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Forbes, June 4, 2007 article

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"Those companies did not break the law; they are benefiting from an outdated and overly generous stock option tax rule that produces tax deductions that often far exceed the companies' reported expenses," says Levin.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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