This article is reprinted with permission from the
May 31, 1996
edition of
New York Law Journal.
1996 NLP IP Company.


Treatment of Stock Options

By Joseph E. Bachelder.


RECENT DEVELOPMENTS affecting stock options include some relating to the Financial Accounting Standards Board (FASB) and a recent private letter ruling on transferable options.

Shareholder Approval

It is a new stock option has been adopted subject to shareholder approval, it is not uncommon for corporate employers to grant stock options to executives pending shareholder approval of the plan, with the options being subject to such approval.

What happens if the stock goes up in value between the grant date and the shareholder approval date? Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" (1995) (FAS 123), provides that "[awards made under a plan that is subject to shareholder approval are not deemed to be granted until that approval is obtained unless approval is essentially a formality, for example, management and the members of the board of directors control enough votes to approve the plan." FAS 123, P395 (from Glossary definition of "grant date").

An increase in fair market value between date of actual grant and date of shareholder approval would result in a discount in the exercise price from the fair market value on the deemed grant date (the date of shareholder approval), requiring a charge against earnings.

There had been hope that the exception noted in P395 of FAS 123 in the case of approval that is "essentially a formality" might be expanded from the narrow circumstance given there as an illustration.

In February, Michael J. Morrissey of the Office of the Chief Accountant of the Securities and Exchange Commission questioned the scope that would be given to the noted exception. He made the following statement at the 1996 AICPA Conference on SEC Developments:

For purposes of applying Opinion 25, the staff is aware that many intend to analogize to the grant date guidance in Statement 123 when determining the measurement date in plans requiring shareholder approval. While the staff believes such an analogy is logical regarding this specific matter, the staff notes an open question as to any other fact patterns where approval is "essentially a formality" as is implied by the definition in statement 123.

Accordingly, absent clarifying guidance from the FASB or EITF on this matter, the staff expects analogies under Opinion 25 to the definition of grant date in Statement 123 to be limited to the specific example provided wherein management and members of the board of directors control enough votes to approve the plan.

Subsequent discussions with Mr. Morrissey and with the FASB staff confirm that there is no intent to expand the interpretation to any situation beyond that specifically noted in the example.

This position should not, it is hoped, force an adverse result under Code 162(m) in a situation in which an option grant occurs prior to shareholder approval. The applicable regulation under Code 162(m) provides that, in order to be excepted from inclusion in compensation for purposes of the $1 million deduction cap, an option must have an exercise price equal to fair market value as of the date of grant. Treas. Reg. 1.162-27(e)(2)(vi). For purposes of Code 422 (incentive stock options) and Code 423 (stock purchase plans) an option or stock purchase right is deemed granted on the date of actual grant regardless of its being conditioned on subsequent shareholder approval. Code 424(i). Presumably, the IRS will take the same positions under Code 162)m)

Use of Non-Recourse Notes

The Emerging Issues task Force (EITF), which makes decisions on technical matters under FASB standards (such as FAS 123), recently issued a decision regarding the consequences of using a non-recourse note to exercise a stock option. EITF 95-16 (March 21, 1996).

When a non-recourse note is given in payment of the exercise price, the note typically is secured by the stock issued on the exercise of the option. In such a case, the option holder is not "at risk" -- even after exercising the option with the non-recourse note. He still can "walk away" from the stock purchase without liability.

The effect of such a transaction, says the EITF, may be the grant of a new option. (This reflects the position taken in APB 25, "Accounting for Stock Issued to Employees" (1972) P8, note 2 and clarifies FAS 123. Depending on the circumstances, this may or may not result in a charge against earnings.

If the non-recourse note has the same term as the original option and the interest rate is fixed and is a recourse liability, there should be no substantive accounting consequence -- the original option grant will be treated as continuing in the form of a fixed (not variable) award (this assumes it was a fixed award to begin with).

Possible Consequence

On the other hand, there may be a consequence to the accounting treatment in circumstances such as the following:

(i) If the note has a term beyond the original term of the option (and the note's term was not fixed in the original option) a new option grant with a new measurement date is deemed to have occurred and an accounting charge would be incurred to the extent the market value of the stock exceeds the exercise price on the date the note is given in exercise of the original option.

