Accounting treatment of option plans.

Many companies, particularly start-ups, consider stock options the best form of compensation. Stock options are popular with employers because it is not necessary to part with cash to keep key employees well-compensated. These companies are also willing to accept some amount of shareholder dilution in exchange for the "incentive" that stock options can instill in employees.

The recent volatility of the stock market, however, has caused many to question if stock options are still the best form of incentive compensation. Besides that, the Financial Accounting Standards Board (FASB) is revising the accounting rules, so that companies with stock-based compensation arrangements need to determine if the revisions will negatively affect their financial statements.

History of Accounting Rules

The accounting rules associated with stock-based compensation plans are complex. The current generally accepted accounting principles (GAAP) for stock-based compensation plans are laid out in Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation (October 1995).

SFAS 123 encourages employers to adopt its fair value methodology to determine compensation expenses associated with stock-based compensation. Companies can elect to continue following Accounting Principles Board (APB) Opinion No. 25, for stock-based compensation, but only if a footnote disclosure showing the pro forma effect of using the fair value method is included. The rules of SFAS 123 and APB 25 apply to all forms of stock-based compensation, but the greatest impact is on stock options.

Recently, a series of technical bulletins and pronouncements clarifying SFAS 123 was released. However, these clarifications pertain primarily to footnote disclosures, because most companies continue to follow APB 25 for employee awards. However, now that the FASB is "cleaning up" APB 25, companies may have to change the way they account for their stock option plans. While the FASB's project is intended to clarify (not alter) the provisions of APB 25, several items will have different interpretations as a result.

The most recent information from the FASB indicates that the new interpretation will be effective prospectively for all awards made after Dec. 15, 1998; the exposure draft will be released in the first quarter of 1999 and the final pronouncement will be released in the fall of 1999. The discussion that follows is based on the FASB meetings to date. The rules will continue to evolve during the year as the exposure draft is released and the final pronouncement is developed.

The changes have not been released and an effective date has not been announced, but companies may want to begin evaluating the possible impact on their stock option plans. An exposure draft of the changes is expected in early 1999.

Definition of "Employee"

There have always been some unanswered questions under APB 25, such as whether options granted to nonemployee outside directors should be treated the same as those granted to employees. Because the guidance was nonspecific, options granted to outside directors have traditionally been treated the same as those granted to employees (i.e., an accounting charge for most options in the group).

However, the new interpretation limits the definition of "employee" to common-law employees as defined for employment tax purposes. This clarification will require every company that grants options to nonemployee directors to include an expense for the fair value of these options on its income statement. Additionally, any awards granted to individuals whose status changes between employee and nonemployee will be treated according to the new status prospectively from the date of the change.

During recent meetings, the FASB determined that options on parent-company stock awarded to employees of a subsidiary would be treated as employer options subject to APB 25 on the consolidated financial statements, but as nonemployer options on the separate financial statements of the subsidiary. However, in its last meeting on Dec. 4, 1998, the FASB made an exception allowing these options to be treated consistently as employer options subject to APB 25 on both the consolidated financial statements and the separate financial statements for the subsidiary.

The FASB recently determined that the definition of "employee" is limited to common-law employees. If and when this becomes final and effective, stock options granted to nonemployee directors will require a company to recognize a compensation expense determined using the fair value methodology outlined in SFAS 123, even though the recognition provisions of SFAS 123 are not adopted. This change will affect most publicly held companies.

In addition to options granted to outside directors, two other groups of options will be affected by this interpretation:

1. Options on stock awarded to a subsidiary's employees will not be treated as employer options on the subsidiary's separate financials, and

2. Options that continue to vest after a change in status from an employee to a nonemployee (e.g., an executive who retires and is subject to a consulting agreement) will be treated as nonemployee options prospectively from the date of the change.

Look-Back Provisions

Another provision being "cleaned up" pertains to determining whether a plan is compensatory or noncompensatory. Compensatory plans give rise to an accounting charge, although the amount of the charge may be zero (e.g., typical at-the-money options granted to employees).

Noncompensatory plans will not give rise to an accounting charge (even if granted at a discount), because the amount of benefit transferred to the employee meets certain criteria. The focus of the compensatory versus noncompensatory issue involves plans with look-back provisions. The most common example of a look-back option is an employee stock purchase plan described in Sec. 423. These plans typically allow employees to purchase stock at a 15% discount, based on the trading price on the date the option is granted or the date the option is exercised (whichever is less).

