NOVEMBER 2005 — After more than a decade of debate, in December 2004 FASB issued SFAS 123 (Revised), Share-Based Payment. requiring that compensation costs for employee stock options granted be recorded as expenses. Many investors agree with FASBs action, claiming the need for better information; many companies and their option holders lobbied against this proposal. Senators and congressmen also entered the debate, delaying resolution of the issue. Even after the statement was issued, the SEC pushed back the required compliance date for large companies.

In 1993, FASB issued an exposure draft that would have required companies to report the value of stock option grants issued to employees as compensation expense in the year the grant was made. It was met with resounding opposition. Detractors claimed that the dramatic hit to earnings would have detrimental effects on competitiveness and innovation. The final regulation, SFAS 123, merely encouraged companies to adopt this reporting approach, while continuing to allow reporting under APB 25 rules so long as footnotes contained a pro forma presentation of earnings as if SFAS 123 had been adopted. The APB 25 rules required compensation expense to be reported only if the exercise price was less than the extant stock price at date of grant. In most cases, options are granted with an exercise price at or above the current stock price. The result was that most companies did not report stock option expense on the income statement.

Companies experience no cash outlay upon granting of stock options. Upon exercise by the employee, companies were allowed to deduct, for tax purposes, compensation in the amount of the difference between the exercise price and the actual stock price, resulting in (often large) tax savings. The compensation was not, however, included in the income statement as an expense but reported as an adjustment to equity. David Zion, an analyst at Bear, Stearns & Co. estimated that S&P 500 companies would have reported an average of 9% less earnings in 2000 if options had been expensed on the income statement. For tech companies, this reduction would have been even greater; for some, profits would have turned to losses. Zions colleague Patricia McConnell examined 287 of the S&P 500 and found that option compensation expense had more than doubled, from $21 billion dollars in 1999 to $47 billion dollars in 2001. When some companies expense stock options and others do not, comparison of financial statements becomes more difficult.

For many years companies have been incorporating employee stock options into the compensation plans of their executives. During the 1960s, qualified stock option plans were the primary form of long-term incentive offered. Use of qualified plans allowed for capital gain treatment by the employee upon the subsequent sale of stock obtained through the plan if held for three years. Because the top marginal personal tax rate on ordinary income at the time was 70%, compared to a capital gains rate of 25%, this was a particularly attractive form of compensation for the executive. Under APB 25, companies did not report compensation expense at date of grant or at exercise, nor did they receive a tax deduction; however, the savings to the employee far outweighed the cost of the lost tax deduction.

In the 1970s, there was a move away from qualified options toward a diverse set of compensation components, notably non-qualified stock options (NQSO), to address the incentive issue. Under APB 25, issuance of NQSOs required no compensation to be reported by either employer or employee at the time of grant. When (or if) the employee exercised these options, he would report income, and the company would receive a compensation expense tax deduction in the amount of the spread between the exercise price and current market price of the stock (the intrinsic value). This change in compensation strategy may have been due to a reduction of personal tax rates to the point where the combined tax of the employee and employer tended to be less under a plan that allowed for the employers tax deduction.

An additional impetus for change in compensation plans was the growing concern over the amounts being paid to top executives. Throughout the 1980s and early 90s there was an outcry for more correlation between pay and performance. In 1992, the SEC began to require that a firms proxy statement contain details of compensation for the CEO and the next four highest-paid executives. In 1993, IRC section 162(m) denied a tax deduction for compensation in excess of $1 million that did not take the form of incentive compensation. Because NQSOs fall into the category of incentive compensation eligible for the deduction, this form of compensation became increasingly popular in the mid- to late 1990s.

In 1993, FASB issued an exposure draft on share-based compensation. The draft called for recognizing the fair value of stock options granted to employees, making option-reporting consistent with reporting for other forms of compensation. This would also level the playing field, between fixed and variable stock option awards. Options regarded as fixedthat is, those options wherein all factors are known at the grant dateare not adjusted once reported. With an unknown (adjustable) exercise price, NQSOs might be considered variable options, and increases in value would be reported periodically as compensation.

