FASB Reaffirms Desire To Expense Options When Granted

NORWALK, Conn. (Dow Jones)--The group that sets U.S. accounting rules reaffirmed its desire to require companies to deduct the costs for employee stock options from profits when they are granted.

The issue of how to treat employee stock options as an expense came up Wednesday when the seven-member Financial Accounting Standards Board met to discuss the accounting for stock options awarded to non-employee workers, such as those whom companies outsource work to.

The board agreed that a single set of accounting principles should apply to options issued to both employees and non-employee workers. The latter, though not as commonly used as the employee stock options, is not rare either, said Michael Tovey, a FASB staff member.

Companies in Silicon Valley, for instance, have paid in the form of stock options - instead of cash - those who do Web or software design work for them.

In a recent decision, the FASB unanimously voted in favor of expensing stock options. But that's just the first of many steps needed for the board to issue any new guidelines on the matter, expected to come later this year or early 2004.

The particularly thorny question now is how stock options should be valued, with problems including how to measure such costs prior to the options being exercised by the recipient.

The FASB's advising panel of valuation experts - specifically set up to help solve the valuation puzzle - will hold an open meeting for the first time early next month; the board is expected to make related decisions later this summer.

Stock options give the holder the right to buy shares at a set price in the future. The purchase price is set usually on the day the option is granted, so the holder will only profit if the market price of the stock increases.

Meanwhile, the cost to the company comes when the options get exercised, because it is selling its shares for less than what it would get if it were selling them on the open market. Thus, proponents of expensing stock options argue that stock options are a real cost to a company's existing shareholders and should be recognized on its income statement when they are granted.

The existing accounting rules require only that companies estimate the cost of options in footnotes to their financial statements. The FASB, which tried to require the expensing of stock options a decade ago but backed down under heavy business lobbying and political pressure, decided to revisit the issue earlier this year in the wake of a slew of corporate scandals involving management abusing stock options for their personal gains.

Still, the opposition, especially in the technology sector, remains strong. Critics of the FASB's efforts have said treating options as expenses would deter companies from using them, hurt rank-and-file workers, and hit cash-poor start-up companies especially hard. They have also challenged whether the board can work out a reliable method to value stock options.

In the latest call against expensing stock options, the International Employee Stock Options Coalition, an industry group, issued a statement Wednesday to applaud U.S. Rep. Dick Gephardt's support for a bill aimed at getting the Securities and Exchange Commission to study the stock option issue for three years, thus blocking the FASB's efforts to change the rules in the near future.

Gephardt, who made the announcement in a Tuesday speech in Silicon Valley, became the first among the nine Democratic presidential candidates to back the bill and join the fight with high-tech executives against expensing stock options.

Earlier this month, Robert Herz, the FASB chairman, denounced the measure, saying such congressional actions would undermine the board's authority in setting accounting rules.

The particularly thorny question now is how stock options should be valued, with problems including how to measure such costs prior to the options being exercised by the recipient.

This has always been my objection to expensing options. There are also several different tax treatments for both the option holder and company depending on ISO's vs NQ's which can't be fully predicted until exercise. The AMT get's it's fingers in here as well.

Meanwhile, the cost to the company comes when the options get exercised, because it is selling its shares for less than what it would get if it were selling them on the open market.

Not always...the smart strategy is to exercise as close to the grant price as possible to minimize recognizeable gains. It also depends on vesting and whether the Co's stock price has risen. Options are also used in lieu of financial compensation, so the salary or performance bonuses an employee waived benefits the company but as this was a hiring negotiation point, it won't have an accounting journal entry.

I can get you a pretty good value for the variance of the option

Stock options aren't publicly traded like CBOT options, hence they have no FMV, but the gain/loss is computed against the exchange traded stock price when exercised, so how would you compute a varience?

Inquiring minds wanna know.

IF we assume that the underlying security is driven by logarithmic Brownian motion (and perhaps that interest rates are generated by arithmetic Brownian motion) then the the value of any option may be simulated by by discounting the future values against a (two) Brownian paths. By running several (about a million) paths, the mean and variance can be computed. Of course, these computations are only projections into the future and the results would be different on different days. Journals like "Management Science" or the "Journal of Derivatives" discuss this type of problem.

I'm not sure how to convert this into an expense.

It's a sad day when we have to rely on the RATS to be on the right side of a business issue.

Good points except you missed one - stock options are already accounted for in the most important way - by diluting the share count. If stupid investors would just merely start focusing on net income per diluted share as the bottom line they wouldn't find such simplicities to seem so complicated.

One could use the income per undiluted share and income per diluted share as bounds on income per share. Then one could model the probability of option conversion as a function of the share price and an estimate of the expected income per share. This could be extrapolated as I noted in a previous post.

It doesn't matter so much what method (within reason) is used as long as the methods are standardized among companies.

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