FASB Interpretation No. 44

By Anthony F. Cocco and Glenn Vent

In Brief

Rules Instead of Accounting Purity

The plan was to resolve all the stock compensation issues--including stock options issued to employees--with FASB Statement No. 123, Accounting for Stock-Based Compensation. But the plan was abandoned when political pressure caused FASB to allow disclosure to take the place of recording compensation expense for stock-based compensation. Companies were also permitted to continue to account for employee stock options under APBO No. 25, Accounting for Stock Issued to Employees.

APBO No. 25 lacks a strong conceptual underpinning; FASB thereupon set out to solve a number of implementation problems that had long existed with the document and in March issued FASB Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation. As evidenced by the dissenting votes of two of the board members, FASB labored over the issues that needed fixing in ABPO No. 25. The end result is practical guidance for the many entities that issue stock options to employees. The interpretation took effect July 1.

Accounting for employee stock options has been one of the most interesting issues in the history of accounting standards setting. The business community and FASB have struggled with the difficult question of whether or not the issuance of stock options to employees constitutes compensation expense. The controlling accounting standard has been Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APBO No. 25).

Traditionally, businesses have structured their option plans to avoid reporting compensation expense under APBO No. 25. For several years, FASB indicated that it favored the measurement and reporting of compensation expense in the income statement when options were issued, and in the early 1990s FASB issued an exposure draft that would have required such reporting. However, in 1995 FASB adopted a more modest standard, FASB Statement No. 123, Accounting for Stock-Based Compensation, which requires expanded footnote disclosures in lieu of reporting compensation expense on the financial statements.

FASB Statement No. 123 permits companies to continue to apply APBO No. 25, and most companies have done so. Recently, FASB issued Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation: An Interpretation of APB Opinion No. 25. The interpretation provides additional valuable guidance in certain practice issues related to the application of APBO No. 25.

Types of Employee Stock Options

A stock option gives the holder the right to buy a given number of shares of stock at a preestablished price. This price is referred to as the option price by FASB but is usually called the strike price by the business community. There are two types of employee stock option plans, noncompensatory and compensatory, depending on the purpose of the plan. If the purpose of the plan is to raise capital or obtain more widespread ownership of the company's stock by its employees, the plan is noncompensatory. If the purpose of the plan is to compensate employees beyond the amount of their cash salary, the plan is compensatory.

The Accounting Principles Board (APB) established GAAP for stock option plans by the issuance of APBO No. 25 in October 1972. In accordance with the provisions of APBO No. 25 certain criteria must be met for a plan to be considered noncompensatory (See the Table). Options under a noncompensatory plan are not accounted for when granted, and no compensation expense is ever contemplated. When such options are exercised, the transaction is accounted for as a normal sale of stock.

Compensatory plans are the focus of the recent Interpretation No. 44. Under these plans, stock options can be fixed or variable. The most common are fixed stock options, which vest after the employee has worked for the company for a set period of time. With fixed option plans, both the number of options and the strike price are established on the date the options are granted. With variable stock options, the number of options and the strike price are not established on the grant date but are usually contingent on future events, such as meeting target amounts of return on equity or assets or earnings per share.

All employee stock option plans that do not meet the criteria of a noncompensatory plan are considered compensatory plans. The amount of total compensation associated with a compensatory stock option must be determined, then amortized to compensation expense over the service period, which is normally the period of time that the option takes to vest. Under APBO No. 25, total compensation per option is measured as the difference between the market price of the stock and the strike price on the measurement date. The measurement date is the first date on which both the number of options and the strike price are known. This method is called the intrinsic-value method.

For fixed stock options, the measurement date is the grant date, which is the date the options are issued to the employees. Since most companies set the strike price equal to the market price on the grant date, no compensation expense is ever recorded. For variable stock options, the measurement date is usually the exercise date. Compensation expense is recorded over the service period based on the market price of the stock at intervening dates.

