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The controversy over stock options.

The controversy over whether to require the expensing of stock options once again is making the headlines in the financial press. The controversy is over whether stock options granted to employees should continue to receive an exception to the usual process of recording an expense for goods and services In economics, economic output is divided into physical goods and intangible services. Consumption of goods and services is assumed to produce utility (unless the "good" is a "bad"). It is often used when referring to a Goods and Services Tax.  based on the value transferred to the recipients. The two different viewpoints are:

1) To continue the practice of not recording any amount of expense for the value transferred through the use of stock options.

2) To record an estimated expense for the value transferred through the use of stock options.

The FASB FASB

See: Financial Accounting Standards Board


FASB

See Financial Accounting Standards Board (FASB).
 (April 22, 2003 vote) and the International Accounting Standards Board An editor has expressed concern that this article or section is .
Please help improve the article by adding information and sources on neglected viewpoints, or by summarizing and
 (Proposed IFRS IFRS International Financial Reporting Standard(s)
IFRS Inter Frame Relay Service
IFRS Indiana Facilities Registry System
, Share-based Payment issued in November 2002) have announced an intention to require the expensing of stock options. These standard setters are supported by the Securities and Exchange Commission SEC, Warren Buffet, and others, including the over 200 companies that have already adopted expensing or announced the decision to adopt expensing. They represent the viewpoint that stock options to employees and directors, currently not expensed, should be expensed. Alternatively, Intel, Cisco Systems “Cisco” redirects here. For other uses, see Cisco (disambiguation).
Cisco System,Inc. (NASDAQ: CSCO, HKSE: 4333 ) is an American multinational corporation with 54,000 employees and annual revenue of US $28.48 billion as of 2006.
, and other companies have banded together to influence the U.S. Congress to oppose the expensing of stock options. They have formed an organization called the International Employee Stock Options Coalition, which can be found at www.savestockoptions.org.

The Accounting Principles Board The Accounting Principles Board (APB) is the former authoritative body of the American Institute of Certified Public Accountants (AICPA). It was created by the American Institute of Certified Public Accountants in 1959 and issued pronouncements on accounting principles until 1973,  promulgated prom·ul·gate  
tr.v. prom·ul·gat·ed, prom·ul·gat·ing, prom·ul·gates
1. To make known (a decree, for example) by public declaration; announce officially. See Synonyms at announce.

2.
 the accounting standards currently being utilized for employee stock options in Opinion No. 25, issued in 1972. Stock options issued to employees with a fixed number of shares and at the market price on the date of the grant (generally termed fixed plan options)currently result in no compensation expense being recorded. The accounting treatment specified in APB Opinion APB opinion

A determination by the former Accounting Principles Board regarding the way a certain financial transaction is to be treated for reporting purposes.
 No. 25 was an exception to the financial reporting model that equity securities (an option being an equity security)issued for goods and services constitute a cost that would become an expense at some point in time. FASB Chairman Herz, in his comments before the Congressional Roundtable on Stock Options on May 8, 2003, commented about APB Opinion No. 25 and the financial reporting model:
   Partly because techniques to estimate the value of stock
   options did not yet exist, the drafters of Opinion 25 created an
   exception to the normal financial reporting model. That model
   encompasses the general principle that all of an enterprise's
   costs should be included in the enterprise's financial statements;
   otherwise, the enterprise's income is overstated.

   Under the Opinion 25 exception, only stock options granted to
   employees that meet certain specified criteria (so-called
   fixed plan options) are not reported as an expense. All other
   options and all other forms of stock-based transactions result
   in expenses to be included in the financial statements consistent
   with the general principle.


