Ethical, Economic Consequences, and Political Context of Accounting for Stock-Based Compensation - Case Study Example

Regis College for Professional Studies – School of Management MBA MSA A603 – Financial Reporting Policy and Practice Facilitator: Facilitator’s last name Term: e.g., M8W1-12 Summary Issue Analysis (Research Paper) The Ethical Issues, Economic Consequences, and Political Context relating to Accounting for Stock-based Compensation Instructions for Completing Summary Issue Analysis Assignment The objectives of this template and its instructions are to maximize students’ learning and grade by: 1. Providing students with clear expectations for this assignment; 2. Reducing students’ inefficient use of time speculating on matters like expectations, required content, and required document organization and formatting; and 3. Helping students to ensure a professionally prepared assignment that the facilitator can read and assess efficiently Enter responses in the “box” that follows each heading. 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Purpose The purpose of this paper is to examine and discuss the ethical issues, economic consequences, and political context of accounting standards and financial reporting for stock-based compensation (most commonly in the form of employee stock options). This paper begins by identifying the stakeholders and the nature of their stake in the decision of a company, about whether it has to (a) adopt the optional fair value method of accounting for stock options, which existed under SFAS No. 123 (Original) during the 1995 – 2004 period and (b) adopt SFAS No. 123 (Revised), which requires companies to use the fair value method, prior to its required effective date of January 1, 2006 (for calendar year public companies). Next, the paper (a) describes the Economic Consequences (as defined in Week 1 of the course) claimed by affected companies that result from their accounting policy decisions related to employee stock options and (b) evaluates the validity of these claims from the perspective of the capital markets. For this purpose, “capital markets” includes both current and prospective (i) stockholders and (ii) non-trade creditors. This paper then describes the relevant political context that existed in the U.S. leading up to the issuance of Statement of Financial Accounting Standards No. 123 (Revised), Accounting for Stock-Based Compensation, in December 2004. Finally, the paper analyzes and states the ethical dilemma for accountants, who are responsible for deciding whether the company has to (a) adopt the optional fair value method of accounting for stock options that existed under SFAS No. 123 (Original) and (b) adopt the required fair value method under SFAS No. 123 (Revised) prior to its required effective date. In addition, this paper relates the ethical, economic, and political considerations to one another. Introduction and Background This analysis accepts, without further debate, the theoretical arguments for the view that stock-based compensation, including employee stock options, represents a real economic cost that requires accounting recognition in general-purpose financial statements prepared according to U.S. GAAP, consistent with the existing Conceptual Framework of the FASB. Nor does this paper formally consider the ongoing controversy regarding which option-pricing model(s) appropriately measure the fair value of non-traded employee stock options as a basis for measuring compensation cost recognized in financial statements.  APB Opinion No. 25 – Intrinsic Value Method. Accounting for stock-based compensation (hereinafter, referred to simply as employee stock options or ESOs) is among the most controversial issues in the modern U.S. history of financial reporting. Beginning in 1973, the Accounting Principles Board (predecessor to the FASB) required, in APB Opinion No. 25, Stock Issued to Employees, that companies record compensation expense should equal to the intrinsic value of ESOs (the intrinsic value method). (In general, “employees” includes officers and directors, as well.) Intrinsic value is the excess, if any, of a company’s stock price over the exercise price of an ESO, which is set forth in the ESO grant document. ESOs, having intrinsic value, are “in the money.” Under APB No. 25, companies recorded compensation expense for ESOs that were “in the money” at their grant date (the “measurement date”). Otherwise, a company recognized no compensation expense as a result of granting ESOs to its employees. When the APB issued APB No. 25, accountants and financial analysts generally understood that the intrinsic value (if any) of an ESO represented only a portion of its total fair value. The fair value of a financial option is the sum of its (a) intrinsic value, if any, and (b) its time value. Time value results from the fact that the option holder need not exercise it immediately. During the term (or exercise period) of an option, its fair value may increase significantly because of events and conditions not foreseen at the date of its creation. Many ESOs have lives of three to ten years. SFAS No. 123 (Original) – Optional Use of Fair Value Method or Intrinsic Value Method with Pro forma Disclosure: Recognizing the theoretical weakness of