No Longer an Option

FASB mandates how companies should account for share-based compensation.

BY TIM V. EATON AND BRIAN R. PRUCYK
April 1, 2005

EXECUTIVE SUMMARY
IN DECEMBER 2004, FASB ISSUED ITS NEWEST standard, Statement no. 123(R), Share-Based Payment. It is proving to be as controversial as its predecessors. The most significant change is the requirement that companies use the fair value method to account for share-based compensation.

STATEMENT NO. 123(R) ELIMINATES THE USE of the intrinsic value method of accounting for share-based payments under APB Opinion no. 25. Many companies had continued to follow it even after FASB issued Statement no. 123 in 1995.

TO FOLLOW THE FAIR VALUE METHOD, most companies will have to use an option-pricing model to estimate the fair value of employee share options. There are several methodologies to choose from, including a closed form model or a lattice model. Most companies that currently use the fair value method use Black-Scholes-Merton, a closed-form model.

ALL MODELS RELY ON A NUMBER OF ESTIMATED items—including the exercise price of the option, its term, the current market price of each share of underlying stock, expected volatility and dividends and the risk-free interest rate—that can greatly influence the fair value of share-based compensation.

CPAs CAN EASILY CHOOSE SEVERAL MODEL components while others are more complex and rely on forward-looking information. Companies can begin by examining historic information but should make appropriate adjustments to reflect the future.

TIM V. EATON, CPA, PhD, is associate professor of accounting at Marquette University in Milwaukee. His e-mail address is tim.eaton@marquette.edu . BRIAN R. PRUCYK, PhD, is assistant professor of finance at Marquette University. His e-mail address is brian.prucyk@marquette.edu .

he controversy over accounting for stock options and similar compensation continues. While the wounds from the fight over FASB Statement no. 123 a decade ago are still healing, FASB issued a revised standard, Statement no. 123(R), Share-Based Payment, in December 2004. The board said its goal was to provide investors and other financial statement users with more complete and neutral information by requiring companies to recognize the compensation cost related to share-based transactions in their financial statements.

Initial reaction to the standard shows the debate over the best way to account for share-based compensation has not been fully resolved. Congress, corporations and individuals have voiced strong concerns about the new rule. In September 2004, the FASB Web site listed over 6,500 comment letters on the exposure draft for Statement no. 123(R); a typical ED generates fewer than 100. CPAs will find the revised standard will have long-term implications for their clients or employers. This article explains the important details of the statement and offers CPAs some suggestions for implementing its provisions.

Voluntary Compliance

FASB says approximately 750 public companies in the United States are voluntarily applying the fair value method of accounting for share-based payments in Statement no. 123 or have announced plans to do so.

Source: FASB, Norwalk, Connecticut, www.fasb.org .

A BRIEF HISTORY OF STOCK OPTION ACCOUNTING
In 1972, the Accounting Principles Board issued Opinion no. 25, Accounting for Stock Issued to Employees. It used an intrinsic value method of valuing stock compensation. The basic methodology involved calculating the difference between the market price of the underlying stock and the exercise price of the options on the date the company granted them. For example, an option to purchase a share of stock with a market price of $50 on the grant date and an exercise price of $40 would have an intrinsic value of $10. This method allowed companies to recognize no compensation cost assuming they met certain criteria. Although issued more than 30 years ago, until very recently most companies chose to continue following Opinion no. 25 for financial reporting purposes.

The genesis of the new standard goes back to 1993 when FASB issued an ED on stock-based compensation that changed the emphasis from the intrinsic to the fair value method of valuing stock options. Under this approach the option value (and related compensation expense) was based on the market price of an option with the same or similar terms (when available) or estimated using an option pricing model (applicable to most companies). The option we referred to above that had an intrinsic value of $10 would have a fair value of $18.34, using the Black-Scholes-Merton Model discussed in detail below.

Black -Scholes-Merton at a Glance

Under tremendous pressure, FASB issued Statement no. 123 in 1995. It encouraged but did not mandate companies’ use of the fair value method to determine compensation expense on the income statement. As a result of having this option, most companies continued to use the intrinsic value method to report compensation expense.

In 2003, members of Congress developed the Stock Option Accounting Reform Act, which would challenge FASB and mandate how companies should account for share-based compensation. To date no legislation has passed. In the midst of the controversy FASB issued Statement no. 123(R) late last year. (See “Official Releases,” page 91.)

