FAS 123: boon or boondoggle?

You can't sidestep the latest FASB accounting rule on stock-based compensation. So turn on your computer and start figuring on disclosing more of your company's financial information.

About 40 percent of American companies link pay to performance via stock-based compensation. The incentive: The better the company does, the better the employee does. This used to be as simple as 1,2,3. Now, it can be as complex as FAS 123.

The Financial Accounting Standards Board's newest rule will send CEOs and CFOs scurrying to turn on their computers, while boards re-evaluate stock compensation plans and shareholders attempt to interpret two sets of numbers. Issued last October, FAS 123, Accounting for Stock-Based Compensation, encourages - though doesn't mandate - expense recognition for stock-based compensation. However, FAS 123 does require all companies to disclose in a financial statement footnote net income and earnings per share determined according to the rule's new - and more complex - fair value accounting.

Is it time to panic? Not exactly. The good news is companies can stay with current accounting rules for reporting stock compensation expense (called APB 25), which typically have no impact on profit or loss for traditional stock options and thus generally produce less expense. The bad news is they still must do the extensive calculations FAS 123 requires and disclose additional information about their stock compensation programs.

RAMIFICATIONS FOR BUSINESS

Most companies will continue with APB 25, because expense generally will be higher under FAS 123, particularly for smaller growth firms where stock options often substitute for higher cash wages or other benefits. In many cases, expense for traditional stock options is zero under APB 25. But under FAS 123, high-tech companies with broad-based option plans and numerous and significant option grants could see net income reduced by 30 percent to 50 percent. Almost every company we've talked with that has primarily fixed stock options and employee stock purchase plans is staying with APB 25. A few corporations with primarily performance-related stock plans may adopt FAS 123, because expense is actually lower, but that probably will be the exception rather than the rule in the near term. Either way, FAS 123 will have a significant impact on corporate America. Here's why:

Public companies must use option-pricing models, such as the Black-Scholes model, to compute FAS 123 fair values. (Non-public companies can use a simpler method that excludes a volatility assumption.) FAS 123 doesn't require a particular model, and, in some cases, using an alternative model may reduce the expense calculations.

For example, the Cox-Ross-Rubinstein model (also called the binomial model) is a series of Black-Scholes models that allows for differing assumptions over time. It may produce lower values if the company had assumed its dividend payout would increase in the future, rather than work with the stable dividend yield incorporated in the Black-Scholes model.

A path-dependent model may be used to incorporate probabilities of future stock price appreciation in modeling the value of plans with performance goals tied to the company's own stock price. For these plans, the additional complexity involved may result in lower option values and expense than Black-Scholes' figures.

FAS 123 does require that any option-pricing model selected incorporate the following six factors:

* Current price of the underlying stock.

* Exercise price of the option.

* Expected life of the option (also referred to as the expected option term).

* Expected volatility of the underlying stock.

* Expected dividends on the stock.

* Risk-free interest rate during the expected option term.

These assumptions are highly judgmental. Small changes in assumptions - particularly in the expected option term and stock volatility - change fair values considerably.

FAS 123's impact on net income will vary considerably from company to company, so you cannot assume your company is average. A 1993 Coopers & Lybrand study of 26 companies, conducted while the rule was being developed, showed the average emerging company had a 31 percent reduction in annual net income after full phase-in. On the other hand, the average mature company experienced a reduction in annual net income of 4 percent. Individual companies in the sample varied greatly. One mature company had a 3 percent reduction in annual net income, a growth company had a 16 percent reduction, and a high-technology company had a 44 percent reduction [ILLUSTRATION FOR GRAPHIC OMITTED].

FAS 123 directly affects financial statement disclosures. The new rule arms financial analysts with additional information that might alter how your company compares with its competitors. Besides disclosing the potential earnings impact of fair value accounting on your company, you also must disclose expected dividend yields and expected stock volatility.

In addition, it is not yet clear how financial analysts will utilize the disclosed pro forma net income and earnings-per-share numbers of companies that report expense under APB 25. For example, if one of several competing companies elects to adopt FAS 123, financial analysts might adjust the numbers for analysis purposes to level the playing field.

FAS 123 may affect your relationship with shareholders. For instance, you may need to provide shareholders with the projected FAS 123 fair values when you seek shareholder approval for a new stock compensation program or an increase in stock option grants.

Performance-based stock compensation plans are treated more favorably under FAS 123 than under APB 25. This may prompt companies with these plans to adopt FAS 123, because expense generally will be lower. Compensation committees should consider this in developing any new compensation strategies.

Two popular performance-based plans currently being implemented are:

* Performance-accelerated options. The executive/employee receives options with a fixed vesting period; vesting is accelerated if the company meets certain performance goals.

* Performance-contingent options. Options never become exercisable unless the company achieves specified goals, such as a targeted stock price, market share, or return on equity.

