Accounting for Stock Options

The Controversy Continues

By Nicholas G. Apostolou and D. Larry Crumbley

In Brief

Survey Identifies Impact of Accounting Alternatives

Instead of replacing APB 25’s intrinsic value based method of accounting for stock-based employee compensation plans, SFAS 123 allows a choice between the intrinsic value method and the fair value method. The intrinsic value method, however, triggers footnote disclosure of the effect on earnings, whereas the fair value method does not. Since the great majority of publicly traded companies continue to use the intrinsic value method, the grant of options does not dilute reported earnings. Thus, stock options continue to be “stealth compensation,” deductible for tax purposes without diluting financial earnings.

Warren Buffet, CEO of Berkshire-Hathaway, criticized the current rules for accounting for options in his company’s 1998 annual report: “If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”

The authors surveyed the 1998 annual reports of 30 companies that used the fair value method rather than the intrinsic value method. In certain situations, the difference in earnings is so great that financial statement users’ decision making could be affected.

For years, stock options have been “stealth compensation”: expenses that are not charged against financial statement income but are deductible for tax purposes. Nevertheless, stock options dilute earnings, meaning that they are not free to shareholders. In 1995, FASB adopted SFAS 123, which established financial accounting and reporting standards for stock-based employee compensation plans. In addition, FASB released Interpretation 44, which could result in significant accounting charges for many companies. The two significant issues raised by FASB are the definition of an employee for the purposes of applying APB 25 and accounting for the repricing of employee stock options (SFAS 123).

Definition of an Employee

Under the IRC, an individual who meets the common law definition of an employee is classified as an employee for payroll tax purposes. Nevertheless, APB 25 only applies to company stock issued to officers and other employees of the company. Interpretation 44 expands the application of APB 25 to include any individual that meets the common law definition of “employee”: An individual is considered an employee “if an entity has a right to direct and control the individual’s work, both as to the final results and the details of when, where, and how the work is to be done.” The interpretation further states that “the designation of an individual as an employee for payroll tax purposes generally determines whether an individual qualifies as an employee for purposes of applying APB 25.” Consequently, grants to independent directors, contractors, and other service providers that are not employees for payroll tax purposes should be accounted for at fair value in accordance with SFAS 123.

Repricing of Stock Options

The repricing of stock options is a particular cause of disagreement. Interpretation 44 would require any company that reprices stock options to recognize compensation expense for the difference between a stock option’s price and its market value on the financial statement date. This method, referred to as variable-award accounting, is not really a new requirement but a stricter interpretation of APB 25, originally published in 1972. FASB now requires that companies changing option prices after the grant date use variable-award accounting. Although repricing has been relatively rare during the stock market’s ascent, its use would likely accelerate in a market downturn. An example of repricing occurred in February 1998, when Applied Magnetics tried to revive the value of 300,000 stock options owned by its CEO by cutting their exercise prices. By the fall of that year, the stock fell even further; the company responded by again slashing the exercise price. Furthermore, the company repriced an additional 400,000 of the CEO’s options for the first time. Other companies that have repriced their options include Cendant and 3Com.

Background

Two issues have historically dominated standards setting in the area of accounting for stock options: Should compensation expense be recognized for stock options? If so, over what periods should it be allocated?

Under APB 25’s intrinsic value method, compensation expense was determined as the excess of the stock price at the measurement date (generally, the grant date) over the option exercise price. Since most stock option exercise prices were equal to or greater than current market prices, no compensation expense was recognized. The accounting profession found this approach unsatisfactory because it ignored the possibility—or even likelihood—that the stock price might one day exceed the exercise price.

By adopting SFAS 123, FASB attempted to recognize the reality of stock option value. The statement required stock options to be measured based upon the many factors that reflect their underlying values and, therefore, total compensation expense to be computed based on the fair value of the options expected to vest on the grant date. Fair value would be estimated using an option pricing model (Black-Scholes or binomial). SFAS 123 allows—but does not require—that compensation cost resulting from the granting of stock options be measured and reported currently in the income statement and allocated over the remaining life of the option.

Consequently, companies granting stock options to employees can choose to follow either APB 25 or SFAS 123. The fair value method must be used for nonemployee compensation where warrants are issued in return for goods or services. Companies that account for their stock option plans under SFAS 123 will recognize some compensation expense in the income statement over the vesting period. Companies that continue to use APB 25 generally will not recognize that compensation expense.

Because the APB 25 approach most often results in higher reported earnings, the great majority of companies have not adopted the fair value method in SFAS 123. However, SFAS 123 requires that companies that account for their stock option plans under APB 25 disclose in the financial statement footnotes how the use of SFAS 123 would have affected net income.

