by Glenn Cheney

Norwalk, Conn. — The controversy over accounting for employee stock option compensation has been burning for almost 10 years now, and it just keeps getting worse.

Since the mid-1990s, the Financial Accounting Standards Board has been trying to get public companies to report the value of “stock comp” as an expense on income statements. Statement 123, issued in 1995, allows companies to keep this value off the balance sheet by reporting the estimates in footnotes. FASB is now moving toward a new statement that will require public companies to use an appropriate method to estimate the value of stock option compensation and crank it into the income statement as an expense that is measured at fair value as of the grant date.

Criticism has moved beyond the advisability of expensing stock comp. Now the question is whether such compensation should be considered an equity or a liability. It carries characteristics of both.

In a recent tentative decision, FASB confirmed what it has long held: Stock options are equities, a specific, immutable value that is given to employees on a certain date.

Critics hold that option grants are more of a liability, an intent to transfer stock of an unknown future value for a price less than that value. The difference between those values is a cost to the shareholder — in other words, a liability.

It’s not the compensation itself that would be the equity or liability, but the option grant, the other side of the entry, that would credit equity or liability.

Patricia McConnell, a senior managing director at Bear Stearns and chair of the Global Financial Reporting Committee of the CFA Institute, said that financial analysts would like to see the other side of the entry be a credit to a liability account.

“We see an option granted to an employee as a derivative,” said McConnell. “Other derivatives are assets or liabilities that are marked to market through earnings. We feel that an equity option granted to an employee should get the same treatment as any other liability.”

McConnell explained it this way: When a company decides how much to compensate an employee, the next decision is how to finance that compensation. It could pay from cash generated by operations, with the other side of the entry being cash. Or it could borrow it from the bank, creating a liability. Or it could sell stock, creating an equity. Or it could issue stock options on its own stock.

If the company compensates an employee by granting options, the next decision would be to whom it is selling those options: to an investor or to an employee. For tax reasons, they decide to sell to the employee in exchange for services.

As McConnell sees it, the issuing of options is actually a means of financing the transaction. The change in the value of the option after the grant date is a financing cost. If the stock price has risen substantially, the company is, in effect, paying a higher cost of financing, and that, she says, should be reflected in the financial statement.

And that, said McConnell, is where the transaction hits an accounting conflict.

“The problem that FASB faces is that stock options, whether granted to an employee or third party, do not currently meet the board’s conceptual framework definition of a liability,” she explained. “Under that framework, a liability is a current obligation that will be settled by the future outflow of cash or other assets. But stock options are settled in the future by equity, not cash or other assets.”

To be able to record stock option compensation as a liability, McConnell said, FASB would have to go back and change its conceptual framework — a major undertaking that would hold up the long-embattled, long-awaited share-based compensation project.

Board member Michael Crooch brushes off the issue as a non-controversy that has seen little mention in letters commenting on the exposure draft that was issued in March 2004, with its comment period closing on June 30. “My reaction is that this has not been a big issue,” Crooch said.

Kim Boylan, chief consultant to the International Employee Stock Option Compensation Coalition at Latham & Watkins, said that the equity-liability issue is less important than the overall issue of whether to expense stock compensation and, if it must be expensed, how to measure its value.

Cisco speaks out
Boylan cited testimony at a recent FASB roundtable meeting in Palo Alto, Calif., where Silicon Valley companies battered the board with reasons why stock comp should be left in the footnotes and kept off the balance sheet.

Dennis D. Powell, senior vice president and chief financial officer of Cisco Systems, said that the proposed valuation method was “seriously flawed” and violated “the concept of reliability, comparability and accuracy.”

Cisco came to that conclusion after using the binomial method to crunch various assumptions that would be acceptable as “reasonable.” The results were shocking.

“We did this for every year since 1990, the year that we went [public],” Powell explained to the board. “Using reasonable assumptions for all of the different variables that went into the binomial method ... the range, by our valuation expert, [showed] a valuation flux that averaged well over 300 percent in terms of what that range of that value could be. It was as high as, I believe, 365 percent.”

Board member Crooch said that he was surprised when he heard those results, and the board has been reacting.

“Obviously, we are concerned about this,” Crooch said. “We are asking to see Cisco’s data. We’re looking at it and trying to make sure our proposal is correct and see whether he has misunderstood our guidance. We don’t have anything to report as yet.”

Boylan said that FASB has declined to conduct a broad field test along the lines of Cisco’s in-house test. She would like to see FASB’s final statement, which is expected by the end of the year, delayed while a field test determines its accuracy and usefulness.

Crooch sees little possibility of a full-blown field test.

“I think we’ve done enough work to make this standard appropriate and do what it’s supposed to do,” he said. “There’s been an awful lot of people who have been making these measures for an awful lot of years. I recognize that there’s concern about having to measure at fair value in the income statement, but we believe that between our field visits and the fact that people have been doing this for six or eight years, there is enough data for us to move forward.”

Model misunderstanding
Crooch also explained a roundtable comment that had been made by Dr. Mark E. Rubenstein, a professor of finance at Berkeley’s Haas School of Business. Rubenstein said that he was one of the inventors of the so-called lattice or binomial model that is used to value stock options. At the round table, he said that the model doesn’t work and should not be used.

Crooch explained that Rubenstein had probably applied the model to a situation in which options had to be valued once every quarter rather than at fair value on the grant date only, as required by the proposed standard. For grant date measurements, Crooch said, the binomial model works quite well.

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