Stock compensation accounting.

What is today's most controversial accounting issue? Adjusting investment securities to market value? Loss recognition for impaired loans? Surprisingly, the answer might be accounting for employee stock options. On the Financial Accounting Standards Board agenda since 1984, the stock compensation issue has been relatively dormant in the last few years. It now promises to be the subject of intense debate in the coming months. Interest runs high because much is at stake-over 90% of U.S. publicly held corporations offer top executives some form of stock options.

THE CONTROVERSY

One critic of executive pay practices, Senator Carl Levin (D-Mich.), described employee stock options as "stealth compensation." That's because even though options intuitively have some value and many options result in an ordinary and necessary tax deduction to the company upon exercise, they typically result in no charge to a company's earnings. Senator Levin has held hearings on a proposed bill to mandate that the Securities and Exchange Commission require public companies to reduce earnings by the fair value of employee stock options. (No action was taken pending the outcome of SEC and FASB activities). Other proposed legislation, favored by President Bill Clinton, would limit executive pay tax deductions to some arbitrary level, such as $1 million.

Companies are understandably concerned changes in stock option accounting could adversely affect net income, making options less attractive as employee incentives. The impact could be significant when options are key elements in the overall compensation package, as often is the case with start-up or high-technology companies. Just as many companies are reducing medical and other postretirement benefits in reaction to FASB Statement no. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, so too might companies cut back on options.

As an indication of the controversy surrounding stock options, the FASB already has received nearly 400 comment letters even though it has not yet published an exposure draft of the proposed standard. Many of the letters argue there is little demand for change by practitioners or by users or preparers of financial statements. Others believe that since accounting has no effect on cash flows or net equity and dilution already is reflected in earnings per share (EPS), the potential improvement in financial reporting is not worth the effort. The FASB's limited resources should be directed to more critical accounting issues. From an accounting standpoint, many believe option awards are capital transactions that should not result in expense and a reliable method of estimating option values does not exist.

Is there any common ground between these diverse views? This article explores some of the criticisms of current accounting rules, highlights some of the central accounting issues and describes current developments at the FASB and SEC.

CURRENT ACCOUNTING

Under Accounting Principles Board Opinion no. 25, Accounting for Stock Issued to Employees, stock options and similar awards are fixed or variable. In both cases, expense is measured by the excess, if any, of the underlying stock value over the option exercise price (the intrinsic value). The key difference between fixed and variable plans is when expense is measured, which occurs only when the number of shares to be received and the exercise price are known.

For fixed awards, expense can be measured when the option is granted. The typical result is no compensation expense, since employee stock options generally have no intrinsic value when granted. In a variable plan, expense isn't finalized at the grant date; the number of shares an employee receives might depend on achieving a future performance target or on future fluctuations in the stock's value (as is the case with stock appreciation rights [SARs]). For variable awards, expense must be estimated and accrued between the date of the grant and the final measurement date.

These rules lead to some interesting anomalies. Even though an option contingent on performance is less valuable than a fixed option--since it can be exercised only if the target is met--it can result in more compensation expense. That seems counterintuitive. Similarly, a stock option and a SAR with similar terms may provide an employee with an identical economic benefit but do not result in the same expense amount.

The FASB added stock compensation to its agenda to resolve such inconsistencies. By 1988, the FASB was leaning toward the conclusion expense should be recognized based on the option's fair value at the vesting date. However, the FASB deferred further work on the project until it resolved the question of whether options and similar instruments are liabilities or equity instruments.

CENTRAL ISSUES

Accounting for stock options is replete with unresolved problems. Based on the debate so far, however, the most significant issues seem to be

* Whether the granting of stock options should result in expense recognition.

* If it does, how the expense should be recognized.

* When the expense should be measured.

Whether. Some believe employee stock options should not result in expense because company assets are not consumed and no liabilities are incurred. Since an option dilutes existing shareholders' ownership, its issuance is viewed as a transaction among shareholders that should not be subject to financial statement recognition. Reflecting the dilution in EPS along with financial statement or proxy statement disclosure is considered sufficient.

