says Bill Mackenzie, president of shareholder advocate Fairvest Corp. "But it became such a huge payola. It just became too much of a good thing. Maybe as a small incentive it might have been a nice thing to have, but it just got too insane."
Dale Richmond, CEO of the Ontario Municipal Employees Retirement Board (OMERS), said he believes the tide started to turn around 1998 as stock option grants spread to more companies and in far larger amounts. They became especially popular for high-tech companies and smaller startups.
"It's grown more quickly than many people would have thought," Mr. Richmond said. "It's an issue of how you share the wealth of a company. As a shareholder, we support that all stakeholders should share. But we don't think any group should share excessively or to the detriment of others."
OMERS and other large institutional investors in Canada have begun a lobbying campaign to urge Canadian companies to record the expense of their stock options on their income statements, hoping that such disclosure will ultimately curb the tendency to grant excessive options. So far, only two major companies — Bank of Montreal and Toronto-Dominion Bank — have agreed to do so, and they are both companies with low option costs for the size of their profits.
"If you wanted to be cynical, it's not surprising that Microsoft was not the first company to expense options," said TD chief financial officer Dan Marinangeli.
TD estimates its earnings per share will drop by 3 to 5 cents (Canadian) when it records the expense of its options next year — a modest cost for a company with earnings per share of $2.07 last year. Microsoft Corp. of Redmond, Wash., by comparison, would have seen its profit fall by one-third last year if it had expensed the $2.3-billion (U.S.) cost of its options.
The lack of exposure about the real cost of options is only one of many criticisms that shareholders are beginning to air. There is a growing list of concerns about the impact of large option programs, and the greatest worry is the cost to shareholders caused by the dilution of large stock option programs.
Stock options give employees the right to buy shares from the company in the future at a fixed price. When they exercise their options, employees pay their employer cash in exchange for shares. That means many companies issue new shares from treasury to honour the options, which can greatly increase the number of shares outstanding for some companies. Over time, existing shareholders have an increasingly diluted ownership stake in the company, and, therefore, a lower stake in the company's profit.
If stock option programs are small, dilution is minor. As they've grown, however, dilution has become far more significant. Cisco Systems Inc. of San Jose, Calif., issued options valued at $2.6-billion last year alone, while New York-based AOL Time Warner Inc. issued $1.4-billion of options.
In Canada, most companies currently do not provide estimates of their option costs unless they choose to report under U.S. accounting standards. But a look at available data shows a number of significant option programs among Canadian companies. Last year, for example, Toronto-based Four Seasons Hotels Inc. issued options worth $31-million (Canadian), which would have cut its profit by more than 50 per cent if the cost had been recorded as an expense. Barrick Gold Corp. of Toronto issued options valued at $31-million (U.S.) last year, which would have reduced its profit by 32 per cent if the expense had been recorded. Vancouver-based QLT Inc. issued options worth $40-million (Canadian) last year, for a potential 35-per-cent drop in profit if expensed.
James Gillies, a corporate director and founding dean of the Schulich School of Business at York University, says shareholders should see the risks of this dilution measured as a cost on companies' income statements.
"With the experience we've had with Enron and the meltdown of the technology bubble, surely we should be looking for ways to make fair and complete and proper statements on the earnings capacity of companies," he says.
Mr. Richmond said OMERS is voting against any employee stock option programs that lead to excessive dilution for shareholders. OMERS rejects options programs that would increase the number of shares outstanding by more than 10 per cent, and might reject even 5-per-cent dilution for large or mature companies. In a single month this spring, OMERS voted 97 times on various option changes, and voted against 48 of them.
Of course, companies don't have to issue new shares from treasury to honour their employee options. Many companies buy shares in the open market to avoid dilution. But that means there's often a huge cash drain, which doesn't show up on the earnings statement either.
If an option is exercisable at $10, and the employee waits until the market price is $100 to cash it in, the company receives a $10 payment from the employee and hands over a share it had purchased in the marketplace for $100. Some investors believe this is not a highly profitable way for a company to spend its cash.
Even new shares issued from treasury in this scenario are expensive, since they could have been sold in the market for $100, rather than handed over to employees for $10.
As well, Canadian companies cannot write off the expense of stock options as a business cost similar to salary costs, so companies forgo a potential tax benefit by issuing options as an alternative to other methods of compensation.
"There's no cash cost, that's clear," says Paul Cherry, chairman of Canada's Accounting Standards Board. "But you lose a tax deduction. From my point of view, the better approach is to put all the [compensation choices] on the table and let people understand what the pros and cons are. There are all sorts of motivational issues that people can judge for themselves."
Shareholders are also increasingly concerned about the psychological impact on executives when there are extremely large stock option programs. The fear is that a CEO who is sitting on, say, $100-million of stock options has every reason to think short term, knowing that he will soon be enormously wealthy.
This can create an enormous incentive to ensure the share price does not dip, reducing the value of options before they can be exercised. Some shareholders believe this has enhanced the pressure on executives to cut corners to ensure they meet or exceed profit targets.
"You slowly shift your focus from a corporate manager to a stock promoter," says Tom Caldwell, chairman of Caldwell Securities Inc. in Toronto. "Now, beating quarterly earnings becomes very important to you, because you have $50-million or $100-million of value tied up in these things."