(ii) If the interest on the nonrecourse note is nonrecourse or refundable, there also is an accounting consequence. If the interest rate is variable or the note is prepayable, the original option grant will be converted into a variable award (because the interest is treated as part of the exercise price). If the interest rate is not variable and the note is not prepayable, the original grant remains a fixed (not variable award) but the exercise of the option in exchange for the non-recourse not will be treated as a new grant with a new measurement date. In this latter case the accounting measure will be the same as noted in (i) above: there will be an accounting charge to the extent the market value of the stock exceeds the exercise price on the date the note is given in exchange for the exercise of the original option.

Footnote Disclosures

Starting with the current fiscal year, for the first time most public U.S. corporations must disclose, in a footnote to their financial statements, substantial detail regarding their stock option programs, including a pro forma statement as to the impact on their earnings per share if there had been a charge against earnings. Disclosures also must be made regarding other stock and stock-related programs. Substantial work will be required in preparing the new disclosures.

FAS 123, issued Oct. 23, 1995, requires the new footnote disclosures. FAS 123 permits corporations to continue reporting the impact of stock compensation plans on earnings under APB 25, adopted nearly 25 years ago, governs accounting for most sock compensation plans. 1 Under APB 25, there is no charge, customarily, against earnings for the grant of stock options to employees. 2

FAS 123 is a compromise with those who had sought a change in the accounting rules embodied in APB 25. FAS 123, in lieu of requiring a charge against earnings for stock options, has adopted complex new rules for footnote disclosure of stock compensation, including stock options, which will become applicable to most corporations that have such plans. The new footnote disclosures will be discussed as "Pro Forma Disclosures" (net income and earnings per share) and "General disclosures."

Pro forma disclosures. Essentially, pro forma disclosure rules require reporting of net income and earnings per share on the same basis as would have applied if the originals FASB proposal for FAS 123 had been adopted: to charge earnings for the "fair value" of stock option grants. For most companies their annual report for 1996 must include a pro forma disclosure of the impact of a charge against earnings for stock option grants for both 1996 and 1996.

Following is an example of the format for disclosing the pro forma net income and earnings per share after taking into account a charge to earnings for options granted during the year.


Year in Question
Net Income-- as reported $
Net Income - pro forma  
Earnings per share -- as reported  
Earnings per share -- pro forma  


Calculation of costs. As backup to the pro forma disclosure, FAS 123 requires presentation of detailed information regarding the option pricing model used in developing a fair value at time of option grant. It a Black-Scholes option pricing model is used, for example, assumptions to be disclosed will include the following:
* Expected dividend yield
* Expected stock price volatility
* Risk-free interest rate
* Expected life of options

Rather complicated considerations are involved in disclosing the assumptions. For example, the expected life of options (and hence their fair value) may vary by category of employee (e.g., senior management, foreign based, middle level). It may be possible, and desirable, to disclose fair values of options in such separate categories. On the other hand, certain characteristics of employee stock options, such as nontransferability and forfeiture are not permitted to be taken into account in determining fair value. 3

General disclosures. In addition to pro forma disclosures, complex and detailed footnote disclosures as to stock and stock-related plans are required. As previously discussed in this column (New York Law Journal, March 30, 1995), following are general disclosures required as to stock options:

* A description of the plan or plans, including the general terms of the wards, such as vesting requirements, maximum term of options granted and the maximum number of shares authorized under the plan.

* The number and weighted-average exercise prices of options outstanding at the beginning and end of year and the number of options that are exercisable at those dates and the number of options granted, exercised, forfeited or expired during the year. Also, the range of exercise prices and the weighted-average remaining contractual life as of the end of the year must be disclosed. If the range of exercise prices is wide (i.e., the highest exercise price exceeds 150 percent of the lowest exercise price), the information about outstanding and exercisable options should be disclosed by groups of ranges.