ESTIMATED REDUCTION IN NET INCOME AFTER FAS 123 ACCOUNTING IS PHASED
IN

                                   Percent of companies in study

Reduction in Net Income(%)       Mature     Emerging         Total

0-1.9                              62           -               38
2.0-3.9                            19           -               12
4.0-5.9                             -          10                4
6.0-9.9                             -          10                4
10.0-21.9                          19          20               19
22.0-29.9                           -          20                8
30.0-39.9                           -           -                -
over 40                             -          40               15

Total                             100         100              100

Avg. reduction in net income       4%         31%              13%
Number of companies               16          10               26

Assumes annual option grants and that rule had been in effect during
the entire vesting period; data for one mature company was not
included in this analysis.

Reduction Of Net Income In Percent For Three Companies

               Co. A-Mature      Co. B-Growth      Co. C-High-Tech

Year 1               1%                4%                  10%
Year 2               2%                8%                  27%
Year 3               3%               12%                  44%
Year 4                -               16%                    -
Vesting Pd.     3 Years           4 Years              3 Years

Source: Coopers & Lybrand LLP.

In the future, more companies are expected to use performance-based plans, probably in a package along with traditional stock options, restricted stock, and an employee stock purchase plan.

FAS 123 also could have an impact on your company's compensation strategies in other ways and, ultimately, affect your compensation and that of your management and employees. For example, your board might ask to see the FAS 123 fair value numbers before it approves your compensation plans. According to a 1995 Coopers & Lybrand survey, just 13 percent of 250 responding companies use FAS 123-type option-pricing models to determine stock option award size.

While FAS 123 is an accounting rule and does not require any company to change the design of its stock compensation program, some boards are likely to scrutinize the difference between the company's reported net income and the disclosed pro forma net income. If that difference is very large - for example, if the pro forma net income is going to be 50 percent lower than the net income reported in the income statement - a company may consider modifying its stock-based plans.

DECISIONS, DECISIONS

Despite FAS 123's ramifications, it's vital to remember that while financial reporting is important, it should not carry more weight than achieving strategic business objectives. For many companies, stock-based compensation is a critical component of executive and employee compensation and the core of long-term, performance-related incentives. According to the 1995 Coopers & Lybrand survey of 250 companies with stock compensation programs, stock awards make up 70 percent of the average CEO's total compensation and 50 percent of top management's pay. Stock-based programs are provided by 78 percent of companies that report having a long-term incentive program. Stock options (non-qualified and incentive options) are most prevalent today, but performance-related plans increasingly are being used [ILLUSTRATION FOR PIE CHART OMITTED].

As FAS 123 goes into effect this year, CEOs and CFOs must prepare to explain its impact on their companies to their boards, financial analysts, the media, shareholders, and other readers of their financial statements. Both the explanation and calculations may be more easily understood by working with a flowchart that organizes the steps of the FAS 123 process from input to measurement to analysis to decisions to implementation [ILLUSTRATION FOR OPENING GRAPHIC OMITTED].

When choosing which accounting rule to follow and reassessing their companies' stock-based compensation plans, CEOs should keep in mind a few words of advice:

* Don't make any hasty decisions to elect FAS 123 for expense recognition in the income statement. Once you adopt the new rules, you can't go back to the old.

* Have your staff analyze all your company's stock-based plans, not just stock options. The new rules generally consider employee stock purchase plans to be compensatory for accounting purposes. In addition, if you give stock options to non-employees (e.g., suppliers or contractors), your income statement must reflect a charge for the value of the options or an estimated value of the services rendered with no optional disclosure allowed. (This requirement is not new, but FAS 123 makes the accounting much clearer.) Additionally, more companies are moving toward compensating directors with stock options rather than cash. Although directors are treated the same as employees for the purposes of FAS 123, your staff still will need to analyze the impact of these plans with respect to the company's financial statement disclosures.

* Make sure your staff evaluates alternative option-pricing models, assumptions, and measurement approaches before you make decisions.

* Give your CFO several months to do the analysis. FAS 123 requires numerous accounting and measurement steps to determine how a company's stock compensation program affects its bottom line. For companies with calendar year-ends, the FAS 123 amounts must be reported in the 1996 annual report to be issued in early 1997. It takes time to gather the necessary data on plan terms, historical exercise patterns, and stock volatility, as well as to run the option-pricing models and evaluate sensitivities to alternative assumptions. Moreover, for companies considering plan-design changes, even more time is needed, as they may have to provide the compensation committee or board with the FAS 123 numbers before the approval process is completed.

* Understand how your numbers compare to those of your competitors. If there is a large disparity, it could pose a threat to your company's position in the marketplace and to your relations with shareholders.

DOWN THE ROAD

FAS 123 has been a long time in coming. For the last 10 years, a debate has raged over whether the FASB should mandate or merely encourage expense recognition for stock options and other stock-based compensation. Though FAS 123 will result in additional work for business, it does represent a reasonable compromise. At the moment, the FASB has removed stock compensation from its agenda, so for the next decade or so, it appears that mandatory expense recognition under FAS 123 methodology is unlikely. However, in the longer term, the FASB might readdress the issue. In the meantime, don't be daunted by the task ahead.

Nicholas G. Moore is chairman and chief executive of Coopers & Lybrand L.L.P., a $1.6 billion professional services firm.