STOCK OPTION
ACCOUNTING:

“Déjà Vu All Over Again”

By Professor Terry Warfield

In the wake of the dot-com and general market meltdowns caused by accounting, audit and disclosure weaknesses, the Sarbanes-Oxley Act of 2002 was passed and is getting fairly good reviews from management, regulators and investors for restoring trust in our capital markets.
Congress and market regulators, however, are still calling for action by the Financial Accounting Standards Board (FASB) – the private-sector setter of accounting standards – to address the “gaps” in GAAP (generally accepted accounting principles). Ten years ago, the FASB first proposed that companies be required to expense the cost of stock options, only to back off in the face of pressure from business (especially high-tech firms) and Congress. Last March, FASB issued a new proposal that, if adopted, would significantly change the accounting for stock-based compensation. The proposal generated considerable controversy and in October, FASB announced a six-month delay in the long-awaited plan.

At this point, mandatory expensing of stock-option pay would not begin until the third quarter of 2005 for companies with calendar fiscal years, and opposition to the proposal may build to the point that federal legislation is passed to block the proposal for good. Let’s examine this controversial accounting proposal and see how its development has been a great learning vehicle for our accounting students here at the School of Business.

New Accounting for Stock Options
Historically, accounting rules permit companies to report little compensation expense when stock options are issued to employees in exchange for services. This is because expense for stock options is based on the “intrinsic value” of the option on the date of grant. Intrinsic value is the difference between the market price of the stock and the option price – the price at which employees can purchase company shares. By issuing options to employees “at the money,” the intrinsic value is zero and no compensation expense is recorded. Not surprisingly, most stock options are issued at the money and as a result, the expense related to stock options is left out of income.

To address this omission, the FASB has proposed required expensing with measurement of expense based on fair value of the options granted. The expensing requirement would have a significant impact on income. One recent study by Bear, Stearns estimates that 2003 operating income of the S&P 500 would have been 8 percent lower had options been expensed.

How does the FASB, a private, independent body, decide whether to issue a new standard? The Board solicits input on its proposals, receives comment letters and holds public hearings. The FASB commonly conducts field studies to gather information on possible implementation issues on proposed rules. Only after considering all input does the FASB issue a standard.

Where from Here
To date, after receiving input on its proposal, the FASB appears headed toward approving a standard requiring the expensing of equity-based compensation. Not everyone agrees that stock-based compensation should be included in income. Those opposed to expensing stock options generally cite the following reasons in testimony to the FASB: 1) the cost of employee options is dilution of existing stockholders’ equity, and therefore it should not be reported as an expense; 2) existing models for measuring the actual compensation are inaccurate and therefore misleading; 3) expensing stock options will distort the company performance because it is a non-cash charge.

In contrast to when the FASB last proposed expensing options in the early 1990s, even most opponents today agree that some expense should be recorded for equity-based compensation. However, this has not stopped a minority of financial reporting constituents from mounting a “full-court press” on the FASB to halt the issuance of the proposed standard. In addition to lobbying the FASB, these opponents have lobbied Congress. For example, a recent bill passed in the House of Representatives would override the FASB standard and require companies to expense only the options issued to the top five managers (a similar bill is pending in the Senate). These opponents (represented primarily by companies in technology companies, which are heavy users of compensatory stock options) also argue that by requiring expensing of all options, companies will stop issuing options, negatively affecting their competitiveness.

Others, including the chairman of the SEC, the four largest public accounting firms, Federal Reserve Board Chairman Alan Greenspan, major investor groups (and this author) support the FASB’s proposal, noting that options are an expense just as cash compensation is an expense. Goods and services received in exchange for stock options result in a cost and should be recognized as such in the financial statements. Because a valuable financial instrument is being exchanged for employee services, fair value is the most relevant measure of compensation cost. The proposed standard would treat stock-based compensation like other forms of compensation, which is faithful to the economic substance of stock-based compensation arrangements and would increase the ability to compare information reported about stock-based and cash compensation plans. These are the important qualitative characteristics that contribute to the usefulness of financial statements.

Changes in the economic and financial reporting environments in the past 10 years also reinforce the need for an enhanced standard. Most notable are recent business and accounting failures mentioned earlier. During the late 1990s, we witnessed numerous business, auditing, and accounting failures, which raised new concerns about, and demand for, high quality and transparent accounting practices. To many, the accounting for stock-based compensation is an example of less than transparent accounting, by omitting from financial statements an important cost of business. Indeed, beginning in 2002, a number of companies began to voluntarily switch to the fair value method for recording compensation expense related to stock options; by June of 2004 over 600 public companies were using the fair-value method. A major reason for this change was to show the investing community that these companies believed in fair and transparent financial reporting. However, because some companies include stock-based compensation expense in income and others only disclose the pro-forma effects, comparability concerns have been raised.

For all of these reasons, there is broad-based support for the FASB’s proposal. I believe the FASB’s decision to require stock option expensing in 2005 will strengthen investor confidence in the financial statements of all companies, thereby lowering their cost of capital. The efficient allocation of capital depends on high-quality accounting.

Political Considerations
Opponents of the proposal are pursuing political means to affect the outcome of the accounting standard-setting process. A bill to block the FASB’s rule change was passed by the House this past summer (although the Senate so far has refused to take up the bill). These efforts are unfortunate because they may undermine the authority of the FASB at a time when it is essential that we restore faith in our financial reporting system. Indeed, I believe that political pressure on the development of accounting standards, and in particular, assailing the FASB’s role as an independent body, have contributed to the chain of events that led to the corporate scandals of the last several years.

It is important to understand that transparent financial reporting – by recognizing stock-based compensation expense – should not be criticized because companies will report lower income. We may not like what the financial statements say, but we are always better off when the statements are faithful to the underlying economic substance of transactions. Various legislative proposals that call for reporting only part of the expense for stock options in income – are not. Some proposed bills might even preclude companies that have recently begun voluntarily expensing the cost of options from reporting the full cost of their compensation plans
As we teach students of accounting, such reporting is biased – it may be in the interests of managers of some companies but it does not well serve financial reporting or our capital markets. Biased reporting not only raises concerns about the credibility of these companies’ reports, but of financial reporting in general. Consider companies that do not use stock options. Why should they be made to look worse because they use a different form of compensation? As we have learned from Enron, WorldCom, and other recent failures, credibility of financial reporting is fundamental to the efficient operation of our capital markets. Even good companies get tainted by biased reporting of a few “bad apples.”

An additional source of bias in financial reporting arises when political interests attempt to circumvent the due process in the setting of accounting standards in the private sector.

A Great Learning Opportunity
The unfolding controversy over stock option accounting has provided a great learning opportunity for our students. It provides a great case study on the important accounting concepts of relevance and reliability and helps illustrate how each contributes to the usefulness of accounting reports. This issue also drives home the importance of life-long learning and continuing professional education. Within the past 25 years, professional accountants have had to stay informed on changes in accounting standards in this area at least three times. The issue also illustrates the importance of the political process and its impact on accounting standards and practice. Students can see the importance of the FASB’s due process.

Accounting standards can affect behavior. They need to be conceptually sound and accepted by those affected by them. It is my hope that political pressures do not override good accounting.