A vested present value approach to valuing employee stock options.
The Financial Accounting Standards Board's (FASB) Stock Compensation project is one of the most controversial projects that the FASB has considered since its inception over two decades ago. In the early 1980's, the FASB was asked by the Securities and Exchange Commission, the AICPA's Accounting Standards Executive Committee, large accounting firms, industry representatives, and others to reconsider accounting for stock-based compensation. In June 1993, the FASB issued an Exposure Draft (ED) on an accounting standard that would have replaced Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) requiring fair value accounting for stock-based compensation. After lengthy debate and considerable controversy, the FASB issued Statement of Financial Accounting Standards No. 123, Accounting of Stock-Based Compensation (FAS 123).
FAS 123 encourages, but does not require, companies to recognize compensation expense for stock options and other equity instruments issued to employees based on the fair value techniques recommended in the Exposure Draft. Companies that do not adopt the fair value method are required to apply the previously existing accounting rules outlined in APB 25. Although fair value expense recognition for stock-based compensation is not mandatory, FAS 123 does require companies using the APB 25 guidelines to disclose pro forma net income and earnings per share under the fair value method. In addition, all companies with stockbased plans are required to make detailed disclosures about plan terms, exercise prices, and the assumptions used in determining fair value.
This paper reviews the issues surrounding accounting for stock-based compensation, and proposes an alternative vested present value method" for recognizing stock-based compensation expense during the service period. The first part of the paper discusses the historical development of accounting for stock-based compensation. The next section reviews the authoritative literature to discuss the major theoretical issues surrounding the stock-based compensation debate. Section III presents an alternative method for recognizing compensation expense that provides a potentially more reliable measure of total compensation cost than either FAS 123 or APB 25. Finally, section IV summarizes our conclusions and discusses the theoretical benefits that the proposed method provides over the other two methods.
ACCOUNTING FOR STOCK-BASED COMPENSATION
The controversy over accounting for stock based compensation is not a new issue. Many of the same issues that the FASB has debated over the last ten years were originally discussed by the Committee on Accounting Procedure (CAP) in 1953 in Chapter 13B of Accounting Research Bulletin (ARB) No. 43. (These issues were originally considered in ARB No. 37, issued in November 1948. However, ARB No. 37 was revised in 1953 to include consideration of stock purchase plans and recast as Chapter 13B of ARB No. 43.) Chapter 13 considers whether stock option plans are compensation and, if so, when this cost should be measured. The Committee determined that options do have value and should be measured on the date they are granted. However, because these instruments are unique and subject to various restrictions, the Committee recognized that it would be impractical to measure this value. Consequently, it recommended that compensation cost be recorded for the excess of the fair value of the shares over the option price. Realizing that market quotations of stock price were not necessarily conclusive evidence of fair value, the Committee was careful in referring to the fair value of the shares optioned rather than the market quotation of the shares.
In the early 1970's, as the use of employee stock options became more prevalent and the compensation plans became more complex, the Accounting Principles Board revisited the question of accounting for stock issued to employees. APB 25 requires that compensation expense be measured on the first date at which both the number of shares and the amount to be paid for the shares (the exercise price) are known. If both the exercise price and number of shares are known (or fixed) at the grant date (referred to as a fixed plan), compensation expense should be recorded for the difference between the market price of the stock and the exercise price on the grant date (APB 1972, 24).
When the number of shares or the exercise price is not known at the grant date, APB 25 requires that an expense be recognized for the excess of the stock's market price over the exercise price (i.e., intrinsic value) on the exercise date. Prior to exercise, compensation expense is estimated each period based on the award's intrinsic value. Thus, compensation expense for these plans (referred to as variable plans) varies each period up to the measurement date (APB 1972, [paragraph] 29).
The fair value method of FAS 123 measures expense at the grant date for both fixed and variable plans. FAS 123 does not apply to noncompensatory stock plans. An employee stock purchase plan that satisfies all of the following conditions is considered a noncompensatory plan:
1. The plan incorporates no option features.
2. The discount from the market price does not exceed the greater of (a) a per-share discount that would be reasonable in an offer of stock to stockholders or others or (b) the per-share amount of stock issuance costs avoided by not having to raise a significant amount of capital by a public offering.
