Get Ready to Expense Stock Options

In response to a decade-long push by the Financial Accounting Standards Board, more than 750 publicly traded companies now voluntarily expense stock options, and an upcoming FASB rule would require the laggards to join them. But a group of influential businesses, concentrated in high-tech industries, has convinced some members of Congress that mandatory expensing will force them to lay off workers and send more jobs overseas.

The intensive lobbying effort by these organizations netted a win for an anti-expensing bill in the House of Representatives at the end of the last session of Congress. The issue is now before the Senate, where it may or may not be settled before the FASB's implementation date, June 15, 2005.

Not only would the legislation under consideration undercut the proposed FASB rule, but it would also run counter to new expensing requirements of the International Accounting Standards Board (IASB) and would throw into limbo the progress that has been made toward IASB/FASB convergence on accounting standards. The Congressional challenge to the FASB's independence and authority has implications that run far beyond U.S. borders.
Forces have amassed in the Senate to support the FASB and block attempts to truncate the expensing rule. Most experts are betting that the FASB will prevail. The board intends for the rule to go into effect for all fiscal years beginning after June 15 of next year. Congressional attempts to modify the FASB proposal have generated some uncertainty, but CFOs should not postpone their efforts to comply with the rule.
Preparations

"FASB is more determined than ever to get the new option expensing rules in place," explains Stephen W. Skonieczny, partner in the employee benefits and executive compensation group at Philadelphia-based law firm Dechert LLP. In October, the board postponed by six months the rule's implementation date, which was originally December 15 of this year. Finance departments should now proceed as if the revised deadline will be the final deadline. "I am not aware of any willingness to delay the implementation date if Congress has not acted on legislative attempts to stave off the revised FAS 123," Skonieczny says. "My guess is that FASB will stay pretty close to the scheduled rollout."

Many companies will simply jettison their stock option plan for all employees below the top management level rather than begin expensing those options. A midyear survey by Mellon of 108 public companies which grant stock options found that few have done anything to prepare for mandatory expensing other than hold internal discussions and consultations with experts. And 45 percent of the companies plan to eliminate stock options for nonexempt employees if expensing becomes mandatory. In a July survey of 1,600 companies' compensation planning, Mercer Human Resource Consulting found that 33 percent of respondents' companies have a broad-based stock option program, but only 2 percent of represented organizations are considering adding that type of program in the coming year.

Skonieczny notes that some companies are now granting options, which are 100 percent vested and exercisable, at market price to take advantage of an accounting grandfather provision in the FASB rule for option awards made before the expensing deadline. "This needs to be carefully planned and is not for everyone," he says. He advises all companies to prepare for the new rules by working up a pro forma estimated determination of the accounting charge likely to be required to be booked. Companies must also determine whether stock options are still their equity compensation form of choice going forward, and if so, they must understand the valuation model they will use in calculating the new accounting charge.

Valuation Models

Developing and implementing a new valuation model will be costly. The new rule, FAS 123R, initially stated a preference for valuations calculated using the lattice model, but the FASB has now reopened the issue. Although the question of whether stock option expensing should be mandatory has dominated debates on the rule, this stated preference for the lattice model for stock option valuation is one of the most important facets of the rule -- one that deserves finance's immediate attention. The lattice model is a sharp departure from the more commonly used Black-Scholes method. Most companies consider it more complex and cumbersome, but experts generally agree with the FASB's initial choice.

"When properly implemented, the lattice-based model is capable of providing a more supported and rigorous estimate of fair value because of its ability to more fully capture and better reflect the characteristics of employee stock options for each company's particular set of circumstances," reports Stamos Nicholas, principal in Deloitte & Touche's valuation services practice in New York City. "The usefulness of the lattice model for employee stock options originates from the approach of dividing the term of the option into a large number of time intervals or nodes. This allows the analyst to incorporate features and logic into the model that are unique to employee stock options, such as early-exercise behavior, post-vesting forfeiture and performance conditions."

By incorporating an employee early-exercise decision framework, the lattice model better reflects the nontransferable nature of employee stock options. This adjustment is considered to be more accurate than the Black-Scholes model's single-weighted average expected life assumption. Nicholas notes, "The lattice model can also accommodate expected changes in interest rates and volatilities more accurately than employing weighted average assumptions in the Black-Scholes model. The Black-Scholes model is only able to adjust for such factors by using weighted average assumptions, which introduce a fair amount of subjectivity."
Use of a lattice model can bring about valuation results that may be significantly different from those obtained through use of Black-Scholes, but the value is not consistently either higher or lower. "Whether the lattice option model values vary significantly from those of a Black-Scholes model largely depends on the expected life assumption used in the Black-Scholes model," Nicholas says.

