Employee stock option accounting changes.

As readers of the business press are aware, the Financial Accounting Standards Board issued an exposure draft of a proposed statement, Accounting for Stock-Based Compensation, replacing Accounting Principles Board Opinion no. 25, Accounting for Stock Issued to Employees. If adopted, the statement would change financial statements dramatically, especially those of small or start-up companies that rely heavily on stock options as compensation. This article uses some simple examples to demonstrate the proposed standard's financial impact on two hypothetical companies, one large and one small.

OPINION 25 AND THE PROPOSED FASB STANDARD

The controversy that led to the proposed changes involves the measurement and recognition of compensation expense for employee stock option plans. (For more on the historical development of the changes, see "Stock Compensation Accounting," by Robert W. Rouse and Douglas N. Barton, JofA, June 93, page 67.)

Under Opinion no. 25, compensation cost is the excess of a stock's market price over its option price on the measurement date--the first date both the number of shares an employee is entitled to receive and the option price are known. The result is allocated to expense over the period the employee must serve to be entitled to receive the shares. Under this guideline, most companies have offered employee stock options with fixed terms--both the exercise price and the number of shares are fixed at the grant date. This arrangement is attractive since no employee compensation cost must be recognized for fixed options when the exercise price equals or exceeds the stock's market price at the measurement date (so-called out of the money options).

Performance-based stock options are those where the option price or the number of shares an employee is entitled to receive is based on the outcome of a specified future event (such as an increase in the company's earnings per share [EPS]). Such options are less attractive to employers because they are more likely to result in recognition of an employee compensation expense since the option's exercise price may be less than the stock's market price at the measurement date (an in the money option).

Opinion no. 25 has had a negative effect on several aspects of compensation. Of most concern to the FASB is the nonrecognition of an employee compensation cost when stock options are granted. The ED says fixed stock options are the issue that overshadows all others in the project. Opinion no. 25 also discourages the use of performance-based stock options because of the higher probability of eventual compensation cost recognition. The FASB believes encouraging one type of award over another not only makes accounting requirements a significant factor in plan design but also might encourage employers to select plans they otherwise might not.

The ED's most significant change from Opinion no. 25 is the method of measuring compensation costs and the requirement to include all stock-based Compensation in employers financial statements, including the more common fixed stock options. Measurement is based on the award's fair value on the date the parties agree to its terms. Since quoted market prices that qualify as prices at which willing buyers and willing sellers would exchange cash for employee stock options generally are not available, the FASB would require the fair value of employee stock options be estimated using an option-pricing model, such as Black-Scholes.

This requirement is controversial for several reasons. First, most financial statement users--and many accountants and auditors--are unfamiliar with the intricacies and mathematics of option-pricing models. Second, option-pricing models require several inputs, some of which must be based on assumptions and others which may be confidential. Option value and the resulting employee compensation expense are especially sensitive to inputs such as stock price volatility assumptions.

ILLUSTRATIVE EXAMPLES

The best way to understand the proposed statement's effect is to consider its impact on two hypothetical companies of different sizes.

Small company scenario. Smallco, Inc. currently has 10 million shares of common stock outstanding. Annual revenues are $100 million, and expenses are 80% of sales. Because it is a young, growing company with high cash needs, management decides to offer stock options as a substantial portion of top executive compensation. Twenty percent of current outstanding shares are granted as stock options at the beginning of year one. (To support this assumption we found examples of several companies that provide for an additional 20% of outstanding shares to be issued as employee or director stock options.) The Smallco options expire in five years and have a $25 exercise price.

Assuming the stock's current market price is $20, no compensation expense is recognized under Opinion no. 25 because the option is out of the money on the measurement date. However, under the ED's requirements, we calculated a $5.75 value per option using the Black-Scholes option-pricing model. This is based on the assumption the stock price's annual standard deviation is 3a%. If only 1,825,346 of these options vest due to anticipated 3% annual employee turnover, the total compensation cost of this grant is $10,495,739. (For simplicity, we rounded it to $10.5 million.)

Under the ED, total compensation cost is allocated to expense over the employee vesting period. Assuming a three-year vesting period, Smallco would recognize an additional $3.5 million in employee compensation expense in each of the three years. Comparative financial statements and selected financial ratios prepared under both Opinion no. 25 and the proposed FASB statement guidelines are presented in exhibit 1, page 76. The proposed statement's impact on EPS is limited to the reduced reported net income until the options no longer are antidilutive since the use of the Treasury stock method is unaffected by the proposed standard. (Primary and fully diluted EPS computations exclude the options since exercise will increase EPS for the period). In our example, the options would not be dilutive (decrease EPS) until year three.

EXHIBIT 1 Smallco example

[TABULAR DATA OMITTED]

Large company scenario. Largeco, Inc. currently has 100 million shares of common stock outstanding. Annual revenues are $1 billion, and expenses are 80% of sales. Management decides to offer 5% of current outstanding shares as stock options at the beginning of year one. The options expire in five years, the exercise price is $25 and the current market price of the stock is $20; thus, no compensation expense is recognized under Opinion no. 25. Nevertheless, we calculated a $2.80 value per option using the 4,563,365 option-pricing model, assuming the stock price's annual standard deviation is 18%. If only 4,563,365 of these options vest due to anticipated 3% annual employee turnover, the total compensation cost of the grant is $12,777,422.

Assuming a three-year vesting period, Largeco would recognize an additional $4.26 million in employee compensation expense in each of the three years. Comparative financial statements prepared under both Opinion no. 25 and the proposed statement are shown in exhibit 2, page 77.

