The newly calculated core earnings for the companies in the S&P 500 came to $18.48, according to Standard & Poor’s, compared with as-reported earnings per share of $26.74.
Much of the difference in the new numbers comes from items near and dear to plan sponsors – the expensing of options and accounting for pensions. Under the new approach, which S&P unveiled in May , corporate earnings will be viewed through a new prism, including:
- the value of options is treated as an expense in the core numbers
- pension plan earnings gains are excluded from corporate accountings
- restructuring costs are not added back in
S&P noted that when it announced its intention to introduce the core calculations in May , just two S&P 500 firms – Boeing and Winn Dixie – expensed options in their income statements. As of October 10, 110 firms had elected to do so, 58 of them in the S&P 500. Those 58 constitute more than a fourth of the total market capitalization of the index, according to S&P, which said it expects both the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) to require stock option expensing within two years.
The overall impact of stock option expense on the S&P 500 was $5.21/share for the 12 months to June 2002. S&P said that it would be reasonable to estimate that the option grants seen in the past few years typically represent about 8% to 10% of As-Reported earnings.
Year of Pension Accounting Review
However, S&P says that while 2002 has proven to be the “year of stock options,” the firm said that 2003 could be the year of pension accounting review. S&P noted that the disappointing stock market performance of the past three years has highlighted concerns about the adequacy of pension funding, particularly in view of the recent focus on the current accounting treatment of pension income.
Specifically, S&P said that current accounting methods make it difficult to track or discover the true state of corporate pension funding, while pension accounting under FASB 87 serves to smooth reported corporate income and “hides underlying volatility” in a company’s core business – particularly those firms in Telecommunication Services and Industrials, which have “large traditional workforces, often with unions, in companies with long histories”.
The calculation in Standard & Poor’s Core Earnings compares the actual return earned by the pension fund with interest costs. To the extent those costs are covered by the return on assets, the interest costs are not imposed on the sponsoring firm. However, when the actual returns do not cover the projected costs, S&P says, “the corporation must make up the difference.”
Under Generally Accepted Accounting Principles (GAAP), companies are permitted to include the net gains of its pension plan in its net income, even when that is not part of its core business. Those gains are calculated based on expected, rather than actual returns, a practice that S&P said tends to reduce the “true extent” of volatility in a company’s earnings.
S&P said that the pension interest costs not covered by the actual return on pension assets amounted to $4.50 per share for the S&P 500 for the 12 months through June 2002. Standard & Poor’s Core Earnings are likely to be more volatile than GAAP net income, in large part due to the treatment of pension interest costs, according to S&P.
S&P noted, “Virtually no pension fund ever earns its expected return.” However, S&P did note that while objections are often voiced about the use of expected returns of 9%, 12% or more in projecting pension fund returns – the annual total return on the S&P 500 for the twenty years ended in the third quarter of 2002, one of the worst on record – was 13.2%.