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By René Sacasas and Paul Munter

In October 1995, after much controversy and concern, the FASB issued SFAS No. 123, Accounting for Stock Based Compensation. In spite of its title, the reality is that, for most situations, SFAS No. 123 specifies "disclosure" rather than "accounting" standards, since it is clear that the vast majority of companies have opted to adopt the provisions of SFAS No. 123 by pro forma disclosure rather than by recognition and measurement.

SFAS No. 123 allows companies to continue using the provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees, when accounting for stock-based awards issued to employees. However, when stock-based awards are issued to nonemployees, paragraph 8 of SFAS No. 123 states as follows:

Except for transactions with employees that are within the scope of [APB] Opinion [No.] 25, all transactions in which goods or services are the consideration received for issuance of equity instruments shall be accounted for based on the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measurable.

Thus, SFAS No. 123 requires companies to determine the value of a transaction with a nonemployee and account for the transaction at its fair value when stock-based awards are issued to nonemployees.

SFAS No. 123 and APB Opinion No. 25

While SFAS No. 123 requires companies to account for transactions with nonemployees at fair value, it does not specifically define what constitutes an employee vs. a nonemployee. Instead, SFAS No. 123 refers to APB Opinion No. 25 by saying: "[T]his Statement provides a choice of accounting methods for transactions with employees that are within the scope of [APB] Opinion [No.] 25."

Based on this reference, practitioners might presume APB Opinion No. 25 contains a definition of employees that will be helpful in applying the provisions of SFAS No. 123. Unfortunately, APB Opinion No. 25 does not contain any definition or discussion of the concept of employees. The distinction can be important to a company but there appears to be no guidance in the accounting literature as to who is considered an employee. The FASB's Emerging Issues Task Force has discussed two related issues: Issue No. 96-3, Accounting for Equity Instruments that Are Issued for Consideration Other than Employee Services Under FASB Statement No. 123 and Issue No. 96-18, Accounting for Equity Instruments with Variable Terms that Are Issued for Consideration Other than Employee Services Under FASB Statement No. 123. In neither of these issues, however, does the EITF address the question of who is considered to be an employee. Because there is no guidance in accounting standards, a logical place to look for guidance would appear to be the law that does contain guidance on the issue.

Legal Guidance

While it is clear there are serious financial reporting consequences when stock-based compensation is given to a nonemployee, since the issuance of SFAS No. 123 companies have begun to refer to certain individuals as "employees for purposes of applying SFAS No. 123." This is frequently used in discussing the application of SFAS No. 123 to stock grants given to outside members of the company's board of directors. Unfortunately, a contractually agreed upon characterization of an individual's status will not automatically immunize the corporation or the individual from scrutiny by the courts or regulatory bodies. In fact, the status may be recast depending upon the details or relationship between individual and company in several critical areas.

At common law, there are four elements that determine whether the relationship is one of employer/employee or independent contractor:

* Selection and engagement of the employee,

    * Payment of wages,

    * Power of dismissal, and

    * Power of control of the employee's conduct.

The essential characteristic common to each of these elements is the right of control--the right of the employer to order and control the employee in the performance of work, as well as the right to direct the manner in which the work will be done. For an employment relationship to exist, it is essential that the employer have control and direction not only of the employment but also of all of its details and the method of performing the work. If these elements of control and direction are not present, the relationship of employer/employee does not exist at common law.

This common law test has a wide scope, particularly in relation to Federal legislation regulating employment-related taxes and pension issues. Employers who classify their workers as employees are legally responsible for employment-related taxes under the Federal Employment Tax Regulations.

What Is a Corporate Director?

Certain independent contractors are easy to identify. In Issue No. 96-18, the EITF uses the example of outside legal counsel. Likewise, other professional services obtained from outside parties--such as accounting, engineering, actuarial, etc.--would meet the definition of independent contractors. As such, if the company gives stock-based compensation to these individuals, SFAS No. 123 would require the use of fair value accounting for the transaction. In practice, it is not as clear whether members of the board of directors should be viewed as employees or nonemployees when applying the provisions of SFAS No. 123.

