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Intel mini-case

(Employee Stock Options)

The accounting for executive stock options has had a long and contentious history. The original standard relating to the accounting for ESOs was APB25, passed in the early 70’s. At that time little was known about the valuation of ESOs and the prevailing thinking was that they had no value if the exercise was set equal to the market price on the date of grant. As a result, APB25 did not require companies to report compensation expense if they set the strike price equal to the market price.

Since that time, we have come to understand that options do, indeed, have value even if the strike price is set equal to the market price and users of financial statements pressured FASB to recognize this value as compensation expense. Following a decade of debate, FASB finally passed SFAS123 that prescribes new accounting rules for ESOs. Under this standard, companies are encouraged, but not required, to report option value as compensation expense in determining net income. Should they elect not to do so (virtually none do), then they are required to footnote the income effects.

This mini-case is designed to give you an understanding of the accounting for ESOs and their effect on shareholders. Attached are excerpts from Intel’s 2002 annual report. Please answer the following questions:

1. Look at Intel’s footnote relating to employee benefit plans: stock option plans. How many shares (in millions) are under option at 2002? What is the exercise price? How many shares are exercisable? What do you think is the difference between these two definitions?

2. One of the detrimental effects of ESOs cited by critics is their dilutive effect on EPS. To what extent has this been a factor for Intel? Hint: see note 3. Another hint: diluted EPS adds the net increase[1] of exercisable options. Is dilution the proper measure of option cost for Intel?

3. Let’s look at the dilution issue another way. How many shares have been issued due to the exercise of ESOs over the past 3 years? Many companies repurchase shares on the open market to offset the dilutive effects of ESO exercise. How many shares has Intel repurchased over the past 3 years and at what dollar cost? How does the stock repurchase cost compare to Intel’s earnings over the past 3 years? Its net cash flow from operations?

4. Look at the ESO footnote reproduced below. How much would Intel’s 2002 reported profit been reduced had the company accounted for the value of these options as compensation expense? What would have been the effect on EPS?

5. Have existing shareholders been harmed as a result of these stock options?

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[1]The net increase is the number of shares issued due to option exercise less shares repurchased with option proceeds.

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