Stock Options: Easy as SFAS No. 123

Movement toward performance based options will lead to adoption of SFAS No. 123.
Robert WillensMay 29, 2002

The complaints registered about the way stock options are—or are not—accounted for seem to stem from the type of options being granted. That is, the majority of granted options are the non-variable variety. That means that both the number of shares and the purchase price are known at the grant date.

Accordingly, the compensation expense of a non-variable option is measured at the grant date, and is equal to the “spread” (if any) between the then fair market value of the stock, and the exercise price of the option. Indeed, if, at the date of grant, the options has no intrinsic value, there is no compensation expense recorded. This is the accounting that was originally set forth in APB No. 25 and, at an issuer’s election, continues unabated.

However, a different—and infinitely more onerous—accounting treatment applies to options that are granted under variable plans. Why? To start, a prototypical variable option is one that is subject to “performance vesting.” For example, the option will vest only if the corporation’s net income, during some specified period, equals or exceeds certain predetermined and reasonably attainable levels. In such a case, the compensation expense is a function of the spread at the time of vesting. So, if the stock has appreciated during the period between the grant and vesting date, the charge can be considerable.

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What’s more, in variable plans, the compensation expense attributable to the pre-grant spread is accrued over the vesting period; while the compensation expense caused by post-grant changes in the value of the underlying stock is accrued quarterly, as the underlying stock fluctuates in value. In each case, however, the amount of compensation expense is reduced by the expected tax saving created by the exercise of the option. (For tax purposes, the exercise date of an option is the date of reckoning, and the issuer—the “service recipient”—secures a tax deduction measured by the spread on the date of exercise.)

On the theory that outside pressures will prompt many issuers to increase their use of performance based options, it seems likely that the issuers will also seriously consider adopting the provisions of SFAS No. 123 to minimize compensation charges. Apparently, only two S&P 500 companies—Boeing and Winn-Dixie—currently use the provisions to expense options.

Under SFAS No. 123, the distinction between variable and non-variable plans is eliminated; the compensation expense is measured by the fair value of the option (itself) on the grant date; and the value is discerned using the Black-Scholes options pricing model. But corporate denizens should note that if SFAS No. 123 is adopted, it must be used in all of an issuer’s stock-based compensation plans.

When the option value is determined, the charge—which is based entirely on the number of options that actually vest—is then accrued over the vesting period. Lehman Brothers believes that most companies would make an estimate of this number at inception, and then, as the pattern of forfeitures becomes discernable, record credits or additional charges to reflect how the actual experience deviates from the estimate.

Furthermore, under these rules, if an option that has already vested later expires (for example, if it was never “in the money”) no downward adjustment is permissible with respect to previously recorded compensation expense.

Thus, if the charge emanating from performance options under SFAS No. 123 is based on the value of the option at the date it is granted (a manageable number)—and the APB No. 25 charge is based essentially on the spread at the time of vesting (which might be quite substantial)—then any substantial movement toward the use of performance options should, as a consequence, cause companies to embrace the provisions of SFAS No. 123.