* The weighted-average fair values of options granted during the year at the dates granted. If the exercise prices of some options differ from the market price of the stock on the grant date, weighted-average exercise prices and fair value of options must be disclosed separately for options whose exercise price (i) equals, (ii) exceeds, or (iii) is less than the market price of the stock on the date of grant.

* Total compensation cost recognized in income for stock-based employee compensation awards.

* The terms of significant modifications to outstanding options grants.

A company that not only has a stock option plan but also other forms of stock-related plans such as a restricted stock plan or a performance share plan, must provide some of the foregoing information separately for each such stock-related plan. For example, the key terms of each such plan would have to be provided, as well as certain other information about each plan.

Examples of formats used to make disclosures are available in voluntary disclosures made by a number of corporations in their 1995 annual reports. These include General electric Co., Bristol-Meyers Squibb co., Coca-Cola Enterprises Inc., Goodyear Tire and Rubber Co. and Phelps Dodge Corp.

Transferable Options

In a recent private letter ruling, the Internal Revenue Service once again ruled favorably on several tax issues involving transferable stock options. In a number of respects, however, the ruling leaves unanswered significant valuation questions inherent to most stock options.

In PLR 9616035, the IRS ruled in a case in which an executive proposed transferring to a family member a stock option giving the family member exclusive rights to determine when to exercise a stock option. Except as to the circumstances just noted, the ruling is silent as to the terms of the stock option and the terms of the stock option plan pursuant to which it was granted.

Income Tax Issue. because the option lacked a readily ascertainable fair market value (like most options), the ruling holds no income is recognized at the time of option transfer. Instead, income tax will apply to the amount of spread at the time of option exercise by the family member.

Gift and Estate tax Issues. The ruling holds that the transfer of the option is a completed gift at the time of its transfer for purposes of code 2511. The ruling further holds that, once the gift is complete neither the option nor the stock acquired pursuant to its exercise will be includable in the executive's estate. 4

PLR 9616035 represents another in a number of IRS private rulings that, at least on the surface, seem to provide favorable tax treatment, including favorable gift and estate tax treatment, to stock options that are transferable by an executive to family members. However, this ruling does not eliminate concerns previously expressed by the author regarding valuation of stock options for gift tax purposes. See NYLJ, Aug. 31, 1994.

For gift and estate tax purposes, the most recent ruling on valuation of stock options appears to have been issued in 1953. In Revenue Ruling 196, 1953-2 Cum. Bull. 178, the IRS held that the spread between the exercise price of a stock option and the market price of the stock subject to it, as of the applicable valuation date, was includable in the deceased's estate. The ruling does not suggest, however, that the IRS considered whether any value should be assigned to the option right itself. Also, there is no indication as to the length of the period following death during which the estate could exercise its right.

An executive transferring an option with spread in it risks paying a gift followed by a decline in value of the stock, and to that extent he will have paid a gift tax (or used his lifetime credit) for which no benefit was obtained. If the gift is made at the time of option, the risk exists that the IRS will assert a value in the gift based on Black-Scholes or similar model. Again, the executive may pay a gift tax (or use his lifetime credit) in vain unless the stock rises in an amount greater than the value on which the gift tax has been paid (or lifetime credit used).


1 Absence of any charge against earnings assumes, among other things, the options are granted at an exercise price at least equal to fair market value of the stock on the date of grant. A discount in the exercise price from market value on data of grant, for example, would require a charge against earnings for the amount of the discount .

2 Under FAS 123, companies may choose. instead of continuing to treat stock options (and other stock and stock-related compensation) under APB 25, to charge earnings for the fair value of stock option grants. it is unlikely that many corporations will elect such treatment.

3 The pro forma disclosure will require companies to take into account a number of possible adjustments from the actual earnings charge for stock compensation. These additional adjustments are beyond the scope of this column.

4 The ruling considers numerous gift and estate tax issues not discussed in the column. Other rulings that have addressed the issue of whether a completed transfer for gift tax purposes has occurred include PLR 9350016 (discussed in this column appearing in NYLJ, Aug. 31, 1994,) and PLR 9514017.