"Weighty" issue: options debate is front and center.

by Melissa Klein

As investors and regulators cry out for corporate America to clean up its act, the contentious issue of accounting for stock options is back on the front page.

As a number of companies, in a move to restore public confidence in financial reporting, shift to expensing employee stock options, the controversial issue of whether companies should be required to expense the options they award their employees and the even stickier subject of how to value those options are once again up for debate.

Proponents of option expensing say that since options are a form of employee compensation, they should be treated like other forms of compensation and expensed against earnings. Critics, however, contend that expensing options at fair value would hurt companies that rely heavily on options, such as cash-strapped high tech firms that often woo employees with large option grants.

Even those who favor expensing options can’t agree on the best way to account for them. Critics of the popular Black Scholes method say that method and other option value pricing models tend to overvalue options.

With high-profile companies like Coca-Cola, Ford Motor, the Washington Post, and H&R Block, to name just a few, announcing a switch to expensing options, the topic, which caused a firestorm of controversy in the mid-90s, is back on the agenda of the Financial Accounting Standards Board. Thus far over 80 companies have made the decision to expense options.

The FASB, which maintains that the fair value method is the preferable way to account for options, last ruled on the issue in 1995, after it dropped a proposal to make fair value option expensing mandatory under pressure from Congress and members of the business community.

This time around, FASB isn’t looking to make fair value option expensing mandatory, but is looking instead at giving firms that voluntarily expense options at fair value three ways of doing so. FASB has also proposed increasing the disclosure requirements for companies that award options, explained FASB project manager Pat Durbin.

While the intrinsic method for valuing options, which Durbin said is what most companies use, generally doesn’t require firms to recognize an expense, fair value, which Durbin described as a combination of intrinsic value and time value, uses "a fairly complicated mathematical model" to determine the value of options.

"The problem is that we don’t have markets in which employee options are traded. The only technique available is an option pricing model," said Durbin. "A lot of people just don’t like the idea of expensing options. In the Ô90s, people argued that it would be the end of the high tech sector if we made expensing options mandatory because it would severely depress the earnings of high tech companies, who were cash-strapped."

"Even for those who believe that options should be expensed, a common criticism is that they don’t think the Black Scholes or option value pricing model is the proper way to value [options], because they tend to overvalue," Durbin said. "The FASB thought a lot about those arguments and tried to address the more significant concerns on why options might be overvalued and to make some allowances in the accounting standard we have today."

An exposure draft issued by the FASB earlier this month provides three ways for accounting for options at fair value. Under the currently used prospective method, any options granted before a company switched to fair value would be accounted for the same way they were in previous years, while any new awards granted from that point on would be accounted for on fair value. Critics of the method cite a "ramp up" effect on compensation cost that creates an artificial dilution in results.

"Before the statement [123] was issued, no one was really thinking about fair value," said Durbin. "Now, we come to 2002 and all these companies have decided to begin expensing options using the fair value method. Many of them called the board and said this ramp up effect is confusing and it’s difficult to explain results to investors - can we allow some retroactive provisions? That was the genesis for the project."

Rather than eliminating the guidance it originally issued, the board decided to give companies other options for calculating fair value to make it more palatable.

Under the FASB proposal, companies would also have the option to restate prior years as though they were using fair value all along, or to recognize the expense they would have had all along in the year they make the switch so the current year will be comparable to years going forward.

The amendment also increases the disclosure provisions to require companies that aren’t using fair value to disclose in footnotes of their quarterly financial statements what the effect on income would have been if they had used the fair value method, said Durbin. Currently, companies are only required make that disclosure annually.

Meanwhile, the International Accounting Standards Board, which has no existing standard on share-based payment, plans to issue its own Exposure Draft of an International Financial Reporting Standard on share-based payment (including accounting for employee stock options) in the fourth quarter.

According to IASB project manager Kimberley Crook, the draft will propose that all share-based payment transactions, including those involving options, should be recognized in the financial statements and measured at fair value, resulting in the recognition of an expense in the income statement. Crook said the IASB expects to finalize the standard by the end of 2003.

With the goal of convergence between international U.S. standards at the top of the minds of accounting rulemakers on both sides of the Atlantic, the FASB is keeping an eye on what the IASB is doing, Durbin said.

"While the basic principle is same, there’s a lot of difference in how they [the IASB] would go about doing it," he added. "We wouldn’t automatically get to the same place the IASB may end up at. This proposal tries to deal with the short-term problem."

"There’s still a lot of resistance here to mandating expensing. We continue to believe it’s the right thing to do, but there is a process we have to go through before we can decide to eliminate the choice that exists today," Durbin said. FASB expects to have the final statement out by the end of year.

"More companies are expensing options in-wake of concerns about fair reporting. There’s less opposition today [than there was in the mid-90s]. It would be more difficult for Congress to step in and complain about expensing," said Edmund Jenkins, who served as FASB chairman when Statement 123 was issued in 1995.

A group of high profile business and finance executives that includes former Federal Reserve chairman Paul A. Volcker; former SEC chair Arthur Levitt; former comptroller general Charles Bowsher; John H. Biggs, chairman of pension fund giant TIAA-CREF; and Vanguard Group founder John C. Bogle, have thrown their weight behind mandatory option expensing.

All but one member of the 12-person Commission on Public Trust and Private Enterprise endorsed expensing fixed price stock options in a September report on executive compensation.

The holdout was Intel Corp. chairman Andrew Grove, whose company issues options to virtually all of its employees. In his dissension, Grove wrote, "Expensing options may or may not be good accounting, but as a practical matter it will not be an effective deterrent to abuse. It will create new and significant opportunities for managements to manipulate earnings."

While the move toward mandatory expensing appears to be gaining momentum, there is still a large constituency who oppose it. One such group is the Software and Information Industry Association.

"We believe that given the difficulty in valuing stock options and accounting for the cost of options, if companies had to treat them as an expense, it would be with an estimate and we don’t believe it makes sense to force the expensing of an estimate," said SIIA director of public policy David LeDuc. "We think expensing would add additional confusion. Rather than making financial statements more clear, it would make them more deceptive. Companies can’t know what the value [of options] will be. It seems a like a well-intended effort to call for expensing, but we don’t think it’s effective and we certainly don’t think Congress should mandate it."

Responding to the argument that options are a form of compensation and should be treated as such, LeDuc said, "It’s not a direct cost to a company, it’s not an out-of-pocket cost."

The SIIA and other critics of expensing options maintain that mandatory expensing would discourage the use of stock options. "It could effectively kill stock options, which have been an effective tool for companies to attract workers," he said.