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The controversy over stock options.

The controversy over whether to require the expensing of stock options once again is making the headlines in the financial press. The controversy is over whether stock options granted to employees should continue to receive an exception to the usual process of recording an expense for goods and services based on the value transferred to the recipients. The two different viewpoints are:

1) To continue the practice of not recording any amount of expense for the value transferred through the use of stock options.

2) To record an estimated expense for the value transferred through the use of stock options.

The FASB (April 22, 2003 vote) and the International Accounting Standards Board (Proposed IFRS, Share-based Payment issued in November 2002) have announced an intention to require the expensing of stock options. These standard setters are supported by the Securities and Exchange Commission SEC, Warren Buffet, and others, including the over 200 companies that have already adopted expensing or announced the decision to adopt expensing. They represent the viewpoint that stock options to employees and directors, currently not expensed, should be expensed. Alternatively, Intel, Cisco Systems, and other companies have banded together to influence the U.S. Congress to oppose the expensing of stock options. They have formed an organization called the International Employee Stock Options Coalition, which can be found at

The Accounting Principles Board promulgated the accounting standards currently being utilized for employee stock options in Opinion No. 25, issued in 1972. Stock options issued to employees with a fixed number of shares and at the market price on the date of the grant (generally termed fixed plan options)currently result in no compensation expense being recorded. The accounting treatment specified in APB Opinion No. 25 was an exception to the financial reporting model that equity securities (an option being an equity security)issued for goods and services constitute a cost that would become an expense at some point in time. FASB Chairman Herz, in his comments before the Congressional Roundtable on Stock Options on May 8, 2003, commented about APB Opinion No. 25 and the financial reporting model:
 Partly because techniques to estimate the value of stock
 options did not yet exist, the drafters of Opinion 25 created an
 exception to the normal financial reporting model. That model
 encompasses the general principle that all of an enterprise's
 costs should be included in the enterprise's financial statements;
 otherwise, the enterprise's income is overstated.

 Under the Opinion 25 exception, only stock options granted to
 employees that meet certain specified criteria (so-called
 fixed plan options) are not reported as an expense. All other
 options and all other forms of stock-based transactions result
 in expenses to be included in the financial statements consistent
 with the general principle.

The Opposition

The FASB proposed expensing stock options in an Exposure Draft, Accounting for Stock Based Compensation, in 1993, resulting from a project which began in 1984. The proposal faced tremendous opposition at that time. The FASB thus decided in SFAS No. 123 to make the expensing of stock options previously not expensed under APB Opinion No. 25 optional, and extended this practice to options,issued to directors in FASB Interpretation No. 44. The FASB did succeed in making the "fair value method" of expensing the preferred accounting method and now requires proforma disclosure of the potential impact of recording this expense using the fair value method. Dennis Beresford commented in his testimony before the U.S. Congress at a hearing on "Accounting and Investor Protection Issues Raised by Enron and Other Public Companies: Oversight of the Accounting Profession, Audit Quality and Independence, and Formulation of Accounting Principles" on April 26, 2002 about the FASB decision:
 Certain members of Congress were
 sufficiently influenced by the
 appeals from corporate executives that they were persuaded
 to introduce legislation to counter the FASB's proposal. The
 legislation would have prohibited public companies from following
 any final FASB rule on this matter. More importantly,
 the legislation would have imposed requirements that the
 SEC repeat the FASB's process on any new accounting proposals,
 thus effectively eviscerating the FASB. Faced with the
 strong possibility that its purpose would have been eliminated
 by this legislation, the FASB made a strategic decision to
 require companies to disclose the effect of stock options in a
 footnote to the financial statements but not record, the
 expense in the income statement.

