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The AAO Weblog covers accounting issues and current events as they relate the practice of investment analysis. All posts prior to September, 2007 are in the public domain, but after September 4, only subscribers to The Analyst's Accounting Observer will see all posts going forward. Only selected, occasional posts will be released to the public domain from September 4 forward.

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Stock Options: Simmering In The Summer
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Posted by: Jack Ciesielski 6/7/2007 6:46 AM
Maybe it hasn't grabbed you by the shirt collar and shaken you with the same impact as the early revelations about "lucky strikes" timing of option grants, but lately there's been a lot of activity on the employee stock options reporting front. Let's run through some of the goings-on:

Last Thursday, the SEC filed civil fraud charges against Mercury Interactive and four former senior officers, alleging a fraudulent and deceptive scheme employed between 1997 and 2005 relating to their misreporting of stock option grants and the reaping of millions of dollars of benefits through backdating activity.

Cease and desist! That's what the SEC says IBM will have to do when it comes to making misleading statements to analysts, most specifically about the effects of implementing Statement 123R. Of course, now that 123R has been implemented, it's rather a moot point in that particular regard. But Anyway, back in the first quarter of 2005, IBM led analysts to believe (through a chart) that the effect of 123R on first quarter earnings would be $.14 per share, when in fact it was going to be $.10 per share. Analysts' expectations were flummoxed and the bottom line was that the company filed a misleading 8-K statement. That's where the real cease and desist order comes in: no more misleading filings, please.

The SEC's chief economist, Chester Spatt, gave a recent speech on the increasing importance of models in financial reporting. Spatt's remarks didn't send out tremors, but one message in it was his support of the experimentation taking place in the "development of new designs and innovations in this important space, especially in light of the centrality of option grants to the cost structure of many firms." One could surmise that he was referring to the use of ESOARs in valuing employee stock option grants.

Finally, Senator Carl Levin held hearings Tuesday on whether or not there should be a book-tax difference between financial reporting of stock compensation expense and tax reporting of the same. Companies have the incentive to under-report expense to shareholders and to maximize the deductions in tax reporting. And that's pretty much the same for any kind of expense reporting, really. The problem is that the foundations for the two sets of figures are vastly different: if they were the same basis, there might be a natural tension placed on the reporting so that there's less incentive to under-report expense to one party (shareholders) and over-report to another (tax authorities).

Levin has proposed this before, and it didn't catch on. Nevertheless, it's an interesting idea, and there was interesting testimony from Senator Levin himself, acting IRS Commissioner Kevin Brown, SEC Division of Corporation Finance Director John White, and former SEC Chief Accountant Lynn Turner. Whether or not anything comes of it is anyone's guess - but an impressive array of facts was marshaled by these witnesses.

One question arises from the first couple items noted: Is the SEC getting ready to break its logjam of backdating cases? It would be a relief to see an end to the backdating drama. On the other hand, we might just be in for a long, hot summer of simmering stock option cases.
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