The Opposition

The FASB proposed expensing stock options in an Exposure Draft, Accounting for Stock Based Compensation, in 1993, resulting from a project which began in 1984. The proposal faced tremendous opposition at that time. The FASB thus decided in SFAS SFAS Statement of Financial Accounting Standards
SFAS Special Forces Assessment and Selection
SFAS Student Financial Aid Services
SFAS Sport Fishing Association of Singapore
SFAS Safety Features Actuation System
SFAS Statewide Fixed Assets System
 No. 123 to make the expensing of stock options previously not expensed under APB Opinion No. 25 optional, and extended this practice to options,issued to directors in FASB Interpretation No. 44. The FASB did succeed in making the "fair value method" of expensing the preferred accounting method and now requires proforma disclosure of the potential impact of recording this expense using the fair value method. Dennis Beresford commented in his testimony before the U.S. Congress at a hearing on "Accounting and Investor Protection Issues Raised by Enron and Other Public Companies: Oversight of the Accounting Profession, Audit Quality and Independence, and Formulation of Accounting Principles" on April 26, 2002 about the FASB decision:
   Certain members of Congress were
   sufficiently influenced by the
   appeals from corporate executives that they were persuaded
   to introduce legislation to counter the FASB's proposal. The
   legislation would have prohibited public companies from following
   any final FASB rule on this matter. More importantly,
   the legislation would have imposed requirements that the
   SEC repeat the FASB's process on any new accounting proposals,
   thus effectively eviscerating the FASB. Faced with the
   strong possibility that its purpose would have been eliminated
   by this legislation, the FASB made a strategic decision to
   require companies to disclose the effect of stock options in a
   footnote to the financial statements but not record, the
   expense in the income statement.


Subsequently, the FASB issued an invitation to comment (Accounting for Stock-based Compensation: A Comparison of FASB Statement FASB Statement

A standard set by the Financial Accounting Standards Board regarding a financial accounting and reporting method. Essentially, FASB statements determine the acceptable accounting practices that Certified Public Accountants use in reporting
 No. 123, Accounting for Stock-Based Compensation, and Its Related Interpretations, and IASB IASB

See International Accounting Standards Board (IASB).
 Proposed IFRS, Share-based Payment) in June 2002, that resulted in two different types of responses. Corporations opposed to expensing cited the following concerns (based on FASB Chairman Herz's comments on May 8, 2003):

* Does mandated expensing of employee stock options have a clear or widely accepted rationale?

* Is the real cost of issuing employee stock options in the potential dilution potential dilution

The decrease in the proportional equity position of a share of stock that will occur eventually if additional authorized shares are actually issued.
 of existing shareholders' equity Shareholders' Equity

A firms' total assets minus its total liabilities. Equivalently, it is share capital plus retained earnings minus treasury shares. Shareholders' equity is the amount by which a company is financed through common and preferred shares.
 interests?

* Is the cost of employee stock options already reported in corporate financial statements?

* Do existing option pricing models option pricing model

A mathematical formula for determining the price at which an option should trade. The model expresses the value of an option as a function of the value of the underlying asset, length of time until maturity, exercise price, yields on
, including Black-Scholes and binomial-models, even when adjusted, produce inaccurate and misleading information?

* Will expensing stock options lead to an even more distorted picture of a company's financial performance and condition?

* Will mandated expensing of employee stock options destroy broad-based plans and the productivity, innovation, and the economic growth they generate?

All Those in Favor

On the other hand, many individual and institutional commentators support the expensing of stock options. Corporations in favor of expensing options, and who now expense options, generally include big-name companies--Coca Cola, General Motors, Wachovia Bank, Bank One, and Procter & Gamble to name a few. However, according to according to
prep.
1. As stated or indicated by; on the authority of: according to historians.

2. In keeping with: according to instructions.

3.
 the Wall Street Journal in an article entitled "Expensing Options Will Affect Small-Cap Firms" (Talley, Aug. 19, 2002), numerous small-caps have also begun expensing options. Some of the reasons cited for supporting expensing include:

* Expensing may provide clarification to shareholders.

* Expensing allows the company to demonstrate conservative practices and openness with shareholders and analysts.

* Expensing may raise a company's profile and win a greater following on Wall Street.

* It's misleading to say that stock options are not an expense.

An article in Fortune noted on Aug. 12, 2002 (Fox) entitled The Only Option (for stock options, that is) provides further reasons that support expensing:

* Options are not free. We know that because people pay money for such options every day on exchanges around the world.

* If the cost of options is already fully reflected in earnings per share, then outright grants of stock should not be an expense either.

* There are widely accepted mathematical models that can be used to estimate the value of even those options that aren't traded on exchanges.

