Stock Options from an Accounting Point of View - Essay Example

and Section # of Stock Options From an Accounting Point of View   Accounting for stock options has been one of the most litigious topics in accounting during the last decade. The most important debate is whether compensation expenditure must be recognized for stock options and, if so, the periods over which it must be allocated. Up to 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 inherent value technique, whereby compensation expenditure was consummated as the excess of the stock price at the measurement date (generally, the grant date) over the option exercise price. For the reason that most stock options had exercise prices at least equal to current market prices, no compensation expenditure was recognized. This approach ignored any possibility that the stock price would exceed the exercise price in the future. In June 1993, FASB attempted to be familiar with the reality of stock-option value by issuing proposed SFAS 123, which required measuring the option value based upon the scores of issue that reflect its underlying value. As a result, total compensation expenditure was to be based upon the fair value of the options expected to vest on the grant date. No adjustments would be completed following 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. An upsurge of substantial opposition to this fair value technique resulted, led primarily by industries making significant use of stock options, particularly in the high-technology sector. Smaller high-tech corporations were very verbal, arguing that offering stock options was the barely 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 expenditure would impair their stock price and put them at a disadvantage compared to larger corporations better able to absorb the expenditure of stock options (Apostolou, 2005). Opponents to the expensing of stock options embodied many members of Congress. In 1993, Senator Joseph Lieberman introduced a bill that would have mandated the SEC to necessitate that no compensation expenditure be reported on the income statement for stock-option plans. This bill would have set a treacherous precedent for interfering in the operations of FASB. The puissant interests aligned against it forced FASB to compromise. In 1995, FASB decided to hearten, rather than require, recognition of compensation cost based upon the fair value technique and to require expanded disclosures. In other words, SFAS 123 requires corporations that continued to follow APB 25 and did not include stock-option expenditures in the income statement to disclose in the notes to financial statements what such expenditures would have been. This compromise distressed 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. A distressing number of both CEOs and auditors have in recent years acrimoniously fought FASBs attempts to replace fiction with truth and virtually none have spoken out in support of FASB. Critics of the failure to expenditure options (fair value technique) on the income statement became particularly vocal in recent years because of the widespread concern over deceptive accounting practices at corporations arraigned of fraud (e.g., Enron, Tyco, WorldCom). Few corporations prior to 2002 chose to adopt the fair value technique. Buffett was the most famous critic of the failure to recognize stock options on the financial statements. In another place in Berkshires 1998 annual report he stated: Existing accounting principles ignore the cost of stock options when earnings are being calculated, even though options are huge and an increasing expenditure at many corporations. He exemplifies this accounting policy as outrageous and an egregious flaw in accounting procedure. He also stated that he often had to adjust reported earnings per share (EPS) figures of other corporations by 5%, with 10% not at all uncommon. Erstwhile he had made that adjustment; it affected his portfolio decisions, causing him to pass on a stock purchase he might otherwise have made. To examine Buffetts estimates of the degree of dilution from the issuance of stock options, the analyst’s analysis 20 corporations by examining their 2003 annual reports. A renowned high-tech corporation was selected, along with several others used for comparison. Buffetts adjustment to reported earnings of 5% to 10% for stock option compensation expenditure is, in some cases, conservative. The diversity between reported earnings and earnings under the fair value technique (expensing stock options) substantially exceed 10 percent for most of the corporations in our survey. For Yahoo and Adobe, the percentages were 86 percent and 70 percent, respectively. For six of the corporations, the expensing of stock options would have changed a net profit to a net loss (Briloff, 2003). FASB cited four principal reasons for issuing SFAS 123(R): * Addressing concerns of users and others. FASB has received scores of complaints from users that using APB Opinion 25s intrinsic value technique resulted in financial statements that do not loyally represent the underlying cost associated with the issuance of stock options. When employees use their options (that is, buy the stock at the predetermined price), the company has to issue new shares, which reduces the earnings available for each share. * Improving the comparability of reported financial information through the abolition of alternative accounting techniques. Beginning in summer 2002, sundry corporations announce their intention to voluntarily adopt the fair value technique and to expenditure stock options. Currently, more than 500 U.S.