APB 25 states that plans meeting certain requirements are noncompensatory. Specifically, "an example of a non-compensatory plan is the `statutory' employee stock purchase plan that qualifies under Section 423 of the Internal Revenue Code." The example has been interpreted to mean that all plans that qualify under Sec. 423 are noncompensatory. However, the FASB had determined that plans with look-back provisions would be deemed compensatory. Now, the FASB has amended this statement to say that a plan with a look-back provision may be noncompensatory if the requirements are met. The FASB notes that, conceptually, plans with look-back provisions are compensatory.

Repriced Options

Some companies have awarded stock options and later found the trading price of the stock declined during the vesting period. These companies then modified outstanding options to lower the exercise price to the current (lower) trading price.

During a corporate slump, repricing options can be an effective and inexpensive means of providing employees with incentives and keeping their golden handcuffs secure. However, repricing is a controversial practice that is frowned on by shareholder advisers.

Currently, repriced options only require an accounting charge if the new exercise price is less than the fair market value (FMV) of the stock on the date of the repricing. However, under the new interpretation, repriced options will require variable accounting until the date the option is exercised.

Other Issues

At its next meeting, the FASB will consider the appropriate financial accounting for the tax effect of stock options, how stock-based plans and cash bonus plans integrate, and how to account for the exchange of stock options in merger and acquisition transactions. Research suggests stock options are still an effective means of rewarding employees. While accounting rules may become less favorable than they are today, stock options are still the best bargain in incentive compensation strategies.

Companies that grant stock options should continue to provide the best incentives available, but should be wary and avoid unwelcome surprises from the accounting and tax rules associated with the awards.

Other Developments

In addition to the issues described above, the accounting for stock options in business combinations and accounting for the income tax effect of stock options are being clarified. Also, plans that couple cash awards with stock options will require variable accounting under the current version of the project.

The tax and accounting rules applicable to stock options can be overwhelming, but are still manageable through careful plan design. In spite of the uncertainty that comes with change, companies should keep in mind that stock options continue to allow companies to exchange cash flow (in the form of incentive bonus plans) for shareholder dilution and are still the best bargain in incentive compensation strategies.

Summary of APB 25

APB 25 focuses on a few key definitions:

1. A compensatory stock option plan is one in which an accounting charge must be determined.

2. A noncompensatory stock option plan is one in which the compensation element is deemed de minimis and not required to be determined.

3. A fixed stock option plan is one in which both the number of shares to be transferred and the price of these shares are known.

4. A variable stock option plan is one in which either the number of shares to be transferred or the price of these shares is not known.

5. The measurement date is the date on which the number of shares to be transferred and the price of these shares become known.

6. The intrinsic value of an option is the difference between the underlying stock's exercise price and its FMV (the bargain element of the option).

Under APB 25, an accounting charge must be determined for all compensatory plans. For fixed stock option plans, the amount of the charge is the intrinsic value on the date the option is granted. If options are granted "at-the-money," the charge will be zero. The charge is amortized over the accounting periods covered by the vesting schedule, if any.

The cumulative accounting charge associated with variable stock option plans is the intrinsic value at the end of each accounting period until the measurement date. This cumulative accounting charge is amortized over any applicable vesting period.

The amount of compensation expense recognized for each accounting period is the difference between the required cumulative accounting charge and the sum of the charges taken in previous accounting periods.

Summary of SFAS 123

The expense calculation encouraged by SFAS 123 requires companies to value stock options using a mathematical model that considers six variables:

1. The underlying stock's FMV as of the date the option is granted;

2. The option's exercise price;

3. The risk-free interest rate for the option's expected term;

4. The option's expected term;

5. The expected volatility of the company's stock over the option's expected term; and

6. The expected dividend yield during the option's expected term.

The first three variables are objective; they are determined by reading the award agreement and looking in a business newspaper. The last factor, the expected dividend yield, can be determined based on the minutes of the board of directors meeting or the latest proxy.

The other two variables, however, may be more difficult to determine. Further, these two variables affect the option's value more than the others do. While companies should consider historical volatility, this may prove difficult in the future (given the recent history of stock market fluctuations).

Prior exercise patterns should be assessed to determine the expected term of option awards. For companies that recently expanded stock option compensation to include lower levels of employees, however, historical exercise data for executive stock options may not be the best guide.

FROM DONNA LOWE, CPA, DALLAS, TX