Business Ethics:

Examples of Fraudulent Expense Recognition^[1]

Interpretive accounting issues are clearly not limited to the revenue side. Here are some further issues in connection with expenses. The analyst must always be on the alert.

Stock options provided to executives are not accounted for as expenses, thereby giving earnings a boost because there is no associated expensing to salary. According to a study by Ms. Pat McConnell of Bear Stearns, in 1999 net income of the S & P would have been 6% lower had employee stock options been reflected as an expense. Options will be exercised at below the market’s stock prices resulting in an associated cost to the firm. In 1998 and 1997 the reductions would have been 4% and 3% respectively.

The FASB requires that companies include in their footnotes the effect of options granted after 12/15/94. The full effect of this was first felt in 1999 as many companies’ plans allow options to vest in five years or less. If companies choose not to disclose options as a compensation expense (and the FASB does not require this), the disclosure must be made as a footnote reflecting the adjusted net income and EPS had the cost of options been charged. Obviously, most companies chose the latter. Ms. McConnell found only Boeing and Winn-Dixie, i.e., just two of the 500 S & P companies, that chose to report options as an expense. Earnings at 21 companies fell by more than half, if options were expensed; this list includes McDermott International, Yahoo, Autodesk, and Polaroid. Twelve of these companies would have reported a loss, including Micron Technology. She further cites the following declines in earnings due to options:

Overall, the S & P 500 growth rate in earnings would decrease from 11% to 9% over the last three years – if options were expensed.