The fact that some executives own options, but don't own much stock, also means that they don't have the same downside risks, some shareholders argue. When a stock price drops, investors who paid money for shares face an immediate loss on their investment. An executive holding options has put no money on the table, and faces no cash loss. Even if options become worthless, an executive loses the potential gain, but doesn't lose a personal cash investment.
"He doesn't have to worry about downside, he only has to worry about upside," Mr. Caldwell said.
In the same vein, there are concerns that options have not actually led to employee share ownership, but only to employees owning highly leveraged options for a limited period of time. That's because most employees exercise their options and immediately sell their shares to lock in their profits. Only a small number of companies require employees to keep some of the shares they receive from option programs, giving them a direct ownership interest for the longer term.
Bill Dimma, a corporate director and author of the new corporate governance book Excellence in the Boardroom, says executives and corporate directors should be required to retain some shares when they exercise options. He argues directors in particular should not sell shares from exercising options, except to cover their costs, until they retire from the board.
"I just cringe at the insider trading reports that show directors selling their shares. What kind of a signal is that to the market? It's a terrible signal."
Mr. Dimma also advocates options programs that include performance hurdles before the options vest. That means a company has to outperform its peer group or meet internal targets for returns before the options are handed over to executives.
"Rewarding people with excessive grants that pay off simply because the whole market went up in the 1990s just doesn't make any sense," he says.
Perhaps the impact of options that has been most difficult to analyze is their effect on management decisions about how a company should spend its cash.
Some investors now believe, for example, that options are a factor in the long trend toward fewer companies paying dividends. The concern is that executives have a bias against dividends because the cash goes to shareholders, but not to option holders. Mr. Mackenzie says dividends also tend to make a company's shares far less volatile, and thus less likely to soar.
"[As an option holder,] you want volatility because it doesn't necessarily hurt you, and it might give you an opportunity to exercise at a higher price than if there was no volatility," he says.
Similarly, some investors fear that options have increased the popularity of share buyback programs, in which companies purchase their own shares in the open market to boost their stock price. In the past, buybacks were common when companies believed their shares were undervalued. But in the boom market of the late 1990s and 2000, there was a large business in buybacks even when markets were at their peak and shares were considered expensive.
The accusation is that some executives with options have used buybacks to boost the share price in the short term, even when they are not a cost-effective investment choice for long-term growth.
Mr. Richmond at OMERS notes that these sorts of items on the long and growing list of concerns about stock options only become relevant when options programs are large.
"If they aren't excessive, many of those things don't kick in," he says. "But if it's excessive and if it's a very great part of the compensation ... then those things can result."
Shareholders concerned about option costs have focused most of their attention on urging companies to voluntarily record the expense of their options on their income statements. They believe disclosure would discourage companies from thinking of options as "free" compensation that carries no cost.
Accounting regulators, however, have been cautious in their response.
Canadian regulators have taken their lead from the United States. The U.S. Financial Accounting Standards Board (FASB) considered mandatory expensing of options, but dropped the idea years ago after companies — and particularly the technology industry — mounted a furious lobbying campaign. Instead, FASB only requires that companies disclose the value of their options in a note to their financial statements, and it is usually buried deep in the fine print.
In Canada, the Accounting Standards Board (ASB) had a similar debate, and concluded that this country could not adopt mandatory expensing of options after the United States had rejected it, Mr. Cherry said. Instead, the ASB adopted the U.S. rule.
Starting with 2002 financial statements, Canadian companies will also have to either explain the value of their annual option grants in a note to financial statements, or include them as an expense on the income statement. As in the United States, almost all companies are choosing the former.
Cognos, for example, is not going to expense the cost of its stock options, spokesman Sean Reid said, but will comply with disclosure requirements under generally accepted accounting principles. He said Cognos has no comment on the broader debate about mandatory expensing of options.
Mr. Cherry says he believes mandatory expensing of options is coming soon. Nine months ago, he said the change was impossible given widespread opposition. But with accounting scandals mounting, there is greater willingness to make major changes. The International Accounting Standards Board is expected to issue a report later this year endorsing the mandatory expensing of stock options, and Mr. Cherry believes U.S. regulators may now be willing to adopt a new international standard.
"I think we will eliminate this one last loophole. The mood has changed dramatically," he says.
Mr. Gillies from York University says investors need a mandatory rule requiring companies to expense their options. Otherwise, he believes few companies will voluntarily accept the added expense.
"There are certain things that need to be regulated," he said. "I sit on an awful lot of boards, and the reality is that change to deal with external diseconomies never takes place without regulation. It never does."
Mr. Dimma, meanwhile, says shareholders pressing for change have to acknowledge the impact of expensing stock options. Corporate profits will fall, especially in industries that use options most, such as the technology sector.
"And the effect on the stock market, which loops back on the economy, could be significant," he adds. "So it's got to be done carefully. But subject to doing it right, and maybe introducing it fairly gradually, I think the principle does make sense."
For their part, investors say they are willing to accept lower earnings if the numbers are accurate. They argue shareholders are already bearing the cost of options, but it is simply hidden from them by keeping it off the books.
"If they're not expensed, earnings are artificially high," says Mr. Richmond at OMERS. "We want to know what the commitments of these companies are, so that we can make our own risk assessments of the extent to which we want to invest in them."
With a file from reporter Elizabeth Church
© The Globe and Mail
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