Taking stock of Statement 123.
At long last, the Financial Accounting Standards Board has issued Statement 123, "Accounting for Stock-Based Compensation." Starting with calendar-year 1996 financial statements, the standard requires expanded disclosures, rather than recognition of compensation cost, for fixed stock options whose exercise price is at least equal to the stock price at the option grant date (in-the-money options). Companies will still recognize compensation for most performance-based options and other equity securities they issue to employees.
Although the statement doesn't require expense recognition for fixed options, it does encourage companies to use that method. Compensation cost for stock options and other equity instruments awarded to employees would be based on the estimated fair value at the grant date.
If you decide not to recognize compensation cost by adopting that method, you'll need to continue applying the provisions of Accounting Principles Board Opinion 25, "Accounting for Stock Issued to Employees." Opinion 25 requires expense recognition only if an option's exercise price is less than the underlying stock's market price on the grant date or other measurement date. That's normally true only for performance-based stock options, which are exercisable only if certain conditions are met. For garden-variety fixed stock options, Opinion 25 recognizes zero-compensation cost. If you follow Opinion 25, you must disclose in notes to the financial statements the pro forma effects on your net income and earnings per share as if you'd followed the new accounting method for all options. Statement 123 also introduces a new expense-recognition measurement approach for most variable or performance options, awards of restricted stock and other forms of stock-based compensation, for those who choose to move away from Opinion 25.
One caution: You must choose to follow either the recognition provisions of Statement 123 or Opinion 25 for all your stock-based compensation plans. You can't selectively apply the new standard to some plans and the old one to others. And once you've adopted the provisions of Statement 123, you can't switch back to Opinion 25, since the former's cost-accrual provisions are deemed preferable.
Statement 123 is effective for financial statements for fiscal years beginning after December 15, 1995, though the FASB permits earlier adoption. When you first start applying its provisions, you must include in your pro forma disclosures the effects of all awards granted in fiscal years beginning after December 15, 1994.
As guidance for companies applying these principles to optional recognition and to disclosure, the FASB has decided the following:
1. You must measure compensation cost using a valuation method similar to the one proposed in the exposure draft that preceded Statement 123. For options, that means using a pricing model that considers certain factors, such as the expected life of the option, volatility, dividends, the risk-free interest rate, the stock price at grant date and the exercise price. Your judgment will determine the option-pricing model and the assumptions to use in applying it.
2. If you're a nonpublic company, you can exclude volatility in estimating the value of your options, even if your stock trades frequently enough for you to compute volatility.
3. The standard considers compensation cost an expense during the periods in which the employee works for you, with an off-setting increase to equity. The statement presumes the service period is the vesting period, unless the stock-option plan defines some shorter period, and it contains special provisions for options with graded vesting on attributing compensation cost over the vesting period.
4. In measuring compensation cost, the statement addresses the nontransferability of employee options after vesting by using the expected life of the option. But you don't have to go back and adjust the measure of compensation cost at grant date if the actual life of your options differs from the original estimate.
5. The value of an employee stock option at grant date doesn't reflect any special discounts for nonexercisable options during the vesting period. Similarly, the value of a restricted-stock award doesn't reflect a special discount, because the shares aren't transferable during the vesting period.
6. If you change your estimate of the number of awards you expect to vest, you must adjust cumulatively for the effect on previously recognized amounts during the period of change.
7. You may recognize forfeitures as they occur or estimate them at grant date, adjusting them later if actual forfeitures differ from estimates.
8. Account for dividends paid on restricted stock by charging equity when you pay the dividends, except for nonforfeitable dividends on stock that doesn't vest. The present value of expected dividends during the vesting period is excluded from the grant-date stock value if the employee doesn't receive dividends until the shares vest.
9. Look to FASB Statement 109, "Accounting for Income Taxes," for guidance on accounting for the income-tax effects of stock-based compensation. Basically, for stock-based awards that ordinarily result in future tax deductions, such as non-qualified stock options, the cumulative compensation cost recognized in earnings is considered a temporary difference in applying Statement 109, so tax benefits are recognized in the income statement as the compensation expense is recognized. For awards that don't typically result in tax deductions, such as incentive stock options, compensation cost recognized for financial-reporting purposes doesn't result in a temporary difference, so the income statement doesn't recognize tax benefits. The tax-deduction benefits that come from disqualifying employee dispositions of stock purchased under normally tax-exempt awards are recognized in the period they're realized on the tax return.
10. If you have "reload" options, you should treat them as new grants.
11. Modifications of nonvested awards are essentially the same as modifications of vested awards. Modifications will result in additional compensation cost for the incremental value of the new award over the value of the old one at the modification date. You should base the value of the old employee stock option at the modification date on the shorter of the old option's remaining expected life or the new option's expected life. For nonvested awards, attribute the amount of additional compensation cost, plus the remaining unamortized compensation cost for the old award, over the remaining service period.
