Another To-Do Item: Expense Options

Small, and private, companies are struggling to comply with an upcoming deadline to expense stock options.
Helen ShawNovember 29, 2006

Heads up, private companies—an accounting standard compliance deadline looms. January 1, 2007, is the deadline for compliance with FAS 123R, the Financial Accounting Standards Board rule that mandates companies with calendar year ends to expense their stock options. Private companies have been grappling with the standard since earlier in the year, and will continue to do so for the next three to four months as they close the books on 2006. Public companies became compliant by January 1, 2006.

“In general, companies have difficulty understanding the standard because it’s so complex and large,” observes Wade Lindenberger, director of corporate governance at Rose Ryan, a finance and accounting consultancy. In fact, experts agree that there are numerous pitfalls related to stock-option accounting that can catch companies unaware.

For instance, the timely and proper communication of a stock option and its terms to the receiving employee is a critical requirement. Failing to do so leads to accounting implications and the appearance of stock option manipulation or backdating. The accounting standard states that unless the company properly communicates an option’s terms to the employee, then it is not yet a recognized option that should be recorded for accounting purposes, notes Lindenberger.

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FAS 123R also says that if an employee isn’t informed of an option’s terms until after the company stock price has moved, the company would need to change the exercise price. To be sure, the standard allows for a “short time period” to convey the option terms to an employee, and the major accounting firms have informally adopted 14 days as the safe harbor time period, explains Lindenberger.

In the case of a stock price increase during a failure to convey an option’s terms in a timely manner, the company must change the exercise price to a higher price than the original one, otherwise, the option would be granted “in the money.” (Grants described as being in the money are options that are worth cash at the moment they are issued.) Conversely, if the stock price declines before an employee is informed of the option, the exercise price would need to be lowered. Otherwise, there could be the appearance that the company manipulated the option for the employee’s benefit, said Lindenberger.

More complications can result from modified stock option terms, such as the vesting period or the exercise price. In accounting, a stock option’s expense is calculated once and amortized. When the option is modified, the fair value must be calculated again as soon as it is changed. That could lead to undesired results when the share price changes. “If you have an upward stock price, you have an additional expense,” said Lindenberger.

In a situation that Lindenberger observed, a company accelerated an employee’s four-year vesting period to three years to reward performance. The problem for the company: “You’d have to recognize all remaining expense on that particular option,” said Lindenberger. “It could be a significant expense on your books.”

Given the complexities involved in complying with the standard, private companies are trying to simplify their stock option-grant policies, notes Lindenberger. “I would counsel companies to continue to make decisions based on the business implications of your stock options rather than the compliance implications,” he said. While companies will have the additional expense of stock options, its shareholders will be aware of it and it shouldn’t affect perception of the company’s performance, added Lindenberger.