3. Substantially all full-time employees may participate.
All other plans are classified as compensatory and are subject to the requirement to recognize compensation cost in accordance with FAR 123 or APB 25. Under this method, the fair value is estimated on the grant date using an option-pricing model (for example, the Black-Scholes or a binomial model) that takes into account the exercise price and expected life of the option, the current price of the underlying stock, its expected volatility, expected dividends, and the risk-free interest rate for the expected term of the option. This fair value estimate is not subsequently adjusted for changes in the price of the underlying stock or its volatility, the life of the option, dividends on the stock, or the risk-free interest rate.
If a company elects to use the fair value method but it is not possible, or feasible, to reasonably estimate the fair value using the models mentioned above; then, the fair value can be determined using the market price and other factors on the first date they become available, which generally is the vesting date. Firms not electing the fair value technique will continue to use the methods identified in APB 25. In the next section, we identify and discuss some of the conceptual issues and concerns surrounding accounting for stock-based compensation.
THEORETICAL JUSTIFICATION FOR EXPENSE RECOGNITION
The primary controversies surrounding the issue of accounting for stock based compensation include whether these instruments represent an expense that should be recognized in the income statement and, if so, when they should be recognized and how they should be measured. These issues are simple to state and understand, but their resolution is complex and highly controversial.
Recognition of Compensation Cost
The first issue that must be considered is whether stock compensation is an expense that should be recognized in the income statement. Expenses are defined as "outflows or other using up of assets or incurrences of liabilities ... from providing goods or services" (FASB 1985). Wolk and Rozycki (1994) argue against recognizing an expense. Their argument is that even though employee stock options are valuable to the recipient, they do not represent the consumption of an asset or incurrence of a liability by the granting entity. As such, there is no cost to the company and no expense should be recognized in the income statement.
This reasoning, however, seems to suggest that the form of the compensation rather than its substance should drive expense recognition and is inconsistent with existing accounting principles. Specifically, the issues surrounding the valuation of employee stock options and the recognition of stock compensation expense are similar to those associated with valuing and recognizing expenses for defined benefit pension plans. In arriving at its decision to recognize pension costs in the period in which the employee renders the service, the FASB focused on the fact that a defined benefit pension plan represents an exchange between the employer and employee. The employee provides services, and in exchange the employer provides an amount of retirement income (SFAS No. 87, [paragraph] 79). Pension costs are, therefore, contingent upon future events and require estimates of future events which determine the future benefits that will be paid (SFAS No. 87, [paragraph] 82). While these estimates generate uncertainties that make it difficult to measure the amount of pension cost to be recognized, the FASB noted that cost recognition over the employee's service period was a fundamental objective (SFAS No. 87, [paragraph] 95) and that information based on such estimates is useful (SFAS No. 87, [paragraph] 82).
Stock based compensation possesses a number of characteristics that are qualitatively similar to those of defined benefit pension plans. As with defined benefit pensions, stock based compensation is the result of an exchange between the employer and employee just as a defined benefit pension plan. The employee provides services, and the employer provides stock options whose value is contingent on future stock price. Thus, similar to defined benefit pensions, stock based compensation involves exchanging services in the current period for an unquantified amount of compensation in a later period that is contingent upon a future event. Because of this contingency, estimates are necessary to value employee stock options and determine the amount of cost to be recognized. While it is true these estimates generate uncertainties about value and the costs to be recognized, cost recognition should be the fundamental objective and information based on estimates can be useful just as it is with defined benefit pension plans.
