Editor

In the scandal-ridden business world - where allegations of accounting manipulations and insider trading have been flying like chopped food out of an untopped Martha Stewart food processor - biotechnology, like every other sector, has been spattered.

It's a mess.

The proposed cleanup involves (among other things) making CEOs more directly responsible for their balance sheets and changing the way companies keep track of what they pay, how they pay it, and to whom.

Late last month, the SEC ordered senior officers of all publicly traded firms with revenues of more than $1.2 billion during the last fiscal year that's 947 companies to file written sign-offs regarding their companies' financial statements. If the officers can't do so, they have to explain why.

Most companies' filings were due last week, and among those complying were Amgen Inc. and Genzyme Corp., which sent to the SEC letters that now bear the stampings and scribbles of legal and officially filed documents.

The governmental act of requiring company officials to declare separately that their financial reports are not lies is a plain reflection of how low the repute of business has fallen in recent months, and the letters themselves seem to stand as even grimmer proof.

"I, Kevin Sharer [CEO and board chairman of Amgen], state and attest," begins the Amgen letter, which goes on to promise that "no covered report contained an untrue statement of a material fact" and "no covered report omitted to state a material fact necessary to make the statements of the covered report."

Neither company is in any trouble, but Genzyme's letter from CEO Henri Termeer uses similar, congressional hearing-type language.

Also, in July, President Bush signed into law the Sarbanes-Oxley Act, which (among other things) reinforces the SEC rules for all companies and threatens criminal sanctions if they are not followed.

Drawing even more interest are proposed alterations, sought by accounting boards and by legislation, in the way companies account for employee stock options, which often are offered as incentives to new hires. (See BioWorld Financial Watch, April 29, 2002.)

The Financial Accounting Standards Board has met twice this month, taking up the issue of whether to call for listing ESOs as expenses like any other among the company's profits and losses, rather than in footnotes as a pro forma expense.

The FASB examined the idea as long ago as the mid-1990s, but gave it up. Now, the prospect worrisome to biotechnology in particular is back, and with something of a vengeance, said Steve Lawton, vice president for regulatory affairs and general counsel of the Biotechnology Industry Organization.

"There's no question FASB is moving quickly on it," he told BioWorld Financial Watch. "We're very worried that requiring the expensing of stock options would compete with the need to attract and recruit young physicians and scientists."

Right now, two standards rule ESO accounting. One, used by many biotechnology firms, is Accounting Principles Board No. 25, put in place 30 years ago. It allows companies to use "intrinsic value" when figuring the cost of options. Intrinsic value is the difference between the market price of the stock and the exercise price.

The other is the FASB's own rule, Statement 123, the one that dates back to 1995 and recommends the "fair value" method, which is based on an option-pricing model such as the Black-Scholes option-pricing algorithm one that has been criticized for its lack of accuracy. The problem is that ESOs have no value unless vested; it could be said that, at issuance, they are "worth" nothing.

An analysis by Salomon Smith Barney found that using the fair-value approach would mean a net income reduction of between 30 percent and 32 percent for the larger-cap, profitable biotechnology firms. Of those, less likely to be hurt to that degree are Amgen Inc. and Biogen Inc.; firms with more at stake include IDEC Pharmaceuticals Inc., Genentech Inc. and MedImmune Inc., with the last being most affected to the tune of as much as 54.4 percent.

Others have done similar analyses and, although their percentages differ, the estimates are not encouraging.

What's going to happen? At the FASB's most recent meetings last week and the week before, the board (according to a written decision) moved to "undertake a limited scope project to reconsider the transition and disclosure provisions of Statement 123." It "tentatively decided" to let companies using 123's fair-value method choose from one of three "transition methods."

The firms may elect to recognize stock compensation costs for the year of changeover to 123 only for those awards granted after the start of that fiscal year. In other words, they may prospectively apply 123 only to new awards.

Or they may recognize the cost for the changeover year equaling what would have been recognized if FAS 123 had been adopted when the rule was made effective in 1995. That is to say, they may prospectively apply 123 to new awards and unvested portions of awards granted since 1995.

Or they may recognize the cost for the changeover year and restate prior years' financial statements as though 123 had been adopted as of its 1995 effective date so the cumulative effect of retroactively applying 123 would not be reflected as of the beginning of the earliest year that 123 is applied, but the effects would be shown yearly in the statements since 1995.

When FASB came up with 123, it wanted to require that method of accounting, but opposition from Congress and others "directly threatened the existence of the FASB as an independent standard setter," said the board in one of its papers. So disclosure in footnotes continued to be allowed.

Retroactive restatement of financial reports wasn't considered with the original 123 because the impact of expensing options wasn't known, but the footnote disclosure of the pro forma impact of options has made the matter clearer, said analyst Joseph Dougherty with Lehman Brothers, who has been following the subject.

As Lawton pointed out and as many had predicted, recent meetings of the board suggest the picture is about to change. Dougherty believes FASB won't begin talks to require expensing ESOs until after the International Accounting Standards Board yet another "independent standard setter," this one based in London finalizes its position early next year. The IASB is seeking comments on the issue until Oct. 31.

If the FASB ultimately insists that companies include their previously granted options in expense reports, the change could be a jolting transition for some. Dougherty noted in a research report early this month, before either of the FASB meetings that "the current FAS 123 suggests the ramp rather than the leap to steady state, but FASB appears to believe that this guidance is stale and that companies have been on notice about the ESO expense for long enough to move immediately to the steady state."

Whatever IASB decides will become "a roadmap to FASB-mandated option expensing" in the U.S. in 2004, he added.