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By Martin Mellman and Steven Lilien

SFAS No. 123, Accounting for Stock-Based Compensation, issued in October 1995, encourages companies to account for stock compensation awards based on their estimated fair value at the date of grant. Companies are permitted to continue to account for stock options under the rules of APB Opinion No. 25, which does not require recognition of compensation for most option plans. Companies that choose to continue to follow existing standards are required to disclose in a note the effect on net income and earnings per share had the company recognized expense for stock compensation awards based on the new statement.

The Study

To assess the potential impact on net income of the unrecognized expense in stock-based compensation plans, proxy disclosures were used as a basis. SEC rules require companies to disclose for certain executives either the potential realizable value of stock options granted at assumed annual rates of appreciation or grant date present value and the percentage of total options granted to these officers.

For purposes of our analysis, only grant date value (estimated fair value) disclosures were considered relevant. Registrants that report the grant date value use the Black-Scholes or binomial stock option pricing model to report the present values of stock options.

Three industries were selected for study: pharmaceuticals, biotechnology, and computers. A mailing to a total of 450 companies produced 183 proxies and annual reports, a 40% response rate. Of that total, only 11 companies reported a grant date value, the others reported a future value based on five percent and 10% growth rates. Ten of the 11 companies that reported a grant date value provided sufficient information to be used in the study. Table 1 shows for each of the 10 companies the option grant data taken from their proxy statements and computations of total grant date present values of options granted. Table 3 shows for each of the 10 companies the pro forma effect on net income or (loss) of accounting for stock compensation awards under the new statement.

Using Bergen Brunswig Corporation as a case will illustrate how the tables were prepared. In the proxy statement issued to shareholders covering the fiscal year ended August 31, 1993, the company disclosed that it granted options for 118,168 shares to its CEO and four highest paid executives representing 47.1% of the total number of options granted that year. Grossed up, this number produces a total of 250,887 shares for which options were granted. The actual total number of shares granted that fiscal year was 259,668. The difference, which is not significant, could be attributed to rounding or minor stock issues for other purposes. In the remaining nine cases, the grossed up number of shares was approximately the same as the number disclosed in the annual report or 10K. The proxy also discloses that the grant date present value of the options granted to the executives, based on the Black Scholes model, is $982,173. This translates into a per share option value of $8.31 ($982,173 ÷ 118,168). The total value of all options granted in 1993 is $2,157,841, (259,668 x $8.31). The proxy schedule states that the options vest starting one year after the date of grant as follows: 20% after one year and then yearly thereafter at 20, 30, and 30 percent.

The new statement provides that compensation cost for an award with a graded vesting schedule such as indicated in the proxy shall be based on the method described in FASB Interpretation No. 28 if the fair value of the award is determined based on different expected lives for the options that vest each year. If the expected life (or lives) of each award is determined in another manner, the compensation cost may be recognized on a straight-line basis. However, the amount of compensation cost recognized at any date must at least equal the value of the vested portion of the award at that date. Because the method used by the company to determine the expected life (or lives) is unknown, we have assumed it was not computed using the FASB Interpretation No. 28 method. Accordingly the compensation cost has been spread on a straight-line basis over four years. Had the Interpretation No. 28 method been used, costs allocated to the first year would have been significantly higher, but the overall costs would probably be less.

On a straight-line basis, $539,460 ($2,157,841 x 25%) would have been allocated to expense in fiscal 1993 under the new statement. On a net-of-tax basis this would have amounted to $356,044 ($539,460 x 66%). In fiscal 8/31/93, Brunswig reported a net income of $26,037,000. Thus, net income would have been reduced by 1.4% if the company had accounted for stock options as prescribed in the new statement (see Table 3). This effect is limited to the amortization of the grant date value of options granted in fiscal year ended 8/31/93. This approach would be consistent with the new statement's transition rules that would apply only to all awards granted after the beginning of the fiscal year in which the recognition provisions are first applied.

The disclosure requirements of the new statement will be effective for financial statements for fiscal years beginning after December 15, 1995. Pro forma disclosures must include the effects of all awards granted in fiscal years that begin after December 15, 1994. Therefore, during the phase-in period, the effects of applying the new statement for either recognizing compensation cost or providing pro forma disclosures may not be representative of the effects on reported net income for future years. This is because options vest over several years, and additional awards generally are made each year.

To gain an insight as to what the pro forma effect on income would have been had the provisions of the new statement been applied to all awards that had not vested in earlier years but were vested during the year under study, amortization of earlier awards are applied to the fiscal year ending August 31, 1993. To derive a grant date value for the earlier years, it was assumed the ratio of grant date value to the market price of the shares on the date of grant in fiscal year 1993 is fairly stable and therefore applicable to the earlier years. Thus, in fiscal year 1993 the $8.31 grant date value in Table 1 was divided by the exercise price of $20.41 resulting in a ratio of 41%. This ratio was then applied to the average market price of the stock for each of the earlier years involved. Average market price was used because information on the specific dates of the grant was not available for those years. The computed grant-date values for the three earlier years appear in Table 2, Column 2.

Applying the grant-date values to the option granted in the earlier years resulted in total values of options granted as shown in Table 2, Column 3. The total compensation expense (Column 5) was then put on a net-of-tax basis (Column 6) that resulted in an additional expense in fiscal 1993 of $644,399. On this basis, net income in fiscal 1993 would have been reduced by $644,399 plus $356,044 for a total of $1,000,443, or 3.8% (Table 3). The results of applying these techniques to the other nine companies in the study appear in Tables 1 and 3.


