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September 7, 2000

Tech Firms Hide Payroll Taxes On Employees' Stock Options
By Robert Mcgough And Mylene Mangalindan, The Wall Street Journal

More Evidence Of Massive Earnings Manipulation In This Tech Stock Mania! ... Weiss comments

NEW YORK - Nobody likes paying taxes, but some tech companies apparently like reporting them to their shareholders even less.

In their quarterly earnings announcements, businesses such as BEA Systems, Cisco Systems, InfoSpace, Qualcomm and Yahoo! are playing up a net-income figure that ignores the payroll taxes they owe when employees exercise stock options -- as if the taxes had never been incurred.

What a concept! In today's stock market, the companies are under heavy pressure to look as profitable as they can. By stressing an earnings figure that excludes the expense of the payroll taxes, they do look more profitable.

How are the companies able to do this? Thank Silicon Valley's brilliant innovations in the field of pro-forma earnings. At the top of the earnings releases that technology companies publish, they announce their pro-forma earnings. In the pro-forma number, companies get to include -- or exclude -- just about any revenue or expense that they want. The huge body of accounting rules only applies to the dreary official-income figure that shows up later in the news releases. Inevitably, pro-forma earnings are higher than this "generally accepted accounting principles" number reported lower.

Some expenses excluded from pro-forma earnings, such as costs associated with acquisitions, seem reasonable to exclude. They arguably aren't recurring, so their exclusion gives investors a better idea of how the day-to-day business is faring. But payroll taxes? Aren't they a cost of doing business?

To be sure, the payroll tax represents only a small portion of income for the companies that exclude it from the pro-forma figure. Still, nowadays, a penny in per-share income can have a big effect on a stock price. And some accounting experts and investors say the disappearing payroll tax is yet another example of the kind of wacky accounting that shows up in pro -forma income.

"When you're talking about e-businesses, they all come up with their own cookbook for what the earnings should be," complains Jack Ciesielski, publisher of the Analyst's Accounting Observer, a Baltimore newsletter. "It's kind of ludicrous."

The regulation of pro-forma income is up to the Securities and Exchange Commission. Robert Bayless, chief accountant in the division of corporation finance, says the SEC doesn't "have specific rules that go to presentation of alternative measures of performance," but that rules against "presenting misleading or unbalanced information applies to these sorts of things." He didn't specifically address the exclusion of payroll taxes.

Curiously, technology companies, which are often quick to claim credit for technological advances, hasten to give others credit for this accounting innovation. "Cisco, Yahoo and others are doing the same thing. We weren't the first," says Mr. Grannis of Qualcomm. At InfoSpace, which joined the no-payroll-tax parade during this year's second quarter, Ms. Hansen echoes: "Other tech companies have done this as well."

Not all tech concerns play down option-related payroll taxes, and Microsoft is now in this camp. The software behemoth doesn't report pro-forma income in its earnings releases, and "believes that payroll taxes should be included on the income statement as an expense," a spokeswoman says.

Looked at another way, not reporting payroll taxes as an expense is a little like recording a bigger deposit in your bank account than your actual paycheck. Hey, you didn't want to pay those FICA and Medicare taxes, so why don't you just pretend you didn't?

Unfortunately, most of us don't have that option. Amazingly, Wall Street technology firms do, because Wall Street, unlike your bank, doesn't protest the practice.

Not counting the payroll tax as an expense is just one of the many tricks that companies employ to beef up earnings. Generally Accepted Accounting Principles used to be, well, generally accepted. Now they are hardly adhered to by most companies. Tech companies, though, are by far the most egregious offenders, manipulating their earnings to the point where they don't give a clear picture of company earnings at all.

Keeping the payroll tax off the books works more to the advantage of tech companies that are notorious for offering huge stock options packages as a way to attract employees at a lower salary. When these employees cash in their stock options, tech companies don't have to claim it as an expense. This allows tech companies to issue robust earnings reports that Wall Street routinely praises. It doesn't matter to Wall Street if the actual earnings are much less -- by the time anyone looks at the company's SEC filing, the stock has already reaped the benefits of the media attention. It's time for the SEC to crack down on these misleading earnings reports.

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