EXHIBIT Largeco example

[TABULAR DATA OMITTED]

THE RESULTS

For Smallco, exhibit 1 shows that the accounting treatment of employee stock options under the proposed guidelines results in drops of approximately 18% (from $1.20 to $.99) in EPS, 23% (from 12% to 9.3%) in return on assets (ROA) and 24% (24% to 18.3%) in return on equity (ROE). Smallco's cash flows do not change at all under the ED. Compensation expense must be recognized regardless of whether the options ever come into the money or are exercised. if small companies use options as a large percentage of employee compensation, the effect on their financial statements will be dramatic. Analysts must recognize the impact of this accounting treatment or small companies that rely heavily on options could be grossly undervalued.

If small companies are undervalued systematically, they may suffer in terms of their ability to raise new capital. Debt will become more expensive and seasoned equity issues will be more dilutive. If analysts take a short-term focus on quarterly earnings or earnings growth, the ED's accounting treatment may bring about negative reports that could lead to increased stock sales. As other researchers have noted, earnings announcements are critical for small companies because they represent a significant portion of the information available about the company.

Despite the noticeable effect on Smallco, our results actually understate the proposed accounting treatment's impact on start-up companies. Companies with less than $100 million in sales will show even larger percentage decreases in operating performance measures if they make heavy use of options as compensation. For example, if Smallco has $25 million in sales with an expense ratio of 80%, its net income falls from $3 million to $0.9 million under the proposed standard, a drop of over 66%.

For large companies, the ED's impact will be very slight, for several reasons. First, the number of shares under option, although large in gross terms, is small in relation to the number of shares outstanding. Second, the stock price volatility of a large, more established company generally is lower than that of a small company, decreasing the option's value. For example, we assumed an annual standard deviation of 18% for the large company's stock return; the small company's stock return was assumed to have an annual standard deviation of 35%. Otherwise, the options are identical.

IMPLICATIONS

The estimate of a stock's volatility is critical to assessing option value and the subsequent impact of the proposed accounting treatment. Large, established companies with long operating histories should have little difficulty evaluating their stock's volatility. New companies with short operating histories will have higher volatilities on average and more leeway in estimating this variance through assumptions about future performance. To minimize the ED's impact, the tendency is likely to be to try to make the estimates of stock price variance as low as possible.

Another implication involves the terms of the option itself. If the FASB proposal is adopted, companies may choose to issue options that are further out of the money to reduce the negative e impact on current earnings. For example, if the exercise prices of the options in the above examples were raised to $30 from $25, the value of the options using Black-Scholes would fall to $4.56 and $1.57, versus $5.75 and $2.80, for the small and large companies, respectively. Smallco's EPS then would fall only by about 13%, versus 18% calculated earlier. The problem with this approach, however, is that options that are further out of the money may provide less incentive for workers if they view the possibility of payoff as too remote.

If the financial reporting effects of stock options are too burdensome, companies may restrict their use. This would create a disadvantage for shareholders--options help align managers' and stockholders' interests more directly than fixed compensation. such as salaries requires cash. Small, rapid-growth companies generally are cash poor because they have substantial investment needs. Issuing out of the money options to managers does not require an immediate cash outlay. Options flay managers cash only if the company prospers and its stock rises in price.

SIGNIFICANT IMPACT ON COMPENSATION POLICY

The FASB's motive in replacing Opinion no. 2a was to avoid the nonrecognition of compensation cost associated with employee stock options. But, this article demonstrates the proposed standard will have a serious effect on emerging, companies' financial statements. For small companies that rely heavily on options as compensation, EPS, ROE and ROA could drop about 20%. Analysts must recognize this or small companies may be undervalued. The ED also may be a major factor in selecting and designing compensation plans, possibly discouraging the use of options as a compensation tool.

EXECUTIVE SUMMARY

* IF PASSSED, THE FINANCIAL Accounting Standards Board Exposure Draft, Accounting for Stock-Based Compensation, would have a dramatic impact on the financial statements of small companies that use options as a compensation tool.

* THE NEW STANDARD WOULD replace Accounting Principles Board Opinion no. 25, Accountign for Stock Issued to Employees, which generally does not require employee compensation cost to be recognized in the financial statements since fixed options have na exercise price that equals or exceeds the market price when the option is issued.

* IN SOME SMALL COMPANIES, measures such as return on equity and earnings per share would fall approximately 20% when the proposed rules are applied. Small companies not followed by many analysts could be severely undervalued if the impact of the changes is not fully recognized.

* FOR LARGE COMPANIES, THE impact of the proposal should be very slight, due in part to the smaller number of shares under option in relation to the number of shares outstanding and lower stock price volatility.

* THE PROPOSED RULES COULD have a substantial impact on companies' employee compensation policies, despite the FASB's desire that accounting standards not influence such decisions. Some smaller companies may no longer use options as a compensation tool.

CONRAD S. CICCOTELLO, PhD, JD, is assistant professor of finance, Department of Management, the U.S. Air Force Academy, Colorado Springs, Colorado. He is a member of the Financial Management Association and the Pennsylvania Bar Association. C. TERRY GRANT, CPA, PhD, is assistant professor of accounting, School of Professional Accountancy, University of Southern Mississippi, Long Beach. A member of the American Institute of CPAs and the Colorado Society of CPAs, he also is a member of the Institute of Management Accountants and the American Accounting Association.