Coca-Cola to Treat Options as Expenses

As corporate accounting scandals continue to roil the stock market, Coca-Cola Co. on Sunday said it will count employee stock options as normal business expenses, a move executives hope will boost investor confidence in the world’s largest soft drink company.

In recent weeks, the use of stock options, once considered a valuable tool to link the interests of corporate executives to those of shareholders, has been blamed as a potential culprit in the accounting debacles plaguing corporate America.

Critics, including President Bush, have been looking for ways to rein in the practice of providing top corporate managers with huge grants of stock options, which give the right to buy company shares at a set price in the future.

Coca-Cola’s decision could put pressure on other major companies to also adopt the practice of treating options as compensation expenses. The Atlanta-based company will be just the third member of the Standard & Poor’s 500 to do so, after Boeing Co. and Winn-Dixie Stores Inc. Real estate investment trust AMB Property Corp. said last week it would also begin expensing options.

The Senate is expected today to vote on a far-reaching accounting reform bill. Democrats are likely to push for an amendment that would have a new accounting-oversight board study whether stock options should be expensed.

Coca-Cola said that beginning in the fourth quarter it will treat employee stock options as a recurring cost on income statements. Net income this year will be reduced by about 1 cent a share by the change.

“It’s all about transparency,” Coca-Cola’s chief financial officer, Gary Fayard, said in an interview. “This is a new world, and we need to be as transparent as possible. We’re stepping up to the plate, and we hope the rest of corporate America will follow.”

Billionaire investor Warren Buffett, Coca-Cola’s largest shareholder with an 8% stake and a member of its board, called the company’s accounting change a “classy move,” and added that he would feel “far more comfortable” if other companies followed its lead.

“It provides numbers in terms of earnings to the shareholders that far more accurately reflect economic reality than the prevailing system in corporate America,” Buffett told Reuters. “It tells the truth to shareholders about what compensation really costs.”

Though stock options have become an increasingly prevalent form of executive compensation, the vast majority of public companies only mention the options in a footnote in earnings reports rather than deduct them from the companies’ core finances. If the nation’s 500 largest publicly traded companies had counted options as expenses in 2001, their reported earnings would have dropped by 21% on average, according to a report last week by Merrill Lynch.

“The one thing investors respect right now is companies that are brutally honest about their financial reporting,” said Nell Minow, editor of the online publication the Corporate Library. Coca-Cola “sees the writing on the wall. This is something all companies will eventually have to do, and they probably figure they might as well get credit by doing it voluntarily.”

Some, however, say Coca-Cola’s decision is insufficient.

“While I commend Coca-Cola for doing this, having a situation where some companies expense options while others don’t may actually be worse,” said Rep. Brad Sherman (D-Sherman Oaks), a certified public accountant and a member of the House Financial Services Committee. “All companies should be required to do it so their financial results can be comparable. That way, investors can tell the difference between Coke and Pepsi.”

Such accounting loopholes have come under greater scrutiny as lawmakers seek ways to prevent companies from glossing over financial blemishes.

Though Congress last week blocked a bill sponsored by Sen. John McCain (R-Ariz.) to force companies to treat stock options as expenses, lawmakers left open the possibility of revisiting the issue in September when they plan to address corporate governance legislation.

Federal Reserve Chairman Alan Greenspan recently commented on the “significant distortion in reported earnings” of omitting options as an expense.

But other major players, including Securities and Exchange Commission Chairman Harvey L. Pitt and Sen. Joseph I. Lieberman (D-Conn.), have argued against classifying options as expenses because doing so would impede economic growth and raise the complex issue of how to value options.

Coca-Cola said it would use the “fair value” method currently recommended but not required by the Financial Accounting Standards Board. Fayard estimated that the change will initially reduce annual earnings by 1 cent per share. Wall Street analysts on average expect the company to earn $1.79 per share this year, not including the options expense.

As Coca-Cola’s options mature over the years, Fayard expects the effect to peak at 10 cents a share in 2006 and remain at that level from there on.

Coca-Cola’s shares fell $2.06 to $51.05 on the New York Stock Exchange on Friday. The stock has risen 8% this year and is the leading gainer in the Dow Jones industrial average.

Options give holders the ability to purchase stock at a predetermined price.

While this creates an incentive for employees to strive to increase shareholder value, the options also dilute the value of shares already owned by investors.

In recent years, numerous companies granted stock options to employees instead of giving them cash bonuses or raises.

Many grew wealthy on such options. At Enron Corp., former Chairman Kenneth L. Lay exercised $180.3 million in options from 1998 to 2000. Enron’s former chief executive, Jeffrey K. Skilling, received $111.7 million. But rank-and-file workers also benefited in the 1990s. Microsoft Corp.’s stock options, for example, created hundreds of millionaires.

But accounting for such options today would significantly drag down the profits reported by hundreds of companies, according to the Merrill Lynch report.

Technology companies, which have been the most aggressive in granting options, would be hardest hit, with a 70% decline in earnings this year if options were expensed. Telecommunications companies would suffer a 12% drop.

Overall, earnings for the top 500 public companies in the Standard & Poor’s index would decline 10% this year if options were recorded as costs, according to Merrill Lynch estimates.