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Are FASB accounting proposals for stock based compensation a threat to entrepreneurship?

INTRODUCTION

In December 1994, the Financial Accounting Standard Board withdrew the exposure draft of a proposed statement, Accounting for Stock Based Compensation, which had been issued in June 1993. The exposure draft proposed a substantial revision in the way companies account for stock options used to compensate executives, requiring recognition of compensation. The old accounting rules were established by APB Opinion 25, Accounting for Stock Issued to Employees. The FASB's exposure draft met a flurry of opposition from businesses, politicians, and from CPAs in both public practice and in commerce and industry. FASB chairman Dennis R. Beresford stated, "no matter how hard we tried to convince people of the correctness of our stand, there simply was not enough support ..." (Beresford, 1995, 18). The FASB concluded their efforts in the stock compensation area by issuing Statement of Financial Accounting Standards Number 123, adopted January 1996. This statement abandons the accounting methodology proposed in the exposure draft, requiring instead only certain footnote disclosures of what income would have been if compensation were to be recognized.

A major concern of those opposed to the new accounting methods put forth in the 1993 exposure draft was that they would have a disastrous effect on American Business. More specifically, the charge was made that the new accounting standards would be a threat to entrepreneurship. In mid-1993 Congresswoman Anna Eshoo (California) submitted a congressional resolution calling for the FASB not to change its current accounting rules because the new accounting "poses a threat to economic recovery and entrepreneurship in the United States ... and stunts the growth of new-growth sectors, such as high technology, which relies heavily on entrepreneurship" (Kieso & Weygandt, 1995, 823). Indeed, the FASB received more letters on this proposal than any other matter in its history. Senators Gramm (Texas) and Lieberman (Connecticut) "made it clear that if the FASB didn't drop its proposal, they'd kill it in congress" (Colvin, 1995, 16).

Do the allegations that the FASB's accounting proposals threaten entrepreneurship have any basis in fact? We examine this issue and try to provide an answer to the question.

BACKGROUND

In 1984, the FASB started a major project to determine if compensation expense should be reported for stock options granted to executives. From the beginning, the business community opposed the project, feeling the accounting rules under APB Opinion 25 were appropriate. The FASB eventually put the project on hold while it completed a study on more fundamental questions related to debt and equity.

Meanwhile large stock option grants continued to be given to executives. In most cases the company did not report compensation expense. The SEC received criticism from legislators and the press about the lack of reporting on these options and pressured the FASB to do something. In January 1992, Senator Carl Levin (Michigan) introduced a bill in Congress that would require publicly traded companies to recognize an expense based on the fair value of options granted to employees. He delayed action on the bill, provided the FASB issue new accounting rules. In June 1993, the exposure draft was issued. The opposition was intense. The FASB looked for political support but found little. The SEC commissioners all expressed reservations about the proposed ruling. In mid-1994 the FASB agreed to delay, by one year, certain requirements in the exposure draft. Finally, on December 9, 1994, the FASB met and decided against mandating that companies report the value of employee stock options as an expense. They made such accounting optional. If a company chooses not to record these awards as an expense, however, it would have to disclose in a footnote to the financial statements what the effect on net income would have been had the company recognized the expense based on FASB specified guidelines.

THE DIFFERENCE BETWEEN OPINION 25 AND THE EXPOSURE DRAFT

To distinguish the difference in accounting under Opinion 25 and the FASB exposure draft, we will use a simple illustration. Small Company has 1,000,000 shares of common stock outstanding. Annual revenues are $10,000,000 and expenses are $7,000,000 yielding a pre-tax income of $3,000,000. The company is small and growing and decides to save cash by compensating the senior managers by offering stock options as a substantial portion of top executive compensation. Twenty percent of current outstanding shares are granted as stock options at the beginning of year one. The Small Company options expire in five years and have a $30 exercise price. The executives must stay with Small Company three years for the options to vest. The market value of the stock on the date of the grant is $25.

The accounting under Opinion 25 (Figure 1) recognizes compensation expense on the measurement date based on the excess of the market price over the option price at that date. The measurement date is the date at which both the number of shares which can be purchased and the purchase price are known. Opinion 25 does not recognize compensation expense in our illustration because the option is "out of the money" on the measurement date, which means the exercise price is above market. This is normally the case with stock options granted executives because the IRS Code requires that the exercise price be at or above the market price for an option plan to be considered an incentive stock option (a qualified plan). Companies almost always elect a qualified plan because of the tax advantages it provides to the executives. In such a plan, the executive pays no tax at the date the options are received. Tax is also deferred on the date of exercise, although the executive has a gain on the difference between the option price (in this case $30) and the market price which is higher than $30 (or the purchase would not occur). Tax is only paid on the date of the sale of the shares, usually at capital gain rates, depending on the holding period.

Small Company has given its executives the right to purchase 200,000 shares of its stock at $30 per share after year 3 and before the expiration of year 5. This grant is obviously giving the executives something of substantial value, but Opinion 25 recognizes no compensation. The assumption that something of value is being transferred to the executive is supported by consistent evidence that financial markets place value on such options, even though they are below the strike price at the time. The value of such options in the market lies in the potential future value based on the possibility that the market value of the stock will go above the option price before the expiration period passes.

The accounting proposed under the exposure draft (Figure 2) would recognize compensation expense, and allocate it over the three year vesting period of the options, under the assumption that the options do indeed have a value which is subject to measurement even though the option price is above the market price at the date of the grant. The period of the compensation is assumed to be equal to the vesting period of the options, the period over which the Company benefits because the executives must stay with the company in order to exercise the options.

