Examining the Future of Broad-Based Options

By Shah, Sam | The CPA Journal, June 2005 | Go to article overview

Examining the Future of Broad-Based Options


Shah, Sam, The CPA Journal


Sometime in 2005, domestic and international companies can expect to be required to show charges to earnings for all their equity compensation plans. Currently, under Accounting Procedure Bulletin (APB) 25, companies do not have to show charges to earnings for stock options if the date on which the price and the number of the shares offered are known is the same date as when the grant is actually made. These "fixed options" offer employees the right to buy a specific number of shares at a price fixed today for a defined number of years into the future. They do not show up as a charge to earnings, although they count as outstanding shares for earnings-per-share calculations. If options are modified (e.g., if the price is lowered after the grant is made, or the term of the option is extended), or vest only if a performance goal is met, they are considered "variable options" and must be charged to earnings.

Companies can also follow SFAS 123, Accounting for Stock-Based Compensation, which requires estimating the expense of stock options using a model that calculates the options' present value (the theoretical value at which a willing buyer would buy them from a willing seller). For equity pay other than options, companies must currently show a charge to income. All of this changed, however, when the International Accounting Standards Board (IASB) and FASB finalized rules that will require companies to estimate the fair value of all equity pay in their income statements.

The new standards will also require companies to show employee stock purchase plans (ESPP) as an expense. These plans allow employees to buy stock at a discount. The most common, an IRC section 423 plan, allows employees to put aside up to $25,000 in after-tax money to buy stock at up to a 15% discount from (usually) the lower of the price when they make the purchase or the price when they started to put money aside. This offering period usually lasts between three months and two years. By law, at least all full-time employees with two or more years of service must be able to participate. Previously, companies took no charge to earnings for these plans; under the new rules, they must show an expense for the discount and the expected value of the "look-back element" that allows employees to buy at the lower of the beginning or the end of the offering period.

The new standard's requirement of expensing equity compensation has caused enormous controversy and concern among companies that provide stock options. Opponents of accounting reform envisioned the new rules as the deathblow for broadbased equity plans. They claim it is impossible to accurately value options, that the complexity of proposed formulas will confuse rather than clarify, and that current earnings-per-share disclosure rules are adequate. Proponents contend that stock options are compensation and that current procedures mislead investors. Some reformers believe this accounting rule will force companies to reduce outsized options grants to executives; the IASB and FASB say their aim is clarity in accounting.

In addition to the accounting changes, companies are concerned about new NAS-DAQ and NYSE rules for shareholder approval of equity compensation plans. These rules require shareholder approval for almost all equity plans, such as employee stock-ownership plans (ESOP) and 401(k) plans, as well as "material modifications" of existing plans (qualified plans do not need to be approved). Unlike in the past (at least for NYSE companies), brokers holding stock in "street name" (holding shares for investors in their accounts) can no longer vote the shares without specific proxies from investors. This will make obtaining shareholder approval more difficult. Because many companies are running out of approved shares to issue under existing plans, or want to institute new or modified plans, the approval process will become especially important. …

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