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Stock option accounting as a political bellwether. (Trends in Financial Management).

* THE DELUGE OF Companies now volunteering to expense the cost of employee stock options shows how the power of public opinion and politics alone--without regulation--com influence corporate behavior.

As late as mid-July 2002, only two companies among the S&P 500, Boeing and Winn-Dixie Stores, expensed the cost of stock options. By mid-September 2002, more than 90 firms overall said they would, according to Standard & Poor's. (For a complete list of the companies and the pro forma impact of options compensation on 2001 earnings per share (EPS), see S&P's spreadsheet at

This turnabout contrasts markedly with prior rhetoric, lobbying, and financial disclosure practices and comes without any new regulation. In fact, the new corporate regulation legislation President Bush signed into law July 30, 2002, the Sarbances-Oxley Act, conspicuously omits stock option accounting regulation. Instead, lawmakers deferred it to the Securities & Exchange Commission (SEC) and Financial Accounting Standards Board (FASB).

During the prior economic and political era, the FASB sought time and again to change GAAP so companies would have to account for stock options as employee compensation expense--only to be stymied politically and subverted through accounting loopholes (see the special section on stock options in this issue of Strategic Finance and April 2002, "The Stock Options Accounting Subterfuge," by C. Terry Grant and Conrad S. Ciccotello). The result was a "liberal" Statement of Financial Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based Compensation," SFAS No. 123--which took effect in January 1996--recommends but doesn't require companies to charge the fair value of options as a compensation expense to operating income. And, as noted, few companies do--that is, until the proverbial winds changed this year, prompting the voluntary conversion last summer.

Now the issue these firms face is not whether to book options costs as an expense, but how.

The FASB--still not forcing companies to expense the cost of stock options--drafted proposed guidelines in August 2002 that give companies that choose to expense stock options three alternatives:

* The current "clean slate" method, which allows companies to expense options granted since the beginning of the fiscal year in which they decide to begin expensing options.

* An alternative under which companies would expense new options issued since the beginning of the fiscal year as well as the unvested portion of previous awards.

* A retroactive restatement alternative under which companies would have to restate three years of prior statements to reflect options granted during those years, as well as unvested options granted in previous years.

In addition, the FASB proposed that companies that don't expense stock options may still follow SPAS No. 123 and show the pro forma effect on net income and BPS of the fair value of stock options in financial statement notes. but they must do so quarterly rather than annually. They must also include a table in annual and interim financial statements that clearly shows the pro forma stock options costs recognized on the income statement over the last three years. Further, all companies must state what stock option accounting method they are using and how they have accounted for options in the past.

Still, that doesn't resolve the issue of valuing and measuring the cost of stock options.

Under the fair value method of accounting, compensation cost is the fair value of stock options issued, measured by an option pricing model at the date options are granted. Any option pricing model, such as the Black-Scholes or a binomial model, is permitted under SFAS No. 123, provided it "takes into account as of the grant date the exercise price and expected life of the option, the current price of the underlying stock, and its expected volatility, expected dividends on the stock, and the risk-free interest rate for the expected term of the option."

Of course, expected volatility, dividends, and the future interest rates are difficult to project accurately. Small changes in assumptions used to estimate volatility, for example, can crucially change the results-and a company's reported expenses and earnings.

That's a problem because today's trend toward more "conservative" accounting may produce more transparency but less comparability of financial statements. Similar companies may be treating the exact same transactions in very different ways.

Ironically, it'll take accounting rulemakers or regulators to standardize various stock option expensing methods companies are now voluntarily choosing.
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Author:Levinsohn, Alan
Publication:Strategic Finance
Geographic Code:1USA
Date:Oct 1, 2002
Previous Article:Schumpeter's dumpster. (Tech Forum).
Next Article:Dotsam and Jetsam. (End Note).

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