THE REQUIREMENTS
Statement no. 123(R) covers a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights and employee share purchase plans. Some of its key requirements include

Companies are required to use the fair value method to value options and other share-based payments. This means they will recognize compensation cost based on the fair value of equity instruments issued for employee services on the grant date.

This valuation should be based on the observable market price, when available, of an instrument with the same or similar terms.

Since such a valuation usually is not available for most share-based payments, FASB recognizes that most companies will use an option pricing model to estimate the value.

FASB does not require a specific option pricing model. However, any model a company uses must incorporate a variety of factors, including the exercise price of the option, the term of the option, the current market price of each share of underlying stock, expected volatility and dividends and the risk-free interest rate.

Once estimated, the company should recognize the determined compensation cost over the period in which an employee provides service to receive the award (known as the requisite service period).

Public companies must use fair value to measure liabilities in share-based payment transactions. Nonpublic companies, however, may use intrinsic value.

The statement also requires certain disclosures to help financial statement users. These include the details of any share-based compensation arrangements the company offers, their effect on compensation cost on the financial statements and what methodology the company used to estimate the fair value.

Effective dates. Most public companies must implement the new rules as of the start of reporting periods beginning after June 15, 2005. Public entities that file as small business issuers and nonpublic companies have extra time; they must apply Statement no. 123(R) for the first annual reporting period after December 15, 2005.

HOW TO IMPLEMENT THE STATEMENT
In addition to knowing the basic requirements of the new standard, CPAs must familiarize themselves with some important technical terms. These are listed in a glossary . For most companies the next step will be to decide which option pricing model to use. In making this decision CPAs should understand that employee share options differ from the usual exchange-traded options most models were developed to value in a number of ways. The most notable are that the employee options are nontradable and must be used exclusively by the individual to whom they were granted.

Glossary of Key Terms
Binomial model. A lattice model (see below) where the asset price can change to only one of two possible values in the next time period.

Black-Scholes-Merton model. A specific closed-form valuation model for options that cannot be exercised prior to maturity.

Closed-form valuation model. A model where an estimated fair value can be calculated by plugging numbers into an equation.

Expected volatility. The expected fluctuation in the price of a share of stock over the period for which a company is valuing an option. It usually is measured as the standard deviation of expected continuously compounded rates of return on the stock.

Fair value. The amount at which an asset (or liability) could be bought or sold (or settled) in a current transaction between willing parties.

Intrinsic value. A value determined by taking the fair value of the underlying security and subtracting the exercise price of its corresponding option.

Lattice valuation model. A model where the asset price can take on only a discrete number of values in the next period. The derivative security is valued based on these asset prices by recursively working back through the model from the derivative’s final maturity.

Option pricing model. A valuation technique based on established principles of financial economic theory to estimate the fair value of employee stock options and similar instruments.

The choice of which model to use is a critical decision for CPAs and their employers or clients. FASB discusses two basic models—closed-form and lattice. Each has its own advantages and disadvantages. The most common closed-form model is Black-Scholes-Merton; companies may wish to use it precisely because it is the most common option pricing model in practice today. Besides providing greater comparability with other companies that also employ it, it is easier to apply because it is a defined equation. (See “ Black-Scholes-Merton at a Glance .”) CPAs also easily integrate the model into a spreadsheet. Black-Scholes is an acceptable method according to Statement no. 123(R).

Some CPAs may feel a lattice-type model is a better choice for their companies. In fact, FASB originally recommended the lattice model as preferable but backed down after receiving public comment. The most common lattice model is a binomial one. Although companies use it less frequently, some argue the binomial model provides more accurate estimates of option compensation expense because it can take into account more assumptions (early exercise behavior) than Black-Scholes and can incorporate multiple inputs (volatilities), whereas Black-Scholes can only incorporate one set of inputs. However, these same characteristics also make it more complex. In fact, some companies may not have staff with the technical expertise necessary to integrate a binomial model into their option pricing activities.

Once they have selected a model and begin to make the transition to the new standard there are some practical tips CPAs should consider.

Valuing compensation expense is not simply a matter of plugging the “right” numbers into a model. Many of the components are quite complex and involve forward-looking information. While historic information can be a good starting point and may be a reasonable indicator of what to expect, companies should not rely on it alone. Instead CPAs should make appropriate adjustments based on a company’s future.

In calculating meaningful estimates of option value it’s very important to use a consistent verifiable method to estimate the parameters of any valuation model. The approach a company uses should account for most of the factors that have an impact on the input being estimated. For example, in estimating the weighted-average-life of an option using the Black-Scholes-Merton model, CPAs should explicitly account for any period over which the option cannot be exercised and for any predictable employee exercise patterns of which they are aware.

