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Can stock compensation accounting accomplish anything that disclosure can't?

The complex issues surrounding accounting for stock compensation have been debated without resolution for years. The most recent revival of the debate, focused on whether stock options should be counted as employee compensation on a company's income statement, began in late 1991 when Michigan Senator Carl Levin introduced the Corporate Pay and Responsibility Act. If Senator Levin's bill had passed, it would have required the Securities and Exchange Commission to require public companies to account for stock options in their financial reports.

In early 1992, SEC Chairman Breeden asked Chief Accountant Schuetze to work with the FASB to determine if a change in accounting for stock compensation is justified. And then, in October, the SEC issued sweeping new proxy statement disclosure rules for executive compensation that require, among other things, the valuation of stock options through the use either of an option pricing model or of hypothetical future stock price appreciation of 5 percent and 10 percent compounded.

At its meeting in November, the FASB proposed to account for employee stock options using an option pricing model that would take into account such factors as volatility and the expected term of the option. The bottom line of the FASB's proposal is that it would charge 30 percent to 70 percent of the value of the underlying stock to a company's earnings over the vesting period as compensation expense. And it would treat "broad-based stock plans" no differently than any other fixed-stock plan.

A number of organizations and individuals, including the Business Roundtable, Financial Executives Institute's Committee on Corporate Reporting, three of the Big Six accounting firms and many biotechnology and high-technology business leaders, have argued strongly against the FASB's proposal. A pivotal issue underlying the arguments for and against the proposal is the question of disclosure versus accounting.

No one questions the need for adequate disclosure. Investors should understand and evaluate the policies corporate compensation committees follow in deciding executives' compensation and benefits, including their stock compensation. And for investors who want to relate the amount of the executives' stock options to the company's performance, the SEC's new disclosure regulations include a provision that would give investors all the information they need. I think, in short, the SEC's new rules provide the information investors need.

But I join my colleagues in opposing the FASB's proposals for accounting for stock options for three reasons.

1. Stock-option accounting would unduly burden the financial reporting process, and ultimately it could have a detrimental impact on U.S. competitiveness and job growth. Stock options have helped to fuel the creation and growth of many of America's most innovative companies, which in turn create most of the nation's new jobs. If use of stock options were to be limited, entrepreneurism in the U.S. would suffer at a time when innovative companies offer much of the hope for the country's economic recovery and continued growth. Consider the following:

* Employees in companies where stock options are widely granted tend to be more motivated and work better as a team than do employees in companies without stock options. And stock options enable resource-constrained companies to recruit and retain the very best employees.

* The cash infusion that results when employees exercise stock options often provides surely needed capital for a new company's research and development efforts.

* To include stock options as an expense would reduce a company's reported earnings, potentially affecting the market price of its stock and possibly limiting its access to capital markets.

* Lower-level employees, not senior executives, would feel the impact of the FASB proposal most keenly. Merck, DuPont, Pepsico, Toys "R" Us, Waste Management and Wendy's are a few of the major U.S. companies that have granted stock options to all or most of their employees, and others are considering doing so. And a recent survey by the Radford Group revealed that 66 percent of biotechnology companies grant stock options to all of their employees.

But very few companies would be able to afford to issue stock options broadly if they had to charge earnings. A recent survey by Venture-One, a research firm that monitors the activities and financial plans of private U.S. companies funded by venture capital, revealed that nearly half of the chief executive officers and chief financial officers surveyed would reduce the range of employees receiving options if they were required to adopt the FASB proposal. Many of these companies are planning to go public and will carefully consider the implications of retaining their broad-based stock option plan on their access to the public capital markets,

2. Establishing a standardized valuation model for stock-option accounting on financial statements that is reliable, reasonable, objective and comparable across companies works only in theory, not in practice. Considering that it is very difficult to estimate stock volatility, that stock options are not transferable to others and therefore involve no cash consideration from which to measure value and that stock-option plans vary significantly across companies and industries, fair-value measurement of stock options would be imprecise at best.

3. Accounting for stock options would not provide additional benefit to the users of financial statements. In an October 1992 report on improvements needed in U.S. financial reporting, the Association for Investment Management and Research, the trade group of equity security analysts, did not even mention stock options. And, in fact, many users argue that the cost of stock options is measured through the dilution of existing stockholders and that that impact is already reflected in earnings per share.

The FASB anticipates releasing an exposure draft around the beginning of the second quarter of 1993. It is likely to field-test the exposure draft before issuing a final standard in 1994. The FASB has already received many letters from companies and other interested parties on this issue. It is of utmost importance that the FASB carefully consider what are the users' needs for information about stock options and whether these needs are best met through new accounting or through better disclosure.

Mr. Goodwin is controller of Genentech, Inc. and a member of the Financial Accounting Standards Board's Stock Compensation Task Force and of Financial Executive Institute's Committee on Corporate Reporting.
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Title Annotation:Executive Compensation in the Spotlight
Author:Goodwin, Bradford S.
Publication:Financial Executive
Date:Jan 1, 1993
Previous Article:Shareholders look at executive pay.
Next Article:A pension plan for today.

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