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FASB's stock option accounting proposal: correcting a serious flaw.

Almost everything you read in the business press about the FASB's proposal for accruing compensation expense for stock options is negative. Some of the critic disagree with the accounting answer ("there's no out-of-pocket cost to the company"). Others fear the impact ("it's a major blow to American competitiveness"). Still others say the value of employee stock options cannot be reliably measured. Allow me to present a different point of view. Current accounting for stock options is flawed anachronism that needs fixing.

Current Accounting is "Nonaccounting"

Current accounting for stock options is really "nonaccounting" that ignores economic reality and is inconsistent with accounting standards for other types of compensation.

The current accounting standards were adopted in 1972; little changed from rule originally issued in 1948. The standards acknowledged that most stock option plans are compensatory in nature. Because of measurement considerations (the option valuation models in use today were not yet developed), they do not require accrual of compensation cost if the exercise price is at least equal to the market price on the first date that both the number of shares and the exercise price are known. For fixed-option plans, that is the grant date. Thus, for fixed plans, if an option is not in the money on grant date, no cost is recognized, even though on that date the option has a real value due to the tim value of money from delayed payment for the stock and the stock's volatility or potential to increase during the option period.

Current Accounting Ignores Reality

By disregarding an option's value, current accounting ignores the twin realitie that options give employees valuable rights and that options are compensation for services performed.

The value of every other kind of right given to employees as compensation for services performed is accrued as expense over the service period. That includes deferred compensation arrangements, the cost of accrued vacations and sick pay, pensions, retiree medical and life insurance costs, severance benefits, disability-related benefits, supplemental unemployment benefits, stock appreciation rights (SARs), and performance options.

Ironically, compensation cost is accrued today for SARs and performance options even though these tend to be worth less when granted than fixed stock options. Because accounting measures compensation expense for some plans and not for others, accounting has become a significant factor in plan design. To illustrate:

Stock Option. A company's executives are granted 10-year fixed options for 50,000 shares, exercise price $20 per share, stock price at grant date $20 per share, and stock price at exercise date five years later $50 per share. Since the market value of the stock at grant date (50,000 x $20 = $1,000,000) is equa to the exercise price, no compensation expense is recognized then or at exercise. At exercise, the executives pay $1,000,000 and receive $2,500,000 worth of stock, a $1,500,000 net benefit.

Stock Appreciation Right. Same facts except that the executives receive SARs to be settled in shares of stock. On exercise five years later, instead of paying $1,000,000 and receiving stock worth $2,500,000, the executives pay nothing but receive 30,000 shares of stock worth $1,500,000. Since the number of shares was unknown until exercise, compensation expense is determined at that date to be $1,500,000--the market value of shares received minus purchase price of zero.

Performance Option. Same facts as the fixed options, but with a performance condition that the executives can exercise the options only if the company's revenues increase by a specified percentage during the next two years. If at th end of the two years the revenues increased by the required percentage and the stock price is $50, compensation expense of $1,500,000 is recognized.

The substance of all three cases is that the employees were compensated in the amount of $1,500,000. But in one of the cases--the fixed options--expense was not recognized, which if anything are more valuable than the other two awards.

Rebuttals of Opposing Views

Some opponents of expense recognition argue that options are capital transactions with stockholders that never cost the company cash and in fact bring in cash. Others say the values of options cannot be measured accurately enough for financial statement purposes.

Companies acquire all sorts of assets and services in exchange for equity instruments such as stock. Those assets and services are just as valuable as similar items acquired for cash. If a company's attorneys are compensated in stock, legal expense is recognized. If a building is acquired in exchange for stock, depreciation expense is recognized over the asset's service period. Acquiring employee services by issuing options (an equity instrument) is no different. Compensation expense results from using the employees' services, not from issuing the options.

A close cousin of the capital-transaction rebuttal is the argument that compensation from options is paid out of stockholders' pockets via dilution of earnings per share. Under current accounting, if a stockholder directly pays some of a company's expenses, those expense are included in the company's financial statements as a capital contribution and an expense. Otherwise the financial statements would be misleading because some costs are omitted.

As for measurement problems, without question options pose problems. But so do leases, financial instruments, nonmonetary transactions, pensions, retiree medical costs, impairments of value, contingencies, and many other kinds of transactions. Compared to 1948 and 1972, when the current accounting standards for options were adopted, market trading of nonemployee stock options is now common, and various mathematical models to estimate the value of stock options are well developed and widely used in contracts, compensation plans, and investment decision-making. Those models show that the value of an option is a function of a several of factors, including the stock price, the exercise price the time to maturity, the volatility of the stock price, the risk-free rate of return, and expected dividend payments.

"Wait," some people respond. Employee options are different because they are no traded and contain other restrictions that make them worth less. True, they are worth less but they are not worthless. Valuation models can build in a discount for employee options as compared to puts, calls, and other options that are traded without restrictions. The measurement problems can be overcome.