The length of time over which a company computes share price returns can play a significant role in the expected volatility input to the model. For example, companies can use daily, weekly or monthly prices in calculating returns. In most cases the shorter the time period the returns are measured over, the higher the resulting volatility estimate. When estimating the value of an option with an extended time to maturity, CPAs should recommend a longer measurement period (monthly) to produce more consistent results.

PRACTICAL TIPS TO REMEMBER
Statement nos. 123 and 123(R) include some new terminology CPAs should know as they begin to implement the requirements of accounting for share-based compensation.

Many of the models companies use to value share-based compensation arrangements are complex and require CPAs to input forward-looking information. While historic information can be a good starting point, without appropriate adjustment it may not be a reasonable indicator of the future.

When companies are estimating the value of an option with an extended time to maturity, CPAs should recommend they use a longer measurement period to produce more consistent valuation results.

UNRESOLVED ISSUES
The new standard does not answer all of the questions about share-based compensation. Statement no. 123(R) still permits companies to choose which option pricing model they use. Different ones produce different levels of compensation expense. FASB may need to address this lack of comparability by requiring companies to use a specific model. Another concern is that within each model companies can use various estimates based on expectations. As each estimate changes, the compensation expense can vary greatly. FASB will continue to gather feedback from the accounting profession, Congress and the public, making it unlikely the controversy over accounting for share-based compensation will go away anytime soon.

CASE STUDY
Scotts Co. Grows Into Good Governance

I t was back in 2002, in the course of long discussions about good governance and financial transparency, that Chris Nagel, CPA, CFO of the Scotts Co., and his CEO decided to start expensing stock options. The board of directors and the audit committee of the Marysville, Ohio-based company—the world’s largest manufacturer of horticultural products—agreed. And honestly, Nagel acknowledges, he thought every company soon would follow suit. “We took a reading of the tea leaves and thought this was the way the world was headed,” he says. “We wanted to show our investors we were trying to be transparent.” So Scotts took a hit for the third of its outstanding stock options that come due each year, charging about $5 million—roughly 3% of its $160 million pretax earnings—against its 2003 P&L. For 2005, accounting for all stock options will mean expensing $12 million on pretax earnings of $250 million, or about 5%, Nagel estimates.

The world did eventually catch up. With FASB Statement no. 123(R) on the horizon, Nagel shared his thoughts about his three-year odyssey into expensing stock options with JofA managing editor Cheryl Rosen.

It’s your third year of expensing options. What are you doing differently?
We had adopted Black-Scholes, but now believe binomial is the appropriate model for valuing options. A lattice or binomial model offers some improvement over Black-Scholes. To value options, you have to make assumptions about the likely term and volatility, and I think a lattice model captures those variables better. Luckily I’m not the guy who has to grind through the numbers.

Are you rethinking the whole idea of offering stock options as an employee benefit?
No, we still think options are a valuable tool for employee compensation. But we’ll be using a combination of restricted stock and stock options. With stock options, if the stock price goes down, the owner hasn’t really lost anything—the focus is entirely on the up side. We’ve seen that lead to abuses at many companies as they tried to manipulate earnings. So now our idea is to offer a combination of options and restricted stock. That better aligns the goals of our employees with those of our shareholders, because if the stock goes down, the shareholders are not really indifferent. They are really losing value and with restricted stock, so are our employees.

As part of his or her overall compensation, an employee might earn X in base pay and X in options. If we’re going to give $100,000 in option value, we can plug that into Black-Scholes and figure out how many options that is, or we can divide it by our current stock price and just give a number of shares. It’s unlikely to change the ultimate charge on our books, but it changes the employee’s focus. I think a combination of the two will produce the right balance.

Are you glad Scotts took a lead position on expensing options?
Being an early adopter put a burden on our P&L, but it was the right thing to do. I don’t think the market reacted one way or the other to our story—we hit our earnings growth target in 2003 even with the charge. I’m not sure we got any credit for good corporate governance. But every company’s major concern has to be the investor perspective, and we hope we did get credit in the minds of investors; we have no way to measure that. Next year will be nice, though, because the pain of adoption already will be behind us.

Any advice for your fellow CPAs implementing Statement no. 123(R) for the first time?
I suspect that in the first year companies will present pro forma earnings with and without the charge. But as they ramp this up over some vesting period I can’t imagine that many will be able to ask investors to accept this as a reason for lower earnings over three or four or five years. You have to view it as a cost you have to manage. You just have to accept it.

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