Frontline Reaction to FASB 123(R)

EXECUTIVE SUMMARY

The issuance of FASB Statement no. 123(R) forced companies to make several important decisions about their use of stock options as a compensation tool, to select the right valuation model and minimize the impact on financial reporting and public disclosure. A survey showed companies are decreasing their use of options and increasing their use of restricted shares and restricted stock units since FASB issued Statement no. 123(R). Some 61% of companies eliminated or decreased their use of options at all levels; another 26% did so only for nonexecutives. While 56% of companies considered using the binomial model to value their stock options, 86% ultimately elected to use the Black-Scholes-Merton model. The former requires more work with binomial model users dedicating an average of 85% more resources to Statement no. 123(R) compliance than Black-Scholes-Merton users. As expected, nearly 60% of surveyed companies were including in their financial statements pro forma disclosures excluding the Statement no. 123(R) expense or supplemental disclosures explaining the expense amounts. The vast majority—by a nearly 5-to-1 margin—were opting for supplemental disclosures. Many companies are taking a second look at their compensation strategies to see whether they can provide comparable value at a lower accounting cost. Many over-used fixed options because of the previous advantageous accounting treatment. These companies are now cutting the number of options granted or reducing their statutory life. Steven Balsam, CPA, Ph.D., is professor of accounting and Merves Research Fellow, Fox School of Business, Temple University in Philadelphia. His e-mail address is drb@temple.edu. Sebastian O’Keefe is a senior analyst and Mark M. Wiedemer is the senior research director with the Controllers’ Leadership Roundtable program of the Corporate Executive Board in Washington, D.C. Their e-mail addresses are okeefes@executiveboard.com and mwiedemer@executiveboard.com, respectively.

More than a decade after FASB first proposed mandating the expensing of employee stock options, Statement no. 123(R), Share-Based Payment, became effective for fiscal years beginning after June 15, 2005. It has had a major impact on public companies, as well as on their internal and external accountants and the other professionals who help implement stock option programs. This article describes how affected corporations are reacting to Statement no. 123(R), so readers can benchmark their own actions. Using data from a survey by the Controllers’ Leadership Roundtable, the article addresses issues such as Statement no. 123(R)’s effect on compensation structure; valuation models and assumptions; and on public disclosure and reporting.

THE IMPACT OF FASB 123(R)
Many of the objections companies initially had about expensing stock options related to the effect on their financial statements. High-tech companies in particular have made significant use of options and were concerned about the impact on their stock price and their ability to raise capital and recruit employees. Among the steps businesses might be expected to take to minimize that impact are reducing the number of options granted, reducing the per-option cost or making the direct effect of Statement no. 123(R) more transparent for financial statement readers. (A company can reduce per-option costs by changing the terms of the option or the valuation assumptions.) But companies must take steps to avoid potential abuses.

THE EFFECT ON COMPENSATION STRUCTURE
The Controllers’ Leadership Roundtable survey showed corporations reacted to Statement no. 123(R) by decreasing their use of options and increasing their use of restricted shares and restricted stock units. Some 39% of responding companies said they had changed their use of options as a result of Statement no. 123(R). These companies reduced the use of options, with the majority (61%) eliminating or reducing the use of options at all levels. Another 26% eliminated or decreased options only for nonexecutives. Overall, respondents reported that 15.7% of employees received options before Statement no. 123(R), whereas only 13.2% received them after, a 16% drop.

To compensate employees for the decrease in stock options, 44% of companies increased their use of restricted stock. Of the 33% of companies that did not use restricted stock before Statement no. 123(R), slightly more than half began using it after. This shift is consistent with the statement’s intended effect of leveling the accounting playing field; as FASB removed the favorable accounting treatment for options, companies shifted to other forms of compensation that may be better for nonaccounting reasons. For example, when compared with options, restricted stock usually results in less dilution of existing shareholders’ ownership, since a restricted share—effectively an option with a zero exercise price—is worth more than an at-the-money option, meaning the company needs to grant fewer shares to provide the same level of compensation.

Statement no. 123(R) also has affected stock purchase plans. Roughly one in four (26%) survey respondents either eliminated the plan or modified its terms by reducing the market discount or reducing or eliminating the look-back provision. The market discount is the difference between the market price and the price at which the employee can buy shares. The look-back provision allows an employee to buy the shares at the lower of the market price (or a fraction thereof) on the date of grant or on the date of exercise.

VALUATION MODELS AND INPUTS
Although the majority of companies in the study (56%) considered using the binomial model to value their stock options, 86% ultimately elected to use the Black-Scholes-Merton model. Respondents clearly felt the binomial model required more resources to implement, a sentiment echoed by data, which showed 50% of companies using a binomial model outsourced the option valuation process. Binomial model users that did the valuation in-house dedicated an average of 85% more resources to Statement no. 123(R) than did Black-Scholes-Merton users.

