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ESOPs fable: the goose that laid the golden eggs.

For years employee stock ownership plans (ESOPs) have been like the goose that laid the golden eggs. Cash-poor companies struggling for a method to attract good managerial and technical talent have squeezed the stockholder equity goose to produce options that have little present value but possess potential for significant gain when stock prices increase. This method made everyone happy: the executive stood to gain if his or her performance resulted in increased stock prices, the company got the services of the executive without affecting cash or earnings, and the IRS got its cut if the executive subsequently sold any stock at a gain. Now the Financial Accounting Standards Board (FASB) is planning to kill the goose by requiring that employee stock options (ESOs) be deducted from earnings, a move that is estimated to reduce earnings of emerging businesses by some 30%.

According to an FASB exposure draft issued June 30, 1993, not only will ESOs be considered compensation expense, but the measurement method used to determine the amount of expense (at least for public corporations) will be the Black-Scholes (B-S) or similar option pricing model, previously used mostly for financial research to determine the value of call options for stock actively traded on exchanges. Using this model to determine values for options on infrequently traded over-the-counter issues may be about as accurate as reading the entrails of the goose after it has been killed.

The Executive Compensation Controversy

Counting ESOs as compensation expense is a part of the somewhat larger debate over executive compensation in general, and the FASB was somewhat reluctantly drawn into the debate. Historically, the accounting principles that govern ESOs date back to the old 1972 Accounting Principles Board Opinion 25 (APB No. 25, 1972). Under APB No. 25, compensation expense did not need to be recognized unless the market price of the stock exceeded the exercise price on the date of measurement, which was generally the date of the grant. In the case of emerging firms, the market price was likely to be lower than the exercise price, the presumption being that the value of the stock would increase as the firm grew, and no compensation expense was recorded.

Although the FASB occasionally considered the problem of ESOs, no new pronouncements were issued. As late as 1988, the matter was on the FASB's agenda, but the Board instead turned to a discussion of the difference between liability and equity instruments, believing that making this distinction would assist them in deciding the nature of ESOs.

However, in 1991, Sen. Carl Levin (D-Mich.) introduced the Corporate Pay and Responsibility Act which would have compelled the Securities and Exchange Commission (SEC) to require that ESOs be accounted for in financial statements. Even though the bill did not pass, the SEC issued new proxy statement disclosure rules and also asked the FASB to evaluate its position on ESOs. The FASB responded with a review that subsequently led to the current exposure draft. In its original form, the disclosure provisions would have become effective for years beginning after December 31, 1993, and the recognition provisions for awards granted after December 31, 1996. However, the Board has backed off to the extent that disclosure provisions will not be required in 1994 financial statements. The FASB is currently reviewing the information received during the comment period and is not likely to issue a final pronouncement until the first quarter of 1995.

In the meantime, Congress has not been idle. Sen. Levin along with Rep. John Bryant (D-Tex.) has introduced legislation to require public companies to recognize the fair value of ESOs as expense, while Sens. Joseph Lieberman (D-Conn.), Connie Mack (R-Fla.) and Diane Feinstein (D-Calif.) have a bill that would override the FASB's proposal. Similar measures have been introduced in the House.

Objections To the FASB Proposal: Theoretical

Senate hearings on the FASB proposal before the Securities Subcommittee of the Banking, Housing and Urban Affairs Committee in October, 1993, generated at least as much heat as light with Sen. Phil Gramm (R-Tex.) commenting, "the bottom line here is that this is a stupid proposal" (Cox and Elsea, 1993). Stupidity aside, the objections to the proposal have to do with both theoretical and practical concerns as well as apprehensions about the method of measurement.

Under the category of theoretical concerns is the nature of ESOs when the exercise price is equal to or exceeds the market price. In these circumstances is the ESO an expense or an asset? Does the offsetting credit affect equity or liabilities? Or is the whole arrangement a non-transaction that should be disclosed but not booked? According to APB No. 25, compensation expense is recognized only to the extent that market price exceeds exercise price. Where the two are equal or exercise price exceeds market price, no compensation expense need be recorded.

