Magazine article The CPA Journal

FASB's Stock Option Accounting Proposal: Correcting a Serious Flaw

Magazine article The CPA Journal

FASB's Stock Option Accounting Proposal: Correcting a Serious Flaw

Article excerpt

Almost everything you read in the business press about the FASB's proposal for accruing compensation expense for stock options is negative. Some of the critics disagree with the accounting answer ("there's no out-of-pocket cost to the company"). Others fear the impact ("it's a major blow to American competitiveness"). Still others say the value of employee stock options cannot be reliably measured. Allow me to present a different point of view. Current accounting for stock options is a flawed anachronism that needs fixing.

CURRENT ACCOUNTING IS "NONACCOUNTING"

Current accounting for stock options is really "nonaccounting" that ignores economic reality and is inconsistent with accounting standards for other types of compensation.

The current accounting standards were adopted in 1972; little changed from rules originally issued in 1948. The standards acknowledged that most stock option plans are compensatory in nature. Because of measurement considerations (the option valuation models in use today were not yet developed), they do not require accrual of compensation cost if the exercise price is at least equal to the market price on the first date that both the number of shares and the exercise price are known. For fixed-option plans, that is the grant date. Thus, for fixed plans, if an option is not in the money on grant date, no cost is recognized, even though on that date the option has a real value due to the time value of money from delayed payment for the stock and the stock's volatility or potential to increase during the option period.

CURRENT ACCOUNTING IGNORES REALITY

By disregarding an option's value, current accounting ignores the twin realities that options give employees valuable rights and that options are compensation for services performed.

The value of every other kind of right given to employees as compensation for services performed is accrued as expense over the service period. That includes deferred compensation arrangements, the cost of accrued vacations and sick pay, pensions, retiree medical and life insurance costs, severance benefits, disability-related benefits, supplemental unemployment benefits, stock appreciation rights (SARs), and performance options.

Ironically, compensation cost is accrued today for SARs and performance options, even though these tend to be worth less when granted than fixed stock options. Because accounting measures compensation expense for some plans and not for others, accounting has become a significant factor in plan design. To illustrate:

Stock Option. A company's executives are granted 10-year fixed options for 50,000 shares, exercise price $20 per share, stock price at grant date $20 per share, and stock price at exercise date five years later $50 per share. Since the market value of the stock at grant date (50,000 x $20 = $1,000,000) is equal to the exercise price, no compensation expense is recognized then or at exercise. At exercise, the executives pay $1,000,000 and receive $2,500,000 worth of stock, a $1,500,000 net benefit.

Stock Appreciation Right. Same facts except that the executives receive SARs to be settled in shares of stock. On exercise five years later, instead of paying $1,000,000 and receiving stock worth $2,500,000, the executives pay nothing but receive 30,000 shares of stock worth $1,500,000. Since the number of shares was unknown until exercise, compensation expense is determined at that date to be $1,500,000--the market value of shares received minus purchase price of zero.

Performance Option. Same facts as the fixed options, 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 two years. If at the end of the two years the revenues increased by the required percentage and the stock price is $50, compensation expense of $1,500,000 is recognized.

The substance of all three cases is that the employees were compensated in the amount of $1,500,000. …

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