RECOGNITION OR FOOTNOTE DISCLOSURE OF COMPENSATORY FIXED STOCK OPTIONS?

By Anthony Cocco and Daniel Ivancevich

The exposure draft Accounting for Stock-Based Compensation, which was issued by the Financial Accounting Standards Board (FASB) in June 1993, generated a storm of controversy. The FASB received over 1,700 comment letters, with the vast majority opposing the exposure draft. The main point of contention centered around the fact that companies would have to record compensation expense for fixed stock options granted to employees; previously, compensation expense for such options was rarely recognized.

With the issuance of the final statement, Accounting for Stock-Based Compensation, the FASB has delivered on its previously announced position of not requiring expense recognition. The statement merely encourages expense recognition and requires expanded footnote disclosures for those entities that choose not to do so.

Because of the negative effect on net income if fixed stock options are expensed, most companies are expected to elect footnote disclosure. Upon analyzing the financial statement impact and considering certain qualitative factors, however, some companies may discover that adopting financial statement recognition is a more prudent decision. To illustrate such a situation, we present a set of example financial statements where the election to expense seems advisable. We then augment the example with qualitative considerations that would further support financial statement recognition.

The Decision

Should companies automatically choose footnote disclosure over financial statement recognition? A company should carefully consider the potential financial statement impact for its own unique situation. If expense recognition is elected, an asset (prepaid compensation) is increased, along with a corresponding increase in equity (options outstanding). These increases will have an immediate impact on financial statement ratios that include assets and/or equities.

A critically important ratio that will be directly impacted is the debt-to-equity ratio (also known as the coverage ratio). Coverage ratios are of primary interest to bondholders, because they assist in predicting the long-run solvency of the company. Both current and potential stockholders, however, are interested in these ratios because they help measure the solvency risk of the company.

Another ratio that will be directly impacted will be earnings per share (EPS). In assessing the potential earnings per share effect, an important consideration may be whether EPS is a positive or negative number. If the company has experienced net losses, and expects net losses to continue for the next few years, the impact takes on less importance with the expensing of stock compensation. A negative EPS figure would merely become more negative. This decrease may have little or no impact on the perceived solvency risk of the company. On the other hand, if a company displays net income and therefore a positive EPS figure, the financial statement impact of recognizing stock compensation will be a decrease in income and a decrease in EPS. In this situation, the decline may signal a deterioration in the profitability and greater investment or solvency risk.

In addition to quantitative considerations such as the impact on the debt-to-equity ratio and EPS, qualitative considerations may lead a company to choose financial statement recognition. Managers need to weigh the benefits of reporting higher earnings against the perception these earnings are of lower quality because of the accounting method chosen.

Choosing financial statement recognition over footnote disclosure may lead analysts to conclude earnings are of a higher quality. It could send a signal to the market that the company "is not afraid" of the negative earnings impact.

The Example

Example financial statements (based on the financial statements of an actual company) are presented in which there appears to be a beneficial impact from choosing financial statement recognition over enhanced footnote disclosure. In Exhibit 1, the assumptions regarding the stock options are presented. The number of options (1,550) is the approximate number indicated in the footnotes of the company on which the example is based. The stock price ($11.80) was obtained from the company's listing in the Wall Street Journal. The assumed 95% exercise rate is based on observation: In examining various annual reports, the number of forfeited options was extremely small, generally less than the five percent assumed here.

Finally, the 23% figure represents the assumed value of an option as a percentage of stock price. This figure is based on a Coopers and Lybrand study of 27 companies, with 17 companies classified as "mature companies" and 10 as "emerging companies." The study found the value of compensatory fixed stock options as a percentage of the underlying stock price was 34% for emerging companies and 23% for mature companies. We decided to use the 23% figure, which results in a more conservative option value. If the percentage of the underlying stock price is higher than 23%, the approximate value per option would be even greater and would increase the total option value.