Expensing of stock options will have a negative impact on reported corporate earnings. As reported by Bloomberg, "Counting options as a compensation expense would have added $74 billion to the salary costs of the Standard & Poor's 500 Index companies in 2001, according to Credit Suisse First Boston Credit Suisse First Boston was originally the trading name of the Financière Crédit Suisse-First Boston, a London-based 50-50 investment banking joint venture formed in 1978 between the First Boston Corporation and Credit Suisse. . Most of that cost would have been borne by technology companies, which tend to give options to many employees, not just senior executives, Credit Suisse The Credit Suisse Group (SWX:CSGN, NYSE: CS) is a financial services company, headquartered in Zürich, Switzerland. It is the second-largest Swiss bank, behind UBS AG.  said." Consequently, U.S. Senators Enzi (R-NV), Allen (R-VA) and Boxer (D-CA) are leading the fight to have Congress mandate a three-year moratorium awaiting a report at the end of three years from the SEC on reporting for stock options to employees and directors. The chairmen of the respective House and Senate committees have publicly announced that no hearings will be held on these bills.

One argument for expensing is that the development of valuation models clearly is different in 2003 versus 1972. The use of estimates in financial statements has accelerated in that many more balance sheet and income statement accounts now utilize estimates. The use of estimates for items such as uncollectible accounts Uncollectible account

An account which cannot be collected by a company because the customer is not able to pay or is unwilling to pay.
 or warranty commitments has never been a rationale for not reporting expenses or adjusting amounts on balance sheets. However, both the FASB and the IASB have noted a concern for lack of transparency and comparability from having transactions reported differently in financial statements developing from the use of alternative accounting treatments, in this case, expensing versus disclosing.

The Debate Continues

Clearly, the controversy over the expensing of stock options has both opponents and supporters. Public debate will continue since issues concerning valuation methods and the financial reporting model allow for controversy. As the Economist noted on April 26, 2003, in an article titled True and fair is not hard and fast--The future of accounts:
   Most significant of all, perhaps, is the attempt to force
   companies to account for stock options granted to their
   employees. FASB has agreed that the cost of employee
   stock options should be treated as an expense. The question
   is how to value them. The standard-setters may yet
   have a fight on their hands.


Member Views on the FASB Ruling

There is controversy around every corner today. Much of the controversy lately has revolved around the FASB's ruling to treat grants of stock options to executives and employees as expenses.

What we want to know is what do our members think.

According' to a recent Ohio Society Web poll, our members very much agree, with 74 percent voting in favor. In addition to the poll, we received a few letters to the editor sharing their views on this subject.

Society Web Poll:

Do you agree with FASB's decision to treat grants of stock options to executives and employees as expenses?

26% Disagree 74% Agree

Dear Editor:

For financial reporting, I would expense stock options when the options are exercised by the employee. This is generally the same way the matter is handled for income tax purposes. Prior to that time, I would disclose all the usual information about the options, including the potential expense liability. (The "overhang Overhang

Calculated as stock options granted, plus the remaining options to still be granted, and then divided by the total shares outstanding.

Notes:
A high percentage for the overhang is usually a bad thing.
," so to speak. Use Black-Scholles and give a wide range of the estimated liability).

I know this approach will have almost no support from the financial reporting community. The major objection will be that the expense should be recognized sooner, as part of the current year employment expense. No doubt many will point out that options are often exercised by retirees and others no longer employed by the company, so we have failed on the "matching" principle.

Could it also be argued that the work performed by some (many) employees while gainfully gain·ful  
adj.
Providing a gain; profitable: gainful employment.



gainful·ly adv.
 employed has future benefits, so that deferral of some of their compensation (the part contingent upon Adj. 1. contingent upon - determined by conditions or circumstances that follow; "arms sales contingent on the approval of congress"
contingent on, dependant on, dependant upon, dependent on, dependent upon, depending on, contingent
 future appreciation in the value of the stock) provides a better "matching" than to expense all compensation while the employee is active in the business?

Another objection will no doubt be that expensing the options when exercised by the employee will cause significant fluctuations in reported earnings.

Two responses. First, so what? The financial community should be able to handle this (the marketplace would factor it into their estimates of the present and future value of the publicly traded stock). Second, and my major concern with earlier recognition of the expense, this will become another possible area of earnings manipulation--smoothing out income over time--even by the most conscientious of CFOs. For those that have argued against ever expensing stock options because of the measurement problems (i.e., the Black-Scholles model is not up to the task), expensing when exercised provides a very high degree of certainty of measurement.

Whatever the standard setting bodies decide on measurement, I wholeheartedly whole·heart·ed  
adj.
Marked by unconditional commitment, unstinting devotion, or unreserved enthusiasm: wholehearted approval.



whole
 endorse the expensing of stock options. The grant of a stock option to an employee is a compensation expense.