Given the similarities between stock based compensation and defined benefit pension costs, an expense should be recognized for employee stock options just as pension costs are recognized for defined benefit pension plans. The FASB agreed with this assessment in their exposure draft on stock based compensation, noting that nonrecognition of employee stock option costs produces financial statements that are neither credible nor representationally faithful (FASB 1993). (This view is further supported in SFAS No. 87 where the FASB notes that "Footnote disclosure is not an adequate substitute for recognition" and "The usefulness of financial statements are impaired by each omission of an element that qualifies for recognition.") However, in December 1994 the FASB moved away from an expense recognition position to a "disclosure only" approach. In announcing this decision, the Board stated that "there wasn't enough support for the basic notion of requiring expense recognition," even though they remained convinced that options have value and are compensation (Beresford 1995). Disclosure, however, does not eliminate the need to recognize compensation cost stemming from the employee stock options in the financial statements. Paragraph 9 of FASB Concepts Statement No. 5 states:
"Since recognition means depiction of an item in both words and numbers, with the amount included in the totals of the financial statements, disclosure by other means is not recognition. Disclosure of information about the items in financial statements and their measures that may be provided by notes or parenthetically on the face of financial statements, by supplementary information, or by other means of financial reporting is not a substitute for recognition in financial statements for items that meet recognition criteria" (FASB 1984).
If one accepts that stock-based compensation should be recognized as an expense, then the more difficult issues of when and how that cost is to be measured must be addressed.. The next two sections discuss the problems of determining the value of these options.
In the early 1950's the Committee on Accounting Procedure noted that the principal problem surrounding accounting for stock-based compensation was how it was to be measured. Chapter 13 of Accounting Research Bulletin 43 discusses six possible dates for measuring compensation expense related to stock based compensation: the date the plan is adopted (adoption date), the grant date, the vesting date, the earliest possible exercise date, the actual date the options are exercised (exercise date), the date the grantee disposes of the stock acquired (disposal date). The committee quickly eliminated the adoption and disposal dates because they are not relevant to identifying the costs to the granting corporation. The committee also noted that the date on which the grantee may first exercise the option will generally coincide with the actual exercise date and, as such, there is no substantive difference between these dates. Later the FASB considered the three remaining dates (grant date, vesting date, and exercise date) and concluded that valid conceptual arguments support measuring compensation on each of these dates (FASB, 1993).
The grant date is the date the employer determines the number of options to be granted to the employee and the terms of those options. Grant date accounting involves recording an asset for an amount equal to the options fair value on the grant date, and amortizing the asset ratably over the period(s) that the related employee services are rendered. The grant date is theoretically appealing because it is the date the employer commits to the transaction and the employee, by continuing to work for the required service period, controls whether the options are exercised.
The appropriateness of this argument is illustrated by the Committee on Accounting Procedures comment that if the option "were granted as a form of supplementary compensation other than as an integral part of the employment contract..... it follows that the value of the option at that time (grant date).... which for accounting purposes constitutes whatever compensation the grantor intends to pay". The committee also noted that the grant date is "the date on which the corporation forgoes the principal alternative use of the shares which it places subject to option" (Committee on Accounting Procedure 1953).
An alternative to the grant date approach is to measure compensation expense on the date the employee fulfills all the service requirements of the compensation agreement and the option vests. The vesting date is the date on which the grantee has performed any conditions precedent to exercise of the option (Committee on Accounting Procedure 1953). As such, this is the first time that the employer is obligated to allow the options to be exercised. Prior to vesting the employee stock option agreement is merely an executory contract between the employer and employee. Only after the employee has provided the services required under the option agreement is the employer obligated to make the options described in the employment contract available to the employee. Employees that do not provide the service stipulated under the option agreement do not earn the right to exercise the options allotted to them.
Advocates of vesting date measurement also consider it to be consistent with accounting for the issuance of similar equity instruments to third parties for cash (FASB 1993, [paragraph] 87). Swieringa (FASB 1987, p. 560) uses the analogy of accounting for a warrant that is contingent on an uncertain future event. Prior to vesting, the employee does not have the right to exercise the option because they have not provided all the services required under the exchange agreement. As noted above, the stock compensation agreement is still an executory contract between the parties. Once the employee has provided the requisite services required under the stock compensation agreement, the options vest and the employee has the right to exercise the options during the exercise period. In effect, the employee is now in the same position as the holder of a stock purchase warrant, in that he or she has the right to acquire shares of stock at a certain price during a specified period. The choice of when to ultimately exercise the option is then an individual investment decision of the employee. Thus, any subsequent change in the market price should not affect the company's total compensation cost.