Survey of 1999 Financial Statements

An examination of the 1999 annual reports of 30 companies associated the recognition of expense with stock options and the effect of SFAS 123 adoption on net income (see the Exhibit). The companies are predominantly in the high-tech industry; several others from other industries were also studied as a basis of comparison.

The difference between reported earnings (under APB 25) and adjusted earnings (under SFAS 123) exceeds 10% for many of these companies. For example, KLA, Compaq, America Online, and Siebel are overstated by 86%, 36%, 34%, and 22% respectively. Some companies that reported profits under APB 25 would have reported losses under SFAS 123 (Yahoo, Broadvision, Ebay, and Broadcom). Broadcom dropped dramatically from $83 million earnings to negative $105 million earnings and Yahoo crashed from $61 million earnings to a loss of $256 million.

All of the 30 companies surveyed continue to follow APB 25 in the preparation of their financial statements. The SAFS 123 disclosures are reflected, as required, in the footnotes. The companies often expressed their displeasure with the requirements of SFAS 123, especially the Black-Scholes option pricing model used to determine the fair value of an option. A typical example is the PeopleSoft disclosure in its 1999 Form 10-K:

Limitations of the effectiveness of the Black-Scholes option pricing model are that it was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable and that the model requires the use of highly subjective assumptions including expected stock price volatility. Because the company’s stock base awards to employees have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its stock-based awards to employees.

Black-Scholes Option Pricing Model

All of the companies surveyed used the Black-Scholes option pricing model, the method preferred by FASB (alternatives are various binomial models). The Black-Scholes model, developed by Fischer Black and Myron Scholes in the early 1970s, calculates the present value of a stock option as of its grant date, based on specific information about the terms of the option and assumptions about future stock price performance. The value calculated by Black-Scholes is an estimate of the price someone would pay for the option in the market today. The method assumes that the underlying stock behaves in a way that future prices can be modeled by a probability distribution.

One of the variables in Black-Scholes is the estimated future volatility of stock price, defined as the estimated future variance of the stock price based on historical stock price movement and expectations for future stock price movements. Volatility measures the stock price fluctuation relative to itself and should not be confused with beta, which measures the stock price fluctuation relative to a market average. Volatility is expressed as a percentage, a relative measure of the expected difference between the stock price at the end of the stock option’s expected life and the stock price at the date of grant. Volatility is, in effect, the standard deviation of the expected price of the stock. Because future volatility cannot be known, SFAS 123 suggests that historical volatility serve as an estimate of future volatility. This amount is often forecasted by using stock prices over a historical period equal to the expected life of the options.

The volatility computation—clearly the most difficult variable to compute in Black-Scholes—can have a dramatic effect on the value assigned to the options. The companies examined showed a wide variation in volatility, ranging from 30% for Hewlett-Packard to 100% for Ebay.

Another variable in the model, the risk-free interest rate at the time of grant, is determined by reference to the rate on Treasury bills or notes having a remaining term or maturity equal to the expected life of the options. The rates chosen by the companies surveyed ranged widely, from 4.5% for Altera to 6.4% for Adaptec, some of which is due to the difference in the expected life of the options.

One of the objectives of SFAS 123 is to allocate compensation cost to the periods in which services are provided to the granting company. Typically, the options are not exercisable until the vesting date, which usually occurs several years after the grant date. Compensation cost should be accrued in the period from grant date to vesting date, based on the estimated number of options expected to vest or be exercised. In the Black-Scholes model, one of the variables is the expected life of the stock option, defined by SFAS 123 as the expected period of time that the option will remain outstanding before being exercised or forfeited. For the companies surveyed, the expected period ranged from less than a year for Broadvision to as much as seven years for Hewlett-Packard.

A Popular Form of Compensation

Stock options are the fastest growing segment of executive pay. Business Week’s executive pay scoreboard (published April 17, 2000) shows that long-term compensation—mostly from exercised options—constitutes 81% of the average CEO’s pay package. The survey also revealed that CEOs at large public companies averaged $12.4 million in compensation for 1999, up 17% from $10.6 million in 1998. Options worth millions of dollars have become commonplace in today’s corporate environment.

As the survey indicates, there is considerable variation in the estimates used to compute the fair value of the options. The difficulty in measurement, however, should not obscure the need for measurement. Options are universally acknowledged to be additional compensation and should be accounted for as such. In time, acceptance of option value estimates will become more widespread as accountants gain additional experience in the application of Black-Scholes and other aspects of fair value accounting. Then, financial statements will become more meaningful to investors.