Stock compensation revisited.

On June 30, 1993, the Financial Accounting Standards Board issued an exposure draft, Accounting for Stock-Based Compensation, that has aroused considerable controversy. (See "FASB Issues Proposal on Stock Option Compensation," JofA, Sept.93, page 23; Highlights, 0ct.93, page 4; "Legislation Introduced to Overturn FASB Stock Option Proposal," 0ct.93, page 15; "Stock Compensation: AICPA Opposes Standard-Setting Legislation," Jan. 94, page 19; and "Stock Compensation: FASB Testimony Responds to Critics," Jan. 94, page 20.) In the opinion of Samuel A. Derieux, CPA, a retired partner of Deloitte & Touche in Richmond, Virginia, and former board chairman of the American Institute of CPAs, the proposal will add needless complexity to financial statements.

FULL DISCLOSURE

I believe full disclosure will serve the FASB's purpose equally as well as including stock options in the body of the financial statements. While the accounting profession is working hard to get government to simplify tax provisions, our private-sector standard-setting body is complicating financial statements on the basis of speculative values. When the FASB was formed, the trustees of the Financial Accounting Foundation ruled out locating it in an academic setting. They did not want the FASB to be an "ivory tower," desiring instead practical solutions to financial accounting problems. Over the years, however, standards have become more difficult to understand. The stock-based compensation proposal is one example.

THE EXPOSURE DRAFT

The FASB's rationale for changing these rules is

* The value of stock options that are issued to employees is compensation.

* Compensation is a cost that should be recognized in the income statement.

* An accounting standard that requires nonrecognition of costs produces financial statements that are neither credible nor representationally faithful.

There are other benefits for which employees may not pay fair market value, including discounted merchandise, health club memberships and subsidized transportation. The difference between employers' cost to provide such items and their fair market value easily could be considered compensation. Thus, it does not necessarily follow that the value employees receive is a cost that must be recognized in income statements for them to be credible and representationally faithful.

Saying something is not credible or representationally faithful is a conclusion--not a basis for reaching a conclusion. The FASB's rationale seems logical; however, recording such costs makes it necessary to contrive the remainder of the entries. To illustrate how illogical the result is, one only need analyze the entries that appear in the ED's appendix B.

The example in appendix B illustrates fixed options, the price of which equals the market value on the grant date. The first entry on the grant date is to recognize the option's fair value using an option pricing model:

Prepaid
compensation     $14,801,736

   Options
   outstanding
   (equity)              $14,801,736

Isn't this interesting? The company's equity has been increased by awarding "compensation" to employees. What a novel way to meet contractual or regulatory equity requirements.

The second entry on the grant date is

Options
outstanding      $5,032,590

   Deferred
   tax liability              $5,032,590

The asset called "prepaid compensation" has no tax effect. Why record a deferred tax liability when the transaction never will result in a liability?

The glossary of FASB Statement no. 109, Accounting for Income Taxes, says, "Events that do not have tax consequences do not give rise to temporary differences." Granting options has no tax consequences; therefore, no deferred tax liability should be recognized. There may be a tax benefit if exercised, but never a tax liability. Perhaps the rationale is that if we recognize fictitious equity, we might as well reduce it by fictitious taxes.

Assuming options to purchase 812,938 shares are exercised at $50 per share when the stock's market price is $70, the entry is

Cash             $40,646,900

Options
outstanding         9,668,435

   Common stock
   (no par)                   $50,315,335

At this point there is a tax deduction for the difference between the market price and the exercise price. Tax expense is debited and paid-in capital is credited to allocate the tax benefit of tax-deductible compensation to equity.

Paragraph 207 of the ED says, "If the options had instead expired unexercised, the options outstanding account would simply have been closed to paid-in capital." In that event, the company would have recorded costs for which no asset was ever expended. Is that credible or representationally faithful?

Even though value can be attributed to stock options when the exercise price is equal to or more than the stock's market price, there are sound reasons for concluding there is no cost. No liability has been created and no asset ever will be expended.

Paragraph 61 of the ED says issuing a stock option to acquire either outside professional services or employee services is similar to issuing an equity instrument to acquire a tangible asset. Something of value, a stock option, is exchanged for something of value, employee services. If cash, another asset or shares of stock are exchanged for employee services, the related compensation cost is recognized. The FASB says it sees no conceptual basis that justifies different accounting treatments for employee stock options and all other transactions involving either equity instruments or employee services.

The FASB need not look far to find the conceptual difference. Granting employee stock options is an internal transaction. No unrelated outside parties are involved nor can the options ever be marketed. When an asset is purchased in exchange for an equity instrument, there is a transaction with an outside party and the value of the purchased asset ordinarily can be determined easily.

The internal creation of value is not recognized until there is a transaction with an outside party. The treatment of goodwill is an example. Goodwill is recognized when it is purchased but not when it is internally generated. To the extent value is created by granting stock options, it is internally generated value that should not be recognized.

This point was illustrated earlier when I questioned increasing equity by granting options. A company that grants options regularly has "options outstanding" in its equity accounts indefinitely. How can a company's equity be increased by giving away something that can never be marketed and may never be exercised? Is this credible or representationally faithful?

TWO BASIC ISSUES

Accounting for stock options raises two basic issues: recognition and measurement. There is substantial doubt recognition is appropriate and the measurement of stock options' value is speculative at best. That being the case, why not settle for the simple, easy-to-understand solution of disclosure?

It is the combination of the speculative nature of measurement and questionable effects of recognition that results in the conclusion disclosure is preferable to recognition. Is it really worthwhile to wade through factors such as the time value of money, probable future dividends and stock price volatility? It seems the FASB's quest for technical purity will cause this issue to be mired in a swamp of subjective complexity.

Stockholders and others are entitled to full disclosure of compensation costs, particularly those of executives. There has been much publicity recently about excessive compensation. However, executive compensation is a corporate governance issue, not a financial accounting issue.

A WILLINGNESS TO RECONSIDER

Accounting for stock compensation has been on the FASB agenda for nine years. Even though the FASB may not be acting in response to the publicity, interest in the subject certainly has intensified as a result of it. In spite of the intensity of opinion, or perhaps because of it, the FASB must honor the exposure process through a willingness to reconsider every aspect of this issue, including both recognition and measurement. To do otherwise would render meaningless the due-process requirements.

If the FASB abandons the position taken in the ED and relies on disclosure, some will accuse it of giving in to pressure. If it does, it will be giving in not to pressure but, instead, to a realization that accounting standards based on common sense and practicality often are preferable to highly technical standards. This is particularly applicable when, as in the case of stock options, the common-sense standard provides the information the public needs.