A New Solution to Accounting for Employee Stock Options

A NEW SOLUTION TO ACCOUNTING FOR EMPLOYEE STOCK OPTIONS

Overview

The public policy debate surrounding stock options revolves around important issues of workforce incentives and corporate governance, and from an accounting perspective, any change from the current methodology should improve, not impede, the understandability of financial statements for the average investor.

It is important to restate a basic principle. Shareholders should approve all stock based compensation plans and do so out of a desire to align their interests with the employees and management of the company. As regards stock options specifically, shareholders are willing to potentially dilute their share of future profits in exchange for the recipient’s contribution to driving performance. This is the transaction for which we need proper accounting.

We have developed an alternative approach to accounting for options that is well grounded in accounting theory and represents an effective middle ground between the supporters and critics of them.

This approach is built upon a new idea we call Stock Option Share Equivalents, or SOSE. Over the past nine months, we have refined the approach and vetted it carefully with institutional investors and experts on accounting, finance, corporate governance and economics. Regardless of whether they were for or against expensing options, all of the experts thought it had technical merit and represented a good compromise position.

Simply described, Stock Option Share Equivalents would be added to a company’s diluted shares at the time of their grant. The number of these new Share Equivalents is calculated by dividing the fair value of the grant by the company’s current share price.

Even proponents of expensing options agree: It is extremely difficult if not impossible to measure reliably fair value, which is a major problem when considering expensing stock options. Although the SOSE methodology is also dependent upon estimation of fair value, any inaccuracies are eliminated over time by a stock’s future performance. This “true-up” mechanism is consistent with accounting principles governing all other estimates in the financial statements.

Over the life of the option, the SOSE balance is reduced as the stock appreciates in value and actual dilution is captured. Even after the SOSE balance is reduced to zero, EPS dilution continues to be captured under fully diluted EPS calculations until the options are exercised, forfeited, or expire. If actual dilution turns out to be less than estimated at the time the options are no longer exercisable, the SOSE balance is removed from diluted weighted average shares outstanding.

This proposal has numerous benefits:

1. The granting of options will be immediately reflected in EPS.

2. The dilutive impact of the grants will not be double-counted in the company’s financial statements, as it would be with expensing.

3. Every company will recognize the dilutive impact of option grants upon award without respect to vesting, allowing for greater comparability of financial statements.

4. Net income will continue to match closely cash flow earnings.

5. Financial reporting will be more transparent.

This proposal is responsive to many constituencies—investors, analysts, compensation consultants, accountants, and the companies that would be responsible for its implementation—and we believe it is worthy of serious consideration.

We call upon U.S. and international standard-setters, regulators and policymakers to consider this and any other new alternatives around which a consensus can be built.

THE STOCK OPTION SHARE EQUIVALENTS PROPOSAL

As of the date of grant, the estimated future dilutive effect of new option grants must be reflected as a capital transaction and recorded as an increase in diluted weighted average shares outstanding, thereby decreasing earnings per share. The increase in diluted weighted average shares outstanding is defined as Stock Option Share Equivalents.

The number of Stock Option Share Equivalents to be added to diluted weighted average shares outstanding is determined by dividing the options fair value on the date of grant, per an acceptable valuation method such as modified Black-Scholes etc., by the company’s current share price.

The Stock Option Share Equivalents must be separately identified in the company’s reconciliation of diluted weighted average common shares outstanding and explained in the footnotes.

The calculation of common stock equivalents using the treasury stock method continues.

On a quarterly basis, the number of Stock Option Share Equivalents is reduced for any dilution that occurs under the treasury stock method.

Even after the Stock Option Share Equivalents balance is reduced to zero, dilution continues to be captured through the computation of common stock equivalents under the treasury stock method until the options are exercised, forfeited, cancelled or expire.

If there is a balance of Stock Option Share Equivalents at the time the related options are no longer exercisable (i.e., actual dilution was less than estimated dilution), they are removed from diluted weighted average shares outstanding.

Effect of Implementation

A current reduction of earnings per share will accompany each grant.