12. You should treat modifications of awards granted before the effective date of the new standard as new grants.
13. Cash repurchases of vested awards for an amount equal to the estimated fair value of the award at the purchase date don't require you to adjust the previously recognized compensation cost.
14. On broad-based employee stock-purchase plans, the new statement says a purchase discount of 5 percent or less is automatically considered noncompensatory. But you're still permitted to justify a higher percentage amount. If the purchase discount exceeds the noncompensatory limit, you must recognize the entire discount as compensation. A plan that includes a look-back provision or other option feature will be considered compensatory.
15. Some companies settle their stock-appreciation rights, or SARs, by paying employees cash, while others give employees stock of equivalent value. Currently, under Opinion 25 and a related FASB interpretation, employers recognize compensation cost by reflecting changes in the intrinsic value of the option over the service period in their earnings statements, and they recognize a corresponding liability. Under the new FASB standard, accounting for cash SARs doesn't change. But you must value SARs that will be settled in stock at the grant date, because, like options, they're equity instruments. The statement encourages companies to recognize compensation cost as expense over the employee service period (the encouraged treatment) or to reflect it in the pro forma disclosure (the permitted alternative).
While the new FASB statement focuses on stock compensation for employee service, the stock or equity instruments companies issue to pay for goods or services from nonemployees are also within its scope. You must account for this compensation based on the fair value of the assets, services or other consideration received or the fair value of the equity instruments issued, whichever is more reliably measurable. That applies regardless of the option you choose for employee compensation.
Disclosures you need to make under the new standard are a description of the plan; the number and weighted average exercise prices of options outstanding and the number exercisable at the beginning and end of the year; the number of options granted, exercised, forfeited or expired during the year; and the weighted average fair values of options granted during the year. Other disclosures include a description of the method and assumptions used to estimate the fair value of options, including the risk-free interest rate, expected volatility factor and expected dividend yield; the total compensation cost recognized for all stock-based awards; and the terms of significant changes to outstanding option grants.
In addition, you must disclose your assumptions about the options' expected lives. You must separately disclose nonexercisable (nonvested) options or restricted stock shares that require only more employee service to become exercisable and options or restricted shares that require an additional condition be satisfied before exercise.
Plus, you should disclose the range of exercise prices (in addition to the weighted average exercise price) and the weighted average remaining contractual life for options outstanding as of your last balance sheet. If the range of exercise prices is wide, you also should include information about outstanding and exercisable options by groups or ranges. If you use Opinion 25, you must disclose the pro forma effect on net income and earnings per share of applying the recognition provisions of the new standard for each income statement.
Overall, the FASB's new stock-compensation pronouncement is a blend of some old and new accounting practices. Because it recognizes compensation cost in earnings, the preferred method is a significant change from the standard followed for nearly 50 years. The allowed alternative, on the other hand, carries present accounting practice forward, with some special disclosures required. It'll be interesting to see which companies follow the recommended accounting and which ones don't, and what their reasons are.
RELATED ARTICLE: HOW THE FASB's NEW RULE WORKS, STEP BY STEP
To illustrate how Statement 123 differs from current accounting rules, assume a company grants its executives 10-year fixed options for 10,000 shares, with an exercise price of $10 per share and a stock price at the grant date of $10 per share. The options vest two years later when the stock price is $25 per share, and executives exercise the options four years after the grant, when the stock price is $40 per share.
Using the same scenario, here are the additional assumptions necessary to value the option under the FASB's new standard: expected option life of four years, which is the average time from grant to exercise; volatility of 30 percent; dividend yield of 1.5 percent; forfeitures of 4 percent per year; vesting period of two years; and risk-free interest rate of 6.5 percent. Here's how the options are treated under the two accounting scenarios.
UNDER CURRENT RULES
Fixed stock option. Since the market value of the stock at grant date (10,000 x $10 = $100,000) is equal to the exercise price, you don't recognize any compensation expense then or at exercise. At exercise, the executives pay $100,000 and receive $400,000 worth of stock, a $300,000 net benefit.
Performance option. Here you have the same facts, 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 four years. If, after four years, the revenues increase by the required percentage and the stock price is $40, you'd then recognize the compensation expense of $300,000.
Stock-appreciation right settled in stock. Instead of options, the executives receive a stock-appreciation right to be settled in shares of stock. On exercise four years later, instead of paying $100,000 and receiving stock worth $400,000, the executives pay nothing but receive 7,500 shares of stock worth $300,000. You recognize compensation expense during the period between grant and settlement, based on the intrinsic value of the stock-appreciation right (the market value of the stock minus a purchase price of zero), a total of $300,000.
Stock-appreciation right settled in cash. The only difference here is you settle the stock-appreciation right in cash. At settlement four years later, the executives pay nothing but receive $300,000 cash. You recognize compensation expense the same as you would with a stock settlement.