On the other hand, issuing equity securities to buy goods or services generally results in expense recognition under generally accepted accounting principles. For instance, assets acquired in a purchase business combination in exchange for stock and warrants are recognized at the securities' fair value, not at zero cost. The assets' depreciation subsequently is charged to earnings. Even shares awarded to employees directly, such as in a restricted stock plan, are expensed over the service period. Throughout their deliberations on employee stock options, the FASB has always agreed expense should be recognized.

How. Under GAAP, most exchange transactions are reported based on the fair value of the consideration given or of the item received, whichever is more clearly evident. Because employee services are difficult to value, Opinion no. 25 measures the exchange by referring to the securities issued. However, Opinion no. 25 measures only an option's intrinsic value. While that works for outright stock awards (including restricted stock), many believe it does an incomplete job of valuing stock options.

Why? In addition to intrinsic value, stock options derive value from the possibility the underlying stock's value will increase before the option expires (time value). Even if an option has no intrinsic value today, it may in the future if the stock price increases. Since most employee stock options have no intrinsic value at the grant date, any valuation approach that omits time value arguably excludes the key element of value for virtually all employee stock options.

Various mathematical models have been developed to estimate the time value of options. The most well known, the Black-Scholes model, was published in 1973, the year after Opinion no. 25 was issued. However, significant differences exist between options typically valued by such models and employee stock options. For example, while standard options generally expire within a year and can trade freely, employee stock options often are exercisable for as long as 10 years, are subject to forfeiture before vesting and cannot be transferred to others.

While compensation consultants have tried to tailor option pricing models to deal with the unique aspects of employee options, no single approach has gained wide acceptance. And since a market confirmation of an employee stock option's value doesn't exist--no trading occurs--it can't really be proved or disproved that the value derived from an option pricing model is accurate or reasonable.

Some critics charge option pricing models aren't useful because they don't accurately predict the exact value received upon future exercise. Why? While an estimate of value must be reduced to a point amount, a whole range of values could occur. For example, assume an option has only two possible outcomes, $0 and $10, each with an equal chance of occurring. Ignoring complicating factors, a rational person would be willing to pay about $5 for the option. Yet the estimated value compared to either of the values at exercise would be 100% wrong 100% of the time! Does that mean the estimated value is meaningless, since it can differ frequently and significantly from the ultimate value? Many believe the answer is no, since the estimate represents the option's current value rather than a prediction of exact value.

With respect to nonpublic companies, the FASB also is considering less subjective and easier-to-use valuation techniques. One example is the minimum-value method, which estimates an option's value as the current value of the underlying stock less the present values of both the exercise price when the option is exercised and the dividends foregone before it is exercised.

In any case, it now seems the most significant issue the FASB must resolve is whether option pricing models can be relied on to estimate the employee stock options' fair value at a reasonable cost and with a reasonable degree of reliability.

When. The FASB decided in early 1992 to proceed with the stock compensation project using existing definitions of liability and equity instruments. That decision was important because while changes in a liability's value between issuance and settlement are recorded in income, similar changes in an equity instrument's value are not. Assuming employee stock options are equity instruments, expense would be measured at the grant date and later changes in value would not affect income. An advantage of grant date accounting is it reflects the value the company and employee had in mind when they agreed on the exchange. A variation is the modified grant-date method, which measures expense based on the stock value at the grant date but subsequently adjusts that amount only to reflect whether the award is earned (for example, whether a performance goal is achieved). No further adjustments are made for changes in the stock's value. The two chief alternatives are vesting-date and exercise-date accounting, but neither is being seriously considered by the FASB.

CURRENT DEVELOPMENTS

Both the FASB and the SEC are reviewing stock option accounting.

