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Reporting on employee stock compensation plans: case not closed.

Stock compensation plans are complex and a sophisticated analysis is a prerequisite to sound reporting. An accountant must understand what events and transactions can occur as an employee acquires, vests and exercises rights under an employee stock compensation plan. For example, even if two types of plans affect employees similarly, the employer may have to report on them differently under current rules. Yet the Financial Accounting Standards Board has backed away from even defining the term "compensation cost" as it is used with regard to these plans--and therefore from facing the even more fundamental issues of whether and when the employer incurs such costs under the plans.

In March 1988, four years into the FASB's project of reexamining financial reporting on employee stock compensation plans, FASB Chairman Dennis Beresford described the area as "extremely complex." Soon afterward, the board acknowledged it was unable to agree on "a conceptually valid and practical improvement to current accounting for stock compensation." It folded the project into its financial instruments project.

The history of the project made that result understandable, and probably inevitable, because the FASB had avoided grappling with what it described as a "fundamental conceptual issue."



When it initiated its project on stock compensation plans in May 1984, the FASB issued an invitation to comment on Accounting for Compensation Plans Involving Certain Rights Granted to Employees. The invitation was based on an issues paper, Accounting for Employee Capital Accumulation Plans, which the American Institute of CPAs accounting standards executive committee (AcSEC) had prepared and sent to the fASB in November 1982. The invitation also contained some explanatory material on stock compensation plans and questions on which to comment.

But the FASB eliminated much of the conceptional analysis that was contained in the AcSEC's issues paper from its invitation to comment. The board dismissed the AcSEC's analysis as "beyond the scope of this project."


Compensation cost is presumably the cost an employer incurs in providing benefits to the employees under the plan. The view that employers do not incur such a cost, which the AcSEC presented in its position paper and the FASB stated was beyond the scope of its project, was described in the FASB's invitation to comment:

"[A]n enterprise does not incur a cost (in the sense of giving up something of value to it) in a nonreciprocal transfer, such as by issuing stock for employees' services; therefore, a nonreciprocal transfer results in a dilution of interest to existing shareholders instead of a cost to the enterprise." To say this differently, there are two issues:

1. Is the transfer in which a particular employer receives services nonreciprocal?

2. If it is, does that employer even incur compensation cost when it receives services, and possibly cash, under a stock compensation plan?

How these issues could be beyond the scope of a project considering how to report on these plans is not clear. Instead, because the question of how to report on them is in fact "extremely complex," it would be reasonable to expect the FASB to explore every avenue that might offer guidance.



As the AcSEC issues paper recognized, the question of whether cost is incurred in nonreciprocal transfrs is a settled issue in financial reporting. The issues paper referred to Accounting Principles Board Opinion no. 29, Accounting for Nonmonetary Transactions (a pronouncement on the same level as FASB accounting standards in the hierarchy of generally accepted accounting principles). Opinion no. 29 defines a nonreciprocal transfer as "a transfer in one direction of resources or obligations, either from the enterprise to other entities or from other entities to the enterprise." The issues paper also referred, for further discussion, to APB Statement no. 4, Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises.

APB Opinion no. 29 defined the concept of a nonreciprocal transfer so it could specify how to report on one. It isn't clear why the nature of nonreciprocal transfers is understood adequately enough to form the basis for reporting requirements in Opinion no. 29 but is beyond the scope of a project on reporting on employee stock compensation plans. As the AcSEC's issues paper recognized, the concept provides a basis for examining how to report on these plans.



The AcSEC issues paper said in effect that to know how to report on a particular kind of activity the accountant must first find out what happens during the activity and how it affects the reporting entity. In that sense, it echoed FASB Concepts Statement no. 2, Qualitative Characteristics of Accounting Information, which said financial statements should have representation faithfulness. How can an accountant figure out how to represent something faithfully in financial statements without first finding out what that something is?

The following discussion highlights the type of analysis that was contained in the AcSEC issues paper but omitted in the FASB's invitation to comment. Like the FASB's project, it pertains only to the portion of an employee's services received because of the plan and excludes the exchange of a portion of an employee's services for cash salaries and bonuses.

