Fitch: Bond Holders Have Option Expensing Stake

Fitch Ratings says there is a potential in the FASB’s Exposure Draft for long-term, cumulative distortions between the income statement, operating cash flow and equity. These distortions in turn add “additional levels of complexity for fixed income investors” that will necessitate adjustments to traditional measures of cash flow and leverage, according to a news release.

“While most of the controversy around this topic has been focused on the direct impact on earnings per share calculations and potential unintended consequences for cost of capital, employee options have a real and measurable cost for many companies,” Roger Merritt, Managing Director, Credit Policy, Fitch Ratings said in the release.  

“Interestingly, this proposal fails to fully recognize this cost through a periodic mark-to-market of the option’s cash value,” Merritt says.   Rather, Fitch finds the expensing of options as proposed in the FASB Exposure Draft will result in point-in-time estimates of compensation expense that may have no relationship with the actual cost.

Under the provision of the Exposure Draft issued on March 31, 2004, allforms of share-based payments to employees would be treated the same as other forms of compensation by recognizing the related cost in the income statement. The expense of the award would generally be measured at fair value at the grant date (SeeFASB Hands Down Option Expensing Proposal). 

“The proposed standard creates potential issues that from an investor’s perspective are clearly relevant. The full economic cost may never be reflected in operating earnings since there is no requirement to capture changes in fair value from period to period or adjust the original estimate to actual cost in the future,'” Joseph St. Denis, Senior Director, Accounting Research and Policy, Fitch Ratings said in the release.

To make the disclosure more relevant for purposes of fixed-income evaluation, Fitch Ratings says any final rule should include adequate disclosure requirements to allow investors to make appropriate adjustments to make up for the discrepancy in the point-in-time estimates.

A copy of the Fitch Ratings report, “Accounting for Stock Options: Should Bondholders Care? ,” is available on the Fitch Ratings Web site at  www.fitchratings.com .