Purpose and Provisions of FASB Interpretation No. 44

FASB had intended that its June 1993 exposure draft would lead to an accounting standard that would supersede APBO No. 25. As such, the board did not address the questions about it that had developed over time. However, since APBO No. 25 was not superseded--and is in fact used much more in practice than FASB Statement No. 123--the purpose of Interpretation No. 44 is to identify and provide guidance on certain practice issues related to the application of APBO No. 25.

Interpretation No. 44 addresses (in a question and answer format) the issues that, according to FASB, were identified by constituents as needing clarification. The major subject areas covered in the questions are--

* criteria for noncompensatory plans
* scope of APBO No. 25: What is the definition of an employee?
* plans with a look-back option
* parent-company stock issued to employees of subsidiaries
* definition of grant date
* accounting for deferred taxes
* cash bonus plans linked to stock compensation awards
* cash paid to settle options or repurchase shares
* modifications that renew or increase plan life
* modifications that reduce exercise price or change the number of shares.

Criteria for noncompensatory plans. For noncompensatory plans, APBO No. 25 requires that the discount from the market price of the stock may be no greater than would be reasonable in an offer of shares to stockholders. Noncompensatory option plans may have discounts of no more than 15%. For example, a plan that qualifies under IRC section 423 of the federal tax code is an example of a noncompensatory plan. The criteria for noncompensatory option plans are shown in the Table.

Scope of APBO No. 25. The guidance in APBO No. 25 should be limited to persons that fit the common law definition of an employee. In the exposure draft for Interpretation No. 44, FASB concluded that this would exclude independent members of the board of directors; however, the board modified its position in the final interpretation. APBO No. 25 should be applied to stock options granted to outside directors for their fiduciary role of representing the interests of shareholders.

Plans with a look-back option. Although a plan with a look-back option is considered by FASB to be by its nature compensatory, it may still meet all of the criteria for a noncompensatory plan. Thus APBO No. 25 permits a look-back option plan to be accounted for as either compensatory or noncompensatory.

Parent-company stock issued to employees of subsidiaries. Parent-company stock issued to the employees of a subsidiary company should be accounted for in accordance with APBO No. 25 in the subsidiary's financial statements, if those options are also accounted for under APBO No. 25 in the consolidated financial statements. APBO No. 25 would not apply to options granted to employees of investees that are accounted for under the equity method.

Defining a grant date. If options are issued under a plan subject to shareholder approval, the options are not considered granted until shareholder approval has been obtained, unless such approval is in essence a formality.

Accounting for deferred taxes. Deferred tax assets should be determined on the basis of the compensation expense recognized to date, not on an estimate of future tax deductions. If it is deemed more likely than not that future taxable income will be insufficient to recover the deferred tax assets, a valuation allowance to reduce the carrying value of the deferred tax assets should be established.

Cash bonus plans linked to stock compensation awards. A cash bonus plan is considered linked to a stock option plan when the payment or refund of a cash bonus is contingent upon the exercise of the options. A variable cash bonus that is linked to either a fixed or variable option plan is considered a combined variable plan. A fixed cash bonus linked to a fixed option plan is considered a combined fixed plan. Nevertheless, both fixed and variable cash bonus plans that are contingent on vesting of stock options should be reported separately from the option plan.

Cash paid to settle options or repurchase shares. If cash is paid to settle options, compensation cost should be recorded at an amount equal to the original intrinsic value of the options plus the excess of the cash paid to the employee over the intrinsic value measured at the original measurement date or the settlement date, whichever is less. In addition, if shares are repurchased within six months after the options are exercised, a similar treatment is required. Since the original intrinsic value will most often be zero, a company will generally need to record compensation cost for the entire amount paid. This accounting treatment may discourage the settlement of options or the repurchase of shares.

Modifications that renew or increase plan life. A modification that either renews or increases the life of an option plan results in a new measurement date. The intrinsic value of the modified options must be recognized as compensation cost just as if new options had been granted on that date. For example, accelerated vesting due to a modification that was not part of the original plan will require a new measurement date. However, accelerated vesting that results from terms of the original plan does not establish a new measurement date.