Subsequently, the FASB issued an invitation to comment (Accounting for Stock-based Compensation: A Comparison of FASB Statement No. 123, Accounting for Stock-Based Compensation, and Its Related Interpretations, and IASB Proposed IFRS, Share-based Payment) in June 2002, that resulted in two different types of responses. Corporations opposed to expensing cited the following concerns (based on FASB Chairman Herz's comments on May 8, 2003):

* Does mandated expensing of employee stock options have a clear or widely accepted rationale?

* Is the real cost of issuing employee stock options in the potential dilution of existing shareholders' equity interests?

* Is the cost of employee stock options already reported in corporate financial statements?

* Do existing option pricing models, including Black-Scholes and binomial-models, even when adjusted, produce inaccurate and misleading information?

* Will expensing stock options lead to an even more distorted picture of a company's financial performance and condition?

* Will mandated expensing of employee stock options destroy broad-based plans and the productivity, innovation, and the economic growth they generate?

All Those in Favor

On the other hand, many individual and institutional commentators support the expensing of stock options. Corporations in favor of expensing options, and who now expense options, generally include big-name companies--Coca Cola, General Motors, Wachovia Bank, Bank One, and Procter & Gamble to name a few. However, according to the Wall Street Journal in an article entitled "Expensing Options Will Affect Small-Cap Firms" (Talley, Aug. 19, 2002), numerous small-caps have also begun expensing options. Some of the reasons cited for supporting expensing include:

* Expensing may provide clarification to shareholders.

* Expensing allows the company to demonstrate conservative practices and openness with shareholders and analysts.

* Expensing may raise a company's profile and win a greater following on Wall Street.

* It's misleading to say that stock options are not an expense.

An article in Fortune noted on Aug. 12, 2002 (Fox) entitled The Only Option (for stock options, that is) provides further reasons that support expensing:

* Options are not free. We know that because people pay money for such options every day on exchanges around the world.

* If the cost of options is already fully reflected in earnings per share, then outright grants of stock should not be an expense either.

* There are widely accepted mathematical models that can be used to estimate the value of even those options that aren't traded on exchanges.

Expensing of stock options will have a negative impact on reported corporate earnings. As reported by Bloomberg, "Counting options as a compensation expense would have added $74 billion to the salary costs of the Standard & Poor's 500 Index companies in 2001, according to Credit Suisse First Boston. Most of that cost would have been borne by technology companies, which tend to give options to many employees, not just senior executives, Credit Suisse said." Consequently, U.S. Senators Enzi (R-NV), Allen (R-VA) and Boxer (D-CA) are leading the fight to have Congress mandate a three-year moratorium awaiting a report at the end of three years from the SEC on reporting for stock options to employees and directors. The chairmen of the respective House and Senate committees have publicly announced that no hearings will be held on these bills.

One argument for expensing is that the development of valuation models clearly is different in 2003 versus 1972. The use of estimates in financial statements has accelerated in that many more balance sheet and income statement accounts now utilize estimates. The use of estimates for items such as uncollectible accounts or warranty commitments has never been a rationale for not reporting expenses or adjusting amounts on balance sheets. However, both the FASB and the IASB have noted a concern for lack of transparency and comparability from having transactions reported differently in financial statements developing from the use of alternative accounting treatments, in this case, expensing versus disclosing.

The Debate Continues

Clearly, the controversy over the expensing of stock options has both opponents and supporters. Public debate will continue since issues concerning valuation methods and the financial reporting model allow for controversy. As the Economist noted on April 26, 2003, in an article titled True and fair is not hard and fast--The future of accounts:
 Most significant of all, perhaps, is the attempt to force
 companies to account for stock options granted to their
 employees. FASB has agreed that the cost of employee
 stock options should be treated as an expense. The question
 is how to value them. The standard-setters may yet
 have a fight on their hands.

Member Views on the FASB Ruling

There is controversy around every corner today. Much of the controversy lately has revolved around the FASB's ruling to treat grants of stock options to executives and employees as expenses.

What we want to know is what do our members think.

