Risk & Compliance

Congress, FASB in Stock Option Flap

Dreier-Eshoo bill would prevent expensing of stock options -- and derail FASB initiative. Plus: IPO changes coming?
Craig SchneiderJune 2, 2003

They’re at it again.

A bill that would temporarily prohibit regulators from recognizing standards requiring companies to expense employee stock options gets an airing this week — much to the chagrin of members of the Financial Accounting Standards Board.

On Tuesday morning, the House Financial Services Capital Markets Subcommittee will hold a hearing on HR 1372, the Broad-Based Stock Option Plan Transparency Act. The bill, introduced by Reps. David Dreier (R-Calif.) and Anna G. Eshoo (D-Calif.) on March 20, requires greater disclosure of corporate stock options.

But the proposed legislation would also commission a three-year study of the effects of such disclosure. During that time, new accounting standards governing options would not be recognized.

The bill’s sponsors argue that mandating companies to expense options would effectively eliminate the use of broad-based options plans as an incentive for rank-and-file employees. They also claim such a move would create less accurate financial information for shareholders.

Employee stock options are the only form of stock-based compensation that are not required to be expensed under GAAP.

Not surprisingly, standards-setters at FASB, which has tentatively decided to require companies to book stock options as an expense, strongly oppose HR 1372. Beyond the proposal to stall FASB’s final rule from being recognized as GAAP by the SEC, the proposed legislation calls into question the accounting rulemaking body’s independence.

Michael Crooch, a FASB board member, tells CFO.com that the FASB is “very concerned” about the bill, which would “disrupt the independent process we use to make, unbiased, objective and neutral decisions.” Crooch is also worried that the proposed legislation would set “an unwise precedent that likely would encourage further political intervention in the independent process of setting standards.”

As you may recall, the FASB backed away from a requirement to have companies expense stock options in the 1990s. The about-face came under similar pressure from Congress and lobbyists for the high-tech industry.

But Crooch, who will accompany FASB Chairman Robert Herz as he testifies at Tuesday’s hearing, is hopeful that several developments in the financial markets have turned the tide in favor of expensing.

He may be right. A growing number of individual and institutional investors have been expressing a desire to see the value of employee options expressed in the income statement as an expense rather than a disclosure in the footnotes. The sentiment has grown particularly strong in the wake of scandals at Enron, Worldcom, and others marquee corporations.

Reportedly, 280 companies are already expensing the cost of employee stock options — or plan to do so.

Corporate executives are also starting to explore employee compensation alternatives, such as variable options, as a better performance driver than fixed options, Crooch says. There’s also seems to be some interest in converging FASB’s approach to stock option accounting with the tack taken by the International Accounting Standards Board. Currently, the IASB requires companies to expense stock options.

Opponents of convergence argue that such a move would likely reduce the number of companies that offer the options to employees. Executives at a number of high tech companies — often big issuers of employee stock options — claim that stock options align executive and shareholder interests. They also insist that options enable start-ups and fast-growing companies to attract prized workers — without draining corporate coffers.

Some academics also assert that options are difficult to value for accounting purposes. Attempts to place a value on stock options, they say, could lead to a misrepresentation of company assets. That’s an issue which the FASB plans to address as early as this month.

Interestingly, Finance Committee Chairman Richard Shelby recently denied a companion bill to the Dreier-Eschoo effort from receiving a hearing in the Senate. According to Reuters, the chairman said he did not think lawmakers should be interfering in FASB’s affairs.

The measure’s Senate sponsors, John Ensign (R-Nev.) and Barbara Boxer (D-Calif.), could still try to bring the bill to the floor as an amendment to another piece of legislation, the newswire noted.

Exchanges Look to End Friends and Family Deals

The meteoric rise in price of many hot initial public offerings during the ’90s stock market boom is something that regulators would prefer not to see again. In fact, they’re advising against it.

An IPO advisory committee formed by the New York Stock Exchange and National Association of Securities Dealers, has made 20 recommendations to boost the public’s confidence in the integrity of the IPO process. Exchange officials say investor faith was undercut by “dramatic and immediate run-ups of IPO prices in the immediate aftermarket — particularly during the bubble period of the late 1990s and 2000,” according to a report issued last week.

The committee’s review determined that the price spikes (some created artificially) helped create much of the abusive behavior that occurred. Certain underwriters allocated IPO shares to directors and/or executives in exchange for investment banking business (a practice known as “spinning”). Others allocated IPO shares on a potential investor’s commitment to purchase additional shares in the aftermarket at specific prices (called “laddering”).

