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).
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Data
Collection
We sent a 36-question
survey via e-mail to
representatives of the
650-plus organizations who
belong to the Controllers’
Leadership Roundtable research
program run by the Corporate
Executive Board. The
roundtable’s membership spans
industries and auditors and
includes organizations with
annual revenue in excess of
$750 million. Some 132
corporations responded to the
survey, although not all
respondents provided answers
to each question. The survey
then was followed by a
teleconference that both
conveyed the results to
roundtable members and
elicited further understanding
of the issues and responses.
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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.
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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.
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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. |