The Spirit of Accounting: It’s time to reform accounting for stock-based compensation
We’re laying down a strong challenge to today’s liberated Financial Accounting Standards Board to fearlessly reform shortcomings in GAAP for stock-based compensation (SBC). Those defects arose when an intense political battle in the 1990s strong-armed the board into crafting deficient practices that still allow managers to avoid reporting the whole truth.
FASB was a hotbed of contention 25 years ago as it considered whether to report compensation paid with stock options. Aligned against it were the entire corporate community and their auditors, as well as many members of Congress.
The project was so controversial that then-Securities and Exchange Commission Chairman Arthur Levitt was compelled to tell the board that he couldn’t protect it.
When FASB issued SFAS 123 in 1995, it encouraged managers to recognize an expense but begrudgingly allowed disclosure instead. With only rare exceptions, everyone chose the footnote route.
These comments in the standard candidly explain how the members rationalized voting for it (italics added):
“The debate on accounting for stock-based compensation unfortunately became so divisive that it threatened the board’s future working relationship with some of its constituents. Eventually, the nature of the debate threatened the future of accounting standards-setting in the private sector.” (par. 60)
“The board chose a disclosure-based solution for stock-based employee compensation to bring closure to the divisive debate on this issue — not because it believes that solution is the best way to improve financial accounting and reporting.” (par. 62)
With these words, the members confessed that they designed both the footnote cop-out and the accounting method to allow them to fight another day.
In 2004, FASB dispatched the disclosure-only alternative after the Sarbanes-Oxley Act bolstered its independence. Alas, it has never gone back to revisit the compromises in the original standard. As we describe momentarily, it is now actually proposing to expand these deficient practices.
Thus, we ask: Why hasn’t today’s FASB replaced the SBC standard that was concocted to survive political threats that no longer exist? We think such a project is long overdue.
Even though managers will surely object to laying the full facts open to scrutiny, the board no longer needs to curry their favor but can instead focus like a laser on promoting greater capital market efficiency through more useful information.
In 2004, we sent a comment letter to FASB in which we described SBC as a gift that keeps on giving because the recipients can reap a harvest that greatly exceeds their grants’ initial values. Importantly, whatever wealth they receive is also the company’s cost. (See http://cobe.boisestate.edu/mbletter.)
Another absolutely crucial truth about employee options and other stock-based grants is that they are call-option derivative contracts linked to the future value of the grantor’s shares. As a result, using them as compensation (or consideration to non-employees) is highly risky because the grantor’s full sacrifice is neither known nor knowable until these derivatives are exercised or expire.
It’s also crucially true that their cost equals the forfeited next best use of the issued shares, specifically the incremental cash that the issuer could have raised from selling those shares at their fair value on the exercise date. Compared to this amount, the derivatives’ grant date value is an unreliable expedient substitute that minimizes the reported cost.
Consider three more facts about these instruments:
- They do not create equity because the holders don’t enjoy the full benefits of ownership, including the rights to vote, receive dividends, and dispose of their interests at will.
- Rather, they’re liabilities, because the issuer is presently obligated to make the future sacrifice of selling the shares at less than market value.
- Throughout their existence, their values tend to be highly volatile because nobody knows what the future holds.
Therefore, representationally faithful and fully useful financial statements must report these derivatives as liabilities, mark them to market, and flow their value changes through earnings.
Anything less conceals useful truth.
In contrast, FASB’s politically pressured practices display six deficiencies:
- The derivative liabilities are misleadingly placed among the company’s equity account balances.
- This misclassified account’s balance is accrued over the vesting period until it equals the grant-date value and is then fixed at that amount, apart from actuarial adjustments.
- This fixed total SBC cost is reported as compensation expense over the vesting period as if its amount is just as certain as a contractual cash payment.
- The footnote description of the derivative contracts’ dilutive “overhang” is expressed only in terms of shares, not dollars.
- On their issue date, shares are recorded as if they were sold at their grant-date value (or at the options’ grant-date value plus the strike price).
