By Kenneth E. Dakdduk

A number of changes to consider--There is more to it than, at first,
might be thought.

As a result of the issuance of SFAS No. 123, Accounting for Stock-Based Compensation, companies will have to make a number of decisions. The first is whether to elect the new method of accounting for stock compensation or continue with the old. Either way, new computations will have to be made that require other decisions. Now is the time to study the alternatives.

After more than ten years of deliberations and significant controversy, the Financial Accounting Standards Board issued in October 1995 SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123 establishes new fair value-based accounting and reporting standards for all transactions in which a company acquires goods or services by issuing its equity instruments or by incurring a liability to its suppliers in amounts based on the price of its common stock or other equity instruments. Thus, it covers stock-based compensation plans including all arrangements (except employee stock ownership plans) under which employees receive shares of stock or other equity instruments of an employer or an employer incurs liabilities to its employees in amounts based on the price of its stock (e.g., stock appreciation rights).

Despite the board's view that fair value-based accounting would improve financial reporting, it became clear that the board's constituents were not likely to accept a method that would significantly change the accounting for employee stock options and other employee stock-based plans. As a result, while describing its accounting as preferable to the old rules, the board decided to make the accounting under SFAS No. 123 optional for stock-based employee compensation. Consequently, SFAS No. 123 encourages employers to adopt its prescribed fair value-based method of accounting for stock-based employee compensation. However, it does not require that method to be used and explicitly provides that employers may continue to account for stock-based employee compensation using the accounting prescribed by APB Opinion No. 25, Accounting for Stock Issued to Employees (Opinion 25). Employers that do so must still comply with the disclosure requirements of SFAS No. 123 and, in addition, must disclose pro forma net income and, if the company presents earnings per share, pro forma earnings per share, as if the fair value-based method of accounting had been applied.

The discussion that follows describes some of the significant provisions of SFAS No. 123. The statement should be reviewed carefully to obtain a complete understanding of the changes it brings about. In addition, sidebars are presented that set forth the specific disclosure requirements of the statement, its transition rules, and one of a series of flow charts developed by Coopers
& Lybrand L.L.P. to assist in implementation decisions.

Measuring Fair Value

Compensation expense for most stock-based awards under SFAS No. 123 will be measured at the grant date based on the fair value of the award at that date. The board settled on the grant date as the measurement date because that's the date the employer and employees come to a mutual understanding of the terms of the stock-based award. For public entities, the fair value of a stock option or similar instrument must be determined using an option-pricing model (e.g., Black-Scholes or a binomial model) that takes into account the following factors.

Current Price of the Underlying Stock. The higher the current price of the underlying stock, the more valuable will be the option.

Exercise Price of the Option.An option with a higher exercise price will have a lower value since optionholders must give up more cash to exercise the options and obtain the underlying stock.

Expected Life of the Option. term because the optionholder will generally have more time in which to decide whether and when to exercise after vesting.

Expected Volatility. Volatility is the measure of the amount by which the stock price has fluctuated or is expected to fluctuate during a period. The volatility assumption reflects the benefit of an optionholder's right to participate in upside potential (i.e., stock price increases) without exposure to downside risk (i.e., stock price decreases). The higher the expected volatility of the underlying stock, the higher the value of the option.

Expected Dividends on the Stock. As long as an optionholder continues to hold an option, he or she is foregoing the right to receive dividends paid on the underlying stock. The higher the expected dividend during the expected term
of the option, the lower will be the option's value.

Risk-Free Interest Rate for the Expected Term of the Option. This assumption represents the return on the cash an optionholder does not have to pay until exercise. Because the holder can use that cash for investment purposes until deciding whether and when to exercise after vesting, holding an option to buy stock rather than purchasing the stock has value to the optionholder; thus, the higher the risk-free interest rate on investments the holder can purchase during the option term, the higher the value of the option.