The recognition of compensation expense over the service period focuses attention on the vesting date (FASB 1987, p. 559). The accrued compensation expense is estimated at the end of each service period until the vesting date when the actual total compensation cost is known. There are some measurement problems for the intervening period between the date of grant and the vesting date, but these are not uncommon accounting problems.
The third potential measurement date is the date the option is exercised by the employee. Proponents of using the exercise date argue that employee stock options are a contingency until they are exercised or lapse. Thus, the ultimate value of these options cannot be determined until the exercise date (Bohan 1979). The accounting under this approach would be similar to the accounting for stock appreciation rights, where compensation costs would be accrued each year until they are exercised or lapse (Balsam 1994). This method has the advantage of being simple and straightforward. It also produces symmetry between the compensation cost recognized by the employer and the value received by the employee. However, as pointed out in the vesting date discussion above, the services have been performed and the options earned over the vesting period. The decision to exercise is an individual investment decision that is determined based on personal preferences, such as risk preferences (see Huddart 1994). Thus, using the exercise date as the measurement date would lead to compensation expense being a function of personal investment decisions rather than the services performed by the employee.
Each of the possible measurement dates discussed above have conceptual merit and were considered by the FASB in their deliberations prior to issuing the exposure draft. Most Board members thought that a reasonable conceptual case could be made for either the vesting date or the grant date (FASB 1993, [paragraph] 99). In the exposure draft, the FASB decided to focus on grant date measurement because this is the date that both parties agree to the terms of the stock compensation arrangement. Some FASB members were concerned about the volatility in interim reported compensation cost that might result from using the vesting date or the exercise date. However, FASB Chairman Beresford, in an interview shortly after the ED was issued, stated that "most FASB members agree that the vesting date is at least as conceptually appropriate for measuring option value as the grant date, and the use of the vesting date might eliminate the measurement difficulties that were inherent in the exposure draft position" (Bureau of National Affairs 1994). In Section III we offer an alternative vesting date model that seems to minimize some of the problems inherent in the grant date approach.
The final issue in accounting for stock based compensation involves measuring the fair value of employee stock options (ESO), which determines the amount of compensation expense. This is, perhaps, the most controversial issue surrounding the stock compensation debate, and as a result the most difficult to resolve. The fair value of an ESO is driven by two elements: the intrinsic value of the option and its time value (Robbins 1988, p. 567). The intrinsic value is the difference between the exercise price of the option and the market price of the underlying stock on any given date. This value will be positive when the price of the underlying stock increases above the exercise price. When the stock price is below the exercise price, however, the intrinsic value of the option is zero. Thus, the option holder can benefit from upward price movements, but will not experience direct losses from downward price movements. (If the stock price falls below the exercise price, the option holder will simply choose not to exercise the option.) The time value of a stock option reflects the one-sided risk-reward characteristics of an option. The option-holder benefits from the stock appreciation without having to purchase the underlying stock. The time value decreases as the measurement date approaches and will be zero on the measurement date.
The difficulties in measuring the fair value of stock based compensation lies in identifying a clear, objective method for determining the fair value of the option's intrinsic value and time value elements. The FASB concluded in the ED that option pricing models provide the best measure of an ESO's fair value. They preferred these models because they consider the volatility value of the option; whereas, other approaches such as discounted cash flow techniques do not.
The FASB's primary argument for using option pricing models to value ESO's was that the resulting fair values and compensation cost would provide more useful and relevant financial information (FASB 1993). However, the overwhelming message from the public hearings and comment letters was that there was a need for a more reliable measurement of compensation cost than that suggested in the Exposure Draft (Coopers & Lybrand 1993, p. 23). Accounting information is reliable to the extent that it is verifiable, representationally faithful, and reasonably free of error and bias (FASB 1980). Most discussants agreed that the ED provided better neutrality than APB 25 (see Coopers & Lybrand 1993). However, these discussions also identified three critical limitations of option-pricing models that lead to serious concerns about the verifiability and representational faithfulness of the resulting fair value estimates.
