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It seems there’s plenty of time to keep the debate raging over whether and how to treat employee stock options as an expense.
The Financial Accounting Standards Board appears to be making some progress on that front. In a recent decision, the board unanimously voted in favor of expensing stock options. But it is only the first of many moves as FASB looks to issue an exposure draft on the matter later this year. A final draft is being eyed for 12 months from now, but the stock-based compensation project, concedes Michael Crooch, FASB board member, has been “a little bit of a moving target.”
Today, the board is scheduled to discuss measurement and attribution issues related to stock-based compensation transactions. At its April 22 open meeting, the board has tentatively determined, among other things:
- That the exchange of goods or services received for stock-based compensation should be measured at the grant date and
- That the measurement attribute for the exchange is fair value.
In today’s meeting, Crooch says he and his FASB board members will determine “how to attribute the cost of the options over the vesting period so that the cost of the option plan can be charged to income each period.”
One choice, he says, could involve spreading the value equally over the vesting period of the stock option grant.
Alternatively, the board may allow companies to make certain assumptions in their calculations that effectively lower the value of the options expense. For instance, a company would not have to account for options granted to a number of employees who management figures will leave the company before the vesting date and thus forfeit their options. Managers could then “true up” or adjust the estimates, Crooch says, if they were wrong because more or less employees left the business.
FASB is reexamining accounting for stock options in the wake of several high profile accounting scandals where corporations used stock options to avoid paying U.S. taxes while overstating earnings. Aside from the stock option abuse, the board is also looking to provide new rules that converge with international accounting standards, as well as address the general disenchantment with today’s employee stock option valuation methods.
Crooch notes that the board has already spent a lot of time on stock-based compensation and valuation of employee stock options in the early ’90s. Given that, FASB’s advisory panel of valuation experts will look for “any breakthroughs since the last time that will help us get a better measurement.”
Still, many managers at high-tech companies — companies which freely issued high amounts of stock options in the last decade to recruit and retain employees — continue to rail against FASB’s recent decision to expense options. It’s not hard to see why: The final change to GAAP could reportedly see some companies’ earnings cut in half.
Indeed, John Chambers, CEO of Cisco Systems Inc., warned last week that the U.S. technology sector will be badly hurt if IT companies are forced to book stock options as a business expense. According to a Reuters report, Chambers claims “jobs would go in the first decade, followed by companies.” Reportedly, 80 percent of Cisco stock options are awarded to employees below the vice president level.
Some other critics charge that the negative impact on reported earnings would require cuts to stock option grant programs — as it already has for Dell Computer. Last month, Dell reportedly announced its intent to scale back stock options issuance by about half.
Of course, even a scaled-back options program will require an accurate pricing model. And many critics of options expensing say no such animal exists. Black-Scholes, the standard gauge for pricing options, has been widely criticized by executives and auditors for overstating the value of employee stock options.
Why the bump up? Mostly, because the model is built on options that are short-term and marketable. Typically, employee stock options are neither. The assumptions required for Black-Scholes prices also are subject to a high degree of judgment and variability that can make the output inconsistent, or worse, subject to manipulation.
FASB’s advising panel of valuation experts (specifically established to address the valuation issue and consider alternative methodologies) is expected to meet for the first time later this month. Other employee stock option-related topics on the Board’s agenda: income taxes, disclosures, effective dates, and transitions.
Apple Shareholders: Expense Sooner Than Later
Meanwhile, in a reported first for stock option expensing-averse Silicon Valley, Apple Computer’s shareholders approved a nonbonding measure advising management to put the options costs on the books — rather than the currently allowed footnote to the income statement. This, according to a recent Reuters report, which notes that Apple management hasn’t indicated whether it will follow its shareholders’ advice.
Earlier this year, Apple CFO Fred Anderson voiced concern for inadequacies inherent in available option-pricing models, including Black-Scholes. In a letter to FASB, he asserted Black-Scholes “overstates the value of employee stock options by a factor of two to three times.” He added: “Reflecting these inflated values in either pro forma disclosures or as a recognized expense has an inappropriate impact on financial statements.”
Stock option expensing measures have reportedly passed at NCR, PPG, U.S. Bancorp, Kimberly Clark, Weyerhaeuser, and Delta Airlines. Similar proposals by shareholders of other tech companies (including Hewlett-Packard and IBM) failed by narrow margins.
But Richard Shields, CFO at Southwest Water Company, is happy to grin and bear the flaws in the option-pricing model — at least until FASB offers up something better. Southwest Water became one of a select few to recently announce it would account for employee stock options as an expense and retroactively adjust its earnings for the past several years. Not surprisingly, the hit to the company’s earnings is far less dramatic than it would be to many tech companies. Currently, stock options comprise just 3 percent of Southwest Water’s outstanding shares.
“Our analysis is that expensing stock options doesn’t have any impact on our ability to pay dividends,” Shields says. “It improves visibility and supports our objectives of showing that we are a company with outstanding corporate ethics.”
Shields, however, knows he’s in a fortunate position. “I think it would have been different in a tech company,” he adds, noting that because depreciation and amortization are large portions of Southwest’s business, “investors are more used to taking a look at cash flow from operations and Ebitda than perhaps some tech companies.” The company’s stock price also hasn’t seen the historical volatility of Silicon Valley businesses — businesses which will see higher expenses under Black-Scholes because of that beta.
Not surprisingly, Shields calls Black-Scholes “a decent estimate of a stock option expense” and a “respected methodology for companies moving onward, expanding disclosure and reporting.”
Crooch also takes issue with critics who argue that FASB is “rushing to an answer” on requiring companies to expense stock options. He responds: “Were taking it very seriously, and we’re going to go through our administrative procedure on each step.”
On the Calendar
• Wed, May 7: FASB Open Meeting
Skinny: In this go-round, the standards-setting board will review several hot-button topics, including (as mentioned above), the expensing of stock options. Also on the FASB agenda: revenue recognition, liability extinguishment/broad performance views, and short-term convergence. The convergence discussion will examine whether FASB should fall in line with the IASB, which maintains that excess idle capacity and spoilage costs are period costs that should not be included in the cost of inventory. FASB will also look at the topic of business combinations — or more specifically, how measuring the fair value of assets acquired and liabilities assumed might be applied to transactions and events other than a business combination.