FASB. As of this writing, the FASB tentatively has concluded expense should be measured for an employee stock option based on its fair value at the grant date and recognized ratably over the vesting period. That amount would be adjusted in subsequent periods only to reflect changes in the expected or actual outcome of service-or performance-related variables (that is, to reflect whether or not the award actually vests or is earned). The amount would not be adjusted for subsequent changes in the value of the underlying stock. Compared to the present rules, this would result in greater expense recognition for most fixed options, but the expense for most variable awards would be considerably less and would not fluctuate due to subsequent stock price changes.

Rather than specify a particular option pricing model, the FASB probably will require only that the valuation consider the variables normally included in such models (such as volatility and the option term). The FASB also will likely permit nonpublic companies to use a simplified approach that does not consider a stock's volatility, such as the minimum-value method.

Recently, a broad coalition of financial statement preparers and users proposed the focus of the FASB project be changed from measurement to disclosure. In response, the FASB decided to proceed with developing an exposure draft that would provide a three-year period of footnote disclosure of the fair value of stock and option grants, beginning no earlier than calendar year 1994. After that disclosure period, the expense would have to be included in the determination of net income. An exposure draft may be issued in the first half of 1993.

SEC. In February 1992, the SEC asked its chief accountant to study accounting for stock compensation and report on the need for any change. As of this writing, that report has not been issued. However, given the SEC's historical position of looking to the private sector to establish and improve accounting principles, it is unlikely the SEC will preempt FASB deliberations.

In October, the SEC adopted significant revisions to executive pay disclosures required in corporate proxy statements, replacing narrative discussions of compensation with several required tables relating to the compensation of the CEO and the four other highest paid executives. The summary compensation table highlights all forms of cash and equity compensation during the most recent three years. Additional tables disclose more detailed information about stock options and SARS, including the "value" of current-year grants. The disclosure requirement can be met either by using an option pricing model or by disclosing the potential realizable value that would result at the option's expiration, assuming 5% and 10% annual rates of stock price appreciation.

The new rules also require a report from the board of directors compensation committee discussing compensation policies for executives and the bases for determining the level of CEO compensation in the company's last fiscal year. A stock performance chart also must be included showing five-year cumulative returns to stockholders compared to returns on a broad market index such as the Standard & Poor's 500 and a peer group index, such as an S&P industry index.

SIGNIFICANT IMPACT

Employee stock compensation is highly controversial because it could have a significant impact on financial statements and on the nature and level of employee compensation. Since the conceptual issues are difficult and many of the alternative solutions have merit and given the strong opposition, the project's direction over the next few months should be interesting to observe.

EXECUTIVE SUMMARY

* ACCOUNTING FOR EMPLOYEE stock options might be today's most controversial accounting issue. Over 90% of U.S. public corporations offer stock options to top executives, and the Financial Accounting Standards Board has been studying the issue since 1984. * COMPANIES ARE CONCERNED changes in stock option accounting could affect net income adversely, making options less attractive as employee incentives. Others, however, are concerned the granting of options is a transaction that should be reflected in a company's income statement. * THE DEBATE OVER accounting for stock options centers on three key questions: Should granting stock options result in expense recognition? If so, how should the expense be recognized? When should it be measured? * AN IMPORTANT CONCERN in stock option accounting is the difficulty of valuing employee options. Several mathematical models have been developed to estimate the time value of options. The FASB must decide whether option pricing models can estimate the fair value of employee stock options at a reasonable cost and with a reasonable degree of reliability. * BOTH THE FASB AND the Securities and Exchange Commission are reviewing stock option accounting. An exposure draft may be issued by the FASB in the first half of this year. The SEC has asked its chief accountant to study the issue and issue a report but is unlikely to preempt FASB deliberations.

ROBERT W. ROUSE, CPA, is chairman of the accountancy and legal studies department of the College of Charleston School of Business, Charleston, South Carolina. DOUGLAS N. BARTON, CPA, is a partner of Deloitte & Touche in Wilton, Connecticut. Both previously were fellows in the Securities and Exchange Commission Office of the Chief Accountant in Washington, D.C.