Compensation Plans and the New Stock Option Accounting Rules

Early Adopters Plan for Changes

By J. Gregory Kunkel and Richard T. Lau

Opponents of the proposed standard argue that its implementation will hurt the competitiveness of American industry, especially of technology companies that rely on stock options to attract and retain key employees. Opponents argue that existing accounting standards adequately disclose the effects of stock option grants through diluted earnings-per-share calculations and the required footnote disclosure. In addition, opponents argue that FASB’s proposed methods of valuing stock option grants will yield meaningless expense numbers. The lobbying against the proposed standard has become so intense that the House of Representatives recently passed a bill that would require expensing of options for only the top five executives of publicly traded companies.

According to Standard & Poor’s, the proposed accounting rules would reduce reported 2004 earnings among the S&P 500 by 7.4%. The effect on the reported earnings of many technology firms will be much greater. For example, in an August 2, 2004, press release, Intel reported that its second-quarter 2004 profit would have decreased 17% if it had expensed its stock options. As a result, trade groups, such as the American Electronics Association, have vigorously opposed the proposed rules.

The proposed standard has at least one virtue: It levels the playing field between stock option grants and other forms of stock and cash compensation. Under existing accounting rules, restricted stock grants are considered an expense, but fixed, “at the money,” stock option grants are not. Under the proposed standard, there will no longer be an obvious accounting advantage to one form of compensation. The choice of compensation vehicle should become less driven by accounting considerations and more driven by proper incentive-design
considerations.

The proposed standard suggests an important question: How will companies change their equity compensation programs in response to new FASB requirements? This will obviously depend on the particular company and industry, but general implications might be discerned. For example, will stock options become a less important part of the compensation package? Will the size of stock option grants be reduced? Will stock options be granted to fewer employees in an organization?

Methodology

To gain insight into these questions, the authors, using Dow Jones News Service’s press releases, identified 150 companies that have voluntarily decided to expense stock options in anticipation of the proposed FASB rules. These companies cover a wide variety of industries (see Exhibit 1), with some concentration in financial services, and with technology companies underrepresented. The survey instrument asked human resources directors simple questions about changes to their company’s equity compensation programs in response to their decision to expense stock options. There was a 21% response rate.

Survey Results

Of the companies responding to the survey, 31% indicated that stock options will remain their primary long-term incentive vehicle after their decision to expense stock options, while 56% replied that stock options will no longer be their primary long-term incentive vehicle; 13% were undecided (see Exhibit 2).

Many companies, of course, use combinations of stock options, restricted stock, and performance plans in their long-term incentive programs. The survey asked whether companies intended to place more emphasis on some form of long-term compensation other than stock options; 68% replied yes, 16% replied no, and 16% were undecided (see Exhibit 3).

It is difficult to determine causality from the data. Did the decision to expense stock options result in less of a reliance on stock options, or did a decision to rely less on stock options result in a decision to expense them? Nevertheless, a requirement to expense stock options will remove any obvious bias toward their use, and will likely cause companies to consider using other forms of long-term compensation. When asked what type of long-term incentive vehicle would be used more frequently, 50% of respondents mentioned restricted stock and 34% mentioned a long-term performance plan payable in cash or stock.

Many factors (e.g., maturity, growth potential, industry, market conditions), of course, affect a company’s decision regarding what type of long-term incentive program to use. Nevertheless, FASB’s proposed standard will probably cause companies to look at other forms of long-term compensation, such as restricted stock and performance plans. Such programs are usually less risky than stock options and are considered by some to be a “giveaway.” Given the current level of shareholder activism, it remains to be seen whether shareholders will approve such programs.

Fifty-three percent of respondents mentioned that they do not intend to restrict or reduce the level of employees eligible for long-term incentive grants, while 34% do intend to restrict or reduce the level of employees eligible for long-term incentive grants; 13% were undecided (see Exhibit 4). Many of the companies that intend to restrict or reduce the number of employees eligible for long-term incentive grants intend to reduce eligibility by “one level”; for example, from director to vice president. Others intend to reduce the number of employees eligible at the lowest level.

Finally, respondents were asked if they intended to reduce the size of stock option grants or their allocation across levels of employees. Responses to these questions were inconclusive. Many respondents intend to keep the “value” of long-term incentives the same while substituting, for example, restricted stock grants for stock options. Of those companies that intend to reduce the size of stock option grants, many seem to be implementing reductions across the board, although it is not clear from the responses if lower-level employees will feel the brunt of the cuts while the value of top management’s long-term incentives remains intact.

The survey’s overall findings seem to indicate that, for many companies, the role of stock options in the compensation package will be diminished, and other forms of compensation (e.g., restricted stock) will gain more prominence.

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