Despite the objections of many in industry, the FASB issued a exposure draft that changes the accounting for stock-based compensation plans. This will result in the recognition of compensation expense where none is now presently recognized. But how is the stocck option's value determined? The author describes the method to be used and provides other background material to help us understand the proposed statement.

In June 1993, FASB issued an exposure draft of a proposed statement of financial accounting standards, Accounting for Stock-Based Compensation. This exposure draft comes after nearly a decade of deliberation by the Board on issues related to stock-based compensation, many of which were initially identified in the FASB's May 1984 Invitation to Comment, Accounting for Compensation Plans Involving Certain Rights Granted to Employees. The accounting required by the proposed standard differs considerably from existing practice and is quite controversial. Particularly at issue is the Board's tentative conclusion to require recognition of compensation expense for certain fixed stock options which, under current accounting rules, do not usually result in expense. The strength of resistance to the new accounting guidance is evidenced by the hundreds of comment letters the Board received disagreeing with its tentative conclusions even before the issuance of an Exposure Draft. Strong opposition has come from business groups, institutional investors, compensation consultants, and the Big Six accounting firms, who have urged the Board to accept a disclosure-only resolution to its stock compensation project.

Nevertheless, there are many who applaud the Board's conclusion that an entity gives something of value to its employees when it grants stock options and, accordingly, incurs an associated cost. For example, in a 1992 letter to the shareholders of Berkshire Hathaway, Inc., CEO Warren Buffet chastised those opposed to the recognition of compensation expense for stock options and admonished the profession and the SEC for deferring to business executives on this issue. In the letter, he summarized his views on the reality of stock options by the following: "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?"

Basic Concerns Motivate the Board

The Board has basic concerns regarding accounting for stock-based compensation under current accounting pronouncements. They believe those concerns to be important enough to warrant a reconsideration of the authoritative guidance relating to stock compensation.

Different Results. The first concern arises because certain differences in the terms of stock-based compensation plans may lead to different accounting results, even though the economic benefits received by the employees and the costs incurred by the employer are practically identical. This situation is illustrated by comparing a stock option and a stock appreciation right, both with an exercise price equal to the market price at the date of grant. If the market price of the underlying stock subsequently increases, the benefit to grantees and the cost to the employer of the two plans are virtually identical. Currently, compensation cost is recognized for the stock appreciation to the extent of share price appreciation at the exercise date, but no compensation is recognized for the stock option because option price is equal to market price on the grant date.

Less Valuable, Greater Cost. A related incongruity in current accounting is plans with contingencies that render them less valuable to employees frequently result in a greater amount of compensation cost to the employer than other plans which are unquestionably more valuable because of the relative certainty of their awards. This anomaly results from the accounting distinction currently made between fixed and variable plans. Specifically, compensation expense for a stock-based plan whose terms are contingent upon the attainment of future performance goals (a variable plan) is measured at the measurement date, one subsequent to the grant date when the price and/or number of shares are determinable.

In contrast, a plan with terms fixed at the date of grant (a fixed plan) involves the measurement of compensation cost at the date of grant. If the plans are identical, except for the additional uncertainty incorporated in the performance-based plan, and the market price of the underlying stock rises, the performance-based plan will result in greater compensation cost to the employer, despite the fact it is obviously less desirable to the employee.

The accounting treatment accorded variable plans is problematic for another reason. An implication of measuring compensation expense at a date subsequent to the date of grant is certain increases in stock price unrelated to an entity's performance could materially affect the compensation expense recognized for the entity. This would result in the illogical situation of stock price determining earnings rather than earnings determining stock price. It may also serve to discourage employers from granting performance-based or other variable plans, even though they may be superior methods of rewarding employees or motivating them to meet organizational goals.

It's the Total Compensation Cost Stupid. A more fundamental concern relates to the effect current treatment of stock compensation plans has on the employer's recognition of total compensation cost. Because the cost of stock-based compensation is not always recognized under current accounting rules, a company that chooses to pay its employees more in stock options and less in cash and other current and deferred benefits will report lower total compensation in its income statement. The very same cost--the cost of compensating employees for services they provide- -is reflected differently in the financial statements of employers depending upon how they choose to pay their employees. Consequently, the deficiencies of existing accounting rules for stock compensation result in financial statements that are not comparable across entities.

Enter New Developments. Finally, an additional incentive for re- examining current authoritative guidance is the proliferation of plans unforeseen at the time current accounting rules were developed. In addition, the development and computerization of techniques for valuing non-employee stock options has resulted in a methodology which can be easily adapted and applied to the measurement of employee stock options. The application of this new technology results in an estimate of the value of the option itself--an estimate practically unobtainable in 1972 when APBO No. 25 was issued.

