Magazine article Business Credit

The Physics of Change

Magazine article Business Credit

The Physics of Change

Article excerpt

Physics teaches us that for every action there is an opposite and equal reaction. This concept may also apply in the realm of executive compensation. In June 1993, FASB published an Exposure Draft which would change the methods under which stock options are reported and expensed. The changes will not take full effect until 1997, but beginning this year, companies will be required to record the financial impact of stock-based compensation (i.e., restricted stock, options, awards to Employee Stock Ownership Plans, phantom stock plans, and/or Stock-Appreciation Plans) as an expense on their financial statements.

It is not FASB's intention to discourage the use of stock option plans, but rather to properly recognize their expense in a more timely and accurate manner. The issues arise when deciding at what point in time the options should be recognized as compensation and, therefore, as an expense.

Should the options be recognized when they are granted or at the time they are exercised by the executive? The value of the award is to be recognized over the time period that the employee renders services. If the award is for past service, then it is valued and expensed on the date of the award. However, with the more typical practice of granting an award dependant on future service, the value and expense of the award is to be recognized across the period of future service.

If there was consensus on how to calculate the hypothetical value of stock options, then greater comfort with identifying the compensation could be gained. Unfortunately, there is not a consensus. The reason for waiting until 1997 for full recognition by FASB is to allow time for companies to become familiar with the various methodologies used in valuing stock options.

A company could use one of several methodologies to calculate the value of its options each year and then choose the methodology that yields the most favorable outcome, but this process may not produce financial statements that are credible and faithful.

Considerable debate has emerged since the publication of the Exposure Draft as to the merits and practicality of annual stock-option valuations. The American Institute of CPAs and the Securities and Exchange Commission have asked FASB to reconsider current accounting for stock compensation. Sen. Joseph Lieberman, (D-Conn.), has introduced the Equity Expansion Act of 1993, which, if enacted, will overrule the proposed FASB changes.

In response to the controversy, FASB seems to be considering a broader look at the issues. Testifying before the Senate Banking, Housing and Urban Affairs Subcommittee on Securities, FASB Vice Chairman James J. Liesenring reported that FASB is reconsidering a current accounting for stock compensation issue.

Stock Options Clearly Attract Talent

As a compensation element, stock options clearly are capable of attracting--and perhaps motivating--executive and research talent. For large corporations, the financial impact of current stock option accounting rules will be minimal as they will identify or create offsetting assets. Stock options will, nevertheless, become less attractive as a compensation reward if a company is required to expense their hypothetical value each year. The advantages of rewarding an executive with potential capital accumulation and not incurring an expense until it is exercised will be lost. …

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