Wednesday September 30, 1998 5:00 am Eastern Time

Company Press Release

SOURCE: Parish & Company

Back to Parish & Company Home Page

Employee Stock Option Accounting Implications: Microsoft, Cisco Systems, Long-Term Capital, Convergence Asset Management, FASB, Alan Greenspan & Federal Reserve, Robert Rubin & Treasury, Janet Reno & Department of Justice, Art Levitt of SEC, Ralph Nader, John McCain, Carl Levin, & Bill Archer

PORTLAND, Ore., Sept. 30 -- Bill Parish of Parish & Company Portfolio Advisors of Portland, Oregon today released an official response to numerous inquiries made based upon a press release issued on Monday 9/28/98 regarding the accounting for employee stock options based upon the 1997 10K SEC filings for Microsoft and Cisco Systems. This response includes an update based upon 1998 SEC 10K filings made this week. .

Based upon this updated analysis of Microsoft and Cisco Systems 1998 10K filings and the near failure of the Long-Term Credit Corp hedge fund last week, Parish & Company now officially adopts the position that the Financial Accounting Standards Board (FASB) should report to and be overseen by Arthur Levitt and the Securities and Exchange Commission (SEC) for the purpose of instituting accounting reform in order to restore confidence and stability to the global capital markets. More independent oversight is needed from outside the accounting community.

It is now also the official position of Parish & Company that Robert Rubin of the Treasury Department, Alan Greenspan of the Federal Reserve, John McCain, Carl Levin, & Bill Archer in the U.S. House of Representatives, Ralph Nader, Consumer Advocate and Janet Reno of the Department of Justice should collaborate and intervene on the SEC's behalf to affect this change immediately and eliminate the speculative bubble created by employee stock option accounting which could seriously disrupt the financial system. This is particularly important given that these hedge funds are using technology securities to justify leveraging derivative based investments.

In a related position, Parish & Company now also adopts a stance that the anti-trust case against Microsoft scheduled for October should be dismissed. This position is based upon the rationale that technology products become rapidly obsolete and that Microsoft's core strength is instead the ability to hire and retain smart, highly motivated, creative and dedicated employees. A key part of this strategy is to liberally issue employee stock options and when the cost of these options is not recorded on the financial books, earnings are overstated and lead to an inflated stock price and the capacity to continually hire this top talent. It is rather surprising that options granted in fiscal 1998, per the 10K filing this week, already have a overall market value in excess of the exercise price of $3.6 billion. That alone eliminates more than 50 percent of the entire net income for 1998.

By achieving accounting reform in this area, large dominant technology firms including Microsoft and Cisco Systems will most likely be more conservative in issuing stock options which will in turn channel more of these top workers back toward smaller newer firms able to issue stock options more liberally. This will also allow companies in older established industries to compete with Microsoft and Cisco Systems on a more level playing field given that these firms typically do not issue stock options. Simply put, earnings will be comparable again and stocks will be valued accordingly.

If such accounting reforms were instituted for employee stock options, the net income for Microsoft and Cisco Systems would be restated as follows for fiscal year 1998. This is based upon requiring two changes. The first change would require that compensation expense taken on their internal tax books be also reflected on the external financial statements. The second change would require accruing an expense for 15 percent of the remaining future obligation outstanding, effectively amortizing this future liability over 6.5 years. A review of the last 3 years, per the 10K, indicates between 16 and 19 percent of options outstanding were indeed exercised the following year.

Microsoft's Chief Financial Officer did note in a 12/4/97 Wall St. Journal article by Roger Lowenstein that this obligation to employees ``is probably the most important liability we have.'' This would seem to present a strong case to institute these reforms, restate earnings as follows and help stabilize the global capital markets. His remarks came when the liability was $26 billion. It has now grown to $40 billion, almost 10 times annual net income based upon the 10K SEC filing made this week and Parish & Company calculates that this will grow by $2.2 billion for every $5 increase in the price of Microsoft's stock. Cisco Systems liability has similarly grown to $15 billion, more than 10 times their record setting annual net income.

                                                   Microsoft     Cisco Systems

    Fiscal Year 1998 Net Income per SEC 10K           $ 4.5          $ 1.3
    Less After Tax Expense Taken on Tax Books
     for Employee Stock Options per 10K                 2.9             .8
    Adjusted Income                                   $ 1.6           $ .5
    Less:  After Tax Amortization of 15 percent
     of Remaining future Liability for Stock Options
     at end of Fiscal 1998
      Microsoft  ($40B x .15 x.65)
      Cisco Systems ($15B x .15 x.65)                   3.9            1.4
    Restated Earnings per Parish & Company Analysis    (2.3)           (.9)

An estimate of the restated price earnings ratio is not possible since this restatement of earnings indicates that both companies have a net loss for fiscal year 1998 after reporting the deduction for the exercise of options that was taken on the internal tax books and accruing for 15 percent of the remaining future obligation to employees outstanding. A common error is to relate the cost of stock options to the overall market value of the stock rather than the operating results of the business. After adjusting net income to reflect this compensation expense, net income can then be related to the market value of the stock. The combined market value of Microsoft and Cisco Systems is now more than $380 billion.

Parish & Company maintains that with this restatement both Microsoft and Cisco Systems, even though great industry leading companies, are indeed unprofitable businesses. Investors appear to be in a mathematical vice given that every $10 increase in the stock eliminates more than 25 percent of annual net income, even before making the above adjustments.

Most unusual about the accounting for employee stock options is that for fiscal year 1998 Microsoft received a cash benefit of $2.5 billion which financed almost 30 percent of their entire annual operating expenses. This came in two pieces, the first being employees paying the exercise price to get options and secondly from the IRS in the form of reduced taxes by taking a $4.4 billion deduction for compensation expense on its tax return. Many top CPAs see this as a positive impact but a closer look reveals the obvious, employees are prepaying their own wages in a massive pyramid scheme.

As index mutual funds are forced to continue purchasing these shares based upon inflated earnings, Parish & Company also maintains that a classic asset bubble is being created in capital markets and will contribute to additional financial difficulties unless reform is initiated. The largest index fund, the Vanguard Index 500, is now the second largest mutual fund in the country and a prominent fund in many 401K retirement plans.

In an unrelated matter, Parish & Company also notes that Microsoft earned $538 million in 1998 from selling put options on their own stock. Not disclosed is the average strike price and risk exposure if their stock were to decline sharply. This is clearly a highly speculative hedging activity that requires more in depth disclosure.

Three related articles of interest regarding the accounting of employee stock options include the following: ``Stock options are not a free lunch'' by Gretchen Morgenson of Forbes Magazine May 18, 1998 (Cover story), ``Coming Clean on Company Stock Options'' by Roger Lowenstein of the Wall St. Journal on 6/26/97 and ``Cracking the Books: Cisco: Talk About Wage Inflation!'' by Kevin Petrie of on 9/21/98.

Parish & Company is an independent Fee Based Investment Advisor to Individuals, Trusts and Retirement Plans based in Portland, Oregon. The firm produces objective financial analysis based upon accounting facts, manages individual and trust investment portfolios and advises companies on how to improve their retirement plans by providing independent oversight utilizing an employee based benchmark system. No fees are accepted from the investment industry, either directly or indirectly. Bill Parish can be contacted through the following web site at or by phone at 503-643-6999. 

SOURCE: Parish & Company

Back to Parish & Company Home Page