Stock Option Accounting: Defying the Usual Answers

By Gregory J. Baviera and Larry M. Walther

E-mail Story Print Story

The Outcry to Expense

Recent accounting scandals have moved the topic of executive compensation to the forefront. Stock options are a substantial part of many compensation packages. While the size of the grants varies among industries, most major corporations use them to some extent.

The accounting treatment for employee stock options is generally found in Statement of Financial Accounting Standards (SFAS) 123, Accounting for Stock-Based Compensation, and Accounting Principles Board Opinion (APBO) 25, Accounting for Stock Issued to Employees. SFAS 123, issued in October 1995 after much debate, required expensing in all but one circumstance, fixed options—the most common form of stock option in the United States—which could continue to be accounted for under the nonexpense approach of APBO 25. Interestingly, FASB did not vote its conscience in adopting SFAS 123, which would have required expensing of all stock options; instead, FASB buckled to pressure from constituents, including certain members of Congress. The debate escalated to the point that FASB feared for the survival of private sector standards-setting if it held its ground.

Since the fight over SFAS 123, however, the political winds have shifted and stock options have come under intense scrutiny. FASB and Congress have also gained an important and unexpected new ally: corporate America. Many prominent corporations, including Ford, General Motors, and Coca-Cola, and several large financial firms have announced their decision to voluntarily expense stock options. This change of heart has been attributed to two factors. First, these companies are trying to win favor with the investment community by their new openness. Second, according to a recent survey conducted by Standard & Poor’s Quantitative Services and published in the Wall Street Journal Online, these companies will not recognize a serious hit to earnings by choosing to expense options.

Not all companies have followed suit, however. Many high-tech companies declared that they do not intend to voluntarily expense stock options. These companies use stock options as a major component of executive compensation; as such, fair value expense treatment will significantly affect their bottom line.

At the heart of the argument for expensing options is the three-way relationship between the employee, the entity, and the shareholders. Granting options is not merely a rearrangement of ownership interests, in this view, but a transaction related to the entity. Commentators point to a number of indicators, including the entity’s market purchases of shares to fulfill their side of the bargain when options are exercised, the issuance of shares that could otherwise be sold to raise cash, and the nature of the contracting between boards and managements. They conclude that the substance and form of stock option grants make them more than rearrangements of existing ownership, although they could be structured this way in form.

The theoretical argument against expensing stock options hinges on the entity concept. This argument is presented in more detail below. Regardless of one’s conclusions about stock option expenses, the debate points up a problem in applying the entity concept in its purest form: The transactions of the entity should be accounted for separately from its owners’. There may be a need to reexamine the entity theory to expand it to include situations where the affairs of owners, the entity, and entity employees become intertwined.

The Entity Assumption

A basic accounting assumption, the entity concept, circumscribes the economic activity accounted for. The long-accepted view is that economic substance prevails over legal form in identifying the entity for which to account. Relevance requires that accounting information be related to the business unit that is substantively impacted by a transaction or event. For example, accountants often prepare consolidated statements for separate legal entities. Conversely, sole proprietorships are reported upon separately and apart from the personal affairs of the owner. In other words, transactions are attributed to the appropriate unit of accountability.

In the case of stock options, some proponents of expensing confuse the legal and economic substance of the transaction, and possibly may be unaware of the entity assumption; this makes some of their statements and reasoning inconsistent. For example, Alan Greenspan at the 2002 Financial Markets Conference of the Federal Reserve Bank of Atlanta said: “[A] stock option is a unilateral grant of value from existing shareholders to an employee.” While this might be true in some limited circumstances, it is especially confusing in light of Greenspan’s ardent support of expensing stock options because the “entities” Greenspan identified in his comment were the shareholders and the employees, not the company.

A company that owns its own shares does not account for them as corporate assets but as treasury stock. When a company grants options, it is not transferring its assets, nor is it creating a corporate liability; rather, it is compensating the grantee with unissued shares or treasury shares. Because there is no asset transfer or liability creation, expensing opponents argue that a stock option grant fails to meet the definition of an expense as defined in Statement of Financial Accounting Concepts (SFAC) 5, Recognition and Measurement in Financial Statements of Business Enterprises. Instead, in this view the existing shareholders are redistributing (either explicitly through proxy vote approval, or implicitly by powers delegated to the board of directors) units of ownership, with the company serving as the conduit through which the transaction passes (except for the option price itself, which does accrue to the corporation upon exercise, and the accounting for which is not at issue). Because neither corporate assets nor corporate liabilities have changed, total equity remains unchanged. But total equity has been redistributed.