Under the FASB's proposal, the ESO represents compensation expense with the value of the option determined by an option pricing model for public companies and by the minimum value method for nonpublic firms. At the time of the grant, the company records an asset account for prepaid compensation with a corresponding credit to equity for options outstanding. In addition, a deferred tax liability is recorded. The prepaid compensation account is then amortized (expensed) over the service (attribution) period, which is usually the period from the grant date to the vesting date. All stock-based compensation is included, even stock-based instruments available to a broad range of employees. Besides the entries that will affect the body of financial statements, significant disclosures will be required, including the method and assumptions used to estimate the value of the options.

The contention in favor of the FASB proposal is that if employees agree to accept stock options as part of their compensation package, the options are compensation and should be valued in some fashion and treated as expense. Mary Barth (1994), Chair of the FASB Committee of the American Accounting Association, summarizes this argument as, "stock options and other forms of stock-based awards represent compensation and should be recognized as such. These awards differ from other types of compensation only in form, not in substance."

Those who disagree with the FASB believe granting ESOs is an internal transaction. They believe that the effect of ESOs is best shown by dilution of stockholder interest rather than by expense. In their landmark 1973 article, Black and Scholes point out that equity itself in a leveraged firm is really a call option on the value of the firm. Granting of options then certainly should be considered an equity transaction.

In an article titled, "Accounting for Stock Options - Am I Missing Something?" P. Norman Roy (1993), president of the Financial Executives Institute observes that:

"All proposals for the establishment of stock option and other stock compensation plans must be voted on and approved by current stockholders... If the expected result is achieved and the company's shares appreciate in value, the stockholders agree to share a portion of that appreciation with the management that contributed to the positive outcome. When options are exercised, there is an increase in the number of shares outstanding and per share values are affected, but net earnings are unchanged and there is no expense to the company."

Although there are many who object to the exposure draft on the theoretical grounds that granting ESOs is an internal transaction best shown by stock dilution, there are even more who object to the measurement method.

Objections To the FASB Proposal: Measurement Method

Since performance-based ESOs are typically issued when the exercise price is higher than the market price of the stock, the value could be considered nonexistent or even negative at the date of the grant. This makes the determination of value very difficult. The FASB's solution to this problem is to use an option pricing model, at least for public companies. The Black-Scholes model and its variations is the most popular of these models although a binomial model such as the Cox-Ross-Rubinstein model is permitted.

There is a certain natural appeal to the B-S model because its equations can be solved by computer, given the input of 5 or 6 variables. The inputs that the FASB (1993) proposal mandates are: exercise price and expected term of the option, the current price of the underlying stock, its expected volatility, the expected dividend yield on the stock, and the risk-free interest rate during the expected term of the option.

The crucial B-S assumptions relate to volatility and expected term. The more volatile the stock price, the greater the value of the option because there is a greater probability the price will rise to a level which makes the option valuable. Furthermore, the longer the period of time an option is in effect, the greater the probability this type of opportunity will occur.

It is these two assumption that present the most difficulties in valuing ESOs. Volatility in the B-S model is the annualized standard deviation of the natural logarithms of the possible future stock price changes. To use the FASB's (1993) example, "to say that a stock now trading at $100 has a volatility of 30% means that approximately two-thirds of the possible variation in stock price will fall within the range $70 to $143 (between 7/10 and 10/7 of the $100 price.)."

Obviously, it is very difficult to estimate volatility in stocks with' an established trading history on an exchange. Events such as the market crash of October, 1987, present difficulties to even sophisticated financial analysts. However, approximating volatility in the case of infrequently traded stock is nearly impossible. Recognizing this difficulty, the FASB has permitted the minimum value method for nonpublic corporations without a trading history. The minimum value method calculates the value of the option as the difference between the current price of the stock and the sum of the present value of the exercise price and the expected dividends on the stock during the term of the option. Using the minimum value method may solve the volatility problem for nonpublic companies but leaves difficulties for a host of small public companies that trade over-the-counter in regional or local markets.

The problem with companies that have infrequent trades at widely differing prices is that the volatility factor is very high, which causes the option price to be high. The higher the option price, the greater the compensation expense and the larger the hit on earnings.

Black and Scholes (1973) themselves noted certain problems with their model when they used it for empirical testing, noting that "tests indicate that the actual prices at which options are bought and sold deviate in certain systematic ways from the values predicted by the formula... The market appears to underestimate the effect of differences in variance rate on the value of the option." In other words, the model overestimates the effect of differences in variance rate or volatility.