This exposure draft met with immense opposition. Objections included the substantial hit to net income, the current availability of the information, the inability to reliably value employee stock options, the claim that at the money options have no value, and the uncertainty as to whether options would ever be exercised. Other potential effects of expensing options included employees fears that companies would discontinue stock option programs if they were forced to include the value in net income, that debt covenant restrictions would be triggered by the decreases in reported net income, and that increased political or shareholder pressure would be placed on managers due to the added exposure of compensation expenses.

Even though FASB discounted most of these arguments, the board agreed to allow companies the choice of continued application of rules under APB 25 while encouraging adoption of SFAS 123, Accounting for Stock-Based Compensation. as finally released in 1995. Although not as tough as the exposure draft, the final ruling required a pro forma presentation of earnings as if the value of the current periods option grants had been reported as an expense.

The bull market of the 1990s gave way to the bear market of the 2000s. With stock prices plummeting, options are no longer as attractive as they once were. As fewer options are being exercised, companies are not getting the huge tax benefits (based on the now smaller difference between market price and exercise price) that they were once getting. In addition, recent scandals have shown how some corrupt managers cashed in on their options and left investors with nothing. In 2001, only two companies in the S&P 500 Index reported stock option compensation expense under the SFAS 123 method. By 2004, companies garnered press by voluntarily agreeing to expense options. Some, like Microsoft, have even stopped issuing options in favor of actual shares of stock. The calls for mandatory expensing began again, but this time, its opponents were fewer.

Renewed Arguments

Reading an income statement issued in the past few years, it is hard to determine the compensation cost of stock options, making comparisons of the results for different companies more difficult. If a company reported under APB 25, there is no compensation expense in the income statement but the notes would indicate a pro forma net income as if options had been expensed. If a company used the prospective method of reporting, current option costs are included in the income statement but not the cost of earlier awards. A pro forma disclosure reveals the full effect of the options but only footnote form. The modified prospective approach places the costs for current and past awards in the current income statement. Finally, under the restatement method, previous years are restated and comparison is enhanced.

Yet, even if one knows what reporting method was used to disclose the option cost, the valuation methods may obscure the compensation cost information. SFAS 123 states:

For stock options, fair value is determined using an option-pricing model that 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 rate of interest over the expected life of the option. Nonpublic entities are permitted to exclude the volatility factor in estimating the value of their stock options, which results in measurement at a minimum value. The fair value of an option estimated at the grant date is not subsequently adjusted for changes in the price of the underlying stock or its volatility, the life of the option, dividends on the stock, or the risk-free interest rate.

Under fair value reporting, options are valued using the Black-Scholes option-pricing model, a binomial model, or some other acceptable model with modifications allowed for early exercise and other factors. A company may use its discretion to determine the parameters to be used to calculate these values (risk-free interest rate, expected volatility, expected duration, and dividend yield). A small decrease in the estimated life of the option or its estimated volatility can result in large reductions in the computed value. Because these estimated values are not subsequently adjusted, initial valuation is especially important.

Black-Scholes and other binomial pricing models are typically used to compute the initial valuation. These models, however, were developed to assess the value of traded options, not employee stock options. ESOs are often subject to vesting requirements; they may be forfeited completely if the employee terminates employment. ESOs are also not transferable and are often exercised long before the expiration date. Using binomial formulas, early exercise would cause fair values to be overstated.

Opponents to expensing argue that current disclosures are sufficient. FASB has always held that disclosure is not equivalent to recognition. Disclosure alone requires users of the financial information to become experts in finding and analyzing the data. Those critics that reject expensing on the grounds that valuation is imprecise should also consider that many amounts reported in the financial statements are based on estimates. Warranties, doubtful accounts, depreciation, and pension costs are not left out of the income statement because of uncertainties inherent in each of them. Options are instruments with reasonably estimable values given to employees in return for service. There is no reason to allow inconsistent treatment.

Examples of Reporting for Employee Stock Options (Before and After SFAS 123)

Exhibit 1 illustrates the reporting requirements under both APB 25 and SFAS 123 for fixed stock options where the exercise price is equal to the market price at the time the options are granted. This is the most common scenario. Under APB 25, the company yielded tax benefits at time of exercise without ever reporting compensation expense. SFAS 123 requires that compensation expense be reported over the vesting period based on the fair value of the options at the grant date.