Directors of a corporation are elected by the shareholders. They ordinarily attend meetings, exercise judgment on propositions brought before the board, vote, and direct management. Directors may be "insiders"--officials/officers of the corporation--or "outsiders"--independent members of the board. Indeed, the audit committee as well as other key committees such as the compensation committee are composed primarily, if not exclusively, of outside directors. As such, outside directors now constitute the majority of the board on almost nine out of ten boards of directors of publicly-held companies.

Accounting for Stock Grants to Directors

What, then, are the accounting implications? If directors are, indeed, independent contractors and not employees, SFAS No. 123 would require companies to report the value of stock-based compensation awarded to directors as an expense. This treatment would appear to be contrary to the typical accounting treatment for such stock awards as indicated in recent SEC filings by public companies. As a consequence, it may be that at the worst, companies have an unrecorded compensation cost for stock grants given to non-officer directors, and at the least, there is an undesirable diversity in practice.

Another important element to SFAS No. 123 is that a fair value model is required for stock grants given to nonemployees. If the company is unable to determine the fair value of the services provided by these directors, the valuation model (e.g., Black-Scholes model) approach specified in SFAS No. 123 would need to be applied by companies to determine the value-- and the related expense--associated with the stock grants provided to nonemployee directors.

Current Accounting Practice

A review of recent SEC filings shows that only about 15% of the registrants distinguish between stock grants to inside directors and outside directors in making financial statement disclosures. Additionally, only a very small number (perhaps fewer than five SEC registrants) indicate they value stock grants to outside directors using the model of SFAS No. 123. When executives of other companies who did not apply the provisions of SFAS No. 123 were asked why, they replied that either the amounts of the grants to outside directors were not material to the financial statements, the cost of developing the information outweighed the benefits of measuring and accounting for the grants using the SFAS No. 123 valuation model, or the company simply did not consider that SFAS No. 123 was applicable to stock grants awarded to outside directors. It is clear from the current corporate experience that most companies are applying the provisions of APB Opinion No. 25 to their stock grants to employees as well as those granted to outside directors.

FASB's Agenda Project

In the last several years, many questions had been raised about a variety of implementation issues associated with APB Opinion No. 25. Because the FASB had originally planned to supersede APB Opinion No. 25, it did not focus on those issues. However, since SFAS No. 123 left APB Opinion No. 25 in place as an alternative accounting model, the FASB is now in the process of addressing certain practice issues related to APB Opinion No. 25. In its Status Report of January 14, 1998, the FASB lists 12 issues it intends to address relative to APB Opinion No. 25 and the first of these is: "the scope of Opinion 25, including the definition of 'independent contractor.'" Thus, it would appear this issue has been determined to be of sufficient concern to warrant board attention and deliberation. Members of the SEC staff have observed privately that the staff does not expect to challenge companies' treatment of stock awards to outside directors until the FASB resolves the matter. The implication is clear, however, that once the FASB has provided greater clarity on this issue, the SEC will move quickly to ensure that companies do begin recognizing grants to outside directors as an expense if the FASB states that this is the appropriate accounting.

Future Implications

A reasonable question to ask is: What is the significance of treating directors as nonemployees? A special blue ribbon commission formed by the National Association of Corporate Directors recently reported that currently approximately half the value of compensation paid to directors is in the form of stock options or restricted stock. Furthermore, the commission reported that the amount of stock-based compensation to directors has been increasing over the past five years and this trend is expected to continue.

As a consequence, if nonofficer directors should be treated as nonemployees under SFAS No. 123, it would seem that the prevailing practice (e.g., to view such directors as employees for purposes of applying SFAS No. 123) will understate the compensation cost for board members. As more and more companies look to align board members' views with those of shareholders (primarily by providing more stock-based compensation to directors), the issue of whether directors can be classified as employees becomes increasingly important. *

René Sacasas, JD, is an associate professor of business law and Paul Munter, PhD, CPA, the KPMG Peat Marwick Professor of Accounting at the School of Business Administration, University of Miami.

Douglas R. Carmichael, PhD, CPA
Baruch College

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