Among the panel’s recommendations:

  • Require each issuer to establish an IPO pricing committee of its board of directors that must include at least one independent director to oversee the pricing process.
  • Require underwriters to provide to the issuer’s pricing committee all indications of interest before the issuer determines the IPO price.
  • Prohibit, for the first trading day following the IPO, the placing of unpriced orders to purchase an issuer’s shares.
  • Raise the SEC’s threshold requirement for amendment to a prospectus from 20 percent to 40 percent in cases of increases to the IPO offering price or shares offered.
  • Eliminate regulatory impediments to the development of alternatives to bookbuilding, such as Dutch auctions.
  • Prohibit the allocation of IPO shares 1) to executive officers and directors (and their immediate families) of companies that have an investment banking relationship with the underwriter, or (2) as a quid pro quo for investment banking business.

The committee’s report states that its recommendations are intended to complement the numerous recent legislative and regulatory initiatives, including the recent global settlement among regulators and major investment banks.

(To download a PDF file of the full report, click here.)

As CFO.com reported last week, a shareholder lawsuit against John Hancock Financial Services alleges that the life insurer illegally linked the CEO’s pay and that of other company officers to the performance of Hancock’s 2000 initial public offering.

Report: SEC Says E&Y’s Internal Controls Lacking

It’s becoming clear that the Securities and Exchange Commission is very serious about policing corporate internal controls.

Last week, the SEC okayed a final rule requiring corporations to make sure their controls over finance were up to snuff and fully reported on. But even before that, the commission was reportedly taking legal action against the one of the Big Four audit firms — and its apparent lack of good internal controls.

The SEC, in fact, has asked an administrative law judge to ban Ernst & Young from accepting new clients for six months because of alleged lapses in the firm’s internal controls, according to The Washington Post.

The commission is reportedly charging E&Y with failing to report on its business relationships with audit clients, particularly PeopleSoft. The SEC also alleges that the firm has failed to supply a clear way for employees to speak out internally about partnerships between E&Y and its audit clients.

In court documents cited by the newspaper, commission lawyers called E&Y’s control “woefully inadequate, internally inconsistent, and under-publicized within the firm.” The firm was apparently cited for lacking centralized records that could be regularly looked by regulators wanting to trace E&Y’s client joint ventures.

In a 128-page court brief, the commission reportedly charged E&Y auditors with “widespread independence cluelessness.” For example, the firm’s lead partner for its PeopleSoft account, “remained totally unaware” of a joint software venture until 1999, the SEC alleges. That was “four years into his tenure as PeopleSoft’s auditor certifying E&Y’s independence.”

For their part, E&Y executives strongly defend their policies. “Our people know how to raise the issues, and they did,” Beth Brooke, an E&Y vice chairperson, told the Post. E&Y’s audits of PeopleSoft have never been questioned, she said, noting that the firm has sold its consulting practice.

But the SEC believes the firm maintained an improper relationship with PeopleSoft while the accountancy served as the software maker’s external auditor, according to the newspaper. From 1994 through 2000, E&Y and PeopleSoft jointly developed and marketed a software product called “EY/GEMS for PeopleSoft,” which incorporated components of PeopleSoft’s proprietary source code into software previously developed and marketed by E&Y’s tax department, according to the SEC.

The SEC sued Ernst & Young last year, charging the firm with violating commission auditor independence rules and generally accepted auditing standards. According to those allegations, E&Y was serving as PeopleSoft’s auditor while simultaneously incorporating the software maker’s source code into its product.

E&Y also allegedly agreed to pay PeopleSoft royalties ranging from 15 percent to 30 percent from each sale of the resulting product, with a guaranteed minimum royalty of $300,000.

The SEC also charged that during the period, E&Y earned hundreds of millions of dollars in consulting revenues from implementing PeopleSoft software for third parties.

Citing government sources, the Post reported that while a ban on obtaining new clients is a serious sanction, it may have little lasting impact on firms seeking an auditor. That’s because companies tend to review their choice of auditor only once a year.

SEC officials had thought about asking for a longer suspension than six months, according to The Wall Street Journal. But they were worried that it would put too great a limit on the choice of auditors available to public companies.

The SEC staff has also recently warned auditors against potential conflicts of interests when marketing software to help clients track and evaluate their internal controls. In a separate story by The Post, the paper noted that Scott A. Taub, the SEC’s deputy chief accountant, said that such moves could raise questions about auditor independence if accounting firms are helping to set up the systems they later evaluate. “Companies and their auditors need to be mindful” of those problems, Taub said.

Among its advisory services, Ernst & Young helps corporate clients determine if their internal controls meet requirements mandated by the Sarbanes-Oxley Act.

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