No phase-in period is required. The Stock Option Share Equivalents for all prospective awards will be fully recognized on the date of grant.

EPS, especially when compared over time, will be a more accurate representation of a company’s performance.

The granting of options, irrespective of the type (fixed, discounted, performance based, etc.) is immediately reflected in the calculation of earnings per share presented in each company’s income statement.

The dilutive impact of the grants will not be double counted in the numerator and denominator of the earnings per share calculation.

Every company will recognize the dilutive impact of option grants upon award without respect to the vesting of the awards, which will allow for comparability of financial statements.

Net income will continue to closely match cash flow earnings allowing for better comparability between companies and transparency in financial reporting.

Analysts will be able to track a company’s “grant rate” (i.e., the percentage of fully diluted outstanding shares due to options granted in the year).

Companies will be able to appropriately balance awards that deliver current incentive compensation with those that provide potential capital accumulation.

Illustrations

The Stock Option Share Equivalents approach to accounting for stock options calls for an increase in the calculation of diluted shares outstanding at the time of grant reflecting the estimated dilutive effect of options granted.

By using the Stock Option Share Equivalents approach, the effect of stock option grants will be reflected as a capital transaction and stock option grants will have an immediately dilutive impact on EPS.

The proposal calls for Stock Option Share Equivalents to be added to diluted shares outstanding at the time of grant. The number of Stock Option Share Equivalents is calculated by dividing the fair value of the grant per an acceptable valuation method (with inputs for relevant items such as the risk free rate, current stock price, exercise price, stock price volatility, stated maturity, expected life, vesting period and liquidity), by the company’s current share price.

Following is a simple illustration of the concept. The Stock Option Share Equivalents balance is established at grant. When the stock price rises value is created for option holders. This value is captured in the current fully diluted calculation through application of the treasury stock method. The Stock Option Share Equivalents balance is reduced by the number of common stock equivalents as determined by the treasury stock method. However, total diluted weighted average shares outstanding do not change.

Options Granted – Base Case

Now let’s assume the options were issued at a discount. Expense, as well as dilution, will be recognized for options issued at a discount (those where the exercise price is less than the quoted market price of the stock on the date of grant). Consistent with accounting for restricted stock under FAS 123; expense is recognized for the intrinsic value of the grant, which excludes any estimate of future appreciation.

Options Granted at Discount

If dilution under the treasury stock method exceeds the Stock Option Share Equivalents established at grant (the Stock Option Share Equivalents balance has been reduced to zero), dilution continues to be captured through the computation of common stock equivalents until the options are exercised, forfeited, cancelled or expire.

Additional Dilution Recognized

If there is a remaining balance at the time the related options are no longer exercisable, (i.e., actual dilution was less than estimated dilution), the Stock Option Share Equivalents balance is eliminated from the earnings per share calculation.

Basis for Conclusions

Purpose of an employee stock option

The purpose of an employee stock option is to align the interests of the option holder with those of shareholders. Stock options are issued to drive employee performance over a long period of time.

Value of an employee stock option

Unlike freely traded options, there is no market for employee stock options.

Their value can only be realized from exercise of the option.

The option cannot be sold or pledged as security and furthermore the employee must vest in the award.

If employee stock options are granted at fair market value, only future appreciation will create value that can be realized upon exercise. All shareholders enjoy this future appreciation.

If employee stock options are granted at a discount, the stock does not have to appreciate for value to be realized by the option holder.

If the share price remains below the exercise price for the term of the option, the options expire worthless.

“The value of stock options is directly related to the growth and growth potential of the employer stock” quoted from the Deloitte & Touche Executive Compensation Catalog.

Employees are awarded a right to a future ownership position in the company.

For all of the above reasons it is difficult to estimate the value of an employee stock option, but it is possible.

Accounting for the discount element in an employee stock option

Any discount given, calculated by subtracting the exercise price from the fair market value of the employer stock on the date of grant, should be expensed.

