Taking Stock / A Nice Story About an Imaginary Company

Ask the U.S. Financial Accounting Standards Board (FASB), and it will say options are obviously an expense. The problem is the Wall Street lobby has managed to harness Congress into torpedoing legislation that would force them to expense these perks.

Here is a nice story about an imaginary company.

In the last four years, it has netted $8 million. That achievement is especially remarkable given the weakness of its market. It also achieved cash flows of about the same magnitude, actual money that it actually made, not mere accounting mirages.

But when you browse through its balance sheet, showing its liabilities and assets, you discover that in the last four years, its shareholder equity did not grow by one single cent. Its liquidity actually deteriorated. How could that be?

Simple: the company gave all its profits as dividends to shareholders. Right?

Wrong. Its statement on cash flow from financing operations discloses that it gave not one red cent as dividends to shareholders.

Simple: the company used all the money it made from current operations to repurchase its own shares on the open market. When a company does that, it reduces its shareholder equity. Right?

Indeed, the company's cash flow report shows that in the last four years, it bought back shares for about the same amount it earned. Repurchasing shares reduces the company's outstanding share capital and increases its earnings per share. That is a good thing, because what shareholders really care about is not absolute net profit, it's net profit divided by the number of shares.

Surprise! The bottom line of its profit and loss statement shows that the company's number of shares in circulation hasn't dropped at all, even though it bought back large amounts of shares.

Well, that's simple too. The company issued new shares, about the same amount as it bought back. So its number of outstanding shares remained stable.

Wait a moment. If the company issued shares, then its cash flow report should show the proceeds from the offering.

Indeed, the company's cash flow report contains an item, "Proceeds from offering of new shares". But - surprise! The amount is equivalent to a tenth of the investment in buying back shares, even though the company bought back and issued the same number of shares.

How could that be? Well, that's simple too. The imaginary company sold shares for $5 each and bought them back for $50. It sold on the cheap and bought extremely dearly.

Something is not working out here. If our company bought back so many shares at top price and sold them dirt cheap, it should have posted a major loss on the dealing.

No. The new shares were issued to the company's managers and staff, under its options program. American accounting rules allow companies not to expense options it gives workers, if the option price is the same as the market price. And our imaginary company is American.

Now we understand the story of our imaginary company. It netted $8 million, took the money and gave the lot - lock, stock and barrel - to its staff, not through salaries, which would appear as an expense in its P&L statement, but through issuing options and buying back shares.

Or, our imaginary company wants to present profits as high as possible. So instead of giving its workers huge raises, it gives them huge numbers of options, and cancels out the dilution caused by the allocation by repurchasing shares using the cash it could post because it hadn't routed the reward into salary, but into stock options.

A nice story, isn't it? It is entirely imaginary of course, because in reality, the company netted $8 billion in the last four years, not $8 million, and that's roughly the amount it routed to its management and workers without a sign of its practice appearing in its P&L statement.

Yes, we're talking about Dell Computers, one of the most successful companies in the world. Its share price has multiplied by one-hundred in the last decade, and it managed to rake in tremendous profits despite the feebleness of the technology market during the last four years. Tremendous profits, that now sit happily in the pockets of its management and workers.

Ridiculous, you snort, can't be. Clearly you aren't following events on Wall Street. Hundreds of companies are doing the same thing - remunerating through options that they do not expense, while sinking their profits into their own shares to prevent dilution of earnings per share.

We wrote about one such company just last week - Mercury Interactive. For 2003, it presented a net profit of $41.5 million. But in its notes, it admits that it would have presented a loss of $94 million if it had expensed its options to managers and employees.

On Wednesday, Koor Industries reported its first net profit for two years, of $10 million. It can thank its Wall Street listing for this because Israeli law allows it to use U.S. reporting standards, including avoidance of expensing stock options. If it had, it would have posted a loss of $25 million.

What does all that mean? Ask the companies and they'll tell you stock options aren't an expense, and if they're booked as one, the high-tech industry would collapse and unemployment would skyrocket.

Ask Doron Tsur, an analyst who has been tracking the shenanigans of Wall Street companies for years (and writes a weekly column in TheMarker) and he'll say that one day, investors will clamber to their feet and discover that the profits companies have been reporting are fictitious.

Ask the U.S. Financial Accounting Standards Board (FASB), and it will say options are obviously an expense. The problem is that the Wall Street lobby has managed to harness Congress into torpedoing legislation that would force them to expense these perks.

But the FASB is proving to be pretty irrepressible. Ten years after being beaten back, it has sprung up again. On Wednesday, it revealed a draft directive that would force Wall Street companies to expense options. We can expect its move to spark another battle of titans between Wall Street and Washington that will echo around the world, causing shudders in all the markets linked to Wall Street, including Israel's.