The obvious problem is how to assign a value to the options. The exposure draft requires the use of an option pricing model such as Black-Scholes. Under the exposure draft requirements we use the Black-Scholes model, assuming a risk free interest rate of 7% and an annual standard deviation of the stock price of 40% and calculate a $10.03 value for each option. If only 182,535 of these options vest due to an anticipated 3% employee turnover, the total compensation cost of this grant is $1,830,822 or $610,274 per year. Clearly, in our example, the effect on the Income Statement is substantial, exceeding 20% of pre-tax income. The accounting for these options under the FASB proposal and under APB 21 is illustrated in Figures 1 and 2.

The material impact on earnings illustrated in Figures 1 and 2 are typical for a small start-up company. Ciccotello and Grant (1995: p. 74-75) argue that the FASB proposed accounting will affect small companies much more than large companies for two reasons: (1) the number of shares under option for large companies, although large in gross terms, is small in relation to the number of shares outstanding; and (2) the stock price volatility of a large more established company generally is lower than that of a small company. The higher stock price volatility causes the options of the smaller company to be valued higher, while the higher proportion of options to shares outstanding for the small company dramatically increases the materiality of their effect on the income statement.

THREAT TO ENTREPRENEURSHIP?

The exposure draft is controversial for many reasons. Applying the FASB's own standards as established in their conceptual framework, recognition of an item in the financial statements requires that the item must meet the definition of an element in the financial statements and be reliable, relevant, and measurable. (FASB, 1984: par. 63) After exhaustive consideration of these issues, the FASB concluded that the stock option transactions met all the criteria for expense recognition. These conclusions can be questioned from a number of theoretical perspectives, the most crucial being the reliability of using an option pricing model to measure the value of the options. These concerns are valid, although estimates are used in numerous other areas of accounting. The purpose of this paper, however is not to argue these issues but to focus on the validity of the entrepreneurial threat argument.

This argument seems to rest on the assumption that the accounting rules in the exposure draft will result in recognition of additional expenses for American Businesses, particularly new start-up companies in the high-tech areas which traditionally rely on stock options to attract management and engineering talent. It presumably is assumed that these additional expenses will make it more difficult for these companies to succeed by making it more difficult to attract capital and reduce the value of their equity securities in the market place. Such thinking, if taken at face value, is almost certainly illogical. The FASB addresses this issue:

Some opponents of recognizing compensation cost for stock options are concerned about the adverse effect they contend it will have on the income statements of American Businesses. The Board believes that the effect of recognizing compensation cost for employee stock options is neither more or less adverse than the effect of recognizing depreciation (or any other) cost. Recognition of depreciation always reduces a company's profit or increases its loss. American businesses would look more profitable on paper if they discontinued that practice. However, no one recommends not recognizing depreciation to eliminate its adverse effect on the income statement. The Board believes that the rationale that a potentially adverse effect on income statements argues against recognition is no more compelling for compensation than any other cost. (FASB, 1993: par. 70)

The contention that the accounting proposed in the exposure draft is a threat to entrepreneurship is, in our judgement, misguided. The implicit benefit of issuing an accounting standard is the increased credibility and representational faithfulness of financial reporting as a result of the revised accounting. The issue is whether the recognition of compensation cost for stock-based compensation paid to employees will improve the representational faithfulness and credibility of financial statements. All parties involved will make better decisions with information which better represents actual results.

Those opposed to the new standard would better base their opposition on attacking the representational faithfulness of the new standard, rather than suggesting that entrepreneurship is better off with misleading or inaccurate information. Steven Wallman, a commissioner of the SEC has this to say about the stock compensation matter:

There can be no ignoring ... the political and lobbying campaign that was waged with respect to this issue. Regardless of your view as to whether [the] FASB reached the preferred result, no one can believe that the best mechanism for establishing accounting standards is to politicize them ... (Wallman, 1995: p. 83)

REFERENCES

Beresford, D. R. (1995). Financial reporting-FASB revises position on stock options. Journal of Accountancy, February, 18-19.

Ciccotello, C. S., and Grant, C. T. (1995). Employee Stock Option Accounting Changes. Journal of Accountancy, January, 72-77.

Colvin, G. (1995). Another win for the corner office. Fortune, January, 16, 1995, 15-16.

Financial Accounting Standards Board (FASB) (1984). Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises. Stamford, Conn.

Financial Accounting Standards Board (FASB) (1993). Proposed Statement of Financial Accounting Standards, Accounting for Stock Based Compensation. Norwalk, Conn.

Kieso, D. E. & Weygandt, J. J. (1995) Intermediate Accounting, Eight Edition. New York: Wiley, 820-832.

Wallman, S. M. H. (1995). The Future of Accounting and Disclosure in an Evolving World: The Need for Dramatic Change. Accounting Horizons, September, 81-91.

David Coffee, Western Carolina University

John Beegle, Western Carolina University

Beth Jones, Western Carolina University
Figure 1
APB Opinion 21 Accounting
Small Company
Income Statement
Year 1

Sales $10,000,000.00
Expenses 7,000,000
Pretax income 3,000,000
Taxes 1,200,000
Net income $1,800,000
Earnings per share $1.80

Figure 2
FASB Proposed Accounting
Small Company
Income Statement
Year 1

Sales $10,000,000.00
Expenses 7,610,274
Pretax income 2,389,726
Taxes 955,890
Net income $1,433,836
Earnings per share $1.43
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Author:Coffee, David; Beegle, John; Jones, Beth
Publication:Entrepreneurial Executive
Article Type:Company overview
Date:Sep 22, 1996
Words:2237
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