Lead editorial on Monday 10/5/98 based upon Parish & Company Analysis.

Sometimes the biggest stories are those sitting there on your own front door step, but for some reason everyone chooses to ignore them. The accounting implications of Microsoft's employee stock option scheme might not immediately seem like one of these, but that's because most people do not realize the extent to which the software goliath has been paying its workers in shares.

As an example of the speculative froth that has built up on Wall Street over the past five years, the Microsoft employee share option scheme, taken together with the company's hedging activities in its own stock, takes some beating. Indeed what Microsoft has built for itself could reasonably be viewed as a financial pyramid.

A potentially vast, unrecognized liability has been accumulated. And its relevance to us here in the UK? Microsoft's share price has so far proved remarkably resilient to the correction in markets. Even a worldwide slump is not going to stop Bill Gates, is the general view. But can this really be true? Is not the rise and rise of the Microsoft share price the Wall Street bubble in microcosm?

Like most US technology companies, Microsoft has had to promise big stock options in order to attract the caliber of employee it needs to stay competitive. Its own chief financial officer has admitted that but for payment in stock yet to be exercise, the company's wage bill - its main cost - would be two to three times higher than it is. The effect has been to establish a potential liability running to some $34 billion, or eight times annual net income.

Some of this liability has been hedged, either by buying Microsoft stock directly, or by selling put options in the market - that is selling investors the right to put their shares in Microsoft on the company at a predetermined price. But a large and undefined part of it appears not to have been.

According to Parish & Company Portfolio Managers, an Oregon-based consultancy, if this liability were adequately accounted for, then Microsoft and some other leading Wall Street technology companies wouldn't make any money. Already, the valuations put on these companies might seem stretched enough at upwards of 50 times earnings, but if it were generally accepted that the emperor had no clothes at all, then they would seem like pure fantasy.

What Microsoft should perhaps be doing given the importance of these options as a way of remunerating staff is accounting for them against profit as if they were an ordinary cost. Present accounting rules in the US do not require that Microsoft do this, for it would destroy the illusion of profit if they did.

And yet the only reason people want to go and work for these companies is that they are offered stock in an enterprise whose share price only seems to go up. It can readily be seen that Microsoft and others have created for themselves not only a very large potential liability, but also a serious operational problem should the stock head south, as it is now beginning to, and employees' expectations are disappointed. But that, as they say, if only the half of it.

Microsoft has also been selling put options in its own stock on a grand scale. You may well ask what a serious commercial company is doing speculating in its own stock, but actually they do it all the time before these days - a process we have come to know as share buybacks.

In theory, selling a put option is no different. But in practice it may very well be, since Microsoft actually books the money it earns from selling options in its own shares. Last year it earned hundreds of millions of dollars in this manner. If the stock plunges through the value of the option, as it is almost bound to in a crash, then Microsoft has to fund the difference. Again this would seem a highly dangerous and speculative activity for a company whose business is not that of investment banking but one of designing and selling computer software.

It may seem odd that a company made up of such self evidently clever people could allow itself to become as exposed as this. You could argue that if the stock collapses, then it's nobody's problem but that of the employees, since it is the value of their share options that disappears down the plug hold and Microsoft's liability with it.

But just as the illusion of profit would be shattered by proper accounting for this form of remuneration, so too would be the illusion of wealth once the fragility of the structure it is built upon is realized. Isn't that rather what's happening to financial markets as a whole right now?