Plans and the New Stock Option Accounting Rules
Adopters Plan for Changes
J. Gregory Kunkel and Richard T. Lau
2005 - Its exposure draft to require the expensing of stock
option grants is one of the most controversial standards ever
proposed by FASB. Supporters of the standard argue that stock
option grants are indeed a form of compensation and should
be recognized as an expense on the body of the income statement.
FASB’s proposal is also in line with the current requirements
of the International Accounting Standards Board.
of the proposed standard argue that its implementation will
hurt the competitiveness of American industry, especially
of technology companies that rely on stock options to attract
and retain key employees. Opponents argue that existing
accounting standards adequately disclose the effects of
stock option grants through diluted earnings-per-share calculations
and the required footnote disclosure. In addition, opponents
argue that FASB’s proposed methods of valuing stock
option grants will yield meaningless expense numbers. The
lobbying against the proposed standard has become so intense
that the House of Representatives recently passed a bill
that would require expensing of options for only the top
five executives of publicly traded companies.
to Standard & Poor’s, the proposed accounting
rules would reduce reported 2004 earnings among the S&P
500 by 7.4%. The effect on the reported earnings of many
technology firms will be much greater. For example, in an
August 2, 2004, press release, Intel reported that its second-quarter
2004 profit would have decreased 17% if it had expensed
its stock options. As a result, trade groups, such as the
American Electronics Association, have vigorously opposed
the proposed rules.
proposed standard has at least one virtue: It levels the
playing field between stock option grants and other forms
of stock and cash compensation. Under existing accounting
rules, restricted stock grants are considered an expense,
but fixed, “at the money,” stock option grants
are not. Under the proposed standard, there will no longer
be an obvious accounting advantage to one form of compensation.
The choice of compensation vehicle should become less driven
by accounting considerations and more driven by proper incentive-design
proposed standard suggests an important question: How will
companies change their equity compensation programs in response
to new FASB requirements? This will obviously depend on
the particular company and industry, but general implications
might be discerned. For example, will stock options become
a less important part of the compensation package? Will
the size of stock option grants be reduced? Will stock options
be granted to fewer employees in an organization?
gain insight into these questions, the authors, using Dow
Jones News Service’s press releases, identified 150
companies that have voluntarily decided to expense stock
options in anticipation of the proposed FASB rules. These
companies cover a wide variety of industries (see Exhibit
1), with some concentration in financial services, and
with technology companies underrepresented. The survey instrument
asked human resources directors simple questions about changes
to their company’s equity compensation programs in
response to their decision to expense stock options. There
was a 21% response rate.
the companies responding to the survey, 31% indicated that
stock options will remain their primary long-term incentive
vehicle after their decision to expense stock options, while
56% replied that stock options will no longer be their primary
long-term incentive vehicle; 13% were undecided (see Exhibit
companies, of course, use combinations of stock options,
restricted stock, and performance plans in their long-term
incentive programs. The survey asked whether companies intended
to place more emphasis on some form of long-term compensation
other than stock options; 68% replied yes, 16% replied no,
and 16% were undecided (see Exhibit
is difficult to determine causality from the data. Did the
decision to expense stock options result in less of a reliance
on stock options, or did a decision to rely less on stock
options result in a decision to expense them? Nevertheless,
a requirement to expense stock options will remove any obvious
bias toward their use, and will likely cause companies to
consider using other forms of long-term compensation. When
asked what type of long-term incentive vehicle would be
used more frequently, 50% of respondents mentioned restricted
stock and 34% mentioned a long-term performance plan payable
in cash or stock.
factors (e.g., maturity, growth potential, industry, market
conditions), of course, affect a company’s decision
regarding what type of long-term incentive program to use.
Nevertheless, FASB’s proposed standard will probably
cause companies to look at other forms of long-term compensation,
such as restricted stock and performance plans. Such programs
are usually less risky than stock options and are considered
by some to be a “giveaway.” Given the current
level of shareholder activism, it remains to be seen whether
shareholders will approve such programs.
percent of respondents mentioned that they do not intend
to restrict or reduce the level of employees eligible for
long-term incentive grants, while 34% do intend to restrict
or reduce the level of employees eligible for long-term
incentive grants; 13% were undecided (see Exhibit
4). Many of the companies that intend to restrict or
reduce the number of employees eligible for long-term incentive
grants intend to reduce eligibility by “one level”;
for example, from director to vice president. Others intend
to reduce the number of employees eligible at the lowest
respondents were asked if they intended to reduce the size
of stock option grants or their allocation across levels
of employees. Responses to these questions were inconclusive.
Many respondents intend to keep the “value”
of long-term incentives the same while substituting, for
example, restricted stock grants for stock options. Of those
companies that intend to reduce the size of stock option
grants, many seem to be implementing reductions across the
board, although it is not clear from the responses if lower-level
employees will feel the brunt of the cuts while the value
of top management’s long-term incentives remains intact.
survey’s overall findings seem to indicate that, for
many companies, the role of stock options in the compensation
package will be diminished, and other forms of compensation
(e.g., restricted stock) will gain more prominence.
Editor’s note: As of this writing,
FASB’s new standard on stock option accounting remains
an exposure draft.
Gregory Kunkel, PhD, is a professor of accounting
at California State University–Los Angeles, and specializes
in financial accounting and compensation and benefits planning.
Richard T. Lau, PhD, is an associate professor
of accounting at California State University–Los Angeles
and specializes in financial accounting.