Nonpublic entities can estimate the value of their options using an option pricing model but do not have to make assumptions about the expected volatility of the underlying stock. The board provided this exception because most nonpublic companies generally do not have a stock trading history and would presumably be unable to make estimates about the expected volatility of their stock. Excluding volatility from the estimate of fair value results in what the FASB refers to as a "minimum value."

As an alternative to using an option pricing model, nonpublic entities are permitted to measure fair value using present value techniques (i.e., the current price of the stock less the present value of a) expected dividends and b) the exercise price). However, once a nonpublic entity becomes a public entity, it will need to switch to an option pricing model and establish a volatility assumption. In that situation, the company will need to look to the average volatilities of similar entities for an appropriate period following their going public to establish its own expected volatility.

Segregating Options

SFAS No. 123 points out that determining option value based on a single-weighted average option life that includes widely differing individual option lives will overstate the value of the entire award (and thereby overstate expense). To reduce that overstatement, SFAS No. 123 indicates employers may wish to segregate options into several groups, each of which has a relatively narrow range of lives included in its weighted-average life. For example, if the experience of an employer that grants options to all levels of employees indicates that executives hold their options longer than middle-management and that hourly employees exercise their options earlier than any group, the employer may choose to value an award based on weighted lives for each group rather than use a single weighted-average expected life for the entire award. An analysis conducted by Coopers & Lybrand L.L.P. revealed that aggregating options can result in a significant reduction of the overstatement that can result from using a single weighted average option life.

Segregating options is not required under SFAS No. 123 and, if chosen, does not have to be applied to all awards. However, before deciding to segregate, employers with awards that have a graded vesting schedule, such as an award that vests 25% each year over a four-year period, will need to consider the trade-off of lower overall expense for higher expense in the early years of the vesting period. That's because if options are segregated for an award with graded vesting, SFAS No. 123 requires entities to allocate the resulting expense related to future service in accordance with FASB Interpretation No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans (Interpretation No. 28); they would not be able to allocate expense on a straightline basis over the vesting period as otherwise permitted by SFAS No. 123.

Under Interpretation No. 28, expense will be considerably frontloaded because it requires entities with a graded vesting schedule, such as the one described above, to allocate to expense in year 1 the portion of the award that vests in that year plus one-half of the award that vests in year 2, one-third of the award that vests in year 3, and one-fourth of the award that vests in year 4. Consequently, an election to segregate options for an award with graded vesting (or an election to apply Interpretation No. 28 absent graded vesting) should only be made after considering the frontloading effects of Interpretation No. 28.

Awards to Nonemployees

SFAS No. 123 does not change the current practice of applying fair value accounting to transactions in which equity instruments are issued to nonemployees such as vendors and suppliers. Those transactions continue to fall outside the scope of Opinion No. 25, which applies only to employees. SFAS No. 123 stipulates that expense for those transactions is to be based on the fair value of the equity instruments issued or the fair value of the consideration received, whichever is more reliably measurable. The disclosure alternative is not permitted for those transactions.

Some board members, however, were troubled that current practice has extended the scope of Opinion No. 25 to include option recipients treated as independent contractors for tax purposes. Although those board members believe it is inappropriate to do that, the board as a whole decided that resolving scope questions about Opinion No. 25 would need to wait until the SFAS No. 123 project was completed. Thus, for the time being, there is no change to the current practice of accounting for options issued to outside directors under Opinion No. 25. If a company elects to continue accounting for its employee stock-based compensation under Opinion No. 25, that election will also apply to awards issued to its outside directors.

Recognition of Compensation Expense

Compensation expense recognized under SFAS No. 123 for an award of stock-based employee compensation is to be based on the number of instruments that eventually vest. Thus, if employees forfeit an award because they fail to satisfy a service requirement for vesting or because the entity does not achieve a performance condition necessary for vesting, no compensation expense will be recognized for the forfeited award. Generally, if options do not vest, any previously recognized compensation expense would be reversed.

