Accounting for Stock Options

By Apostolou, Nicholas G.; Crumbley, D. Larry | The CPA Journal, August 2005 | Go to article overview

Accounting for Stock Options


Apostolou, Nicholas G., Crumbley, D. Larry, The CPA Journal


Update on the Continuing Conflict

In December 2004, a decade after bending to Congressional pressure and backing away from requiring the expensing of options on financial statements, FASB issued a revised standard to recognize stock-option compensation as an expense on income statements. Many in Congress may try to thwart the proposal before it becomes effective. A bill by Representative Richard Baker of Louisiana that would require expensing the cost of stock options for only the top five executives of a company has drawn the support of those groups still resolutely opposed to expensing.

This time, however, FASB is likely to prevail. Investors are demanding tougher accounting standards, and the International Accounting Standards Board (IASB) has already passed rules requiring the expensing of options. Many large U.S. corporalions have already voluntarily agreed to expense options. Finally, there is more concern about, and less support for, Congressional interference in FASB's standards-setting process.

History of the Debate

Accounting for stock options has been one of the most controversial topics in accounting during the last decade. The principal debate is whether compensation expense should be recognized for stock options and, if so, the periods over which it should be allocated. Before 1995, the provisions of Accounting Principles Board (APB) Opinion 25, issued in 1972, determined accounting for stock options.

APB Opinion 25 measured stock options using the intrinsic value method, whereby compensation expense was determined as the excess of the stock price at the measurement date (generally, the grant date) over the option exercise price. Because most stock options had exercise prices at least equal to current market prices, no compensation expense was recognized. This approach ignored any likelihood that the stock price would exceed the exercise price in the future.

In June 1993, FASB attempted to recognize the reality of stock-option value by issuing proposed SFAS 123, which required measuring the option value based upon the many factors that reflect its underlying value. Therefore, total compensation expense was to be based upon the fair value of the options expected to vest on the grant date. No adjustments would be made after the grant date in response to subsequent changes in the stock price. Fair value was to be estimated using Black-Scholes or binomial option-pricing models.

A groundswell of massive opposition to this fair value method resulted, led primarily by industries making significant use of stock options, particularly in the high-technology sector. Smaller high-tech companies were very vocal, arguing that offering stock options was the only way they could hire top professional management. Furthermore, they claimed that the losses that would result from forcing them to recognize stock options as compensation expense would impair their stock price and put them at a disadvantage compared to larger corporations better able to absorb the expense of stock options.

Opponents to the expensing of stock options included many members of Congress. In 1993, Senator Joseph lieberman introduced a bill that would have mandated the sec to require that no compensation expense be reported on the income statement for stock-option plans. This bill would have set a dangerous precedent for interfering in the operations of FASB. The powerful interests aligned against it forced FASB to compromise. In 1995, FASB decided to encourage, rather than require, recognition of compensation cost based upon the fair value method and to require expanded disclosures. In other words, SFAS 123 requires companies that continued to follow APB 25 and did not include stock-option expenses in the income statement to disclose in the notes to financial statements what such expenses would have been. This compromise troubled many observers because the politicized rule-making process was less concerned with proper accounting and more influenced by the economic consequences of a new standard. …

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