Besides the difficulties related to volatility, there is the problem of the exercise period. Earlier proposals by the FASB used the vesting date rather than the grant date as the measurement date. The vesting date vs. grant date question continues to be a problem as pointed out by Christopher Young, who contends that a ten-year option with a three-year vesting period cannot be considered the equivalent of a ten-year call option in the market but is rather like a ten-year option minus a three-year option. The fact that Young's article in Financial Executive (1993) sparked a debate that raged on through letters to the editor for several issues is evidence that there is by no means agreement on the length of the exercise period, even among financial authorities.

Copeland and Weston (1988) point out several difficulties in using the B-S model for real-world pricing, among which is the tendency for the model to misprice deep out-of-the-money and deep in-the-money options. That is, the model is most inaccurate when exercise price and market price differ significantly. In cases in which companies are using ESOs to motivate executives to improve stock prices, there is likely to be considerable difference between the exercise price and market price at the time the grant is made, resulting in an inaccurate price for the option.

Objections To The FASB Proposal: Practical

Besides theoretical concerns and questions over the applicability of option pricing models, there are significant public policy problems associated with the proposed rules for ESOs. Many would agree with Sen. Lieberman's assessment that "as a practical matter it is unworkable. And as a matter of public policy it is simply unnecessary and unusually disruptive. (Ochsner 1993)."

Evidence is mounting that many firms would see substantial reductions in earnings if their ESOs were considered compensation expense. Those hardest hit would include emerging firms, those whose stock has recently gone public. Because they have little trading history the volatility of stock prices would result in a high option value according to the B-S Model. Also feeling the effect would be high-tech firms who use ESOs extensively to attract good managerial and technical talent. Companies that promote widespread stock ownership among employees would also find their earnings diminished by the FASB proposal.

Besides the direct effect on earnings, there are also indications that the process of determining the value of the options will be more than the fill-in-the-blanks exercise envisioned by the FASB. James F. Morgan of the National Venture Capital Association estimates the costs of implementation could increase a company's accounting costs by 10% to 40%. Smaller companies with fewer resources and less access to financial expertise will be the most affected, but any company with ESOs is likely to have some extra cost. In addition, attesting to the value of the options as indicated by the B-S model is likely to be an auditor's nightmare.

According to a 1994 ShareData study of 30 companies, earnings would be reduced by an average of 29% under the FASB proposal. Even with the assistance of two large accounting firms, the ShareData staff found application of the rules expensive and time-consuming.

A study of 27 firms by Akresh and Fuersich (1994) found the effect on earnings of emerging companies to be an average reduction of 31% after the phase-in period. Emerging firms were defined as those whose stock had been publicly traded for less than 10 years. The effect was less significant for mature firms, which had an average reduction in earnings of 4% after the phase-in period. Akresh and Fuersich also found compliance difficult. They reported that:

"For many companies, because information on historical exercise patterns, forfeitures before vesting, and stock price history was unavailable or incomplete, the data collection and analysis phase was the most difficult and time-consuming aspect of the study. Accordingly, some companies will need to spend considerable time and effort obtaining data for the stock option pricing models. Some may need to consider and implement changes in their systems and procedures."

Still another study by the Wyatt Group (Saldich, 1994) indicates the reduction in earnings of high-tech companies would be almost 50%.

The FASB's answer to the claim that earnings will be hurt and some companies may cease to offer ESOs is generally that neutral financial reporting should not be detrimental to the firms involved, and that those that truly benefit from their ESOPs will find it cost beneficial to continue them.

Besides the effects on earnings, some companies may also find there are other repercussions on their financial statements. The increase in equity may impact debt/equity ratios through the increase in the denominator. The Akresh and Fuersich study showed the initial increase in equity averaged less than 2%, indicating the effect may be insignificant. However, companies with debt covenants related to debt/equity or similar ratios should review balance sheet as well as income statement results.

Reactions To the Proposed ESO Rules

Early indications are that many companies will cease or significantly curtail ESOs if the FASB rules go into effect. Bradford S. Goodwin (1993) reports a survey by Venture One revealed that nearly half of the respondent CEOs and CFOs would reduce the range of employees receiving options if subject to the FASB rules. Joyce Strawser (1993) cites a survey of 500 start-up companies that indicated 90% of the respondents would stop issuing options to most employees other than top executives.