A July Mellon survey found that 60 percent of companies with stock option plans have an insufficient understanding of the lattice model. "Under the preexisting FAS 123, companies tended to use a 'least effort' model for calculating cost, since it was only a footnote expense," contends Ted Buyniski, principal and high-tech industry leader in the compensation line of Mellon's human resources and investor solutions division in Southborough, Mass. "With these numbers now becoming 'real' in the sense that they will be reflected in the P&L, companies are expending significant sums to determine a more 'accurate' -- or a lower -- value for these options. Whether it is choosing a different model or different assumptions, they are spending tens of thousands of dollars to address the issue."

In addition, implementation will be costly because the expense will be an actual P&L cost and companies will have to allocate the compensation expense to the appropriate business unit or division, as with other compensation costs. "This means allocating stock option costs on an individual basis," Buyniski says. "Once the costs are calculated, companies will need software that can allocate these costs on a quarterly basis to business units. Existing HRIS software does not do this. Companies will need to spend the money to develop in-house software solutions or purchase software solutions from their outside vendors, who are trying to build solutions before final regulations are available. These software solutions take time and money to debug and roll out."

Broader Implications

Some experts believe that the Congressional challenge to the expensing rule undermines the FASB's status and authority as an independent standard-setting board. "Sarbanes-Oxley reinforced the independence of the FASB as the accounting standard setter," says John Bazley, accounting professor at the University of Denver's Daniels College of Business. "Now Congress is trying to undermine the independence of the FASB by creating legislation that has no conceptual logic and would only create more confusion for investors."

Skonieczny disagrees. "If Congress successfully trumps the proposed FASB rule on option expensing, it will not be as disastrous to FASB as some believe," he says. "Remember, this is one FASB rule out of many, and the FASB will retain its prestige as the preeminent arbiter and setter of accounting policy and literature. After some initial shock, the whole concern will blow over in relatively short order. In a way, maybe it's not such a bad thing that Congress serves in some way as a check against FASB fiat. Moreover, analysts and others who pore over financial statements routinely already take into account the effect of option overhang and dilution when rating companies and opining on their fiscal health."

One major implication of the Congressional action is its potential impact on the drive toward global accounting standards. One of the FASB's stated reasons for proposing mandatory expensing is to create greater international comparability in accounting for share-based payments. The IASB finalized a ruling earlier this year that mandates expensing, effective January 1, 2005. It does not specify which valuation model organizations should use, but experts widely agree that a lattice model would be acceptable under it. The FASB's expensing rule is largely compatible with the IASB rule and constitutes a major step toward global standards.

"The FASB and IASB are working hard to create congruence between U.S. and international accounting standards, which will be of benefit to investors worldwide," says Bazley. "Congressional action will damage the movement towards congruence and therefore hurt investors." Skonieczny notes that if Congress succeeds in preventing the FASB rule, "stock option expensing will continue to be an area where U.S. accounting is out of sync with the IASB's international accounting rules, aggravating the financial statement comparability issue."
In an August Grant Thornton survey of senior finance executives, 71 percent of respondents said stock options should be expensed and 76 percent said there should be uniform global accounting standards. Congress needs to step out of the way.

Steps To Take Now

Finance executives at companies with stock option plans should assume that the new FASB rule for expensing stock options will go into effect by June 15, 2005, or soon thereafter. Ted Buyniski, a principal and high-tech industry leader in the compensation line of business of Mellon's human resources and investor solutions group, advises finance executives to take a few steps now to prepare for expensing.

The first question a company must answer, he says, is whether it wants to continue to offer stock options to a large number of employees, or whether it should limit options to executives. If it wants stock option eligibility to remain broad, then it must decide what level of expenses it can accept.

If that threshold is lower than the lowest option expenses the finance department can model with the company's current grant levels, then decision-makers must take one of the following steps:

• Keep broad eligibility but reduce participation. For example, only 50 percent of eligible employees may receive grants in a given
  year.
• Keep broad participation but reduce grant levels. For example, if
  eligible employees received an average of 200 shares last year, they may receive
  an average of only 125 shares this year.
• Sell the notion of increased costs to the company's shareholders and the investment community.