Compensation Case

Introduction

Since the 1970s, companies have been compensating their employees with stock option plans. These compensation plans sometimes make up large portions of the employee's compensation packages and give them an incentive to achieve the company's goals and in turn increase the company's stock value. The great controversy involving options is centered around whether equity based employee compensation should be recognized as an expense on the company's income statement or not and the means of determining the value of these stock options.

What is an expense?

The FASB's Statement of Financial Accounting Concept No. 6 defines expenses as "outflows or other using up of assets or incurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations." This definition does not make it clear that equity-based payments such as stock options should be classified as an expense, and partly because of this unclear definition and the implementation of APB Opinion No. 25, many companies were not required to recognize the amount of their stock option compensation expense. This vague definition may have provided a foundation for to one of the biggest controversies the accounting world has ever seen.

APB Opinion No. 25

Under APB Opinion No. 25, Accounting for Stock Issue to Employees, which was issued in October of 1972, companies have the choice of offering stock based compensation to employees with fixed terms or performance-based stock terms. Opinion No. 25 measures the employee compensation expense by "the excess of a stock's market price over its option exercise price (the intrinsic value)." (Ciccotello, 1995) While the method of measuring each option's compensation expense is the same, the time at which the expense is measured differs. The expense is only measured "when the number of shares to be received and the exercise price are known." (Rouse, 1993)

When stock options are offered with fixed terms, the number of shares and the exercise price are determined at the grant date. Under Opinion No. 25, companies can avoid recognizing an employee compensation expense on their income statement when offering fixed awards since the expense can be measured "with a grant-date intrinsic value of zero." (Zimmerman, 2007)

Performance-based stock options (variable stock options) are offered as an incentive for employees to achieve the goals of the company and in turn receive more shares of company stock or more valuable stock. If the value of the stock's exercise price turns out to be less than the market price of the stock at the measurement date, the company would have to recognize an employee compensation expense which would lower reported earnings. Because of an increased probability of an expense being recognized, Opinion No. 25 seems to steer employers away from issuing performance-based stock options. Also, while performance-based stock options are less valuable than fixed options because they depend on other contingencies, the consequential compensation expense is larger. This discouragement of making one accounting requirement more appealing to employers than another made the FASB realize that Opinion No. 25 needed to be revised.

Revision of APB Opinion No. 25: SFAS No. 123

In an attempt to resolve the issues presented by Opinion No. 25 and its intrinsic value based cost measurement method, the FASB issued SFAS No. 123 in October of 1995. Statement No. 123 establishes and defines a fair value based method of accounting for stock-based employee compensation plans that would use an options pricing model to determine the fair value of stock options that were granted to employees.. These employee compensation plans include stock options, restricted stock, employee stock purchase plans, and stock compensation awards required to be settled by paying cash. Although FASB encouraged all entities to adopt this new fair value method of accounting and reporting, entities were still allowed to use the intrinsic value method illustrated in APB Opinion No. 25, but under Statement No. 123, companies were required to produce pro forma disclosures of net income and earnings per share as if the fair value method of measuring compensation cost had been applied. These disclosures were also required to include any resulting tax effects that would have been recognized if the fair value based method had been applied.

Under the new fair value based method prescribed by Statement No. 123, the compensation cost equals the value of the award measured at its grant date, and it is recognized over the service period, which is usually the vesting period.

To determine the fair value of stock options, Statement No. 123 requires entities to use an option pricing model that takes into account the stock price at the grant date, the exercise price, the expected life of the option, the volatility of the underlying stock and the expected dividends on it, and the risk-free interest rate over the expected life of the option.

The fair value of restricted stock is equal to the market price of a share of non-restricted stock on the grant date. If a restriction will be imposed after the employee has a vested right to the stock, then the fair value is estimated with the restriction being accounted for.

Employee stock purchase plans allow employees to purchase stock at a price that is less than the current market price. An entity must first determine if this plan is compensatory or not. The summary of SFAS No. 123 defines a non-compensatory stock purchase plan as one that satisfies three conditions: "(a) the discount is relatively small (5 percent or less satisfies this condition automatically, though in some cases a greater discount also might be justified as non-compensatory), (b) substantially all full-time employees may participate on an equitable basis, and (c) the plan incorporates no option features such as allowing the employee to purchase the stock at a fixed discount from the lesser of the market price at grant date or date of purchase." ((FASB), Statement of Financial Accounting Standards No. 123: Accounting for Stock Based Compensation, 1995)

If an employer is required to pay an employee a cash amount equivalent to the amount that the company's stock increases at the employee's discretion or at a specified date, the change of the stock price must be measured and recognized as a compensation cost over the periods that this change occurred.

Amendments to SFAS 123

Although the FASB was satisfied with the