Stock option accounting: back from the '90s.

A big part of the longest economic expansion in U.S. history during the 1990s is attributed to the technology explosion that was driven by thousands of emerging-technology businesses. The financing for and growth of such firms was largely dependent upon awarding employees stock options as a substantial portion of their total compensation packages.

There was heated debate on the accounting treatment for such stock options, culminating in 1995, with the Financial Accounting Standards Board issuing FASB No. 123, "Accounting for Stock-Based Compensation," which was greatly contested.

Fast forward to 2004, with stock options again a hot issue--this time, being blamed for things from corporate scandals and executive greed to misleading financial statements. FASB is again on the brink of issuing a new standard, (Exposure Draft issued in late March), as is the international standard-setter.

The man at the helm of FASB when FAS 123 was enacted, Dennis R. Beresford, speaks about his thinking--then and now--with Financial Executive's Managing Editor, Ellen M. Heffes. Beresford served as FASB chairman for two consecutive terms, 1987-1997, and is now Ernst & Young Executive Professor of Accounting at the University of Georgia.

How would you describe the environment now for a standard on accounting for stock options? Did you expect it to resurface again?

BERESFORD: I think it's best to contrast now with the situation back in the mid-1990s, when I was at FASB. Then, virtually no one was in favor of expensing options, other than FASB board members. Now, we have about 400 or so companies that are already doing so--voluntarily. So, obviously, those people are supporting FASB's approach.

Back in the '90s, we had legislation proposed by Sen. Joe Lieberman (D-Conn.), which would have not only overridden FASB on this project, but also effectively put FASB out of business, because of requiring the Securities and Exchange Commission to go through and redo every project going forward.

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Legislation [now pending in Congress] is a lot less serious this time. With little support in the '90s, this time some members of Congress are very supportive, [and] Federal Reserve Chairman Greenspan is supportive. Most importantly, Sarbanes-Oxley has changed the whole equation. It's given FASB probably more independence. And not just Sarbanes-Oxley, but the problems that have happened in financial reporting, have caused companies to be a little more than defensive about trying to do accounting properly.

The International Accounting Standards Board (IASB) announced that companies following international standards will have to start expensing share-based payments beginning Jan. 1, 2005. Will this affect FASB's task?

BERESFORD: I think it is more emotional and intellectual support for FASB, as opposed to anything that is really that specifically helpful. FASB added this project after IASB had started its work, so I think part of the reason FASB is working on it right now is the internationalization notion.

But the reality is that most corporations and users of financial statements in the U.S. still don't care that much about convergence of accounting internationally. I think those who are opposed to this new requirement will still be opposed, and those who are in favor might say, "One of the reasons is because of international convergence." IASB's action certainly makes FASB board members feel a little more secure in their position, but I don't think it is a major factor.

While many seem resigned to expensing, a big issue that remains is valuation--which method or methods to use. Where is your thinking on expensing, and which method of valuation do you consider preferable?

BERESFORD: Apparently, FASB is going to be relatively specific and say that it prefers a binominal approach to valuing options, a refinement on Black-Scholes. It's also been referred to as a "lattice-type" approach. It requires companies to provide more information--more inputs to the model--but it is still a best estimate rather than an unassailable measure. I know FASB is still open to input on valuation, and I believe this is going to be one of the biggest issues during the comment period--seeing if companies or others can come up with even better ways of estimation.

My preference would be to state the objective simply by saying, "You should record options based on their fair value," and provide more leeway for companies to come up with their approach as to what they think makes the most sense, probably with some additional disclosure on how they do that.

For example: When The Coca-Cola Co. started recording option expense on an estimated basis, it said that it was going to get some actual proposals from investment bankers as to what they thought the options were worth. I'd rather know what market participants would actually pay for an option, so I hope the FASB will provide for this.

The important point this time is that the issue is no longer whether to expense options, but how to measure that expense. The board will probably refine its approach as a result of comments. But I don't believe that the board will back away simply because of valuation concerns.

What do you think is going to be the impact of the change, then, on corporate financial statements?

BERESFORD: Clearly it will reduce net income dramatically for some companies, assuming they continue to issue options in the same numbers as previously. However, we have already seen, over the last year-plus, a shift by some companies to issue, for example, restricted stock, in part, because of anticipating a new FASB standard on options--but, also, because those companies have rethought their compensation practices and feel that options may not always be the best way to motivate employees.

A recent report by Merrill Lynch concluded--as I think most people have up until now--that, in general, this should not impact stock prices. Some had expressed concerns that the stock market will go down a large amount, as a result of recording more expense, but most believe that that is not going to happen. But Merrill Lynch did suggest this could impact the price for at least some individual companies as investors realize a little more clearly the impact of options on their operations.

Finally, how do you anticipate this current expensing issue will turn out? Will any solution be temporary--and somehow intertwined with politics?

BERESFORD: First, it's not over, because the exposure draft will draw hundreds of comment letters. I expect FASB will get lots of good comments, and will have to go through the numerous details that warrant reconsideration, and some changes are inevitable. For example, I expressed specific concerns to the board about the transition requirements for the standard.

But, I believe the board will stand tall. It has said it hopes to issue a final standard very late in 2004. Given how long it has taken to get to this point, and given what I know will still be much controversy, I expect it will more likely be next year before a final standard is issued.

However, I believe it will be issued, and we will then have a level playing field for all stock-based payments; there won't be a significant difference between whether you compensate employees in cash or restricted stock or stock options. I think this will cause many companies to rethink their compensation plans, because you tend to manage what you measure. If you don't have to measure something, it doesn't get quite as much management consideration.

In the final analysis, a couple of years from now, we'll look back on what has been almost a 30-year debate about accounting for stock options, and some people, at least, will wonder what the fuss was all about.

Editors Note: 'Big Four' Support FASB

On March 17, in response to the introduction of a number of bills in Congress recommending legislative action on the accounting for stock options, top executives of the "Big Four" accounting firms sent a joint letter to members of Congress to express their views.

They wrote that Congress should preserve the independence of FASB and avoid legislation that would have the effect of restricting FASB's ability to establish accounting standards. Also, they reaffirmed support for the mandatory expensing of employee stock options whose fair value would be determined in a manner suitable for the reporting company.