Another measurement argument that is often raised is that the value of the option at grant date is different from the value of the benefit the employee ultimately receives at exercise. Agreed, but that's a red herring. The future value of the option is not relevant to measuring compensation cost today. Today's value is relevant. Today's value impounds market expectations of future cash flows, stock price, and volatility. It's the appropriate measure of today' cost.

The FASB Proposal

On June 30, 1993, the FASB published its proposed standards for measuring compensation cost for all stock-based compensation awards. Key provisions:

1. Accounting should treat all stock-based compensation in the same way, including fixed and variable stock options, SARs, and restricted stock.

2. Stock options and other stock-based awards have value and are part of compensation cost that should be recognized by the employer.

3. Compensation cost would be measured on the grant date based on the fair valu of the award for all stock-based compensation awards net of grants that are not expected to vest.

4. On grant date, that cost would initially be recognized in the employer's balance sheet both as an asset (prepaid compensation) and as an element of stockholders' equity (stock options outstanding).

5. The asset would be amortized as compensation expense over the service period--the period of employee service for which the compensation is deemed to be earned, usually the vesting period unless that terms of the grant specify a shorter service period.

6. Public companies will use option-pricing models, such as the Black-Scholes o binomial models, to estimate the fair value of their options. Nonpublic companies may use the minimum value method, which does not require an estimate of the expected volatility of the underlying stock. Minimum value captures only the component of fair value that stems from the ability to defer payment of the exercise price until the option is exercised.

7. The initial measurement of compensation (both the asset and stockholders' equity item) that was based on the value of the award at grant date would later be adjusted, if necessary, to reflect the outcome of any performance conditions or service-related factors. Those subsequent adjustments could result in zero cumulative compensation expense being recognized if the options ultimately are forfeited or not earned. However, compensation cost would not be adjusted for changes in the stock price after the grant date.

Effect of Proposals on Practice

How would these conclusions affect current practice? We can use the earlier example of the fixed option, SAR, and performance option to illustrate (50,000 shares, exercise price $20 per share, stock price $20 per share at grant date, $50 at exercise date). Additional assumptions necessary to value the option are risk-free interest rate 6.5% expected option term four years, expected volatility 30%, expected dividend yield 1.5%, expected forfeitures 5% per year, and vesting period two years.

Since fixed options and the SARs would be accounted for exactly the same way under the proposal, we can consider them together. Using the Black-Scholes and binomial models, these options are valued at just about $6. The minimum value i $3.50. With an expected forfeiture rate of 5% per year, at the grant date we ca expect that 45,000 options will actually vest. So total expense is $270,000 (45,000 x $6), recognized $135,000 each year for the two year vesting period. The amount of expense will be adjusted if it turns out that the actual rate of forfeitures is not 5% per year or the actual term is not four years, but not fo changes in the market price of the stock.

The only difference for the performance option is the need to estimate at grant date whether it is probable that the performance condition will be met by the end of the two years. If we think it will be met, we would accrue compensation expense of $135,000 in year one. In year two, we would accrue the additional $135,000 if the goal is met or we will reverse out the prior accrual if the performance condition is not met.

The proposed accounting standards for asset and expense recognition would go into effect in 1997 and would apply only to new grants, not to existing grants. Beginning in 1994, disclosure would be required of the pro forma effect of adopting the new accounting.

Concerns about "Economic Consequences"

I cannot conclude without addressing a group of concerns about the FASB proposa that collectively can be called "economic consequences" concerns. Examples:

* An accounting standard that requires accrual of compensation expense for stock options will be a disincentive for American entrepreneurship.

* The FASB is involving itself in corporate governance because of complaints that executive compensation in America is too high.

* FASB is responding to political pressure from the SEC and others.

Accounting standards seek to measure and report faithfully the economic events and transactions that have taken place. That objective applies equally to event and transactions that are favorable to the business and those that are unfavorable. Accounting standards are not and should not be designed to obscure or distort reality. If the reality is that stock options have value and are intended to motivate employees and to compensate them for their services, accounting should reflect that reality.

In the U.S., accounting standards are not designed to color the numbers, rosy o otherwise. Resource providers need good financial information to determine whether an entrepreneurial business is deserving of capital. It seems to me tha to argue against an accounting standard because it might provide information that will discourage investment in any particular company or industry is to argue in favor of perpetrating a fraud on the capital provider.

Paul Pacter, PhD, CPA, has been a Professor of Accounting at the University of Connecticut's Stamford MBA Program since 1990. He is the author of the FASB Research Report, Reporting Disaggregated Information (1993), and the FASB Discussion Memorandum, Consolidation Policy and Procedures (1991).
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Title Annotation:Accounting; Financial Accounting Standards Board
Author:Pacter, Paul
Publication:The CPA Journal
Date:Mar 1, 1994
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