The Board's Proposal

The proposed standard on accounting for stock compensation responds to the perceived inadequacies of the existing accounting rules and reflects the developments described above. The Board's proposal would require that compensation cost for stock options and other awards of equity instruments be measured at the fair value of those awards as of the grant date, based on the stock price at that date and the best estimate of the outcome of service and performance related conditions. Under the proposed standard, all awards of equity instruments would be accounted for in the same manner. The current distinctions between fixed and variable plans would no longer be relevant. The new accounting guidance would apply equally to all plans, eliminating contemporary inconsistencies in the recognition of expense for different types of plans.

In addition, plans currently classified as noncompensatory under APBO No. 25 (stock purchase plans with characteristics that indicate they are not intended primarily to compensate employees) would be subject to expense recognition under the proposed accounting. In effect, the proposed standard would insist employers recognize that stock options and other awards granted to employees have value and involve a cost to employers.

Measuring Compensation Expense

The fair value of a stock option or equivalent award would generally be estimated using an option pricing model that considers the following factors:

* The current (grant date) price of the underlying stock;

* The expected volatility of the underlying stock (i.e., the expected variance of returns on the stock);

* The option or exercise price;

* The expected life of the option;

* Expected dividends on the stock; and

* The expected risk-free rate of return during the option life.

The proposed standard would not require use of a particular option- pricing model or approach, but does specifically identify Black-Scholes and binomial option pricing models as being appropriate. The method used to estimate fair value should explicitly incorporate each of the factors enumerated above. This is critical because the proposed accounting would require compensation expense and the value of the award be adjusted to reflect subsequent changes in the expected life of the option. To appropriately adjust for changes in this estimate, its role in the determination of fair value must be explicit.

There are several relatively inexpensive software packages that value options based on user specification of these six input values. With the availability of these option-pricing packages, determining the appropriate assumptions to use as software inputs is expected to be the most difficult task in the valuation process.

The Board has suggested the expected volatility of the underlying stock over the option life is likely to be the toughest assumption to make. It also recommends historical volatility be considered, along with factors such as the company's maturity and general market levels of volatility. The risk-free interest rate should be the rate currently available for zero-coupon U.S. Government issues with a remaining term equal to the expected term of the options being valued.

Most nonpublic companies would have difficulty establishing a measure of expected volatility for their stock because of the infrequency with which their shares are traded. Accordingly, nonpublic companies without sufficient trading to establish a reasonable measure of expected volatility would be allowed to value their options by applying a pricing model that does not consider expected volatility--the "minimum value" method. Under this approach, the fair value at the date of grant would be measured as the current market price of the underlying stock reduced by the present value (using the risk-free rate) of 1) the option price (discounted from the expected exercise date) and 2) the amount of dividends expected to be paid on the underlying stock during the period in which the options are expected to be outstanding. A nonpublic company is an entity 1) whose equity securities do not trade in a public market, 2) that has not made a regulatory filing in preparation for sale of equity securities in a public market, and 3) that is not a subsidiary, corporate joint venture, or other entity controlled by an entity that fails to satisfy criterion 1) or 2).

Adjusting the Option-Pricing Approach

Because vesting requirements and the nontransferability of employee stock options reduce their value relative to freely traded stock options, the proposed accounting would require adjustments be made to the values provided by traditional option pricing models to compensate for these differences. One adjustment already mentioned is the substitution of the options' expected life for the maximum term of the options as an input in estimating the fair value. Using the expected rather than maximum term incorporates the effect of the restriction on sales of employee options by recognizing that early exercise of the option forfeits the options' remaining time value, a value which could be captured if the option were sold.

Further, to incorporate the continued employment requirement, total fair value would be calculated using an estimate at the grant date of the number of options or awards expected to vest. This estimate would be based on the employer's historical experience with respect to turnover rates at the level of the grantees involved and should incorporate the effects of future expectations regarding turnover.

To illustrate, assume on the first day of the year a company grants 20,000 employee stock options and estimates a $25 per option fair value by applying a Black-Scholes model with appropriate inputs. The company determines the total fair value of its award on the grant date by estimating the total number of options expected to vest and multiplying that estimate by the fair value per option. Thus, if a two-year vesting period is specified and the company expects a 2% turnover rate in each year during that period, the total fair value is estimated as $480,200 |(20,000 x .98 x .98) x $25.

Similarly, the value of performance-related stock option awards would be determined based on the number of options expected to vest, the level of performance expected to be achieved, and the estimated fair value of each option. For performance-based plans that provide for an all-or- nothing award, an accrual would be made only if it is probable that the performance criteria will be met.

Modifying the Grant Date Measurement

The approach proposed is referred to as a "modified" grant date approach because the fair value estimated at the grant date would be subsequently adjusted to reflect the actual outcomes of service-related factors and performance conditions of the award. Specifically, fair value of the award and resulting compensation expense would be adjusted for changes in estimates of option life, forfeitures prior to vesting, and the probability of attaining performance criteria upon which certain awards are based. Adjusting expense for actual outcomes ensures the employer records compensation expense only for those rights or awards that do vest. The measurement would not be adjusted after the date of grant for any fluctuations in the underlying stock price, dividend yield, risk- free interest rates, or expected price volatility.

