ARM profits threatened by auditing reform

Silicon Fen waits nervously as the microchip maker considers dramatic changes to its accounting methods

ARM, the microchip maker which until recently was in the FTSE 100, is considering becoming the first major group in the UK to charge the costs of its share option programme against its profits.

The move could cut as much as a third off ARM's profits, which analysts are expecting could be around £66m this year. ARM's chief executive, Robin Saxby, is likely to make a statement when the group reports second-quarter profits of about £15m on Tuesday.

It is understood that ARM is in talks with its auditors, PricewaterhouseCoopers, about the change. Although it is hard to assess how the move would impact on this year's figures, analysts at Dresdner Kleinwort Wasserstein have estimated that if the options cost had been expensed against profits last year it would have cut ARM's after-tax earnings by 34 per cent.

One of the beacons of the Cambridge cluster of technology companies, ARM has been keen to promote share options as a way of retaining key staff. But the attractiveness of the perk has waned as the group's shares have fallen from a peak of 986p in March 2000 to just 138p in Friday.

The accounting change was recommended last week by the International Accounting Standards Board in the wake of accounting scandals at WorldCom, Enron and Xerox. Among the issues that have arisen has been the fact that the cost of share options given to directors and employees as part of their remuneration packages – often running into hundreds of millions of dollars – are not shown as an "expense" in the profit and loss account.

US standards require that the expected cost of the share options is shown as a note to the accounts. But Warren Buffet, the famous investor known as the Sage of Omaha, has long argued that this is the wrong way to deal with them, maintaining they should be shown as a cost because they cut the value of the investment for other shareholders.

US groups such as Coca-Cola, Washington Post and Boeing have said they will be treating the options as costs. A study in the US suggests that if all US companies were to follow suit, it could knock up to a fifth off total corporate profits and send well-known groups such as Eastman Kodak and Hewlett-Packard into losses.

A similar study conducted by Dresdner Kleinwort Wasserstein into European companies suggests the effect could cut corporate profits by a tenth.

DKW focused on the technology sector and pointed to groups such as Ericsson, Philips and SAP as being among those most vulnerable to this accounting change.

Sage and Computacentre are two other UK companies in the same sector as ARM who would be hit by the change. Neither of those currently shows the costs of its share options programme in its accounts, making it hard to estimate the costs accurately.

Outside the technology sector, GlaxoSmithKline and BP are among the companies with the widest share option programmes. The effect of the changes could knock hundreds of millions of pounds from their pre-tax profit totals each year. The IASB recommendation means that the new accounting standard is likely to be introduced in the next 18 months and will apply to all UK companies.

In a note written last week, Alan Brown, global chief investment officer of State Street Global Advisors, said: "It is easy to conclude that if we were to start taking a more conservative view of accounting, and in the wake of Enron and WorldCom et al this may be mandated, then we could easily wipe 20 per cent or more off corporate earnings."