Thomas C. Mowry Manager Healthserve LLC (Logical Link Control) See "LANs" under data link protocol.

LLC - Logical Link Control
 

Dear Editor:

Once again the accounting profession fails in its attempt to self-regulate by missing the entire point, and as a CPA (Computer Press Association, Landing, NJ) An earlier membership organization founded in 1983 that promoted excellence in computer journalism. Its annual awards honored outstanding examples in print, broadcast and electronic media. The CPA disbanded in 2000.  with a forensic accounting Forensic accounting, sometimes called investigative accounting, involves the application of accounting concepts and techniques to legal problems. Forensic accountants investigate and document financial Fraud and white-collar crimes  as well as a tax background that is licensed in Ohio, Florida and Maryland, I find this outrageous! (Thank God for Senator Paul Sarbanes Paul Spyros Sarbanes (Greek: Παύλος Σπύρος Σαρμπάνης) (born February 3, 1933), a Democrat, is a former United States Senator who represented the state of Maryland.  and Representative Mike Oxley Michael Garver "Mike" Oxley (born February 11, 1944) is an American politician of the Republican party who served as a U.S. representative from the 4th congressional district of Ohio. !)

Yes, expensing of stock options is an excellent idea and one that is long overdue! (Just ask Warren Buffet or Allen Greenspan.)

When stock options are exercised, the capital markets have basically determined the perceived value of the stock which translates into compensation expense for the difference between the executive's option price and the fair value at the time of exercise. This spread, which the IRS An abbreviation for the Internal Revenue Service, a federal agency charged with the responsibility of administering and enforcing internal revenue laws.  allows as a tax deduction Tax deduction

An expense that a taxpayer is allowed to deduct from taxable income.


tax deduction

See deduction.
 for non-qualified options and ISOs that are treated as disqualifying dispositions disqualifying disposition

The sale, gift, or exchange of stock acquired through an employee stock purchase plan within two years of enrollment or one year of the purchase date. A disqualifying disposition results in ordinary income for tax purposes.
, should also be an expense for GAAP GAAP

See: Generally Accepted Accounting Principles


GAAP

See generally accepted accounting principles (GAAP).
 accounting.

Why not simply follow the tax rules for deducting compensation expense as a result of the exercise of options?

Secondly, until such time as an option is exercised, the "fair market value," however it is determined, could be accounted for as a component of comprehensive income, similar to the way that unrealized gains Unrealized Gain

A profit that results from holding on to an asset rather than cashing it in and using the funds.

Notes:
Let's say you own a stock that has doubled, but you haven't sold it yet. This is said to be an unrealized gain.
 and losses are handled for securities, interest rate swap Interest Rate Swap

A deal between banks or companies where borrowers switch floating-rate loans for fixed rate loans in another country. These can be either the same or different currencies.
 contracts, and other forms of derivatives. (If this treatment is good enough for securities and derivatives, it should be good enough for stock options.)

As a long-term capital markets investor and shareholder advocate that has witnessed the erosion of value and confidence in the capital market system as a result of the corporate accounting fraud scandals, it is due time that financial reporting start utilizing economic reality standards.

Brent D. Berkman, CPA Senior Manager Reznick, Fedder & Silverman CPAs'

Connie Esmond-Kiger, CPA, Ph.D., is an assistant professor in the School of Accountancy at Ohio University Ohio University, main campus at Athens; state supported; coeducational; chartered 1804, opened 1809 as the first college in the Old Northwest. There are additional campuses at Chiillicothe, Lancaster, and Zanesville, as well as facilities throughout the state. . Her current teaching and research interests are in corporate financial reporting, accounting education strategies, and ethics in reporting.

Ray G. Stephens, D.B.A., C.P.A., C.M.A., is professor and director, School of Accountancy at Ohio University. His current teaching and research interests are in corporate financial reporting and attest services.
COPYRIGHT 2003 Ohio Society of Certified Public Accountants
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Title Annotation:expensing of stock options supported by Financial Accounting Standards Board and International Accounting Standards Board
Author:Esmond-Kiger, Connie; Stephens, Ray G.
Publication:Catalyst (Dublin, Ohio)
Geographic Code:1USA
Date:Jul 1, 2003
Words:2275
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