SEC Rule Changes

For the most part, the SEC's insider trading rules under Sec. 16 have limited an executives' ability to exercise stock options. These rules mandated that insiders who exercised an option could not sell the stock within a six-month period before or after the exercise. If the executive sold the stock before the six month moratorium, any profit from the transaction would have to be returned to the company. Thus, executives were precluded from realizing a profit from exercising stock options for at least six months even though they expended cash for the exercise. This leads to multiple strategies by companies to reduce the cash drain of executives and control the risk of holding the optioned shares for the required six-month period.

One popular strategy was to grant a "derivative security" such as stock appreciation rights (SARs), whereby employees would receive in cash the amount of increase in the company's stock price. SARs have the advantage of rewarding holders for increases in the stock's market value without the accompanying cash outflows required to exercise stock options.

Under the SEC rules (240.36(b)-3), which went into effect in 1991, insiders and executives can sell shares immediately after exercise and realize any profit from the transaction as long as the option or the stock acquired by the option was held for six months. In essence, a grant or acquisition of a stock option generally is treated as a purchase instead of the exercise of that option, which starts the six- month holding period. If the option was held for less than six months, there will be a holding period for the shares purchased equal to the remaining portion of the six-month period.

The new rules should allow executives to dispose of shares more readily. Accordingly, stock options will probably increase in popularity relative to SAR plans. Table 1 shows that over the past five years, SARs have declined in popularity among top industrial firms, but SEC changes will probably speed the decline.

Tax Implications

Although there have been no actual changes in the tax code, the SEC rule changes will cause practical differences in the tax consequences of stock options. As a general rule, stock options are deemed to have no value for tax purposes on the date of grant as long as the option price is equal to or greater than the stock's market value. Consequently, the options will have value to the executive and become a cost to the employer only if the market price of the underlying shares increases.

When the stock option is exercised, the difference between the option price and the market value of the stock represents taxable income to the recipient. Prior to the new insider rules, income on the exercise of an option was deferred until the six month restriction lapsed since the income was subject to a substantial risk of forfeiture if the underlying stock was sold prior to the six-month moratorium. This led to a planning opportunity in which executives could exercise options after June 30 of each year and defer the taxable income into the next taxable year. The deferment in income recognition for the executive was accompanied by deferring the employer's deduction.

Old SEC Rules. On March 1, 1992, First Co. granted CEO Peter North stock options with which he could purchase 100 shares of First Co. common stock for $10 a share. The market price was also $10 on this date. In July, when the market price was $15, Mr. North exercised his options and purchased the 100 shares. Mr. North had taxable income of $500 which will be deferred until 1993. First Co. also will have its deduction of $500 deferred because the stock cannot be sold without substantial risk of forfeiture until 1993.

Under IRC Sec. 83, taxable income must now be recognized by insiders at the time of exercise whether or not the shares are sold. Such stock generally will not be subject to a substantial risk of forfeiture, unless the option was not held for the required six-month period. Because the timing of the company's deduction is determined by the executive's income recognition, in most cases the deduction will similarly not be deferred. Further, the potential alternative minimum tax consequences are accelerated to the date the option was exercised rather than six months after exercise.

New SEC Rules. Using the information from the above example, Mr. North would not be able to defer income and would have to report the $500 in 1992. Similarly, First Co. would claim a deduction in 1992 for $500.

Thus, the new SEC rules provide an advantage to executives to exercise options and sell the underlying stock without having to wait for the six-month period to lapse. However, this advantage must be weighed against earlier tax consequences of recognizing the gain from exercising the options.

The tax consequences of SARs are more simplistic. Generally, executives are taxed on the amount of cash received. Thus, there is no longer a practical difference in the tax implications of options and SARs.

Financial Statement Considerations

Accounting for employee stock compensation has been a controversial area of GAAP for many years. Under current rules, companies generally can avoid recognizing compensation expense for stock options by setting the option price equal to or greater than the market price on the measurement date. The measurement date is defined as the date that both the option/purchase price and the number of shares is known. With stock options, this is usually the grant date. The company recognizes no additional expense regardless of the increase in the stock's market value when the options are exercised. FASB has potentially changed this treatment with its recent intent to issue a proposed SFAS which would require assigning a value to the option at date of grant.