- The difference between the derivatives’ values at their grant and exercise dates never passes through earnings.
The only good thing to say is that today’s GAAP is better than the prior practice of reporting nothing. However, it has never been good enough.
A BETTER WAY
We learned from our conversations with board personnel who participated in creating this standard that their interpretation of the conceptual framework’s liability definition precluded recognizing these instruments as derivative liabilities.
After careful analysis, we conclude that these six deficiencies prove that FASB desperately needs either a better interpretation or a better definition, because far more useful information would emerge from reporting these contracts as liabilities. (That stance was supported in 2004 by sophisticated financial analysts, including Pat McConnell and David Zion.)
Further, the liabilities’ current value is their useful measurement attribute because it reveals the real economic volatility caused by the uncertainty and risk associated with them. Using this value also causes financial statements to report compensation (and other) costs that equal the wealth actually received by the grantees when they exercise these contracts.
This method’s initial journal entry credits a derivative liability for its full grant-date value. Because this transaction doesn’t create a real asset, compensation expense is debited. Thereafter, the liability is marked to market and the income statement reports non-operating financial gains or losses. Finally, any issued shares are recorded at their market value.
This method offers four advantages over current practice:
- The derivatives’ full economic cost (compensation plus financial gain/loss) is observed and reported in income over their entire existence, not merely assumed and allocated over the vesting period.
- Balance sheets faithfully present useful measures of debt and equity.
- The liabilities’ reported balance describes the pending dilution overhang in monetary terms, not just shares.
- The issued shares are reported in equity at their full issue date value.
As a bonus, this method also eliminates management’s gambit of buying treasury stock to conceal the dilution created by these contracts.
Managers’ hypocrisy is evident in the fact that they’ve never disagreed with the Tax Code provisions that apply this approach to determine their tax deductions.
COSTS AND BENEFITS
Implementing this liability method will produce vastly more useful information without adding significant incremental preparation cost. That cost will be negligible because the only new efforts involve continuously estimating the contracts’ market values, which the issuers can accomplish with the same algorithms they now use to estimate grant date values.
Two substantial benefits are certain. First, the capital markets’ access to complete and verified useful facts will reduce the users’ information processing costs and management’s capital costs. Second, enabling improved public scrutiny of SBC costs will make management fully accountable for their compensation arrangements.
If FASB were to propose this more complete method, we anticipate the corporate world would unleash a torrent of vacuous complaints, including irrational claims that accurately reporting higher and volatile SBC costs and liabilities would cause share values to plummet and otherwise bring the financial world to its knees.
Instead, just the opposite would occur because the markets’ new access to better information would greatly reduce uncertainty and diminish share price volatility.
We’re also confident that share values would tend to rise to the extent that users have been building a safety cushion by biasing their proprietary estimated costs and liabilities upward.
In the 1990s, the preparer constituency held the purse strings on FASB’s operating budget and wielded dominant political power over the standard-setting process and its outcome, especially the SBC project. However, as we have observed many times, the modern post-Sarbanes FASB is now effectively protected against managers’ bluster.
We believe the board can and should stare down the opposition like never before.
We acknowledge that some people at FASB may be unwilling to open up old institutional wounds from its darkest days.
On the other hand, no current board member was involved in the SFAS 123 project and, at most, only a few staff members went through that painful debacle. Because it’s much easier to repair someone else’s mistakes, we encourage the current FASB team to close this gaping hole in GAAP with a new standard that honors the truth and buries the old politically compromised rules.
Doing so would be a powerful sign that the board is fearless about living up to its responsibility to significantly improve practice.
As we were finishing this draft, we were disheartened to learn that FASB intends to “simplify” accounting for stock transactions with non-employees by shifting their measurement date from the exercise date to the grant date in order to converge with today’s terribly deficient SBC accounting.
Without any doubt, implementing this proposal would move GAAP in the absolutely wrong direction. Instead, the best simplification would measure all stock-based costs as of the date the derivative contracts are exercised or expire.
At the very least, our words have shown the board members that this so-called “simplification” will diminish financial statement quality.