Many companies are already required to comply with Statement 123R, the Financial Accounting Standards Board’s revised rule on stock-option expensing, by including the costs of issuing stock options on their income statements. There’s been uncertainty, however, over whether or when the analysts who cover those companies would follow suit.

Traditionally, most sell-side analysts have used pro forma, or non-GAAP, earnings, which would exclude the expense, and Thomson/First Call has excluded from its consensus analyst estimate anyone not in that majority. That’s placed pressure to conform analysts who want their estimates included in the consensus, explains Rick Sherlund, a Goldman Sachs software analyst who’s also a certified public accountant. “I think a lot of analysts don’t understand accounting so well, so companies are in a position to sway that [pro forma] view,” he says. “Those of us who are CPAs can push back.”

Indeed, several sell-side firms are pushing hard with policies, just under way or soon to be implemented, which require that estimates reflect the costs of options. They include Bear Stearns, Merrill Lynch, UBS, and Credit Suisse First Boston. “Hopefully all firms will support this initiative,” says Sherlund, who notes that Goldman has issued an internal memo but has not yet made a public statement to that effect.

To date, noted CSFB in a recent report, 123 members of the S&P 500 expense their stock options, but the consensus earnings estimate considers that cost for only 96. “I think the remainder of those companies may be providing pro forma results” that exclude the compensation costs, explained CSFB research analyst David Zion, who co-authored the report.

Zion observed that 21 S&P 500 companies have a June year-end; under Statement 123R, they must expense stock options for their first quarter, which ended September 30. Currently, the First Call consensus earnings estimates factor in that cost for only seven of those companies: Affiliated Computer, Automatic Data Processing, Clorox, Microsoft, Parker-Hannifin, Procter & Gamble, and Sysco.

Many investors will be confused, notes Zion, when they must deal with the lack of comparability between company statements, varying analyst approaches to the earnings estimate, and the consensus estimate. “Comparing results across companies or historically could get a bit tricky, especially troublesome for those relying upon quant screens,” he adds

“I think it’s going to be a train wreck,” says Sherlund of Goldman Sachs. “There’s just no consistency.”

As the sell side starts to push for a GAAP consensus, however, some analysts on the buy side appear to favor pro forma figures. While he has not conducted a formal survey, Lehman Brothers accounting and tax analyst Robert Willens says that he’s been surprised, during conversations with many buy-side analysts and hedge-fund managers, that they’ve expressed willingness to ignore the compensation charges and add them back when they’re analyzing multiples and valuations in general.

“I thought people would accept the GAAP number and be done with it,” says Willens. Many of those analysts and managers, he reasons, may still have issues with the option-expensing provisions of 123R: “There’s a lot more people out there who feel it’s not a valid expense” or that “the measurement techniques are so faulty and the number is so unreliable that it’s best to ignore it.”

Regardless, Zion hopes that ultimately, investors will pay greater attention to GAAP earnings that include the cost of stock options. “Even if companies try the pro forma,” he maintained, “if enough of the sell side come out with similar types of policies, then the analysts will have to include it in their earnings estimates, and it will be more difficult to ignore the cost.”

Ted White, deputy director at the Council for Institutional Investors, has been encouraging just such a policy shift through a letter-writing campaign directed at research firms. “We believe this will provide a more accurate representation of the economic performance of companies and improve financial reporting,” he says.

White also recommends that First Call publish some combination of dual estimates — GAAP and pro forma — during the transition, and that it establish a deadline for all estimates to consider stock-option expenses. Sherlund agrees that dual consensus estimates would ease comparability concerns, but he cautioned that when both estimates are presented, investors may simply focus on the pro forma number.

Kathryn Durant, a vice president at Thomson Financial Content Group, says that 600 companies have reported that their earnings would be impacted by option expensing next year; about 20 percent have seen the majority of the analysts who cover them make the switch and include the cost of stock options in their estimates. Durant adds that while the mean consensus estimate will reflect the majority sentiment on the Street, for years First Call has also provided a mean estimate according to GAAP.

In his report, CSFB’s Zion noted that S&P 500 companies are expected to report a total of $22 billion in after-tax option-compensation costs in 2006 — costs that would reduce the S&P 500 consensus earnings-per-share estimate by approximately 3 percent. To be sure, he adds, that percentage has steadily declined in the last several years, due to an overall reduction in the number of stock options granted.

Looking further ahead, Zion predicted that FASB’s rule on stock-option expensing may even inspire groups of companies “to dream up industry-specific versions of pro forma earnings, adding an aura of credibility to the numbers they make up.” He also observed that “as the gap between pro forma and GAAP earnings widens, investors may further question the quality of pro forma earnings and discount them accordingly.”

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