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FASB stock compensation proposal makes good accounting sense.

Much has been written and said about this proposal. Most of the commentary is negative--and much of it is without merit. The proposal actually makes good accounting sense.

The most controversial aspect of the Exposure Draft is the proposed requirement to record compensation expense for stock options based on their "fair value" at grant date. This represents a significant change from current accounting rules: at present, there is no charge for a grant of stock options with an exercise price that equals or exceeds the stock price at date of grant.

Criticism commonly falls into three broad categories: negative public policy implications, stock options becoming a capital transaction, and flaws in the measurement method.

Public Policy

Critics of the Exposure Draft say that the cost of expensing stock options would reduce a company's reported earnings, and, consequently, its stock price. This would increase the company's cost of capital, forcing it to curtail the use of stock options, and, in turn, may lead to a decline in the motivation and productivity of U.S. workers. Companies using options extensively, such as start-ups and high-tech companies, would be hardest hit by this sequence of events. Because these companies tend to be the source of most new jobs in the U.S. as well as many innovative concepts and products, the competitiveness of the entire U.S. economy may suffer under the new rules.

The weakest link in this hypothetical chain of events is the assumption that a decline in earnings due to the expensing of stock options would necessarily result in a drop in stock price. In fact, securities analysts value companies based on the present value of discounted cash flows, not earnings. Since cash flow would not be affected by the proposed accounting rules, there should be no change in how the securities industry values a company.

This view is supported by the fact that most of the information regarding the cash flow impact of stock option grants is already disclosed--in the footnotes to the financial statements, in the earnings-per-share dilution computation, and in annual proxy statements. The Exposure Draft's requirements, therefore, would not provide the analyst community with any new information on future cash flow. Furthermore, numerous studies have shown that changes in accounting principles have little or no impact on company stock prices. Theory and experience thus suggest that an earnings charge for stock options would be a "non-event" as far as the stock market is concerned. (FASB's position is that, even if the public policy arguments were true, accounting information must be neutral and unbiased to be useful.)

Capital Transactions

Some critics of the proposal believe that a grant of stock options or other stock-based compensation is actually a capital transaction that should not flow through the income statement (these are often the same people who believe that if something doesn't require a cash disbursement, it can't be an expense). However, companies routinely acquire goods and services in exchange for equity instruments. The impact of these transactions is reflected in the income statement. A truck that is acquired in exchange for stock is depreciated just as if it were acquired for cash or notes. Professional services paid for using stock are expensed. The services provided by employees who are granted stock options should, correspondingly, be reflected in the income statement.

Measuring Value

The area of greatest--and most justified--concern regarding the Exposure Draft is the reliability of the proposed measurement method. FASB has proposed using the Black-Scholes or binomial option-pricing models to value options. Such models were developed to value publicly traded call options, which differ from employee stock options in some significant ways: employee stock options have much longer terms than traded calls (typically 10 years rather than one year or less); employee options usually carry vesting restrictions that prevent the employee from exercising them for several years; and employee options cannot be bought or sold.

The lengthy term makes it far more difficult to estimate some of the inputs used in the models--most notably the volatility of the stock price. The vesting and non-transferability provisions make an employee stock option worth less than a traded call that is otherwise identical. Some opponents, therefore, reject the Exposure Draft because of these shortcomings in the proposed valuation method.

Some of these critics believe that the best measure of an option's worth is its "intrinsic value," equal to the spread between the market price and exercise price. Unfortunately for these observers, the intrinsic value argument carries with it the dreaded "exercise-date" accounting curse, which says that the true value of an option cannot be measured until it is exercised and the actual gain (i.e., final intrinsic value) is known. This leads to a variable and generally increasing accounting charge derived from "marking the option to market" until the option is exercised. Such an approach is far less attractive for companies than FASB's proposed "grant-date" method, which would allow companies to fix the cost of the option at grant.

In fact, FASB is continuing to address the valuation issue. A round-table discussion of investment bankers, financial theorists, and economists is scheduled for late April to discuss the measurement method--in particular, the vesting and non-transferability restrictions. (The Exposure Draft currently includes some provisions to discount the option value for these two restrictions, but many observers hope these adjustments can be refined.)

Many critics say the proposed measurement method is too imperfect, so FASB should retain current accounting treatment. However, although the binomial and Black-Scholes models are imperfect, they produce far more accurate results than current practice, which values most options as worthless at grant date.

Opportunities for Creativity

The Exposure Draft would correct many of the inconsistencies of current accounting rules, providing companies with a new opportunity to design creative, effective stock compensation plans. In particular, the proposal would "level the playing field" between so-called fixed and performance-based grants. A fixed or conventional option grant that vests over time regardless of performance, currently carries no accounting charge. However, at present, a grant that vests contingent on the achievement of performance goals is subject to "vesting-date accounting," similar to exercise-date accounting described above. This treatment results in an unpredictable and often increasing earnings charge until vesting date. It is no wonder that few companies have implemented such performance-based plans.

Other types of plans that would receive more favorable treatment under the proposal include:

* Options with indexed exercise price: Options granted with an exercise price that increases or decreases based on the stock price performance of a peer group.

* "Performance shares:" Number of shares earned at the end of a multi-year cycle is dependent upon achievement of specified performance goals.

Critics of the Exposure Draft should take a closer look before jumping on the anti-FASB bandwagon.

Susan Eichen, CPA, is a principal specializing in executive compensation and incentive plan design in the New York office of William M. Mercer, Incorporated, international compensation and benefits consultants.
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Title Annotation:Storm Brews Over Stock-Based Compensation Rule; Financial Standards Accounting Board
Author:Eichen, Susan
Publication:Business Credit
Date:Jun 1, 1994
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