According' to a recent Ohio Society Web poll, our members very much agree, with 74 percent voting in favor. In addition to the poll, we received a few letters to the editor sharing their views on this subject.

Society Web Poll:

Do you agree with FASB's decision to treat grants of stock options to executives and employees as expenses?

26% Disagree 74% Agree

Dear Editor:

For financial reporting, I would expense stock options when the options are exercised by the employee. This is generally the same way the matter is handled for income tax purposes. Prior to that time, I would disclose all the usual information about the options, including the potential expense liability. (The "overhang," so to speak. Use Black-Scholles and give a wide range of the estimated liability).

I know this approach will have almost no support from the financial reporting community. The major objection will be that the expense should be recognized sooner, as part of the current year employment expense. No doubt many will point out that options are often exercised by retirees and others no longer employed by the company, so we have failed on the "matching" principle.

Could it also be argued that the work performed by some (many) employees while gainfully employed has future benefits, so that deferral of some of their compensation (the part contingent upon future appreciation in the value of the stock) provides a better "matching" than to expense all compensation while the employee is active in the business?

Another objection will no doubt be that expensing the options when exercised by the employee will cause significant fluctuations in reported earnings.

Two responses. First, so what? The financial community should be able to handle this (the marketplace would factor it into their estimates of the present and future value of the publicly traded stock). Second, and my major concern with earlier recognition of the expense, this will become another possible area of earnings manipulation--smoothing out income over time--even by the most conscientious of CFOs. For those that have argued against ever expensing stock options because of the measurement problems (i.e., the Black-Scholles model is not up to the task), expensing when exercised provides a very high degree of certainty of measurement.

Whatever the standard setting bodies decide on measurement, I wholeheartedly endorse the expensing of stock options. The grant of a stock option to an employee is a compensation expense.

Thomas C. Mowry Manager Healthserve LLC

Dear Editor:

Once again the accounting profession fails in its attempt to self-regulate by missing the entire point, and as a CPA with a forensic accounting as well as a tax background that is licensed in Ohio, Florida and Maryland, I find this outrageous! (Thank God for Senator Paul Sarbanes and Representative Mike Oxley!)

Yes, expensing of stock options is an excellent idea and one that is long overdue! (Just ask Warren Buffet or Allen Greenspan.)

When stock options are exercised, the capital markets have basically determined the perceived value of the stock which translates into compensation expense for the difference between the executive's option price and the fair value at the time of exercise. This spread, which the IRS allows as a tax deduction for non-qualified options and ISOs that are treated as disqualifying dispositions, should also be an expense for GAAP accounting.

Why not simply follow the tax rules for deducting compensation expense as a result of the exercise of options?

Secondly, until such time as an option is exercised, the "fair market value," however it is determined, could be accounted for as a component of comprehensive income, similar to the way that unrealized gains and losses are handled for securities, interest rate swap contracts, and other forms of derivatives. (If this treatment is good enough for securities and derivatives, it should be good enough for stock options.)

As a long-term capital markets investor and shareholder advocate that has witnessed the erosion of value and confidence in the capital market system as a result of the corporate accounting fraud scandals, it is due time that financial reporting start utilizing economic reality standards.

Brent D. Berkman, CPA Senior Manager Reznick, Fedder & Silverman CPAs'

Connie Esmond-Kiger, CPA, Ph.D., is an assistant professor in the School of Accountancy at Ohio University. Her current teaching and research interests are in corporate financial reporting, accounting education strategies, and ethics in reporting.

Ray G. Stephens, D.B.A., C.P.A., C.M.A., is professor and director, School of Accountancy at Ohio University. His current teaching and research interests are in corporate financial reporting and attest services.
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Title Annotation:expensing of stock options supported by Financial Accounting Standards Board and International Accounting Standards Board
Author:Esmond-Kiger, Connie; Stephens, Ray G.
Publication:Catalyst (Dublin, Ohio)
Geographic Code:1USA
Date:Jul 1, 2003
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