This article is reprinted with permission from the
April 10, 2003
edition of
New York Law Journal.
© 2003 NLP IP Company.


Executive Compensation Stock Options: The Expense Issue

On March 12, 2003, the Financial Accounting Standards Board [FASB] announced it will re-examine whether stock options should be a charge against earnings. The "elephant in the living room" is whether an employee stock option can be valued at time of grant with sufficient reliability to justify imposing a substantial charge on the employer-grantor's earnings. Under the widely cited proposal, the Black-Scholes model, this charge would be, in many cases, one-third or more of the market value of the stock subject to the option.1

Background

The issue of whether stock options should be a charge against earnings has been the subject of debate for decades. From 1982 to 1988, FASB and a task force appointed by the American Institute of Certified Public Accountants studied this issue and, after approximately six years of review, FASB declined to change the no-charge rule adopted by the Accounting Principles Board in 1972, APB Opinion No. 25 [APB Op. 25]. From 1992 through 1994 an FASB task force studied the issue again and, again, concluded that stock options should not be a mandatory charge against earnings [continuing APB Op. 25].2

 In October 1995, FASB adopted FASB Statement No. 123 [FAS 123], which sets out the rules for those companies that elect to charge earnings for employee stock options.3

Probably the most significant reason for the impetus today to revisit the no-mandatory-charge rule is a political climate that is very hostile toward CEOs and other high-level executives who realized substantial gains from their stock options over the past decade. There is a widespread belief that companies would have made smaller option grants if options had been a charge against earnings. Scandals involving management at a number of major U.S. corporations have added to the furor.

The second development encouraging re-examination of the no-charge rule has been the increasingly widespread use of the Black-Scholes model to value stock options at the time of grant for purposes other than a charge against earnings. Acceptance of this method of valuation gained impetus when the SEC prescribed it as an approved method for valuing stock options as reported in proxy statements under rules adopted in 1992. The media now regularly report a value for option grants based on Black-Scholes.

This evolution of the use of Black-Scholes has been a misleading and unfortunate one. The Black-Scholes model was developed for the purpose of valuing short-term options [generally options with a time frame of six months or less] traded on public markets. The model takes into account, in valuing an option, the term of the option, historic volatility of the stock, dividend practices, interest rates and other factors. An employee stock option, which has a term that may be cut short by a number of factors including a termination of employment, is not tradable, is not transferable [except in very limited circumstances such as a transfer to a member of the executive's family], is subject to delayed exercisability and vesting, has limited post-termination entitlements and may be subject to "black-out" periods, among other constraints, is not the type of derivative right for which the original Black-Scholes model was designed.

An illustration -- among many -- of the distortion to earnings that the Black-Scholes model would mean if it [or a similar model] became the basis for a required charge against earnings is a stock option grant made three years ago to Steve Jobs at Apple Computer Inc. The option grant to Mr. Jobs, using a Black-Scholes model, had a value of over $500 million. Three years later, the market price of Apple stock had dropped almost $30 from its price on the date of the option grant. As a result, the option is more than $500 million "under water" and Apple stock would have to grow at an annualized rate of over 16 percent over the remaining approximately seven years of the option in order for the stock price to just get even with the original exercise price. It would have been an extraordinary distortion of Apple's income to reduce its earnings by a charge of $500 million for an option that, a relatively short time after grant, is almost worthless.

The decision-makers for the accounting profession appear to favor adoption of a new rule that would result in a charge against earnings. In FASB's news release announcing its re-examination of whether stock options should be a charge against earnings, the chairman of FASB, Robert H. Herz, is quoted as stating "an expense treatment would be consistent with the FASB's commitment to work toward convergence between U.S. and international accounting standards." The International Accounting Standards Board [IASB] has issued a draft accounting standard, as discussed further below, proposing that options be a charge against earnings. Opposing any charge against earnings for stock options are many business leaders [especially those in the "high-tech" industries where stock options are a critical part of executive pay].

The following is a summary of the different parties participating [or who may be expected to participate] in the debate. Both FASB and IASB have indicated intentions to have new rules in place for accounting years beginning in 2004 [albeit FASB's news release indicates an Exposure Draft to "become effective in 2004"]. This is an ambitious schedule in light of the time taken in debate over this issue in the past.

Key Groups Determining the Issue

A. FASB. FASB is the organization primarily responsible for setting accounting standards in the United States. In FASB's March 12 press release announcing its decision to review the issue of whether employee stock options should be a charge against earnings, FASB Chairman Herz stated that FASB "believes that there is a need for one consistent approach to recognize the costs associated with employee stock options" and that a move to require expense treatment "would be consistent with the FASB's commitment to work toward convergence between U.S. and international accounting standards." Chairman Herz reported that FASB had concluded that "it was critical that it now revisit this important subject."

B. IASB. On Nov. 7, 2002, IASB issued its Exposure Draft ED 2 on Share-Based Payment,4 which proposes the expensing of stock-based compensation.5

 Based in London, IASB [a successor to the International Accounting Standards Committee] was established in 2001 for the purpose of developing a single set of global accounting standards. IASB coordinates with national accounting standard-setting organizations like FASB.

A key issue to be considered by FASB in its deliberations is whether there should be a "convergence" of accounting standards on the issue of stock-option expensing. FASB has publicly endorsed the goal of "international convergence," although there is debate in the United States on the feasibility of "convergence." In any event, the standard adopted by IASB likely will be a factor in the decision-making process in the United States.

