January 10, 2005
Future of Stock Options
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Jack Horgan - Contributing Editor

by Jack Horgan - Contributing Editor
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Amidst year end business activities and holiday celebrations and shopping, you may have missed an important announcement.

On December 16, 2004 the Financial Accounting Standards Board (FASB) published Statement No. 123 (revised 2004), Share-Based Payment. Statement 123(R) will provide investors and other users of financial statements with more complete and neutral financial information by requiring that the compensation cost relating to share-based payment transactions be recognized in financial statements. That cost will be measured based on the fair value of the equity or liability instruments issued.

Michael Crooch, FASB Board member and Board collaborator on the project, said “Recognizing the cost of share-based payments in the financial statements improves the relevance, reliability, and comparability of that financial information and helps users of financial information to understand better the economic transactions affecting an enterprise and supports resource allocation decisions.”

The major issue being addressed is the expensing of employee stock options. The action was the result of a two-year effort in response to requests from investors and many others that the FASB improve the accounting for share-based payment arrangements with employees. The FASB held 60 public meetings, conducted field visits with companies and employee benefit consultants, held public roundtables, consulted with numerous valuation experts, companies, auditors, and many others, and reviewed thousands of comment letters from interested parties. The accounting board said that companies that issue stock options must estimate the value of this benefit and deduct it from income statements as
of June 15, 2005. Smaller public firms and non public entities will have until next Dec. 15 to comply.

The action was partly in response to accounting scandals such as Enron and WorldCom, as well as the dot-com tech boom and bust a few years ago.

The accounting board made no recommendations on the method that companies may use to value options, or on the formulas to assign costs to the options. Earlier, the board had appeared to favor the so-called binomial model, which many experts believe is a more accurate way to value options than the Black-Scholes model that many companies now use to estimate option expenses.

Securities Exchange Commission (SEC) Chief Accountant, Donald T. Nicolaisen, issued comments on Statement 123R:
“The issuance of Statement 123R represents another important improvement in US generally accepted accounting principles. It will result in more comparable information in financial statements provided to investors. ...

Now that Statement 123R has been issued, companies should focus on implementation, and I encourage early adoption by those companies who are able to and who choose to do so. I recognize that this accounting standard requires the use of assumptions and estimates about future events, and some of the inputs to valuation models require considerable judgment. Accordingly, in applying the standard, it is important that preparers, auditors and those assisting in valuing equity-based awards use their best judgment.”
Years ago firms following APB Opinion No. 25 Accounting for Stock Issued to Employees used the intrinsic value based method of accounting for stock compensation plans. Since most fixed stock option plans -the most common type of stock compensation plan - have no intrinsic value at grant date (either $0 for startups or current market price for public companies) under Opinion 25 no compensation cost was recognized for them. In October 1995 FASB issued Statement No. 123, Accounting for Stock-Based Compensation that stated that a fair value based method was preferable. This method takes into account the stock price at the grant date, the exercise price, the expected life of the
option, the volatility of the underlying stock and the expected dividends on it, and the risk-free interest rate over the expected life of the option. However, the ruling permitted an entity to continue to measure compensation cost under Opinion 25 providing they made pro forma disclosures of net income and, if presented, earnings per share, as if the fair value based method of accounting had been applied. The board had clearly wanted to go further at the time but relented in the face of considerable opposition.

Over the last few years, approximately 750 public companies have voluntarily adopted or announced their intention to adopt Statement 123's fair-value-based method of accounting for share-based payment transactions with employees.

In February 2004, the International Accounting Standards Board (IASB), whose standards are followed by entities in many countries, issued International Financial Reporting Standard (IFRS) 2, Share-based Payment. IFRS 2 requires that all entities recognize an expense for all employee services received in share-based payment transactions, using a fair-value-based method that is similar in most respects to the fair-value-based method established in Statement 123 and the improvements made to it by this Statement.

Federal Reserve Chairman Alan Greenspan endorsed the expensing of stock options. In a speech in May 2002 he said
“With an accounting system that is, or should be, measuring the success or failure of individual corporate strategies, the evolution of accounting rules is essential as the nature of our economy changes. As the measurement needs change, rules must change with them. This does not lend itself to hard-wired legislation, which makes flexibility of rule-making difficult. We would be best served, in my judgment, by leaving issues such as option grant expense to regulatory bodies and the private sector.

There is a legitimate question as to whether markets see through the current nonexpensing of options. If they do, moving to an explicit recognition of option expense in reported earnings will be a nonevent. The format of reports to shareholders will change somewhat, but little more will be involved. Making an estimate of option expense requires no significant additional burden to the company.

If, however, markets do not fully see through the failure to expense real factor inputs, market values are distorted and real capital resources are being diverted from their most efficient employment. This would be an issue of national concern.

Clearly then, the greater risk is to leave the current accounting treatment in place.”
Critics of the old method complained about dilution of ownership and overstated operating income. When an employee exercises stock options, the company has to either issue new shares or go out on the open market and purchase shares. If new shares are issued, then stockholder ownership is diluted. If the company purchases shares on the open market, then the company, which only receives the exercise price from the employee, has to pay market price for the shares it purchases. This results in a net cash outflow for the company. However, when certain options are exercised, companies receive a tax deduction, which can provide significant income tax savings. Further, when stock options are
exercised by employees, a company increases its shareholder equity account by the amount of the exercise price. This ignores the fact that the stock is actually worth more than the option price at the time of exercise. In effect, this understates the amount of equity capital invested in the business, distorting some productivity measures used by analysts (such as return on invested capital).

Some felt that executives often reaped considerable benefit from stock options due to factors beyond their control like the state of the economy, the stock market and the industry that lift the price of all similar stocks. They also believed that executives have sometimes made decisions for maximum personal rather than corporate benefit.

Warren Buffett wrote in a New York Times Op-Ed piece on July 24, 2002:
“There is a crisis of confidence today about corporate earnings reports and the credibility of chief executives. And it's justified.

For many years, I've had little confidence in the earnings numbers reported by most corporations. I'm not talking about Enron and WorldCom - examples of outright crookedness. Rather, I am referring to the legal, but improper, accounting methods used by chief executives to inflate reported earnings.

Options are a huge cost for many corporations and a huge benefit to executives. No wonder, then, that they have fought ferociously to avoid making a charge against their earnings. Without blushing, almost all CEOs have told their shareholders that options are cost-free...

When a company gives something of value to its employees in return for their services, it is clearly a compensation expense. And if expenses don't belong in the earnings statement, where in the world do they belong?”
Opponents include the International Employee Stock Options Coalition (IESOC). The IESOC is comprised of trade associations and companies representing a diverse range of industries, including high-tech, manufacturing and service companies, in the U.S. and abroad. Trade association members include American Electronics Association, American Business Conference, Business Roundtable, NASDAQ, National Association of Manufacturers, National Venture Capital Association, SEMI, SIA, and Technology Network. Corporate members include Cisco Systems, Sun Microsystems and Intel.

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-- Jack Horgan, EDACafe.com Contributing Editor.


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