Examining the Future of Broad-Based Options

By Sam Shah

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JUNE 2005 - Sometime in 2005, domestic and international companies can expect to be required to show charges to earnings for all their equity compensation plans. Currently, under Accounting Procedure Bulletin (APB) 25, companies do not have to show charges to earnings for stock options if the date on which the price and the number of the shares offered are known is the same date as when the grant is actually made. These “fixed options” offer employees the right to buy a specific number of shares at a price fixed today for a defined number of years into the future. They do not show up as a charge to earnings, although they count as outstanding shares for earnings-per-share calculations. If options are modified (e.g., if the price is lowered after the grant is made, or the term of the option is extended), or vest only if a performance goal is met, they are considered “variable options” and must be charged to earnings.

Companies can also follow SFAS 123, Accounting for Stock-Based Compensation, which requires estimating the expense of stock options using a model that calculates the options’ present value (the theoretical value at which a willing buyer would buy them from a willing seller). For equity pay other than options, companies must currently show a charge to income. All of this changed, however, when the International Accounting Standards Board (IASB) and FASB finalized rules that will require companies to estimate the fair value of all equity pay in their income statements.

The new standards will also require companies to show employee stock purchase plans (ESPP) as an expense. These plans allow employees to buy stock at a discount. The most common, an IRC section 423 plan, allows employees to put aside up to $25,000 in after-tax money to buy stock at up to a 15% discount from (usually) the lower of the price when they make the purchase or the price when they started to put money aside. This offering period usually lasts between three months and two years. By law, at least all full-time employees with two or more years of service must be able to participate. Previously, companies took no charge to earnings for these plans; under the new rules, they must show an expense for the discount and the expected value of the “look-back element” that allows employees to buy at the lower of the beginning or the end of the offering period.

The new standard’s requirement of expensing equity compensation has caused enormous controversy and concern among companies that provide stock options. Opponents of accounting reform envisioned the new rules as the deathblow for broad-based equity plans. They claim it is impossible to accurately value options, that the complexity of proposed formulas will confuse rather than clarify, and that current earnings-per-share disclosure rules are adequate. Proponents contend that stock options are compensation and that current procedures mislead investors. Some reformers believe this accounting rule will force companies to reduce outsized options grants to executives; the IASB and FASB say their aim is clarity in accounting.

In addition to the accounting changes, companies are concerned about new NASDAQ and NYSE rules for shareholder approval of equity compensation plans. These rules require shareholder approval for almost all equity plans, such as employee stock-ownership plans (ESOP) and 401(k) plans, as well as “material modifications” of existing plans (qualified plans do not need to be approved). Unlike in the past (at least for NYSE companies), brokers holding stock in “street name” (holding shares for investors in their accounts) can no longer vote the shares without specific proxies from investors. This will make obtaining shareholder approval more difficult. Because many companies are running out of approved shares to issue under existing plans, or want to institute new or modified plans, the approval process will become especially important. Investors have shown wariness about dilution resulting from equity plans.

Many people have misinterpreted the effect that accounting charges will have. A company would have no more or less in cash or profits after the accounting changes. Moreover, how a company accounts for its earnings has nothing to do with how it records earnings for tax purposes; each procedure has its own rules. What will change is how a company reports results; nothing would change about what the results actually are. Many news stories have, perhaps unintentionally, confused these issues.

Despite the lack of real economic impact on cash flow, assets, or other tangible economic considerations, accounting norms do provide shareholders and potential investors with an idea of how profitable a company is. Changes in accounting procedures that drive reported (even if not actual) profits down raise the specter of shareholders abandoning companies that award options for companies that use other forms of compensation. A company that voluntarily expenses options currently would have a median reduction of about 13% in reported earnings. Because early adopters of expensing may include many companies that have fewer outstanding options than some of their peers, this number will probably increase when expensing is required for all equity pay. In response, many companies are looking into how to reduce their equity compensation plan expenses, whether by changing to another form of equity (as Microsoft did, replacing options with restricted stock), cutting back on who gets equity, reducing the amounts provided, or all of these. On the other hand, a majority (albeit a slim one) of companies plan to stick with what they have.

Those entrusted with handling equity plans would be wise to consider these three questions in the current accounting climate for equity compensation:

  • Is the reaction to expensing rational? The assumption is that expensing will drive down earnings per share, which will discourage investors, which will drive down stock prices. But if investors already incorporate options information into their decisions, as efficient-market theories would predict, then companies will be making decisions about changing compensation plans based not on what is best for the company, its employees, and its shareholders, but on a chimerical expectation. The studies of this issue strongly concur that expensing will not affect share prices.
  • What do companies plan to do? Several surveys provide information about how companies expect to respond to the expensing requirement. Focusing on how these changes will affect one of the most dramatic developments in equity compensation over the last 15 years, the rise of broad-based options plans and employee stock-purchase plans, the surveys suggest about 40% to 45% of the companies will either eliminate awards to nonmanagement employees (for options) or change their plans so that they will have little appeal to these workers (particularly employee stock-purchase plans). But a majority of companies plan to retain their broad-based plans.
  • What works best in equity plans: focusing awards on executives, or making them broad-based? Decisions are being based largely on arguments and assumptions rather than on data about what really works. The research is recent and quite compelling: Broad-based ownership improves corporate performance, and ownership concentrated at the top either has no effect or is harmful.

Sam Shah is project director at the National Center for Employee Ownership (www.nceo.org).




















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