An exception to these measurement requirements is provided for options with terms that make estimation of their fair value at the date of grant impracticable. An example is a stock option whose exercise price is tied to changes in the price of the underlying stock. In cases such as this, the fair value at the date of exercise would be used as the final measure of compensation expense.

Awards that Create Equity

The proposed standard requires the option's fair value or other equity award be recognized as an additional component of equity at the date of grant using an account entitled "options outstanding." The proposed accounting is based on the view stock options and other awards are issued to acquire an asset--the future services of the grantees. Thus, amounts related to future service would be initially recorded as prepaid compensation, an asset. This represents another change from the APBO No. 25 treatment of these amounts as deferred compensation, a contra-equity account. Accordingly, total assets and equity would increase in each period by the estimated fair value of stock-based compensation awards granted in that period.

Compensation expense would be recognized by amortizing prepaid compensation ratably over the period in which the award or option is earned by employees. The service period would be presumed to be the vesting period--the period from the date of grant to the date the employee's right to the award is no longer contingent on additional service--unless an earlier or shorter period is explicitly defined by the employer. Compensation expense for an award made solely in exchange for past service would be recognized completely in the period in which the award is granted.

Awards that Create Liabilities

If an employee can compel the employer to settle a stock-based compensation award by the transfer of cash or other assets to the employee, the award results in the incurrence of a liability for the employer. Under the proposed standard, the amount of the liability under this type of plan would be measured each period based on the current stock price (consistent with a mark-to-market approach). For example, an employer would record a liability for a stock-appreciation-rights plan where share appreciation is paid in cash or, at the employee's option, in cash, stock, or a combination of the two. This accounting would not differ from the treatment accorded stock appreciation rights under FASB Interpretation No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans. In contrast, if a stock- appreciation-rights plan provides that the appreciation is to be paid in stock or the employer may choose the form of payment, the award is considered an equity instrument, and modified grant date accounting would be used to record compensation expense.

Disclosures

The proposed accounting would require footnote disclosures of--

1. a description of all stock-based compensation plans, including the general terms of awards made;

2. the number of options outstanding and number of options exercisable at the beginning and end of the year along with information on the grants, exercises, forfeitures, and expirations that led to changes in those figures;

3. the weighted average exercise price of options outstanding, granted, and exercised and the weighted average fair values of options granted during the year at the dates granted;

4. a description of the method and significant assumptions used to estimate the fair value of options, including the risk-free interest rate, expected volatility, and expected dividend yield;

5. total compensation expense recognized for stock-based compensation awards; and

6. significant modifications to outstanding option grants.

Transition and Effective Dates

The proposed standard would provide for a two-stage transition to the new accounting requirements. A three-year period of required footnote disclosures would begin with awards granted after December 31, 1993. During this interim, in addition to the required disclosures enumerated above, pro forma disclosures of the effects on net income and earnings per share of adopting the proposed statement would be provided. The recognition provisions of the proposed standard would become effective for awards made after December 31, 1996, with earlier application encouraged.

The Board plans a six-month comment period on the proposed standard, during which a field test will be conducted to examine the effects of the new guidance on selected employers' plans.

Other Issues

The proposed standard also provides accounting guidance relating to 1) modifications to the terms of grants under stock compensation plans, 2) accounting for tax consequences of temporary differences resulting from stock compensation plans, and 3) implications of the new accounting rules on earnings-per-share calculations required under APBO No. 15.

What Happens Now?

The delayed effective date and two-stage transition approach have caused many who oppose the proposed change in accounting to continue to hope the Board's tentative conclusions are modified before expense recognition provisions become effective. These commentators would be pleased to see a final standard that incorporates only the proposed disclosures, and many will undoubtedly lobby the Board for this outcome.

Meanwhile, a large number of employers have announced their intentions to reduce or eliminate stock option plans in light of the Board's proposal. The Wall Street Journal recently reported results of a survey of 500 start-up companies in which 90% of the respondents indicated that a requirement to deduct stock-option values from profits would prompt them to stop issuing options to most employees other than top executives. Consultants believe stock option plans provided to top executives are less likely to be eliminated because the performance of these executives is most influenced by stock-based compensation. The Board responds to these assertions by arguing that if stock options provide real economic benefits, companies should reduce stock-option programs only if the cost of providing this kind of compensation exceeds those benefits. Further, unless companies measure and report the cost of options, they can not evaluate the efficacy of stock option plans.

Joyce A. Strawser, Phd, is an assistant professor at Baruch College--The City University of New York.