Shimko and Tucker (1993) report still another study by the Hay Group that indicates only 21% of the CEOs surveyed said their programs have been or would be modified because of the proposed rules. However, 48% said they might curtail the number of employees entitled to stock options and 47% said they might reduce the size of the grants.

The response of some companies has been to stock-pile shares for ESOs to be granted before the close of 1996 when the new rules take effect. A 1993 Fortune article indicated stock authorized for options plans at an all-time high of 9.11% of total outstanding shares, up from 6.9% four years previously.

Although some are calling for a grass roots campaign to get the FASB to back down, it is unlikely the FASB will consider any further reactions, having gone through the usual comment period. At this stage all firms with or considering ESOs need to take a hard look at the effects on earnings these plans will have. Furthermore, they should evaluate the data-gathering and systems changes needed to implement the FASB rules. Finally, they should keep an eye on legislation and actions of the SEC relating to ESOs.

References

Accounting Principles Board, Accounting for Stock Issued to Employees, Opinion No. 25 (New York: American Institute of Certified Public Accountants, 1972).

Akresh, Murray S. and Janet Fuersich, "Stock Options: Accounting, Valuation, and Management Issues." Management Accounting, March 1994, pp. 51-53.

Barth, Mary, "Taking Account of Stock Options (Comment Letters)." Harvard Business Review, January-February 1994, pp. 33-34.

Black, Fischer and Myron Scholes, "The Pricing of Options and Corporate Liabilities." Journal of Political Economy, May-June 1973, pp. 637-654.

Copeland, Thomas E. and J. Fred Weston, Financial Theory and Corporate Policy, 3rd Edition (Reading, Mass.: Addison-Wesley Publishing Co., 1988.

Cox, Bill D. and John E. Elsea, "Stock-Based Compensation Controversy Heats Up." Practical Accountant, December 1993, pp. 30-41.

Fefer, Mark D., "Stocking up Stock to Option." Fortune, November 15, 1993, p. 14.

Financial Accounting Standards Board. Accounting for Stock-Based Compensation (Exposure Draft) (Hartford, Conn., Financial Accounting Standards Board, 1993).

Goodwin, Bradford S., "Can Stock Compensation Accounting Accomplish Anything that Disclosure Can't?" Financial Executive, January-February 1993, pp. 22-23.

Morgan, James F. "Taking Account of Stock Options (Comment Letters)." Harvard Business Review, January-February 1994, p. 32.

Ochsner, Robert C., "FASB Exposure Draft on Accounting for Stock Options is 'Bad Economics and Bad Accounting' (Responses)." Compensation & Benefits Review, November-December 1993, pp. 17-20.

Roy, P. Norman, "Accounting for Stock Options - Am I Missing Something?" Financial Executive, May-June 1993, p. 1.

Saldich, Robert J., "Taking Account of Stock Options (Comment Letters)." Harvard Business Review, January-February 1994, pp. 32-33.

ShareData, Inc., Field Study of the Financial Accounting Standards Board's Proposed Statement of Financial Accounting Standards Accounting for Stock-Based Compensation (Sunnyvale, Calif: Coalition for American Equity Expansion, March 1994).

Shimko, Barbara Whitake and James J. Tucker, III, "Proposed Accounting Rules for Employee Stock Options: The Potential Impact and Implications." Compensation & Benefits Review, November-December 1993, pp. 31-36.

Strawser, Joyce A., "Accounting for Stock-Based Compensation: The FASB's Proposal." The CPA Journal, October 1993, pp. 44-47, 90-91.

Young, Christopher K., "What's the Right Black-Scholes Value?" Financial Executive, September-October 1992, pp. 57-59.

Carole Cheatham, PhD, CPA, CMA, is a professor in the department of accounting, Leo R. Cheatham, PhD, is a professor in the department of finance and economics and Michelle McEacharn, DBA, CPA, is an assistant professor in the department of accounting at Northeast Louisiana University in Monroe.
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Title Annotation:employee stock ownership plans
Author:Cheatham, Carole; Cheatham, Leo R.; McEacharn, Michelle
Publication:The National Public Accountant
Date:Apr 1, 1995
Words:3287
Previous Article:Reporting on internal control: a business opportunity for accountants.
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