The measurement of compensation cost may require estimates and the revision of those estimates in later periods. For instance, when vesting is accelerated, a greater number of a plan's options may be exercised. The compensation cost that must be recognized is based on the estimated additional number of vesting options and the intrinsic value of those options at the new measurement date.

Modifications that reduce exercise price or change number of shares. A number of companies lowered the strike price of their options in fall 1998, when the stock market dropped nearly 20%. The intention of such repricings is to retain employees that might otherwise jump to a competitor that can offer a more attractive option plan.

Traditionally, companies have not recorded compensation expense when options are repriced, so there has been no financial statement impact associated with the repricings. Interestingly, there is an Emerging Issues Task Force (EITF) consensus on this topic. According to Issue 87-33, Stock Compensation Issues Related to Market Decline, companies are required to record compensation expense for the difference between the original strike price and the new strike price. However, many companies may be unaware of this EITF issue.

Interpretation No. 44 stipulates that a change in the strike price of a fixed option or the number of shares granted under a fixed option alters the option, such that it would then be considered a variable option. Variable-plan accounting would then be applied from the date of modification until the date of exercise.

Under variable plan accounting, the total amount of compensation expense cannot be determined until the options are exercised. From the grant date until the exercise date, cumulative compensation expense is measured by multiplying the number of options by the difference between the market price of the stock and the strike price. Compensation expense for a particular period is increased if cumulative compensation expense increases during the period and decreased if cumulative compensation decreases during the period.

Small technology firms that rely heavily on stock compensation plans will be especially impacted. The application of these guidelines will also have potentially significant, yet unpredictable, effects on reported basic and diluted earnings per share. Ordinarily, options are dilutive whenever the strike price of the option is less than the market price of the stock. However, this is not the case with variable stock options. The assumed conversion of these options will have an effect on both the numerator and the denominator of a company's earnings per share (EPS). The increase in the numerator is due to the elimination of the compensation expense that occurs under the EPS assumption that the options are converted at the beginning of the year, or when issued if that date is later. As a consequence, variable stock options can be antidilutive.

Effective Date and Transition Rules

The effective date for Interpretation No. 44 was July 1, with some exceptions for earlier application. For instance, the requirement to reclassify a fixed option award as a variable award applies to stock options for which there were changes in exercise prices made after December 15, 1998. Also, the interpretation's definition of employee applies to options awarded after December 15, 1998. Thus the period from December 15, 1998, to July 1, 2000, is a transition period.

The creation of a transition period adds complexity to the application of the new guidelines. For example, if options were repriced on or before December 15, 1998, the interpretation would not apply. However, if an event requiring variable option accounting occurs subsequent to December 15, 1998, a company should recognize only the compensation expense that accrues after July 1, 2000.

To illustrate the effect of the transition period, assume that on January 1, 1999, a company lowered the exercise price of a compensatory stock option plan to the then current market price of $15 per share. The company would be required to account for the options as a variable plan on a prospective basis. If the options were fully vested by July 1, 2000, compensation expense should only be recognized to the extent that the market price of the stock exceeded its price on July 1, 2000 (the effective date). If the market price were to fall after compensation expense had been recognized, the expense reversals would be limited to the amounts previously recorded. In situations where the market price of the shares on the effective date is less than $15, compensation expense would be measured and recorded only if the market price were to rise above $15.


Once a fixed stock option is reclassified as a variable stock option, compensation expense must be recorded. Furthermore, the amount of compensation expense from year to year is largely driven by movements in the stock price, which creates a paradox. Increases in market price reduce net income, whereas decreases in stock price increase net income.

Finally, the effect of the transition period has major ramifications for companies. Accountants need to be aware that events during the transition period, such as the repricing of options or canceling and reissuing of options within a six-month period, will result in variable-plan treatment for those stock option plans. *

Anthony F. Cocco, PhD, CPA, and Glenn Vent, PhD, CPA, are associate professors in the department of accounting at the University of Nevada, Las Vegas. They can be reached at cocco@nevada.edu and vent@nevada.edu.

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