During the Roundtable’s teleconference (see “Data Collection” sidebar), one participant said his audit firm discouraged the company from using the binomial model, as the auditors were concerned about their ability to effectively audit the results. Several other participants echoed this view during informal conversations. To minimize complexity and implementation costs, almost two-thirds of responding corporations grouped all employees together when evaluating exercise behavior for the expected life calculation required by Statement no. 123(R).

We found the vast majority of companies used either historical volatility or some combination of historical and implied volatility as the volatility input in their option valuation model. A substantial portion—40% of survey respondents—reported reducing the volatility assumption post-Statement no. 123(R), with the effect of decreasing compensation expense. In contrast, only 9% reported increasing volatility.

In perhaps the survey’s most surprising finding, companies were more likely to increase the expected life of their options than decrease them, by a 3-to-1 ratio. This is surprising because increasing the expected life increases the compensation expense associated with the option. A possible explanation is that more rigor and detail are now attached to the calculation of this input as the expense moved from the footnotes to the balance sheet and companies and their auditors evaluated the inputs more thoroughly.

One thing we did not observe was companies modifying the terms of their stock option grants. While reducing the option term presumably would allow a company to decrease the option’s expected life and the associated expense, only six companies reported such a change—all to seven years from 10 years.

DISCLOSURE
When it comes to the presentation and disclosure of Statement no. 123(R)-related expenses, we expected to see a large percentage of companies including either a pro forma disclosure excluding the Statement no. 123(R) expense or a supplemental disclosure detailing the expense amounts. This expectation was based in part on the lack of a uniform approach by various ratings agencies and financial analysts in their treatment of Statement no. 123(R)-related expenses and many companies’ opposition to the expensing concept and application of the expense treatment. Corporate reaction has been fairly consistent with our initial expectations—nearly 60% of surveyed companies included either pro forma disclosures excluding the Statement no. 123(R) expense or a supplemental disclosure explaining the expense amounts.

The vast majority of companies that do make such inclusions, by a nearly 5-to-1 margin, included just supplemental disclosures, rather than creating pro forma financial statements. We observed a consistent approach to disclosure by companies within several of the same industries. For example, in the insurance industry, more than 80% of companies included only U.S. GAAP numbers, while nearly 90% of financial services companies included supplemental information. Interestingly, while we expected to see a more consistent approach among technology companies, there was more diversity in their disclosure practices than in other industries.

“OPTIONS” TO CONSIDER
Based on the survey results and other factors, CPAs should keep several things in mind as they help employers and clients implement Statement no. 123(R).

Compensation considerations. Companies should continue to tailor their compensation programs not only to minimize the accounting cost, but also to maximize the benefits in terms of employee motivation and retention. Managers should not rush into drastic changes in response to Statement no. 123(R).

CPAs should help companies carefully analyze compensation plans to see whether they can provide comparable value at a lower accounting cost. Companies should first consider whether they were overutilizing fixed options because of the advantageous accounting treatment. If they did, they should consider cutting the number of options granted. Then look at the statutory life of the option. Historically most options have been granted with a statutory life of 10 years. Since few employees hold on to their options that long, companies should consider reducing the statutory life and consequently the expected life as well.

CPAs should also encourage companies to look at the use of performance-based options. Previously at an accounting disadvantage because they were treated as variable compensation, the disadvantage now has been removed. Given that companies recognize expense only on the options that vest, performance-based options also may generate lower expenses in periods of poor performance.

Evaluate the binomial model before adopting. Companies still trying to decide on an appropriate valuation model should carefully consider the implications of their choice. Although the binomial model is said to produce a more “accurate” valuation of options, it requires roughly 85% more resources and the participation of external consultants to develop a valuation model. The complexity of the model and related calculations may create resistance from external auditors as many engagement groups lack the skills to assess a binomial model, and its inputs and outputs.

Software vendors still working out the kinks. Some 80% of survey respondents said they had developed manual work-arounds to address software shortfalls. Companies should not wait for one-size-fits-all software resources and should instead become comfortable with work-arounds, as they may be necessary for the foreseeable future.

» Practical Tips

Don’t make drastic changes in the company’s compensation programs in response to Statement no. 123(R). Rather than letting the accounting treatment drive compensation practices, design a package that maximizes the value to employees while minimizing the cost to shareholders. Since few employees hold options for the typical statutory life of 10 years, consider reducing this period to seven years or less. Don’t wait for vendors to develop a one-size-fits-all software resource. Become comfortable with necessary work-arounds until vendors can develop comprehensive programs for option valuation and tracking.

MORE CHANGES COMING
The trends documented in the survey likely will change over time. More companies are likely to consider modifying option terms as the impact of Statement no. 123(R) becomes better understood. Over time, companies likely will pull away from providing supplemental disclosure around stock option expense numbers as the analyst community adopts a more consistent approach to this line item. Still, the swiftness of the response to date is impressive and indicative of the degree to which businesses anticipated the changes FASB made.