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Guest Article

Deloitte logo

(From the April 5, 2004 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

FASB Issues Exposure Draft on Accounting for Employee Stock Option Grants


The Financial Accounting Standards Board on March 31 issued an Exposure Draft that would amend FASB Statement No. 123, Accounting for Stock-Based Compensation, to generally require companies to expense the fair value of stock options issued to employees for fiscal years beginning after December 15, 2004. The Exposure Draft would not change the accounting rules for stock options granted to non-employees or for employee stock ownership plans (ESOPs), but the FASB plans to address those issues in a later phase of its ongoing project on equity-based compensation. As always, Deloitte's National Accounting Services office is the authoritative source for questions or issues arising on FASB pronouncements. The following summary is provided for general information purposes only.

Comments on the Exposure Draft are due by June 30, 2004. The Exposure Draft is available on the FASB's Web site, at www.fasb.org.

Background

The FASB last proposed expensing for stock options in 1993, but backed down in the face of pressure from companies, their employees, and Congress. As a result, Statement 123 currently allows companies to choose either of two methods-- intrinsic value or fair value-- for accounting for stock option grants to employees.

Under the intrinsic value method, established by APB Opinion No. 25, Accounting for Stock Issued to Employees, companies generally do not recognize any compensation expense for stock option grants to employees. By comparison, the fair-value-based method requires companies to recognize on the grant date the fair value of such grants. For companies that choose to use the intrinsic value method, Statement 123 requires pro forma disclosures of the effect of applying the fair- value-based method in their financial statements.

After Statement 123 first became effective in 1995 most companies continued using the intrinsic value method of accounting for stock option grants to employees. But that started to change following a wave of corporate governance scandals that started in 2001. Since then, according to the FASB, "approximately 500 public companies have voluntarily adopted or announced their intention to adopt the fair-value-based method." Among the converts are Coca Cola, General Electric, and General Motors.

According to the Exposure Draft, one reason the FASB is now proposing to make the fair- value method mandatory is that "similar economic transactions should be accounted for similarly (that is, share-based compensation transactions with employees should be accounted for using one method)." Other reasons the FASB cites are concerns that companies using the intrinsic value method may not be accurately reporting their financial conditions, the need to simplify accounting for employee stock option grants, and a desire to keep U.S. accounting standards consistent with those observed by other countries. (The International Accounting Standards Board earlier this year proposed mandatory expensing for stock option grants to employees.)

Summary of the Exposure Draft

The key provisions as stated in the Exposure Draft are:

  • For public entities, the cost of employee services received in exchange for equity instruments would be measured based on the grant-date fair value of those instruments (with limited exceptions). That cost would be recognized over the requisite service period (often the vesting period). Generally, no compensation cost would be recognized for equity instruments that do not vest.

  • For public entities, the cost of employee services received in exchange for liabilities would be measured initially at the fair value of liabilities and would be remeasured subsequently at each reporting date through settlement date. The pro rata change in fair value during the requisite service period would be recognized over that period, and the change in fair value after the requisite service period is complete would be recognized in the financial statements in the period of change.

  • The grant-date fair value of employee share options and similar instruments would be estimated using option-pricing models adjusted for the unique characteristics of those options and instruments (unless observable market prices for the same or similar options are available).

  • If an equity award is modified subsequent to the grant date, incremental compensation cost would be recognized in an amount equal to the excess of the fair value of the modified award over the fair value of the original award immediately prior to modification.

  • Employee share purchase plans would not be considered compensatory if the terms of those plans were no more favorable than those available to all holders of the same class of shares and substantially all eligible employees could participate on an equitable basis.

  • Excess tax benefits would be recognized as an addition to paid- in capital. Cash retained as a result of those excess tax benefits would be presented in the statement of cash flows as financing cash flows. The write-off of deferred tax assets relating to unrealized tax benefits associated with recognized compensation cost would be reported as income tax expense.

  • Nonpublic entities would be allowed to elect to measure compensation costs of awards of equity share options and similar instruments at intrinsic value through the date of settlement. That election also would apply to awards of liability instruments. The proposed Statement also would require that public entities measure compensation cost of awards of equity share options and similar instruments at intrinsic value through the date of settlement if it is not reasonably possible to estimate their grant-date fair value.

  • The notes to financial statements of both public and nonpublic entities would disclose the information that users of financial information need to understand the nature of share-based payment transactions and the effects of those transactions on the financial statements.

The proposed Statement would apply prospectively to public entities for fiscal years beginning after December 15, 2004, as if all share-based compensation awards granted, modified, or settled after December 15, 1994, had been accounted for using the fair-value based method. Nonpublic entities that had adopted the fair-value based method for recognition or pro forma disclosures would use the same transition and effective date as public entities. All other nonpublic entities would apply the proposed Statement prospectively for fiscal years beginning after December 15, 2005.

Will Congress Intervene?

Reports indicate the high-tech industry is leading a lobbying effort to stop FASB from implementing the proposed changes to Statement 123. That effort apparently is gaining some traction on Capitol Hill. Representative Richard Baker (R-LA), chairman of the House Committee on Financial Services' Subcommittee on Capital Markets, Insurance, and Government Sponsored Entities, has scheduled a hearing on the FASB proposal for April 21.

Representative Baker is the lead sponsor of a bill (H.R. 3574, the "Stock Option Accounting Reform Act") that generally would ma ndate expensing of stock option grants to certain of a company's senior executive officers, but also would prohibit the SEC from recognizing any rule requiring expensing of all employee stock option grants pending an economic impact study. Representative Baker's bill has 85 bipartisan cosponsors, including House Minority Leader Nancy Pelosi (D-CA). The Senate companion bill (S. 1890) also enjoys significant bipartisan support.

Of course, other bills (H.R. 626 and S. 182, the "Ending Double Standard for Stock Options Act") pending in Congress would effectively require companies to expense all employee stock option grants. Those bills also have bipartisan support, but not as many cosponsors.

Nonetheless, Congress generally does not become involved in accounting issues. And some influential Members apparently think Congress should continue to honor that tradition. Both Senator Richard Shelby (R-AL), Chairman of the Senate Banking Committee, and Representative Michael Oxley (R-OH), Chairman of the House Financial Services Committee, have indicated they do not believe Congress should interfere in this matter.


Deloitte logoThe information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations.

If you have questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Tom Brisendine 202.879.5365, Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Mike Haberman 202.879.4963, Stephen LaGarde 202.879.5608, J. D. Lutz 202.879.5366, Bart Massey 202.220.2104, Diane McGowan 202.220.2077, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5324, Tom Veal 312.946.2595, or Deborah Walker 202.879.4955.

Copyright 2004, Deloitte.


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