UNDER STATEMENT 123
Fixed stock option. Using an option-pricing model, these options are worth about $3 each. The minimum value is $1.75 (excluding the volatility factor for nonpublic companies). With an expected forfeiture rate of 4 percent per year on the grant date, the company can expect that 9,200 options will actually vest. So the total compensation cost is $27,600 (10,000 x 92 percent x $3). The FASB encourages recognizing $13,800 of expense, and the related income-tax effect, each year for the two-year vesting period. If you choose to follow Opinion 25 and therefore don't recognize the expense, you must disclose the $13,800 amount net of taxes each year, along with the related per-share amount. For nonpublic companies, the total pretax compensation cost would be $16,100 (10,000 x 92 percent x $1.75) or $8,050 per year. You can adjust the amount of expense later if the actual rate of forfeiture turns out to be something other than 4 percent per year, but you can't make any adjustments for changes in the stock's market price.
Performance option. The only difference for the performance option is the need to estimate at the grant date whether the performance condition is likely to be met by the end of the two years. If you think it will be met, you'd accrue or disclose pro forma compensation expense of $13,800 in year one. In year two, you'd accrue or - if you're using Opinion 25 - disclose the additional $13,800 if the goal is met or reverse out the prior accrual if the performance condition hasn't been met.
Stock-appreciation right settled in stock. The new FASB statement changes the timing of cost measurement from settlement date to grant date, which affects the amount of compensation cost recognized. At the grant date, the SAR is valued similarly to the fixed option. The $27,600 compensation cost is recognized as expense over the vesting period. If you continue to follow Opinion 25, you'd recognize the $300,000 compensation cost and would disclose the $27,600 amount in a footnote.
Stock-appreciation right settled in cash. The current accounting remains the same.
PP, EF and PJ
RELATED ARTICLE: CONSIDER YOUR OPTIONS (CAREFULLY)
Undoubtedly, you've already heard (or you will soon) about the nitty-gritty of Statement 123, the final stock-compensation regulation. But how do you decide what to do for your company?
Most companies will use the current rules under Accounting Principles Board Opinion 25, because their compensation expense will be higher under the new rules. That's especially true if you grant traditional fixed stock options and offer employee stock-purchase plans. On the other hand, if you have variable or performance-related stock plans, you'll find your expense is lower, so you may find recognition attractive. Either way, you'll need to model the projected effect of the new fair-value accounting approach to determine the impact on your financial statements.
The net-income reduction from adopting the new rules will be greatest for emerging companies that rely heavily on stock-based programs. Our 1993 study [ILLUSTRATION FOR CHART OMITTED], which was based on methodology similar to that in Statement 123, found that for companies that issue options annually and have vesting periods of more than one year, expense will increase each year as new options are granted and will stabilize after the first vesting cycle. And the study showed considerable variation from company to company.
Note that the assumptions you select at the grant date will drive the numbers, and they aren't adjusted, even if they ultimately differ from actual outcomes. But you'll still need to track the actual exercise patterns and stock-price volatility to predict the assumptions needed to value new grants. Companies may find it difficult to select assumptions because they have incomplete information on historical exercise patterns or don't track annual exercises by individual option grants. So be prepared to expend considerable time, effort and money on modifying systems and procedures and on evaluating the data you need to select assumptions.
Statement 123's valuation guidance indicates it may be important to stratify employees into groups with relatively homogeneous exercise behavior and to select a separate expected life assumption for each group. Plus, companies whose awards are based on graded vesting schedules may need to pick separate assumptions for the options that vest each year (tranches). If you have three employee groups and four tranches, you may need 12 valuations with alternative assumptions.
We've found that stratification by employee group or tranche may reduce overall option values and expense significantly. But, under Statement 123, if you perform stratified measurements by tranche, you must spread the accounting charge by treating each tranche as a separate grant, significantly front-loading the expense charge.
Since many companies offer a combination of fixed stock options, performance-based plans and employee stock-purchase plans, the decision to adopt Statement 123 will be complex. You'll need to evaluate data, alternative models, assumptions and stratification approaches; value your options and measure the impact on net income and earnings per share; and consider early adoption of Statement 123 or the Securities and Exchange Commission's Staff Accounting Bulletin 74 disclosures for 1995.
Mr. Akresh is a director and Ms. Fuersich is a partner in Coopers & Lybrand L.L.P. Human Resource Advisory Group in New York.
Mr. Pacter, a professor of accounting at the University of Connecticut's Stamford MBA Program, is a project consultant to the FASB. Ms. Fender is a project manager at the FASB. Mr. Jones is on the audit staff in the Atlanta office of KPMG Peat Marwick.
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|Title Annotation:||Corporate Reporting; includes related articles; accounting for stock-based compensation|
|Date:||Nov 1, 1995|
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