FASB Offers More Guidance on Stock Options
In March 2000, FASB released an interpretation on several implementation issues related to APB Opinion no. 25 on accounting for stock issued to employees. The guidance defined the term employee for purposes of applying the opinion and clarified accounting for options that have been repriced.
FASB Interpretation no. 44, Accounting for Certain Transactions Involving Stock Compensation, says that when a company directly or indirectly reprices its stock options it changes the terms of its stock compensation plan under the opinion, making it a variable plan. Edmund Jenkins, FASB chairman, said the interpretation brings needed consistency to the reporting of stock option awards and reduces the uncertainty over the appropriate accounting for option plans.
Interpretation no. 44 not only defines employee but also clarifies the criteria for determining whether a plan qualifies as a noncompensatory plan, the accounting consequences of various modifications to the terms of a previously fixed stock option or award and the accounting for an exchange of stock compensation awards in a business combination.
The interpretation says an individual is considered an employee if the company granting the stock options has control sufficient to establish an employer-employee relationship over him or her as defined by case law and IRS regulations.
Jenkins said the questions addressed in Interpretation no. 44 were not new and had been raised at times by preparers and auditors of financial statements since APB Opinion no. 25 was issued in 1972.
Jenkins also said the board based its guidance on the APB opinion and not on the concepts underlying FASB Statement no.123, Accounting for Stock-Based Compensation, issued in October 1995. Under APB Opinion no. 25, fixed option plans—whose terms, including price and number of shares granted, remain the same throughout the life of the plan—have no compensation expense associated with the options when the exercise price is equal to the fair value of the stock at the grant date.
Repricing—why companies do it
According to a knowledgeable industry observer, repricing is a sensitive issue—especially for high-tech companies that experience a lot of volatility in their stock prices.
It is not that those companies automatically have to reprice—it’s just that when the stock value falls, the options are significantly “out of the money” (that is, the option price is below the current price) and the companies are forced to issue options in lieu of cash compensation. In effect, the intrinsic value of an option disappears and a company must reprice to recapture value.
When asked whether more high-tech companies will be repricing, Dennis Powell, CPA, vice-president and corporate controller of Cisco Systems, said, “If a company experiences a decline in the value of its options—and that value is not likely to go up in the foreseeable future—it is going to lose all its employees. This could create a problem for the smaller technology companies.”
Take the case of XYZ Technical Corp., which hired Maria Patton on October 1, 1998. As a hiring bonus, it granted her an option to purchase 5,000 shares of the company’s stock at $25 a share—the closing price of XYZ stock on that date. On October 1, 1999, she was granted an option to purchase another 5,000 shares at $50 per share—the stock’s closing price on that date. By mid-January 2000, the price of XYZ stock had increased to $80 per share. Had she exercised her options at that time, Maria would have experienced a significant financial windfall.
In April 2000, XYZ’s stock price declined to $15 per share. Maria’s options were “out of the money” by $10 and $35 per share, respectively. Since the company’s future prospects were uncertain and her options now worthless, Maria started looking for another job. To persuade her not to leave, XYZ adjusted the price of her two option grants—as well as those of other employees—to $15 per share. Based on the guidance in Interpretation no. 44, XYZ now had a variable stock option plan and must account for it as such on its financial statements.
Impact on high-tech companies
Powell said the FASB position that a company directly or indirectly reprices its stock options when it changes the terms of its plan under Opinion no. 25—making it a variable plan—was an “unfortunate” one.
“A reasonable solution,” added Powell, “would have been to allow one repricing before you had a variable plan—which would have been accepted as a sound compromise.”
What is commonly referred to as the “cash burn” rate could affect the viability of dot-com companies. If they cannot raise additional cash through an offering or some sort of cash infusion from a venture capital company, they have to control compensation—which is probably their largest single cost.
The provisions of Interpretation no. 44 became effective July 1, 2000, and, with some exceptions, will apply prospectively to new stock option awards, exchanges and modifications and changes in status that occur on or after that date.