FASB’s logic and corresponding conclusion approach the problem differently: No one would argue that if a company issued shares for cash, and gave the cash to an employee, then the cash given to the employee should be expensed. Now, if the same shares are instead given to an employee who sells them for cash, all parties are put in
the exact same position. Therefore, the accounting should be the same. Thus, the value of the stock should be expensed. But consider the following scenario: Suppose an entrepreneur started a new business, owning 100% of the stock. The owner promises a manager 10% of the stock if the business revenue exceeds business expenses by X amount. Upon reaching X, would it be fair for the owner to declare that no stock is due the manager because X really means “X plus the fair value of 10% of the stock”? (This is puzzling math, but is exactly the same result as declaring that the value of the stock must be included in the business expense; i.e., “Revenues – Expenses – Stock = Income” is the same as “Revenue – Expenses = Income + Stock.”)

Everyone is entitled to draw their own conclusion about the logic of this outcome, but needless to say, the manager would take issue that the entity assumption was created to separate business income determination from capital transactions. Incorporating the value of share redistributions, in this view, misreports business performance. This is why certain corporate leaders vehemently oppose the proposal to expense stock options. To illustrate, consider an individual who starts a business with a $1,000 investment. The business produces a $2,000 profit and intrinsic business value of $20,000. The business pays the owner a $2,000 dividend. Ten percent ownership (worth $2,000) is transferred to reward the employees. FASB would argue that the business has broken even ($2,000 profit minus $2,000 stock award)—even though its owner has already withdrawn more than his investment.

Stock options are a form of compensation to employees; however, people differ in their conclusions about whether this compensation comes from the existing owners or from the entity. If granting stock options is a redistribution of existing ownership interest, then it is not a performance measurement issue for the company. Even if options should not be expensed, it does not follow that they should be ignored in corporate reporting. Unfortunately, the current accounting model does not effectively capture this transaction unambiguously. Expansion of the approach to the entity assumption is needed.

The Nature of Accounting

The truthfulness and usefulness of any measurement is enhanced by employing triangulated measures. In business, many transactions are themselves triangulated; in the case of options, the triangle includes the entity, the owner, and the employee.

Accounting theory has not embraced “triangulation” measurement concepts. In the accounting model developed over 500 years, the trader or entity has always been regarded as the center. This view has led to one- and two-dimensional accounting conventions and standards. The outcry to expense stock options is based on an attempt to capture a triangular transaction (involving the employee, the company, and the shareholder) in a two-dimensional accounting model that is not capable of presenting it accurately. Accountants must recognize and develop new tools necessary to carry us safely beyond the horizon.

A New Model

Strong support for revising the current accounting model is found in the 1991 Jenkins Committee Report. In their analysis, the Jenkins Committee specifically targeted professional users of business reporting. The committee determined that “professionals generally base their decisions on superior models and methods” and that “because of their training and full-time focus, professionals should be better able to articulate their needs for information.” This focus on professional users is a critical distinction.

The current debate appears to be targeted to a wide spectrum of users. It is widely understood that not all professional users require the same information; it is likely that the same holds true for a broader scope of users. After significant field research, the Jenkins Committee issued several recommendations for facilitating change in business reporting. Of particular interest is its recommendation that companies should be encouraged to experiment with ways to improve the usefulness of reporting, with an emphasis on key statistics and ratios. Redirecting the focus from recognition and measurement to the usefulness of disclosures is the key to altering the accounting model. For example, a new statement that would identify the degree of dilution suffered by shareholders, and the degree to which employees have disposed of or continue to hold their equity share, might be of great relevance for professional users.

Our currently accepted theory does not necessarily support either expensing options or ignoring them. What is needed are new theories, approaches, measures, and reports that more accurately pinpoint the economic positioning of the parties involved in modern business transactions.