First, option-pricing models generate only a mathematically derived "theoretical" value, which is based on a series of assumptions which may or may not be valid in the context of employee stock options. For example, Huddart (1994) illustrates how the assumption that all ESO's recipients are risk neutral may be inappropriate and discusses the impact this error has on option valuation. Because of the broad-ranging nature of these assumptions, the characteristics of ESO's, and the fact that no market exists for this type of stock option, there is no way to determine if the theoretical value approximates the fair market value of the option. The existence of vesting privileges, early exercise provisions, and trading restrictions further complicates the scenario. Such distortions in the foundations underlying these models leads to the perception that the resulting information is not representationally faithful.
Second, all option-pricing models have limitations. Many of the factors that influence fair value are based on expectations of the future that cannot be fully or accurately captured in a model. Even complex valuation models greatly simplify reality. For example, the models suggested in the exposure draft do not incorporate expectations of supply and demand, possible government actions, and changes in the economy, all of which may affect fair value. In addition, option-pricing models are usually designed to price short-term traded options, not long-term options subject to forfeiture and transferability restrictions. Again, these factors generate concerns about the representative faithfulness and reliability of option pricing model estimates.
Finally, values derived from option-pricing models are subjective estimates that are not necessarily comparable across entities or consistent across time. While many of the input variables are somewhat objective, three of the variables (expected volatility, expected dividend yield, and expected term of the option) require highly subjective estimates. Even though these inputs are discretionary, small shifts in these variables can dramatically alter an option's value. For example, the FASB ED illustrates how, using the Black-Scholes option-pricing model, an option with a 6 year term, 30% expected volatility, and 1.5% expected dividend yield has an estimated fair value of $18.10. The sensitivity of this value to changes in the three subjective variables is illustrated in Figure 1, where all three of the subjective variables are adjusted up or down by 50 percent. As the table indicates, adjusting the variables by 50 percent produces a greater than 50% change in the option value, ranging from a low of $7.87 to a high of $29.23.
This illustration highlights how the estimated option values and related expense levels under the ED can vary significantly, depending on the assumptions used in the option pricing models. Although all assumptions affect option value, assumptions about stock price volatility and expected exercise term have the most significant impact on option value (Coopers & Lybrand 1993, p. 65). The non-verifiability and highly sensitive nature of these subjective inputs has generated considerable concern about the reliability of the resulting option values (see e.g. Huddart 1994). These measurement problems lead to questions about whether the perceived need for a new standard is justified and whether the benefits to be derived justify the costs. Most of the concern is not driven by the cost of changing accounting practices and ongoing compliance, but the cost and inefficiency imposed in the marketplace by highly subjective and volatile expense measurements that lack comparability across companies. Relevant financial accounting information means that the information has either predictive or feedback value capable of making a difference in a decision (FASB 1980). The large potential variation in fair value estimates without a corresponding change in underlying economic circumstances greatly diminishes the usefulness of this information for predictive or feedback purposes. Thus, both the relevance and the reliability of the resulting compensation expense is questionable.
The FAS 123 approach provides an improvement in the neutrality of the accounting for employee stock options, but the option valuation methods suggested in the statement appear to be impractical and highly unreliable. This indicates the need for an approach that is both relevant and reliable. The proposal suggested in the next section satisfies both of these characteristics, while avoiding the limitations associated with other measurement techniques.
AN ALTERNATIVE PROPOSAL
The ultimate cost to the company of issuing employee stock options is the difference between the underlying market price of the stock and the option price when the option can first be exercised. This compensation is earned evenly over the entire compensation period, and therefore should be accrued and expensed over this period. The actual amount of compensation cost a company has incurred, however, is not known until after the compensation period has passed. Consequently, it is difficult to determine the amount of compensation expense to be recognized during each compensation period because it is impossible to know what total compensation cost will be until the measurement date.