In contrast, with SAR plans companies usually are forced to recognize compensation expense to the extent that the market value of the underlying stock increases. GAAP requirements for measuring compensation expense technically are the same for both stock options and SARs (e.g., difference between option price and market price at measurement date). However, the practical difference results from the fact that measurement date with SARs is virtually always the date payments are made, because only then is the actual price known.

To illustrate, assume that Company A offers a stock option plan to key executives. The plan provides options to purchase 1000 shares of Company A stock after a four-year service period at $35. On the date of grant, Company A stock is trading at $35. Unless FASB makes a change, Company A will not report compensation expense because the market price is equal to the option price at measurement date. For financial reporting purposes, Company A's stock price when these options are exercised is irrelevant.

TABLE1

GRANTSOFSTOCKOPTIONSANDSARsTOP200INDUSTRIALCOMPANIES

GrantType(NumberandPercent)

19861987198819891990

StockOptions186/93%184/92%182/91%184/92%184/92%

SARs132/66%121/61%116/58%110/55%105/53%

Source:FredericW.Cook&Co.,Inc.

In contrast, assume Company B offers its key executives a similar plan, but instead of granting the right to purchase stock, Company B provides an SAR plan whereby the executives will receive in cash the amount of increase in market value of Company B stock when the rights are exercised. If the SAR grant is made when Company B stock is trading at $35 per share and exercised four years later when the stock is trading at $100 per share, Company B will have to recognize compensation expense of $65 ($100 - $35) per SAR over the four-year period.

CPAs must also be cognizant of the potential reduction in reported earnings per share (EPS) that can result from options and SARs. Although the ultimate cash implications may be similar for executives receiving stock options and SARs, the compensation devices reduce EPS for different reasons. Since companies utilizing option plans do issue additional shares of stock, EPS may decline because of an increase in the EPS denominator. EPS under SAR plans could be reduced as the required expense recognition decreases reported earnings, thereby reducing the EPS numerator.

Though the apparent inconsistences between accounting for stock options and SARs have long been noted by accountants, there has been little impetus to change because of the favorable financial statement impact of stock options. Nonetheless, forces may be emerging which alter this situation.

Companies considering adoption of a stock compensation plan should watch for several factors that may impact the accounting consequences. These factors include the FASB's proposals for the accounting treatment of employee compensation as well as public concerns over executive pay.

Public Perception

Both the mainstream and business press are replete with examples of what many consider to be "excess" compensation for key executives. Some businesses are responding to public and stockholder concerns by including more disclosures about stock options in proxy materials. Hopefully, the additional disclosures will reduce the need to value the options at the date of grant.

The SEC is sensitive to concerns over executive compensation. The SEC recently announced several initiatives intended to give shareholders more relevant and understandable information about executive compensation. Specifically, non-binding advisory proposal concerning senior executive and directors' compensation may now be includable in proxy statements. Management was previously allowed to exclude such proposals on the basis that compensation issues were a matter of day-to- day "ordinary business." Additionally, the SEC is proposing revisions to the proxy rules which would clarify and enhance compensation disclosures in the proxy statement.

Other Considerations

In making the final decision regarding which incentive compensation plan is best for their company, management must also factor non-financial considerations into the decision. For example, it is possible that stock options are better long-term motivators than SAR plans because recipients have a vested interest in keeping the stock price up after the option is exercised. No accompanying direct financial incentive exists with SAR plans because the exercise generates the total cash that will be received from these plans. Additionally, firms (especially closely-held firms) should consider the dilution of equity resulting from a stock option plan. Firms with SAR plans must be prepared for the requisite cash outflow resulting from the exercise of an SAR.

|Editor's Note: For a discussion on how to design other types of incentive programs, see "Designing Effective Incentive Bonus Programs," by Frederick D. Heiman, in the February 1993 issue of The CPA Journal.

By Paula B. Thomas, DBA, CPA, CMA, Middle Tennessee State University and Daryl V. Burckel, DBA, CPA, McNeese State University