The rules are slightly different if the performance condition is a target stock price or specified amount of intrinsic value. In that case, SFAS No. 123 provides that compensation expense is recognized if employees remain in service for the requisite period regardless of whether the target stock price or amount of intrinsic value is achieved. In those situations, previously recognized compensation expense will not be reversed even if the options do not vest because the condition is not achieved. If it permitted the reversal of previously recognized compensation expense if a target stock price or specified amount of intrinsic value were not achieved, the board concluded it would need to be consistent and require that additional compensation expense be recognized when the stock price rises. The board rejected that approach because it would result in exercise-date accounting. Moreover, it would erroneously suggest that an option's cost results from subsequent changes in the value of the underlying stock.

Employee Stock Purchase Plans

Another significant change brought about by SFAS No. 123 involves the accounting for employee stock purchase plans. SFAS No. 123 changes the criteria an employee stock purchase plan must satisfy to be considered noncompensatory. The new criteria are generally more difficult to meet than the criteria in Opinion No. 25. As a result, many existing employee stock purchase plans, including statutory plans that qualify under IRC Sec. 423, would be considered compensatory under SFAS No. 123.

An employee stock purchase plan is noncompensatory under SFAS No. 123 if it satisfies all of the following criteria:

• The plan incorporates no option features other than the following: (a) employees are permitted a short period of time (not exceeding 31 days) after the purchase price has been fixed to enroll in the plan and (b) the purchase price is based solely on the stock's market price at the date of purchase and employees are permitted to cancel participation before the purchase date and obtain a refund of amounts previously paid.

• The discount from the market price of the stock does not exceed five percent. If the discount exceeds five percent, the company must be able to demonstrate that it does not exceed the greater of a) a per-share discount that would be reasonable in a recurring offer of stock to stockholders or others or b) the per-share amount of stock issuance costs avoided by not having to raise a significant amount of capital by a public offering.

  Employers with plans that do not meet this criteria must consider the entire discount in determining compensation expense. For example, if a plan allows employees to purchase stock at a 12% discount from market price but the employer can support a discount of only eight percent based on this criteria, the entire 12% discount would be considered in determining compensation expense.

• Substantially all full-time employees that meet limited employment qualifications may participate on an equitablebasis.

SEC Disclosures

At a November 1995 meeting of Coopers & Lybrand L.L.P. consulting partners, members of the SEC staff stated that they will expect registrants to make the following disclosures to comply with the requirements of SEC Staff Accounting Bulletin 74, Disclosure of the Impact That Recently Issued Accounting Standards Will Have on the Financial Statements of the Registrant When Adopted in a Future Period.

Company intends to adopt SFAS No. 123 for recognition purposes. The company should state its intention to adopt the recognition provisions of SFAS No. 123 and, if known, what the estimated impact will be on the financial statements. If the estimated impact is not yet known, the company should state that.

Company intends to remain on Opinion No. 25 for recognition purposes. The company need not disclose anything concerning SFAS No. 125 or Opinion No. 125. (To avoid possible SEC staff inquiries, however, it may be advisable for the company to disclose its intention to remain on Opinion No. 25.) No estimated impact of applying SFAS No. 123 need be disclosed.

Company has not yet decided what it will do - the company should state it is still undecided. No estimated impact of applying SFAS No. 123 need be disclosed.

The Decision

All companies will have to measure the fair value of their awards using the methodology prescribed by SFAS No. 123. If the awards are to employees, companies must decide whether to adopt the new accounting rules and recognize expense in the income statement, or remain on Opinion No. 25 and disclose in the notes to the financial statements the required pro forma information. In most cases, that decision will depend on the impact SFAS No. 123 would have on net income from period to period. The new rules will generally result in lower net income and earnings per share than under Opinion No. 25. Therefore, most companies are likely to elect the disclosure alternative. However, certain companies with performance-based plans may recognize less compensation expense under SFAS No. 123 because fair value determined at the grant date is not adjusted for subsequent increases in the market price of the underlying stock. Companies should begin now to understand the new rules and evaluate the financial statement implications.