In Exhibit 2, the numbers in the footnotes column are the amounts prior to adopting the accounting standard. If footnote disclosure is chosen, there is no financial statement impact. Consequently, the numbers in this column also illustrate the financial statements after adoption of the accounting standard with the footnote disclosure option.

Continuing with Exhibit 2, the numbers in the financials column represent the immediate impact on the financial statements if the accounting standard is adopted and financial statement recognition is selected. The adoption date is December 31, 1995. Observe that both total assets and total equity increase by $4,000 (the value of the options as computed in Exhibit 1), due to the immediate increases in prepaid compensation and options outstanding. This increase in options outstanding has a dramatic impact on the debt-to-equity ratio, changing it from 2.10 to 1 down to 1.50 to 1. Since the expense is not incurred until the amortization of the prepaid compensation occurs, earnings per share is unchanged.

Recall that in Exhibit 1 we assumed a four-year vesting period before the options may be exercised. In Exhibit 3 we examine the financial statements in the fourth year. To isolate the effect of the stock options, all other numbers are held constant. Since the financial statements remain unaffected when management selects footnote disclosure, the numbers in the footnotes column are the same in Exhibit 3 as they were in Exhibit 2.

In the financials column in Exhibit 3, the balance sheet amounts have returned to 1995 pre-adoption levels, and now mirror the amounts in the footnote column. Prepaid compensation has been written off, reducing not only total assets, but also retained earnings. Thus, by extension, stockholders' equity decreases by $4,000 as well. The result is that the debt-to-equity ratio returns to 2.10 to 1.

The income statement numbers in the financials column reflect the yearly amortization of $1,000. This amortization reduces net income by $1,000, which increases the loss per share figure from -$1.20 to -$1.30. This income statement effect would have occurred each year of the four-year vesting period. *

Anthony Cocco, PhD, CPA, and Daniel Ivancevich, PhD, are assistant professors of accounting at the University of Nevada, Las Vegas.

Number of options 1,550

Percent to be exercised 95%

Net number of options 1,472

Stock price $11.80

Percent of stock price 23%

Approximate value per option $2.72

Total option value at grant date $4,000

Vesting period 4 years

Comparative Income Statements for 1995

Base Figures Full

and Footnote Recognition

Treatment

Operating net income $( 7,000) $( 7,000)

Other income items ( 5,000) (5,000)

Net income $(12,000) $(12,000)

Comparative Balance Sheets at December 31, 1995

Footnotes Financials

Current assets $ 13,500 $ 13,500

Long-term assets 17,500 21,500

Total assets $ 31,000 $ 35,000

Current liabilities $7,000 $7,000

Noncurrent liabilities 14,000 14,000

Total liabilities 21,000 21,000

Stockholders' equity 10,000 14,000

Total liabilities and equity $31,000 $35,000

Comparative Key Ratios for 1995

Footnotes Financials

Debt to equity 2.10 to 1 1.50 to 1

Earnings (loss) per share

(10,000 shares) $(1.20) $(1.20)

Editor:
Douglas R. Carmichael, PhD, CPA
Baruch College

NOVEMBER 1995 / THE CPA JOURNAL

Footnote Full

Treatment Recognition

Operating net income $ (7,000) $ (8,000)

Other income (expense)

items (5,000) (5,000)

Net income (loss) $(12,000) $(13,000)

Comparative Balance Sheets at December 31, 1999

Current assets $13,500 $13,500

Long-term assets 17,500 17,500

Total assets $31,000 $31,000

Current liabilities $7,000 $ 7,000

Noncurrent liabilities 14,000 14,000

Total liabilities 21,000 21,000

Stockholders' equity 10,000 10,000

Total equities $31,000 $31,000

Comparative Key Ratios for 1999

Debt to equity 2.10 to 1 2.10 to 1

Earnings (loss) per share (10,000 shares) $(1.20) $(1.30)

NOVEMBER 1995 / THE CPA JOURNAL