the intrinsic value method, in the early 1990s, the FASB placed ESO accounting on its agenda for reconsideration. The FASB encountered considerable resistance during its “due process” consideration of a proposed standard that would require companies to measure and recognize ESO costs using the fair value method. In 1995, the FASB issued SFAS No. 123 (Original), which recommended that companies measure the compensation cost of ESOs using their fair value (the fair value method). However, the statement permitted companies to continue using the intrinsic value method, providing that if used, they needed to disclose pro forma footnote information, setting forth the amounts of net income and earnings per share as if the company had used the fair value method, along with the assumptions used in preparing the pro forma disclosure. SFAS No. 123 (Revised) – Required Use of Fair Value Method: During the late 1990s, the use of ESOs peaked, especially in certain industries, such as “Silicon Valley” start-up companies, many of which were cash-starved and incurring operating losses. Following the bursting of the “dot-com” bubble, as well as the accounting frauds and bankruptcies at Enron Corporation and WorldCom Corporation in 2001, the FASB returned to the ESO accounting issue. After overcoming resistance similar to that encountered a decade earlier, the FASB issued SFAS No. 123 (Revised) in 2004. The revised statement requires all companies to measure and recognize the cost of ESOs using the fair value method. The statement required calendar-year public companies to adopt the fair value method for ESOs on January 1, 2006, approximately one year after its issuance. However, the statement permitted companies to adopt the statement prior to that date. Stakeholders and their Interests in ESO Accounting [300 words] 301 words The stakeholders in Employee stock option (ESO) accounting are the employees, management, shareholders of the firm and business consultants. An ESO is a form of incentive to the employees, which carry only the rights but not the obligation to purchase the shares of the employer company at a very predetermined price. ESO is beneficial, because it is like employees becoming the owners of the firm. Therefore, these employees adopt the same outlook as that of managers and owners of the business. The managers have also high interest in the employee stock options, because they can earn more loyalty from their employees. The shareholders of the firm also aim to increase the profits of the firm. The next big stakeholder, the business consultants also propose the ESO, because this would result in providing better knowledge about the firm to the media and will help in improving the public relations. The employees would prefer in adopting the SFAS No. 123 (revised), which asks companies to use the fair value method in the accounting for ESOs on January 1, 2006 because in most of the instances “the price charged for each individual option under the fair value approach is correct” (The Taxation of Employee Stock Options, 2005, p. 134). The management supports the SFAS No. 123( original), which supports the optimal use of fair value method or the intrinsic value method with pro forma disclosure, because the fair value method does not rely on a comparison with a comparable uncontrolled transaction and is also not relied on the financial statements of a firm. The business consultants and other shareholders of the firm would prefer the SFAS No. 123 (revised) so that the fair value method is in accordance with the fair value market approach used in ordinary share market and the compensation cost is also based on the time factor. Economic Consequences of ESO Accounting for Affected Companies and Capital Markets [400 words] 400 words Corporate America shared a concern that expense of ESO would lead to severe economic consequences. The accounting treatment of ESOs is on corporate investment and thus it has economic consequences. The profitability of a firm is a known aspect to the manager of the firm and uses the private information to determine a firm’s investment strategy. According to the Accounting Principles Board 1972, an employee stock option is valued at its intrinsic value. Intrinsic value is the difference between the market price of a stock and the exercise price of the option. The two economic consequences for a financial issuer are as follows: Accounting of stock should not affect the economic decisions of a firm. “A potential decrease in the use of stock options may occur as a result of users perceiving the cost of stock options as being higher than the cost of normal wages, not as a result of accounting” (Alves, 2010, p. 6). Therefore, stock costs are an expense item in the income statement of the firm. The concern is that recognizing the fair value of ESOs will reduce the stock price of the firm and will hamper the firm’s capital strengthening process. A firm’s stock price reflects not only the firm’s economic activities but also influences the managerial decisions of the firm. The net benefit of the firm’s economic transactions is measurable by way of accounting numbers and is communicated to the capital markets. The preferential accounting treatment of ESOs actually leads to higher overinvestment in the