This expense treatment is consistent with the treatment of restricted stock. In fact, restricted stock is simply an option with a zero exercise price. It is a full value award and the full value on the date of grant is expensed. If the market value of a share of stock were $50 on the date of grant, a grant of a share of restricted stock would generate an expense of $50.

$50	Fair market value
-$0	Exercise price
$50	Expense

When restricted shares are granted only the intrinsic value is expensed, there is no attempt to estimate and expense the future appreciation in the stock.

Other examples of share payments where expense is limited to the intrinsic value of the shares on the measurement date include shares used for pension payments and charitable contributions.

Given the same $50 fair market value on the date of grant, a grant of an option to buy a share at $10 should generate an expense of $40.

$50	Fair market value
-$10	Exercise price
$40	Expense

It then follows that a grant of an option to buy a share at $50 should generate an expense of $0. There is no expense unless there is a discount.

$50	Fair market value
-$50	Exercise price
$0	Expense

Accounting for dilution

The actual dilution that will occur from a particular stock option is not known until the option is exercised and the increase in the company’s share price is known. At that time, the exercise price is paid in cash and the company issues the stock but is able to buy back a portion of the shares using the exercise proceeds. The net increase in shares thus dilutes existing shareholders. For example, if an employee exercises 1,000 options at $50 when the share price has increased to $62.50 the net exercise proceeds of $50,000 could be used to buy back 800 shares ($50,000/$62.50) and shares outstanding would increase by 200 (1000-800).

The dilution from stock options granted can be estimated by dividing the fair value of the option by the fair market value of the stock on the date of grant.

Using the above example, if at the time 1,000 options were granted at an exercise price of $50 (equal to current market) they had an estimated fair value of $12,500 (1,000 x $12.50 per share) the $12,500 would have been divided by the current share price of $50 and 250 Stock Option Share Equivalents would have been added to diluted shares outstanding. This treatment would result in an immediate dilutive effect on EPS.

As noted in their discussions with the IASB, compensation consultants have historically used variations of mathematical models (such as Black Scholes) in helping employers decide how many options should be granted to employees and what dilution they cause.

FASB and IASC standards regarding earnings per share calculations are maintained

The treasury stock method as prescribed in FAS 128 and IASC 33 is maintained. As actual dilution is captured under the treasury stock method, the company’s estimate of dilution (as recorded on the grant date), the Stock Option Share Equivalents balance, is reduced.

A fundamental assumption made with Stock Option Share Equivalents is that a company will not buy back its stock prior to the options being exercised, possibly incurring debt or using excess cash, which would impact operations. We assume, consistent with the treasury stock method, that upon exercise funds obtained by issuers from the exercise of options are used to buy back stock which offsets shares issued. We recognize that funds could be used in many ways with a wide variety of results that cannot be anticipated. This method represents a practical approach to reflecting the net dilutive effect of the option grants and increases transparency and comparability.

As noted by the Ontario Teacher’s Pension Plan Board in their December 7, 2001 comment letter (CL 26) to the IASB, “Institutional investors are most concerned that they possess adequate information to properly assess the present and future economic impact of such equity transactions. We stress the need for transparency with regards to these accounting principles”.

Outstanding stock options are not revalued each reporting period in keeping with the conclusion in FAS 128 that to do so would be inconsistent with FAS 123, which has valuation only at the grant date.

Consistent accounting treatment

The Stock Option Share Equivalents approach to accounting for stock options presents an opportunity to eliminate the “uneven playing field” for reporting different forms of compensation (fixed, variable and performance-based options) with a resulting improvement in the quality of financial statements.

Supporting this is a comment letter (CL 94) to the IASB, “All preparers and users of financial statements would benefit from a level playing field between performance-vesting and time-vesting grants and between fixed-priced options and variable-priced options”.

Footnote disclosure is not a substitute for recognition. Financial statement users are asking that amounts be measured and recognized on a reasonable and consistent basis that takes into account detailed information generally only available to the entity.

Investors want to know the impact on EPS of transactions the company has entered into. They recognize not all transactions will impact the E in EPS.