To understand the effects of various plans on employers, it is useful to consider in detail what types of events--such as grant, vesting, exercise, expiration of restrictions and exercise of rights--might be involved in a particular type of plan. It is also helpful to analyze the transactions that might be involved in each type of plan and the effects a particular transaction has on each of the three possible parties to stock compensation plan transactions: the employee, the existing shareholders and the employer. In summary, one might ask: Who gives what to whom and who gets what from whom?

The issues paper analyzed those effects for eight different kinds of employee stock compensation plans--incentive stock option plans, stock appreciation rights plans, phantom stock unit plans, restrictive stock award plans, performance unit plans, book value unit plans, book value purchase rights plans and performance share unit plans. This article looks only at the basic outlines, using, to illustrate, the cases of stock appreciation rights plans and stock award plans. Although these plans are fairly simple, the analysis explains the process involved and shows why an analysis of transactions and events is necessary.

Under a stock appreciation rights plan, an employer transfers only cash to the employees. The employer's stock is merely the measure of the amount of cash transferred; no stock is actually transferred. Thus each transaction involves only two parties: the employer and an employee.

In contrast, transactions under a stock award plan also involve the employer's existing shareholders because the employees actually receive stock. Exhibit 1 at right (which appeared in the AcSEC issues paper but was omitted from the invitation to comment) shows the three parties involved in a stock award plan and how the plan affects each of them. The analysis that exhibit 1 represents is explained in detail below.

Effects on employees. Employees contribute services and possibly cash to an employer that sponsors a stock award plan and the employer issues shares of its stock to the employees.

From the employees' viewpoint, the transactions are reciprocal transfers--exchanges. The employees give up something they value--services and possibly cash--and in exchange receive shares of the employer's stock, which are also valuable to the employees. However, the employees give up something they value to one party, the employer, and receive something of value from a different party, the existing shareholders. Exhibit 1 illustrates this three-party transaction.

Effects on existing shareholders. A stock award plan also involves a reciprocal transfer from the perspective of the existing shareholders. They benefit indirectly from the employer's receipt of services and possibly cash from the employees because those receipts make the shareholders' investment s more valuable, more secure or both. From this perspective, the employer serves as a conduit for the benefits the existing shareholders indirectly receive from the employees.

In exchange, the existing shareholders suffer dilution--that is, they give up a percentage of ownership of the employer's stock to the employees. Thus, the existing shareholders give something that is of value to them. Exhibit 1 also illustrates these relationships.

Effects on employer. The transactions in a stock award plan are nonreciprocal transfers from the employer's perspective. The employer receives services and possibly cash, which are valuable to it, from the employees. But it gives up nothing of value to it on their receipt. The essence of the transactions is that the employees contribute capital to the employer and, by their contributions of services and possibly cash, pool their resources with those provided by the other capital contributors (the existing shareholders).

Had the employer not issued the stock to the employees, it could have issued the stock on themarket and received cash or other assets from the recipients of the stock. Therefore, because the employer issues some of its stock in the stock compensation plan transactions, it might at first glance appear that the employer does give up something of value to it and thus that the transactions are reciprocal with regard to the employer.

Nevertheless, the transactions are nonreciprocal insofar as the employer is concerned for a number of reasons.

1. The stock of an employer is not an asset of the employer. (If it were, a company could increase its assets simply by issuing some shares to itself.) Therefore, the issuance of some stock to outsiders neither deprives the employer of assets nor causes the company to incur liabilities.

2. Because an employer can issue a virtually unlimited amount of stock to entities that contribute capital to it, the issuance of some of its stock does not limit its ability to issue more stock. Even if all of an employer's authorized shares had been issued, the employer's articles of incorporation could be amend to extend its ability to issue stock.

3. The loss of an opportunity to receive cash from other entities is an opportunity loss, not a sacrifice of an asset in a reciprocal transaction. Opportunity losses are not and, for a number of reasons, should not be reported in financial statements. For example, every entity loses many opportunities--such as the opportunity to float an issue of common stock--every day. Even if opportunity losses should be reported in financial statement, there is no reason the particular lost opportunity occasioned by a stock compensation transaction merits reporting more than any of the others.