-listed corporations have announced their decision to expenditure stock options, including Exxon Mobil, General Motors, and Coca-Cola. Most corporations, however, continue to use APB Opinion 25s intrinsic value technique and do not expenditure options. FASB judged that similar economic transactions must be accounted for similarly, and favors the fair value technique for all publicly traded corporations. * Simplifying U.S. GAAP. SFAS 123(R) would reduce to bare bones the accounting for stock options. FASB conjecture that U.S. GAAP must be simplified whenever possible. Necessitate the use of the fair value technique would eliminate the intrinsic value technique and its many related rules. * International convergence. SFAS 123(R) would better synchronize U.S. accounting standards with international accounting standards (Dyson, 2004). The use of stock options as a compensation tool has expanded radically over the past decade. For instance, one commentator noted that the number of employees receiving stock options grew from about 1 million in the early 1990s to between 7 and 10 million in 2002. (1) This past decade also saw the growth of options grants to a larger number and broader class of employees, nothing like the past when options were primarily offered to a small number of top executives or directors. Even though options were more attractive to executives during the stock market boom than today, they remain a common form of executive compensation. There are still corporate, tax, and accounting reasons to tender stock options as compensation. But the modernistic collapse of Enron Corporation has also focused attention on the cost of options to shareholders, and prompted calls for more explicit disclosures regarding the value of options granted. It is vital for benefits professionals to understand the changing trends affecting stock options so that they can respond to management, employee, and now, potentially, shareholder inquiries about option plans and it’s substitutes. This column describes the basic structure of three widely used option arrangements--non-statutory stock options, incentive stock options (ISOs) and employee stock purchase plans (ESPPs), as well as the tax consequences of such plans and recent proposals regarding their accounting and required disclosure. Stock options and employee stock purchase plans will continue to be a popular form of compensation, so the benefits practitioner needs to be able to understand them and to explain how they operate. As may be seen from the bills introduced to protect their tax advantages, these benefits enjoy significant support in Congress. There will be additional pressure to require that the accounting and disclosure rules regarding options reflect the cost to the company issuing them, but a solution to that question is neither straightforward nor easy (Moran, 2002). Generally, performance-based compensation must meet criteria--that is, the compensation is granted only if certain prescheduled formula goals are met. But because the value of an employees stock rises and falls based on the companys stock price (which reflects corporate performances), stock options and stock appreciation rights are deemed to meet the requirements for performance-based compensation, if certain conditions are met. These conditions include the requirements that the exercise price be equal to or less than fair market value on the date of grant, and that the optionee is unprotected from a decrease in price (for instance, no automatic repricing). Additionally, shareholders must approve the option plan and be told the class of employees who are eligible to receive such compensation, the maximum number of shares for which grants may be made to any eligible individual, and the exercise price at grant. Stock appreciation rights (SARs) are often offered in connection with stock options and avoid the need to spend funds to practice the option. A stock appreciation right gives the employee the right to receive the appreciated value of the employers stock rather than the stock itself. The appreciation is calculated as the difference in value of the stock on the date of bestowed of the right and the value of the stock on the date that the right is exercised. Ofttimes the exercise of a stock appreciation right results in a cancellation of any option that is issued in tandem with that right. Sometimes the value of the appreciation right may be received in employer stock; this in effect allows the optionee to receive stock without spending any of his or her own funds. Stock appreciation rights may be granted in connection with both ISOs and non-statutory stock options. However, if the stock appreciation right is issued in connection with an ISO, it cannot create a right that is inconsistent with the ISO rules (for instance, if the right extends the option beyond the ten-year period permitted for ISOs) (Nawrocki, 2006). Works Cited Apostolou, Nicholas G., and D. Larry Crumbley. "Accounting for stock options: update on the continuing conflict." The CPA Journal 75.8 (August 2005): 30(4).  Briloff, Abraham J. "Accounting for stock options." The CPA Journal 73.12 (Dec 2003): 12(4).  Dyson, Robert A. "Accounting for stock-based compensation: a simple proposal." The CPA Journal 74.8 (August 2004): 6(4).  Moran, Anne E. "Stock option fundamentals." Employee Relations Law Journal 28.2 (Autumn 2002): 115(16).  Nawrocki, Jill. "Taking stock of general counsel compensation." New Jersey Law Journal (August 7, 2006): NA.  Read More