An Acquired Expense

Rolling over unvested options in a merger is no longer a matter of goodwill.

Last year, the Financial Accounting Standards Board issued FASB Interpretation No. 44, on accounting for stock options. Intended to clarify the board’s stand on options accounting under previously established rules, FIN 44 has made its biggest mark so far in the area of stock option repricing. It has made the repricing of underwater options to a lower exercise price potentially prohibitive, because it requires that the repriced options be treated under variable accounting, in which they are marked to market.

But FIN 44 is having an effect on mergers and acquisitions, too. Effective for deals completed as of July 1, 2000, the rule also requires that companies that employ purchase accounting treat the unvested stock options of the acquired company differently than the vested stock options. In the past, companies could lump both into goodwill, which was then amortized over a period of up to 40 years. Now, a portion of the value of the unvested stock options must be booked as unearned compensation and charged against earnings over the remaining vesting period, which is usually just a few years.

Certainly, the charge is never large enough to be a deal-breaker. But in some cases, it could amount to a significant expense to be taken against earnings in the first few years after an acquisition–when management is especially keen on proving the wisdom of the merger. So far, at least, analysts and consultants say that the charge has not been a burdensome one.

To date, the greatest impact FIN 44 has had on M&A has been indirect, in the designing of stock option plans. Since, under the rule, changes in an existing stock option plan can lead to a compensation expense, companies need to be more explicit from the start about what happens to vesting in the case of an acquisition or any other eventuality. Beginning July 1, however, FIN 44 should gain more weight in M&A situations. That’s when pooling-of-interests accounting will be banned. In the future, FIN 44 will apply more often in acquisitions, and the effects of the unearned-compensation expense on earnings will become a lot more visible.


In an acquisition, the acquirer frequently rolls over the target company’s stock options into options on its own stock (“rollover options”). In FIN 44, FASB dealt with the issue of where to put those options on the financial statements. The board’s reasoning was that unvested options, rather than being categorized solely as goodwill, also in part represent compensation for work not yet performed; therefore the portion of those options representing the remaining unvested part should be booked as unearned compensation and expensed as it is earned. What’s actually booked as the compensation expense is a portion of the spread between the price of the stock at the closing of the deal and the exercise price–the so-called intrinsic value.

So far, few companies have been affected by the merger side of FIN 44. For one thing, since the measure took effect, stocks have fallen and merger fever has cooled considerably. “FIN 44 is a significant change,” says Andrew Nussbaum, a corporate partner at Wachtell, Lipton, Rosen & Katz, in New York, “but the demise of the Internet stock bubble has mitigated the issue to a degree.” What’s more, the market’s tumble has wiped out option spreads at many companies. And if a target’s stock options are under water, the acquirer takes no charge at all on the unvested options, because they have no intrinsic value.


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