4. The negative impact of the transaction is on the shareholders, not the corporation, because each issuance of new stock affects the percentage ownership of the existing shareholders.

In contemplating this last point, consider the realities of corporate ownership. Although ownership of an employer corporation usually is administered on the basis of shares held by shareholders, it could be administered according to percentages held by percentageholders. Records of the percentage holdngs would be maintained on a tally sheet that tracks percentages rather than in a share register that records numbers of shares. At all times, the holdings would total 100% of the ownership and the tally sheet would reflect that. The employer would provide no share certificates. Instead, it would regularly send copies of the current tally sheets to the percentageholders.

Under this system, a new percentageholder would be inserted on the tally sheet on receipt of services


Percentage holding

tally sheet

(before receipt of services and possibly cash)
Percentageholders Percentage held
John Jones 15%
Sam Reed 20
George Thompson 17
Ethel Cone 21
Phyllis Blair 27


Percentage holding

tally sheet

(after receipt of services and possibly cash)
Percentageholders Percentage held
John Jones 13.5%
Sam Reed 18.0
George Thompson 15.3
Ethel Cone 18.9
Phyllis Blair 24.3
Mary Smith (new percentageholder) 10.0

and possibly cash. The tally sheet would reflect the percentage holding the new percentageholder received on the transaction, and the percentage holdings of the existing percentageholders would be reduced to reflect the percentage the new percentageholder received. Exhibits 2 and 3 at left illustrate tally sheets before and after a transaction. Both before and after the transaction, the total ownership of the employer reflected on the tally sheet is 100%. However, the percentage holdings of the existing percentageholders are decreased as a result of the stock compensation transaction.

Unlike the percentageholders, the employer would not be affected by changes in the distribution of percentage holdings among the percentageholders reflected on the tally sheets. It would simply receive the services and possibly cash from the new percentageholders, free of charge. (See the discussion in Paul Rosenfield, Accounting and Auditing for Employee Benefit Plans, 1988 supplement [New York: Warren Gorham & Lamont, 1988], page S13B-34.)

Similarity to issuance of stock for cash. The effects on the three parties involved in a stock award plan are essentially the same as the effects on the three parties involved in a reporting entity's issuance of stock for cash. As exhibit 4 below illustrates, a purchaser of the stock contributes cash to the reporting entity instead of contributing services and possibly cash. The only difference between exhibit 1, which depicts a stock award plan, and exhibit 4 is that in exhibit 4 cash is provided rather than services and possibly cash. Three parties are still involved and the effects on each of the three parties are the same.

No one has ever suggested a reporting entity that receives cash for issuing stock incurs a cost in the transaction. Likewise, a reporting entity that receives services and possibly cash under a stock award plan incurs no cost in the transaction. The reporting entity should report on both types of nonreciprocal transfers when they occur and at the fair value of the resources received.

Another issue is segregating receipt and use. Receipt of services under a plan and use of those services are separate events. They may occur at different times. An employer can either use services when it receives them under a plan or incorporate them in assets--for example, as part of inventory--and use them later. Thus, how to report on their receipt and how to report on their use should be considered separately, regardless of whether they are received and used at different times or at the same time.

Determination of measurement dates is currently the key factor in considering how to report on employee stock compensation plans. Identification of when services are received and when they are used is essential if, for example, determination of measurement dates continues to be the valid approach. The types of analyses presented in the issues paper are crucial to this type of determination.


In summary, analyses such as those discussed here would help those pondering how to report the effects of employee stock compensation plans on employer sponsors. They might even shed new light on what appear to be undesirable results of applying current pronouncements on the subject. For example, the approach employed in the AcSEC issues paper shows that two types of plans can have the same effects on employees but different effects on employers. The difference may justify different employer reporting for the two types of plans.

But we won't know until the conceptual issue is faced and the analysis done.
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Article Details
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Author:Jaiven, Mitchell
Publication:Journal of Accountancy
Date:Dec 1, 1990
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