San Diego After two calamitous years, San Diego's Wireless Facilities boasted to its shareholders that it earned 32 cents a share in 2003. But look at the footnotes in the telecom company's annual report to the Securities and Exchange Commission. Under what is increasingly considered a realistic accounting regimen, the company earned 3 cents a share last year, not 32. And rather than losing $1.33 in 2002, it lost $2.03.
Other San Diego companies have grim earnings news tucked away in their footnotes. Biosite, a biotech company, reported that it earned $1.50 a share last year; the footnotes said earnings were less than one third of that. The company reported profits in both 2002 and 2001, but footnotes revealed that the company lost a substantial amount both years.
Telecom giant Qualcomm said it earned $1.01 a share last year. Make that 69 cents. Semiconductor equipment maker Cymer said it made good profits in both 2002 and 2001, but under realistic accounting it lost money both years. Biotech Invitrogen claimed it made $1.17 a share last year; make that 54 cents. Satellite communications specialist ViaSat said it earned 9 cents a share in 2002. Actually, it lost 49 cents a share. Last year it reported a loss of 37 cents a share. Actually, the loss was 86 cents.
Under sensible accounting, the earnings of software maker Websense would have been halved last year. Profits of sleep-disorder equipment maker ResMed would have dropped from $1.33 a share last year to 92 cents.
Are these companies misleading their shareholders and the public? Yes. Are they breaking rules? No. Under current accounting conventions, they are permitted to tout the higher figure when stating their earnings, as long as they draw a true picture in the footnotes.
But this practice is likely to end. The reason for the huge gap in reported and realistic profits is whether or not a company counts the value of stock options it grants to employees as an expense. Now, under standard accounting procedures, companies do not have to report stock-options expense as a cost of doing business.
But that's not likely to last. The Financial Accounting Standards Board, the arbiter on such matters, has proposed that companies be forced to expense the value of options they hand out so promiscuously. The four largest accounting firms agree with the proposal. High-tech and biotech companies -- the ones that abuse current accounting conventions the most -- are screaming. Their lobbyists are descending on Washington, D.C., armed with moolah to thwart the accounting-standards board, just as they did successfully a decade ago. Ron Wangerin, chief financial officer of ViaSat, went with a group of 75 companies that recently flew to Washington to schmooze politicians.
A major proponent of accounting reform is San Diegan Graef "Bud" Crystal, columnist for Bloomberg News and one of the nation's top experts in executive compensation. Along with the legendary Warren Buffett of Omaha's Berkshire Hathaway, Crystal was also prominent in the losing battle of the early 1990s.
"Back then, Silicon Valley howled that the only thing that was keeping the Japanese from crossing the Bayshore Freeway" and wresting high-tech supremacy from the U.S. was American companies' widespread use of stock options, recalls Crystal. The techs argued that if their profits were deflated by stock-options costs, companies would curtail their use, and therefore find it hard to attract engineering and management talent.
Silicon Valley wept that the lowest-paid employees would be wounded. "Liberals such as Senators Barbara Boxer and Dianne Feinstein bought this hook, line, and sinker," recalls Crystal. Some politicians menacingly told the Financial Accounting Standards Board that its usefulness may have come to an end.
The industry won the battle. Thus, phony tech earnings helped inflate the stock-market bubble of the 1990s. Some of the biggest and best-known tech firms were actually losing money in the 1990s, but only investors who read footnotes knew. The non-expensing of options costs was one factor motivating managements to concentrate on jacking up their stock prices instead of focusing on long-term growth. In the 1990s, companies were playing myriad other accounting tricks to create false profits.
The non-expensing of options was one factor in the growing inequality of income and wealth. In the 1960s, corporate chief executives made about 75 times what the average employee made. By the turn of the century, it was 500 to 1000 times. The wild granting of stock options to top executives was a major factor in this runaway greed.
There were other economic distortions. Government tax receipts swelled -- particularly in California, home of the techs and biotechs. But then when the bubble burst, the flow of revenue to government coffers abated. California was clobbered.
Now, the Financial Accounting Standards Board is trying again. "This is like déjà vu all over again," says Crystal. Tech companies are again weeping for wee folk. "They say they will have to lighten the boat and throw the little people in San Diego Bay," says Crystal.
Feinstein and Boxer are still eating it up, but strong politicians such as John McCain are in favor of realistic accounting, "and the corporate governance community is singing out of the same hymnal," says Crystal. For example, the Council of Institutional Investors, representing $3 trillion in state and local government and union pension funds, wants straight accounting.
Crystal and Buffett argue that if a company is compensating its employees with stock, that's an expense. Today, if a company gives somebody a cash bonus, it is expensed and lowers profit. If it pays the person with stock options, that doesn't show up on the earnings statement. Says Buffett, "When a company gives something of value to its employees in return for their services, it is clearly a compensation expense. And if expenses don't belong in the earnings statement, where in the world do they belong?"
Those protesting the change have their own arguments. "If the expensing of stock options becomes mandatory, and earnings are reduced by this noncash expense, we believe it is likely to cause a very negative effect on employee motivation and morale," says Anthony Thornley, Qualcomm president.
John Cajigas, director of finance at Biosite, says there is no good way to put a value on stock options. David Pendarvis, legal vice president of ResMed, says, "The problem with expensing options is valuing them up front without knowing in the end what the actual expense will be."
Wangerin says that 500 companies have begun expensing options, but 10,000 have not. Coca-Cola has begun expensing options. "But Coke has 40,000 employees and only gives options to 400 of them. Some tech companies offer options to 60 to 80 percent of employees."
How can you find out the real earnings of a stock you own? Go to its annual 10-k report to the Securities and Exchange Commission. In the footnotes where it states its earnings, the company must also state what those earnings would have been if the company expensed options. Also, Standard & Poor's has a concept called "core earnings." It not only shaves options expense from a company's stated earnings, but also excludes gains from asset sales, insurance, or litigation from profits. It records pension, corporate restructuring, and merger and acquisition costs that some companies try to ignore. Thus, core earnings eliminate many abuses that have bloated profits for years.
You should be able to get a Standard & Poor's report online or from your broker. If you have questions, ask the investor-relations department of the company about the discrepancy between its reported earnings and core earnings. That is, unless you own stock of Wireless Facilities. Alone among the San Diego companies I contacted, its bean counters said they were not familiar with Standard & Poor's core earnings.