The assumptions in Exhibit 1 include a grant of 100,000 options that vest in three years, no expected forfeitures, and a market price equal to the exercise price of $50. For computing the fair value at grant date, assume a risk-free rate of 7.5%, an expected volatility of 30%, an expected dividend yield of 2.5%, and a six-year life. The employer is assumed to have sufficient net income to use all tax benefits, and a tax rate of 30%. As indicated in SFAS 123, Appendix C, paragraph 290, this set of assumptions will result in a fair value of $17.15 per option under the Black-Scholes option pricing model modified for dividends. (The value using a binomial model is slightly higher, at $17.26.) Assume all options are exercised at the end of three years when the market price is $70.

A comparison of compensation reported under APB 25 and FAS 123 reveals that, for each of the three years, net income would be higher under APB 25 by $400,167 (compensation cost of $571,667 less tax benefit of $171,500 as reported under SFAS 123). The cost of the options under APB 25 would be disclosed in a note showing pro forma net income, but neither the compensation nor the tax effect would appear on the income statement.

If forfeitures are expected, compensation cost may be adjusted annually to reflect current estimates of the number of options expected to vest. If options are not exercised, the paid-in capital (PIC) from options would be closed to another PIC account, but previously recognized compensation cost would not be reversed.

Exhibit 2 illustrates the required entries under APB 25 when the exercise price is less than the market price at the time options are granted. The intrinsic value is reported as compensation expense over the vesting period. Compensation expense is not adjusted for subsequent changes in the market price of the underlying stock. Because compensation under SFAS 123 is at fair value as of the grant date, it is not affected by the exercise pricemarket price spread.

Previously, reporting the tax benefits received due to the exercise of nonqualified employee stock options in the Statement of Cash Flows was not clearly specified in official pronouncements. Both APB 25 and SFAS 123 state that the additional tax benefits are attributable to an equity transaction, implying that the tax benefits should properly be classified as cash flows from financing. In practice, however, these tax benefits are often placed in cash flows from operations, or even in noncash transactions. Some companies clearly label the origin of the cash flow as tax benefits from exercise of employee stock options; others simply include the amount with other cash flow effects.

Reporting tax benefits as cash flows from operations could be justified because taxes may fall into this category and this is simply a reduction in taxes. Using the indirect method of adjusting accrual-basis income to a cash basis, a manager may justify a decrease in deferred tax assets or taxes payable to be an adjustment (increase) in operating cash flows. The implication of reporting a transaction as operating is that it may be perceived to be a continuing item that will affect future cash flows and market price.

Reporting the tax benefits from the exercise of options as cash flows from financing is probably more accurate. Sales of stock are traditionally recorded in this category, and such transactions are less likely to be perceived as recurring. SFAS 123 indicates that the tax benefits from the exercise of employee stock options are attributable to an equity transaction, lending authoritative support to this choice.

Finally, some companies choose to report the tax benefits from the exercise of options as noncash transactions. This classification is appropriate for purchases of assets with long-term liabilities or equity, or for payment of liabilities with equity. At exercise, taxes payable are reduced and paid-in capital is increased due to the compensation expense allowed for tax purposes. Because no cash changes hands, noncash transactions seems to be a logical placement on the statement of cash flows.

The Emerging Issues Task Force (EITF) of FASB addressed the issue of cash flow reporting for tax benefits due to the exercise of employee stock options in EITF 00-15. Effective July 20, 2000, companies were required to report this tax benefit in the cash flows from operating activities (as an add-back to net income when using the indirect method). Many companies still did not comply with this directive. Under FAS 123(R), cash flows from the tax benefits should be reported as cash flow from financing activities.

An Ongoing Debate?

It has taken many years for the battle over the accounting for stock options to reach the point it has now. The Sidebar presents a brief chronology of recent events in this contentious debate. With the expensing of options set to take effect at the end of this year, the standards proponents appear to have finally won the argument. There remains, however, a significant transition period yet to come, as well as ongoing debates about the recognition and measurement of optionsnot to mention how they will be accepted by investorsensuring that the expensing of stock options will remain a controversial and contested topic.

Paulette A. Ratliff, PhD, CPA. is an assistant professor at Arkansas State University, State University, Ark.