C. Major Accounting Firms' Positions.

1. Comments to FASB [January/February].

At FASB's request [as part of its request for comments on IASB's Exposure ED 2 Draft], each of the "Big Four" accounting firms [Ernst & Young, Deloitte & Touche, PricewaterhouseCoopers [PwC] and KPMG] submitted to FASB letters commenting on whether employee stock options should be expensed against a corporation's earnings.

Ernst & Young, by letter to FASB dated Feb. 11, 2003, stated that it "supports the efforts of the FASB and IASB to promote a worldwide accounting standard requiring the recognition of the cost of stock-based compensation based on the fair value of those awards on the grant date." The other three major accounting firms [Deloitte & Touche, by a letter dated Feb. 3, KPMG, by a letter dated Jan. 30, and PwC, by a letter dated Feb. 10] took a cautious approach on the issue of requiring corporations to expense the cost of employee stock options.

2. Comments to IASB [March].

In March, each of the Big Four accounting firms submitted, or was expected to submit, its comments to IASB regarding IASB's exposure draft. PwC, in its letter to IASB dated March 7, 2003, stated support for "including a cost in the income statement to reflect the value of goods and services which the entity has received." It also expressed agreement with grant date measurement provided a fair value measurement technique could be agreed upon. Although PwC recognized that "[a] standard on share-based payment is needed urgently," it expressed its concern about "whether existing valuation techniques such as option pricing models have the ability to measure the fair value of certain types of awards with a high degree of reliability."

PwC's letter further suggested that IASB and FASB should work together to achieve greater convergence and "release final standards on share-based payment in close proximity to each other and with similar effective dates, in order to achieve a level playing field across the world's largest capital markets."

At the time this column was prepared the author had not obtained copies of the March submissions to IASB by the other three Big Four firms.

The SEC

D. Securities and Exchange Commission.

The Securities and Exchange Commission [SEC] has not taken a position on whether employee stock options must be treated as an expense in corporate earnings reports.6

 According to The Washington Post [Feb. 7, 2003, at E1] at his confirmation hearing before the Senate Banking Committee on Feb. 5, 2003, SEC Chairman William H. Donaldson testified in response to a question by Senator John Corzine [D-N.J.] that, in his opinion, Congress should not try to interfere with FASB and that he supported stock option expensing if international standards-setters adopted a similar rule. The author is not aware that the SEC intends at this time to issue any formal comment on the IASB exposure draft or on the pending review and ultimate exposure draft from FASB.

E. U.S. Congress.

On March 7, 2003, 17 senators, and on Jan. 30, 40 representatives, wrote to FASB opposing mandatory expensing of stock options. Expressing the opposite view, on Feb. 3, nine senators and 21 representatives urged mandatory expensing of stock options in a letter to FASB.

Pending Legislation

In the current, 108th session of the Congress, Senators Carl Levin [D-Mich.] and John McCain [R-Ariz.] have introduced legislation [S.181] that would amend § § 108 of the Sarbanes-Oxley Act of 2002 to require FASB to review and "adopt an appropriate generally accepted accounting principle for the treatment of employee stock options" within one year after the date of enactment of such amendment. Senators Levin, McCain, Richard Durbin [D-Ill.] and Russ Feingold [D-Wis.] and Representative Fortney ["Pete"] Stark [D-Calif.] have reintroduced legislation on stock option expensing that they proposed in the last Congress. Their legislation, S.182 and H.R.626, respectively, would prevent companies from taking deductions for stock options granted to employees prior to the year in which the stock option expenses are reflected in their financial statements.


FOOTNOTES:

1 Many prominent business leaders and others argue that an employee stock option, regardless of whether it can be valued, should not be treated as an expense. They argue that an employee stock option represents the transfer of a right to acquire ownership in a business and is not an expense of the business. See e.g., Harvey Golub, "The Real Value of Options," Wall St. J., Aug. 8, 2002, at A12; T.J. Rodgers, "Options Aren't Optional in Silicon Valley," Wall St. J., March 4, 2002, at A14. In this connection, it is noted that under current accounting rules the dilutive effect of employee stock option grants is reflected in the number of additional shares deemed outstanding as a result of outstanding option grants with a resulting diminution in reported earnings per share.

2 The 1992-1994 debate provoked extraordinary resistance from U.S. business leaders. Congress passed legislation intended to prevent adoption of a rule change. There were even threats that FASB might be put out of existence as the body setting accounting standards if it failed to respond to the demands of U.S. businesses that no change be made in the accounting rule.

3 In FAS 123, FASB also established the requirement that companies not charging earnings for stock options must disclose in a footnote to their financial statements what the charge against earnings would be if a charge were taken pursuant to FAS 123.

4  A copy of IASB's Exposure Draft ED 2, titled "Share-Based Payment," is currently available on IASB's Web site at www.iasb.org.uk.

5  IASB has received over 150 comments on its Exposure Draft ED 2. FASB also invited comments on IASB Exposure Draft ED 2 and has received approximately 300 comment letters.

6  IASB has received over 150 comments on its Exposure Draft ED 2. FASB also invited comments on IASB Exposure Draft ED 2 and has received approximately 300 comment letters.