At long last, the Financial Accounting Standards Board has issued its final rule mandating that companies expense at fair value the stock options that they grant to their employees.
The contentious rule, years in the making, moves options from the footnotes of companies' financial statements and onto their income statements as an expense. It also brings U.S. rules in line with similar rules on options issued recently by FASB's overseas counterpart, the International Accounting Standards Board.
Echoing a sentiment put forth for years by the board in its efforts to push forward on expensing, FASB board member and collaborator on the project Michael Crooch said, "Recognizing the cost of share-based payments in the financial statements improves the relevance, reliability and comparability of that financial information, and helps users of financial information to understand better the economic transactions affecting an enterprise, and supports resource allocation decisions."
Sen. Peter Fitzgerald, R-Ill., hailed the rule a "victory," and urged the next Congress "to respect FASB's decision-making authority and permit the new FASB rule to stand."
Some members of Congress had moved to block the board's final rule by offering up their own bills on options expensing. In July, the House passed H.R. 3574, a diluted options expensing measure that would require companies to expense options given to their top five executives.
According to some experts, the FASB rule will require nothing less than a sea change in the way some companies interpret, report and treat employee stock options.
Adoption of Statement No. 123, Accounting for Stock-Based Compensation, could have a major impact on the earnings of some companies that grant stock options extensively or that tend to have volatile stock. It will also put the valuation methodologies they use under scrutiny by auditors and regulators.
For some companies, the rule could have a chilling effect on issuing options. "The way some companies have used options, this could really hit their earnings," noted Stamos Nicholas, national business valuation leader for Deloitte & Touche and a principal in the firm's valuation service practice. "Some companies may reassess their compensation programs if the hit is very big and may not issue as many options. "
Part of the controversy related to options expensing has surrounded the issue of how to value them. "In my estimation, companies can measure the value of these options reasonably accurately," said Nicholas. "Extracting the data that goes into the [valuation] model is the big issue -- it's what you put in the box."
The board backed off an initial preference for the lattice, or binomial valuation method, and instead decided to let companies decide for themselves what valuation method to use. But companies will not only have to decide which method to use - they'll need to be able to back up their choice to auditors, regulators and the investing public, notes Nicholas.
"Companies can use whatever model they want, but they have to be able to defend it and explain it," Nicholas said. "That's left a lot of people scratching their heads ... asking, 'What is right methodology to use?'"
Whatever amount that companies determine they must expense "will be closely scrutinized by auditors, the Securities and Exchange Commission and investors, and companies will need to make disclosures about how that amount is determined," he said.
Historically, most companies have used the Black-Scholes methodology. "The problem with Black-Scholes is that it's a static model," said Nicholas. "You enter some key inputs and get an answer. ... Using the lattice methodology can give you more flexibility," because it allows companies to put in different assumptions over time.
But Nicholas notes that valuing options isn't one-size-fits-all. "A combination of things need to considered," such as the volatility of the company's stock, and whether the company is in a slow growth or static situation. "It comes down to understanding what's going on with the business, how the company issues options, and the exercise behavior," he said.
"A lot of companies have been looking at this in a compliance view. Once they realize the dimensions of what it means, they may fundamentally alter some of their other operations as well. [The rule] has broad implications," said Nicholas, who noted that in addition to involving staff from the systems side, companies will need their human resources and tax staffs to be involved in the process in order to get the data needed to value the options.
"There will be an investment in terms of setting up the process and making sure it gets vetted properly by the auditors and the SEC. How big depends on how much companies want to invest in getting a precise answer," said Nicholas.
Thanks to a decision to delay the effective date by six months for public companies, the rules are effective for those companies for fiscal periods beginning after June 15, 2005. For private companies and small business issuers, the standard will apply for fiscal years beginning after Dec. 15, 2005.
Accounting rule-makers made the decision to delay the effective date for public companies in October, after weighing input from preparers, who said that they needed more time to meet the demands of Sarbanes-Oxley. A FASB spokesman said that the board's decision was due in part to concerns over the pressure on companies to implement SOX Section 404 for the first quarter, combined with the fact that the board wanted to be sure to give companies sufficient time to absorb the new standard and to apply it appropriately. FASB also voted to allow for modified retrospective application going back to the beginning of the fiscal year for companies that wish to implement the rule early.
FASB says that about 750 public companies in the U.S. are currently expensing options voluntarily or have announced plans to do so.
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