Table 1 demonstrates there are significant differences in the percentage of total options that companies granted to their CEOs and four highest paid executives. For example, in 1993 Microtouch Systems awarded 69.6% of the total options granted to its CEO and four highest paid officers. In contrast, Hewlett Packard in 1994 extended their awards more widely to its management with only 3.8% being awarded to their CEO and four highest paid executives. The present value of the total options granted by the 10 companies ranged from $55,977,708 for Hewlett Packard to $179,449 for Scan Optics, Inc.

Table 3 provides an insight into the potential impact of the new statement on reported financial information. For example, if Microtouch Systems Inc. in 1993 had recognized stock-based compensation under the new accounting rule, its reported income would have dropped by 11.5%. Under APB No. 25, Microtouch Systems, Inc., recognized no compensation expense in 1993, since the company granted fixed options with an exercise price approximating the market price at the date of grant. Similarly, the net loss reported by QMS, Inc. in 1993 would have increased by 7.9% from $3.396 million to $3.664 million. Larger companies such as Hewlett Packard Company would have been less affected by the provisions of the new pronouncement and would have experienced a reduction in income of only .6% in 1994.

Our analysis in Table 3 incorporates the effects of options granted in earlier years. Including earlier periods' amortization of deferred compensation costs proves to be quite dramatic with QMS, Inc., increasing compensation expense in 1993 from $267,566 to $2,042,113 and increasing the reported net loss by 60% percent rather than 7.9%. Similarly, Microtouch Systems, Inc. would have experienced a reduction in net income of $949,592 or 42.5% of reported net income instead of a reduction of $257,572, which is 11.5% of net income. The numbers reported in Table 3 for total amortization are obviously sensitive to the grant date present value used as an estimate for earlier periods.

The results reported in this study suggest that many firms will opt for the disclosure alternative, particularly considering the few firms that estimated grant-date values under the implementation choices in the proxy requirements. The study shows the initial adoption impacts can, in fact, be quite dramatic, but users should also recognize that under the transition rule no amortization amount is recorded for options granted in years past which had not vested as of the date of initial adoption of the new standard. Pro forma disclosures must include the effects of all awards granted in fiscal years that begin after December 15, 1994. *

Martin Mellman, PhD, CPA, is a professor of accounting at Hofstra University and Steven Lilien, PhD, CPA, a professor of accountancy, at Baruch College/CUNY. The authors wish to acknowledge the assistance of Lynda Kaufman, an MBA candidate at Hofstra University


By Thomas E. Wilson, Jr., Suzanne Pinac Ward, Dan R. Ward, and
Larry D. Guin

The FASB has issued SFAS No. 123, Accounting for Stock-Based Compensation, requiring disclosure of the value of stock options granted to employees in exchange for services. As in the exposure draft, the FASB employs the Black-Scholes option pricing model in their illustration for option pricing. However, the model employed by FASB in the statement is a refined version of the one used in the exposure draft. The following spreadsheet program allows accountants to construct an option pricing template that values options consistent with SFAS No. 123. The template differs from an earlier version (The CPA Journal, March 1995) in its computation of the effect of dividends on option values. A more precise approximation of the normal distribution is also employed.

What You Need

As before, six variables are needed to compute the value of an option. They are the--

Stock Price--the price of the firm's stock at the time the option is granted;

Exercise Price--the price at which optionholders may purchase shares of the firm's stock;

Term (in years)--the period between the date the options are granted and their expiration date;

Risk-Free Rate--the risk-free rate of interest;

Dividend Yield--expected dividends as a percentage of the stock price over the option term;

Variability--the expected volatility of the stock price over the option term.

Building the Model

The option-pricing program can be set up in rows and columns in the spreadsheet as follows:

1 Stock Price50
2 Exercise Price50
3 Term (in years)6
4 Risk-free Rate.075
5 Dividend Yield.025
6 Variability.3

The data in column B are taken from the first option pricing illustration in SFAS No. 123. Using these inputs as the spreadsheet is constructed will provide a way to check that the equations have been entered properly. Next, in another area of the spreadsheet, enter the following:

1((@1n(B1/B2)+H1- B6*

Cells H1 and I1 should have values of .7756 and .0408 respectively. Those familiar with the Black-Scholes model will recognize these cells as the intermediate values labeled d1 and d2 in many versions of the model. The next step is to determine the normal distribution values for d1 and d2. The following formulas provide a close approximation of the normal distribution values. First enter the following formulas in the cells as shown:

3 1/((2*@pi)^.5*@exp((H1^2)/2))
4 @if(H1>0,1/(1+.33267*H1),1/(1-.33267*H1))
5 @if(H1>0,1-(H3*(.4361836*H4-

Now, copy the formulas located in cells H3 through H5 into cells I3 through I5. These cells should now contain the following numbers: H3=.2952; H4=.7948; H5=.7810; I3=.3986; I4=.9866; I5=.5162.

The formula generating the option value can be placed in the area of the spreadsheet where the initial inputs are located. This new section should be formatted to display numbers in the currency format. You may also wish to modify the formula to round up to two decimal places.

9 Option Value(@exp(B5*B3*-1)*B1*H5)

The option value should be $17.15, which is the result in the illustration in SFAS No. 123. *

Thomas E. Wilson, Jr., PhD, CPA, Suzanne Pinac Ward, PhD, CPA, and Dan R. Ward, DBA, are associated with the University of Southwestern Louisiana. Larry D. Guin, PhD, is with Murray State University.

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