A reliable measure of total compensation cost for the plan at any interim period is the present value of the difference between the current market price of the stock and the option price multiplied by the number of options granted. This total estimated compensation cost should then be allocated over the service period, with an expense (or a decrease in expense if the market price falls) recorded in each period. At the end of each interim period, total compensation expense reported to date should equal the percentage of the total service period that has elapsed multiplied by the present value of the estimated compensation cost.
This Vested Present Value (VPV) approach is a variation of the method applied for stock appreciation rights outlined in FASB Interpretation No. 28 "Accounting for Stock Appreciation Rights and Other Variable Stock Awards" (1978). The primary difference between this method and that identified in Interpretation No. 28 is that the VPV approach discounts the estimated compensation during the service period. Because this approach measures compensation cost over the service period and focuses on present value methods rather than option pricing models, it resolves concerns about the reliability of option pricing models and allocating compensation cost to the appropriate periods.
To illustrate the VPV method, consider a company which grants options to purchase 1000 shares of common stock at an option price of $20 on January 1, 1995 when the market price is also $20. The options vest on December 31, 1998 and are compensation for 1995, 1996, 1997, and 1998. The options can be exercised any time between January 1, 1999 and January 1, 2005. The market price of the stock on December 31, 1995; 1996; and 1997 is $26, $25, and $28, respectively. On the vesting date, December 31, 1998, the market price is $30.
Under current accounting requirements (APB 25), no compensation expense would be recorded at any time regardless of changes in the market price of the stock during the option period because the market price did not exceed the option price on the grant date. However, under the Vested Present Value approach, the company will have incurred a $10,000 cost on the vesting date (1,000 options times the difference between the market price and the option price on the vesting date) since the market price has risen to $30 by the vesting date. Figure 2 illustrates the amount of compensation expense to be recorded under the VPV approach, assuming that all of the options vest on December 31, 1998.
On January 1 1995, the grant date, there is no compensation cost because the market price does not exceed the option price. On December 31 1995, the market price on the vesting date is estimated using the current market price ($26). (Alternatively, the future market price could be estimated using an empirical model based on the firm's earnings history, dividend distributions, and discount rate. Because of the subjectivity of the inputs required for empirical modelling, however, we use current market price to approximate market price at the vesting date.) The estimated total compensation cost would be $6,000, the difference between the market and exercise price. The earliest that this cost could be incurred by the company, however, is three years in the future. Thus, conceptually the company should take the present value of this expected cost using the company's cost of capital (assumed to be 10% in this example). Multiplying this amount by the percentage of the service life completed provides the cumulative compensation that should be accrued to date. Since 1995 is the first year, the entire amount is recorded as compensation expense.
On December 31, 1996 the cumulative compensation is $2,065, the difference between the market price of $25 and the exercise price multiplied by the percentage of the service period elapsed (50%). Since $1,127 was recognized in 1995, the compensation expense for 1996 would be $938. Because compensation expense is measured by the difference between market prices of the stock from period to period, multiplied by the number of options and present value, compensation expense can increase or decrease from one period to the next. This possible volatility may bother some companies, but it would simply be reflecting the volatility of the stock prices. In addition, the net shift in stock price will be dampened because the stock option expense reduces income which is counter to the change in stock price. The total compensation cost allocated over the four years was $10,000, which was the company's actual cost on the vesting date ($30 -$20)(1,000 options).
Figure 3 illustrates the effect that changing the discount rate assumption up and down by 50% has on the outcome of the VPV method. Note that this 50% change in the lone subjective input of the VPV method changes annual compensation expense by less than 5%. This is compared to a greater than 50% change in the fair value of options when the assumptions of the Black-Scholes model are flexed by 50%.
