Boeing a trendsetter on stock option expensing

BY JOHN MORROCCO

The great hue and cry for increased transparency in corporate financial reporting following a series of accounting scandals and excesses has turned a bright spotlight on the controversial issue of stock option expensing, or, more to the point, the lack thereof.

Under current rules, companies are not required to account for the expense associated with share-based compensation plans in their financial results. But a growing number of investors, lawmakers and economists, including Federal Reserve Board Chairman Alan Greenspan, have argued that companies should reflect these expenses in their balance sheets in order to provide a true picture of their financial health to shareholders.

Last month several companies responded to the calls for reform and greater transparency. Coca-Cola, the Washington Post Co. and BankOne were among the first to announce they would change their practices and start expensing the cost of their stock compensation plans.

The Boeing Company, however, has no plans to change the way it reports share-based compensation. "Why's that?" you might ask. Because Boeing has since 1998 been doing what everyone is now calling for.

Until the recent change in attitude, Boeing was one of only two companies in the Standard & Poor's 500 stock index to recognize the expense of its share-based compensation plans in its financial results. At the time, the company adopted a different compensation model than stock options as the main share-based compensation mechanism for executives. In the process, a conscious decision was made to report clearly the expenses involved.

Boeing adopted "performances shares" rather than stock options as the main vehicle for long-term, executive incentive compensation. The company continues to grant stock options, but mainly as performance 38 awards for non-executive employees.

The shift was made in conjunction with a study conducted after the merger with McDonnell Douglas aimed at integrating all executives into a common compensation structure. A conscious decision was made to link executives' long-term compensation more directly to increasing shareholder value through significant stock price growth.

Like stock options, performance shares are designed to incentivize employees to increase shareholder value. Stock options can be exercised at any time after an initial vesting period during the maturity of the plan, usually five to 10 years. So even if the stock goes up only 5 percent a year, at the end of 10 years there can be a pretty handsome payout.

But rather than the time-vesting nature of traditional stock options, Boeing performance shares automatically vest when the company's share price increases to certain, incremental target levels. And those targets represent significant growth rates. A growth rate of 10 percent compounded annually for five years is required before performance shares start to vest. Essentially, that requires a 61 percent increase in the stock price to reach just the first threshold payment of 25 percent of the value of the performance shares. So there has to be a major increase in share price before the plan even begins paying out.

Boeing decided to do this even though the "performance-vesting" nature of the plan meant that it would be required to expense the costs under standard accounting rules. Basically, "expensing" the shares means deducting the cost of the payouts, as they occur, from company earnings.

The company also made the decision to adopt an additional accounting rule called FAS 123, created by the Financial Accounting Standards Board, an independent board that develops broad accounting concepts, as well as standards for financial reporting.

FAS 123 allows the company to record performance share expenses in an amortized fashion, spreading the expenses over the five-year life of the plan. This eliminates big swings in earnings that could otherwise result since it is difficult to predict when or whether the share price will reach the preset payout thresholds. With FAS 123, the value of the maximum possible payout under each annual plan is recognized as an expense over its five-year life. In 2001, Boeing took a $227 million charge to earnings for performance shares, even though no shares were converted during the year because of the decline in share price last year.

One stipulation of FAS 123 is that a company must treat all its stock compensation plans in the same manner. As a result, Boeing also expenses the cost of traditional stock options grants and its ShareValue Trust plan. The combined expenses show up in every quarterly earnings report that Boeing issues, along with a calculation of how they affected earnings per share, or EPS.

While Boeing's adoption of performance shares and the accounting requirements of FAS 123 may act as a drag on earnings, lowering earnings per share, it does provide investors with a clear understanding of the company's finances and total compensation picture.