What Controversy?

I have several comments and concerns about the May article, “Accounting for Stock Options: The Controversy Continues” (Nicholas G. Apostolou and D. Larry Crumbley):

• The “In Brief” says “[t]he intrinsic value method, however, triggers footnote disclosure of the effect on earnings, whereas the fair value method does not.” I think this is backwards: The FASB 123 fair value method “triggers” the extensive footnote disclosures, whereas the APB 25 intrinsic value method did not require any new disclosures when it was originally issued.
• The “In Brief” goes on to say “stock options continue to be ‘stealth compensation,’ deductible for tax purposes without diluting financial earnings.” However, not all stock options are deductible for tax purposes. As opposed to nonqualified stock options, incentive stock options are not deductible for tax purposes either when granted or when exercised. Then it says “[t]he authors surveyed the 1998 annual reports of 30 companies that used the fair value method rather than the intrinsic value method.” Again, this is backwards; in fact all of these companies used the intrinsic value method for financial reporting purposes and the pro forma impact of fair value method was reported in their footnotes.
• The article itself states, “[f]or years, stock options have been ‘stealth compensation’: expenses that are not charged against financial statement income but are deductible for tax purposes.” Again, incentive stock options are not deductible for tax purposes either when granted or when exercised.
• The reason for a parenthetical reference to SFAS 123 at the end of the first paragraph is unclear because FIN 44 interprets only APB 25, not SFAS 123.
• The authors should have updated the article instead of relying on and quoting from the exposure draft issued in March 1999. The two quotes in the second paragraph were not carried forward to the final document. More important, the article says “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.” This is inaccurate. Question 2 of Interpretation 44 says (in part) that “[a] nonemployee member of an entity’s board of directors does not meet the definition of an employee.... However, an exception is made to require the application of Opinion 25 to stock compensation granted to a nonemployee member of the grantor’s board of directors for services provided as a director if the nonemployee director (a) was elected by the grantor’s shareholders or (b) was appointed to a board position that will be filled by shareholder election when the existing term expires.”
• The discussion of repricings is interesting, but the examples are three years old and should have been more recent (e.g., 2000 repricings). Of current interest is the SEC staff’s view on the accounting for the rescission of the exercise of employee stock options, which was a prevalent and recent option transaction (see EITF Topic D-93).
• Under “Background” the authors say “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.” This cost “allocated over the remaining life of the option” is contradicted in the next paragraph, which makes the point that “compensation expense [is recognized] in the income statement over the vesting period” and again later where the authors repeat this: “Compensation cost should be accrued in the period from grant date to vesting date, based the estimated number of options expected to vest or be exercised.”
• Under “Black-Scholes Option Pricing Model,” the article says that the model “calculates the present value of a stock option as of its grant date.” Because this model is not a present value calculation, it would be better to say “calculates the fair value of a stock option.”
• The authors rightfully point out that, of the six Black-Scholes factors, volatility has the most impact on the fair value of the option (i.e., the higher the volatility factor, the higher the compensation cost). However, the next most material input is the expected life of the option. The authors point out the range of lives in the Exhibit (from less than a year to seven years) but omit how important a factor the life is. The authors do discuss the risk-free rate, which has a very minor influence on the fair value (i.e., the higher the risk-free rate, the greater the compensation cost).
• The idea behind the subtitle of the article—“The Controversy Continues”—is never fulfilled. FASB 123 has been in effect for many years, so what is the controversy in 2001? Who are the parties to this controversy?

  Robert N. Waxman, CPA
  Corporate Finance Advisory
  New York, N.Y.

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