period. A capital transaction is one in which shares is issued to settle the exercise of stock options. Capital market includes both current and prospective shareholders and the non-trade creditors. The two economic consequences for the capital market are as follows: The current and prospective shareholders will not be treated in a similar manner and therefore, there will be a high difference in the ways, by which return is calculated on investments or the ESOs. The valuation methods for both current and prospective shareholders should be similar so that there is a reliable basis for comparison. The incorporation of the SFAS No. 123 (revised) will help in the measuring the compensation cost of stocks using the fair value method. This will ensure fairness in measuring the compensation cost with adequate due to the time value of money. The time factor of an ESO is highly variable. Political Context of ESO Accounting Leading Up to SFAS No. 123 (Revised) [300 words] 298 words The FASB first proposed a controversial exposure draft with reference to accounting for stock based compensation in June 1993, which proposed that firms should use the fair value method for the valuation of the employee stock option. However, this did not come into practice because of the tremendous pressures, which included political as well as corporate pressures. The Congress also put a pressure on FASB and the FASB had to compromise on this issue. Then the FASB issued SFAS 123, which required firms to continue with the intrinsic value method while making appropriate disclosures of pro forma stock option expense under the fair value method. In the near future, there were several accounting scandals like the Enron and the Worldcom, which called for the need of a revision of accounting standards. This time the US Congress was in the lead to adopt a greater accountability for financial reporting and there was a new political environment, where some firms came forward to adopt voluntarily the fair value method for accounting for employee stock options. “In response to this new political environment, some firms announced they would voluntarily adopt fair value accounting for stock options. Ultimately, FASB revisited this issue and revised SFAS 123” (Preemption of Compliance Costs and the Voluntary Adoption of SFAS No. 123(R), n.d., p. 1). FASB revisited the issue, which has developed due to the new political movements in the state. Thus, revisions were made in December 2004 and the firms had to recognize the fair value of stock option as an expense from the beginning of June 15, 2005. The US Securities and Exchange Commission (SEC) also supported this idea. The European Commission (EU) also started adopting measures to implement the fair value method in its accounting for stock options. This also motivated the adoption of the SFAS No. 123 (revised) and the political pressures were sidelined. Ethical Dilemma for Accountants Responsible for ESO Accounting Choices [200 words] 200 words Accountants of a company are from ethical backgrounds and there is ethical issue related to disclosures in financial statements. There is ethical dilemma for accountants on whether to adopt the optional fair value method of accounting for stock options, which existed under SFAS No. 123 or to adopt the fair value method under the SFAS No. 123 (revised). Under SFAS no.123 method, the accountants had ethical dilemma because the accounting method adopted was not adequate for not incorporating the total fair value. In the SFAS No. 123, the time value factor was ignored and only the intrinsic value was considered. This did not result in the fair or appropriate valuation of an employee stock option. Accounts have corporate responsibility and they are professionals working in the good of the public. Therefore, they want an appropriate valuation for ESOs. “Pressures on the accounting profession to establish uniform accounting standards began to surface after the stock market crash of 1929” (Financial Reporting Case, 2007). Linking this dilemma to the stakeholder interests and economic consequences that analyzed previously, it can be understood that the ethical dilemma of the accountants was also in the minds of stakeholders as accountants are also important stakeholders as consultants of business. References Reference List Alves, S. (2010). The Controversy Over Accounting for Stock Options: A Literature Review. EuroJournals Publishing, Inc. Retrieved on 15, Dec. 2011. http://www.eurojournals.com/irjfe_53_01.pdf Financial Reporting Case, (2007). Intermediate Accounting. Retrieved on 15, Dec. 2011. http://highered.mcgraw-hill.com/sites/0072994029/student_view0/ebook/chapter1/chbody1/the_development_of_financial_accounting_and_reporting_standards.html Preemption of Compliance Costs and the Voluntary Adoption of SFAS No. 123(R), (n.d). Retrieved on 15, Dec. 2011. https://aaahq.org/AM2011/display.cfm?Filename=SubID_2090.pdf&MIMEType=application%2Fpdf The Taxation of Employee Stock Options, (2005). OECD Tax Policy Studies. Retrieved on 15, Dec. 2011. http://books.google.co.in/books?id=5C6Dt4qILgYC&pg=PA134&lpg=PA134&dq=the+price+charged+for+each+individual+option+under+the+fair+value+approach+is+correct&source=bl&ots=m7LYmF7mqs&sig=SlSepbDZ62QlyPM0SgTKA0bq_fE&hl=en# Read More