As an alternative to the example in Figure 2, Figure 4 illustrates the scenario where market price rises to $30 during the vesting period and then drops to $20 on the vesting date. When the option price is equal to or greater than the market price on the vesting date, then the company has not incurred any cost and the Vested Present Value approach will not show any net compensation expense (any expense recorded in one year would have been credited in a later year). If the market price does not get above the option price until after the vesting date, the company will not show any compensation expense for the employee stock options during any period. If at a later date the market price exceeds the option price and the options are exercised, compensation expense will still not be recorded because the service period has been completed and the total cost to the company is the cost on the vesting date.
While the "true" annual compensation expense should be zero for each of the four years, it is impossible to know this during the years prior to vesting. Under the VPV method the $4,130 ($1,127 & $3,003) of compensation expense recorded in 1995 and 1996 is offset by the reductions in compensation expense of $721 and $3,409 in 1997 and 1998. Thus, the total compensation expense recorded over the four years is zero, which reflects the company's actual net compensation cost for the four year period. The fact that the VPV method recognizes net cumulative compensation of zero with annual expense based on current stock price, yields a more robust expense number than could be generated by option pricing models.
The employee stock option debate is a classic example of the difficulty the FASB faces in issuing an accounting standard. The entire controversy is troubling because the debate has not focused on "proper accounting," but rather on the economic consequences of the accounting issue. If standards are written to achieve social, economic, or public policy goals, then the credibility of financial reporting is in danger. The damaging effect that injecting social engineering into the standard setting process can have on the quality and credibility of this process has already been illustrated by the controversies associated with accounting for pensions, post-employment benefits, and business combinations.
Accounting standards should be neutral in that the resulting financial information reports economic activity as faithfully as possible without trying to influence behaviors. In this case, the standard should neither encourage nor discourage the use of options or other equity securities to compensate employees. Rather, they should neutrally report employers' compensation decisions. The bias in the requirements of APB 25 in favor of fixed plans at the expense of variable plans has resulted in a much greater use of fixed plans than would result if the requirements were neutral (Coopers & Lybrand 1993, p. 13). Since APB 25 uses the intrinsic value on the grant date for fixed plans, most fixed plans result in no expense being recognized. However, since variable plans use the date when both the number of shares and the exercise price are known, many of the variable plans will result in the recognition of an expense (FASB 1993, [paragraph] 55). Unfortunately, this may result in the employer's designing their compensation plans to "get around" the accounting standard rather than establishing plans that provide the best incentives (FASB 1993, [paragraph] 39).
The FASB attempted to remedy this problem with the proposal suggested in the Exposure Draft. The proposal would have significantly increased the amount of compensation expense many corporations recognize. Although this provides the desired neutrality, the option valuation methods suggested in the Exposure Draft are impractical and highly unreliable. The extremely negative reaction that the FASB experienced in response to the proposal probably caused the Board to compromise and issue Statement 123 which allows the APB 25 approach with additional disclosures. However, disclosure does not seem to be an adequate substitute for recognition of transactions such as these that should be treated as an expense. The FASB can be criticized for its measurement techniques, but not for attempting to require the measurement of compensation.
The Vested Present Value approach focuses on measuring both fixed and variable options on the vesting date because it is the date the employee's obligation condition has been satisfied, and the company is obligated to issue shares at the option price from the grant date. The actual compensation cost would be marked to market at the end of each period until the vesting date when the actual cost would be known. The compensation expense allocated to the service period would be the company's actual compensation cost. Options that fail to vest during a period would be part of the adjustment when the annual compensation expense is accrued. Consequently, the measurement amount will be both reliable and neutral.
This proposal seems to satisfy most of the conceptual issues that opponents to the ED have raised. Those opponents who want no expense to be shown or those who feel accounting standards should not necessarily be neutral will probably oppose this alternative. They would prefer the current accounting where the expense can be circumvented. However, if the options were given to independent consultants, or in exchange for materials, the options would be assigned a value and recorded as an expense based upon the services or materials received. Despite the difficulties in measuring the compensation expense, failure to recognize an expense does not seem to be appropriate. This paper provides a reliable and theoretically sound alternative which might provide an acceptable solution to the stock compensation issue.
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Dale Martin, Wake Forest University
Jonathan Duchac, Wake Forest University
FIGURE 1 VARIATION IN BLACK-SCHOLES OPTION PRICING MODEL RESULTS Risk-free Stock Interest Expected Expected Scenario Price Rate Term Volatility Decrease by 50% $50 6.5% 3 yr. 15% Base Case $50 6.5% 6 yr. 30% Increase by 50% $50 6.5% 9 yr. 45% Expected Fair Value Compensation Dividend of the Expense for Scenario Yield [dagger] Option 1,000 Options Decrease by 50% 2.25% $7.87 $7,870 Base Case 1.5% $18.10 $18,100 Increase by 50% .75% $29.23 $29,230 [dagger] The expected dividend yield is increased by 50% in the first row and decreased by 50% in the last row in order to show the potential range of variation in option value under the Black-Scholes model. FIGURE 2 ANNUAL COMPENSATION EXPENSE Market Exercise Compensation Present Date Price Price Recognizable Value (1) 1/1/95 $20 $20 $0 .683 12/31/95 $26 $20 $6,000 .751 12/31/96 $25 $20 $5,000 .826 12/31/97 $28 $20 $8,000 .909 12/31/98 $30 $20 $10,000 1.000 Cumulative Comp. Annual % Accrued Comp. Date Accrued (2) To Date Expense 1/1/95 0% $0 $0 12/31/95 25% $1,127 $1,127 12/31/96 50% $2,065 $938 12/31/97 75% $5,454 $3,389 12/31/98 100% $10,000 $4,546 (1) Assuming an interest rate of 10% compounded annually. (2) The % accrued is based upon the 4-year service period FIGURE 3 Variation in Annual Compensation Expense under the Vpv Method 5% Discount Rate Marke Comp Date t Recognizable Cumm. Price Comp. Annual Acc'd Comp. To Date Exp 1/1/95 $20 $0 $0 $0 12/31/95 $26 $6,000 $1,296 $1,296 12/31/96 $25 $5,000 $2,268 $972 12/31/97 $28 $8,000 $5,712 $3,444 12/31/98 $30 $10,000 $10,000 $4,288 10% Discount Rate Marke Comp Date t Recognizable Cumm. Price Comp. Annual Acc'd Comp. To Date Exp 1/1/95 $20 $0 $0 $0 12/31/95 $26 $6,000 $1,127 $1,127 12/31/96 $25 $5,000 $2,065 $938 12/31/97 $28 $8,000 $5,454 $3,389 12/31/98 $30 $10,000 $10,000 $4,546 15% Discount Rate Marke Comp Date t Recognizable Cumm. Price Comp. Annual Acc'd Comp. To Date Exp 1/1/95 $20 $0 $0 $0 12/31/95 $26 $6,000 $987 $987 12/31/96 $25 $5,000 $1,890 $903 12/31/97 $28 $8,000 $5,220 $3,330 12/31/98 $30 $10,000 $10,000 $4,780 FIGURE 4 Annual Compensation Expense Market Exercise Compensation Present Date Price Price Recognizable Value (1) 1/1/95 $20 $20 $0 .683 12/31/95 $26 $20 $6,000 .751 12/31/96 $30 $20 $10,000 .826 12/31/97 $25 $20 $5,000 .909 12/31/98 $20 $20 $0 1.000 Cumulative Comp. Annual % Accrued Comp. Date Accrued (2) To Date Expense 1/1/95 0% $0 $0 12/31/95 25% $1,127 $1,127 12/31/96 50% $4,130 $3,003 12/31/97 75% $3,409 ($721) 12/31/98 100% $0 ($3,409) (1) Assuming an interest rate of 10% compounded annually. (2) The % accrued is based upon the 4-year service period
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|Author:||Martin, Dale; Duchac, Jonathan|
|Publication:||Academy of Accounting and Financial Studies Journal|
|Date:||Jan 1, 1997|
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