Expensing Stock Options Takes Effect Soon

Expensing Stock Options Takes Effect Soon
Regulators Warn Against Potential Work-Around

By Gary Iliano

Public companies must begin to include the cost of stock options in their financial statements, after the Financial Accounting Standards Board released new requirements to account for share-based payments.

The Board on Dec. 16 released its Statement 123 (revised 2004), Share-Based Payment, calling for all entities to recognize the fair value of share-based payment awards, or stock compensation.

The requirement goes into effect at the beginning of the first interim or annual period after June 15, 2005, for public entities other than small business issuers, and after Dec. 15, 2005, for public entities filing as small business issuers. It is effective for nonpublic entities at the beginning of the first annual period beginning after December 15, 2005.

According to Statement 123(R), an entity is also required to recognize compensation cost for awards outstanding at the required effective date for which the requisite service has not been rendered (such as awards that are unvested because service requirements have not been completed) as the requisite service is subsequently rendered. The compensation cost will be based on the grant-date fair value of the award as determined under Statement 123 for either recognition or pro forma disclosures.

SEC Frowns on Using Acceleration to Avoid Expensing

Professionals are aware that some companies are considering accelerating vesting on out-of-the-money options in anticipation of applying Statement 123(R). Under Opinion 25, Accounting for Stock Issued to Employees, the acceleration of out-of-the-money options generally does not result in additional compensation expense. Therefore, some companies believe they can avoid recognizing compensation expense at the time vesting is accelerated and on the application of Statement 123(R).

It appears that those companies considering accelerated vesting are doing so to achieve a particular accounting result: the avoidance of compensation expense on unvested options.

At the American Institute of CPAs’ National Conference on Current SEC and PCAOB Developments held in December, SEC staff expressed strong concerns about transactions that are structured to achieve a particular accounting result. The staff expects registrants to provide robust disclosure regarding structured transactions, which should include the rationale for and implications of the structuring.

In this regard, paragraph 47(f) of Statement 123 clearly states that for each year an income statement is provided, the terms of significant modifications of outstanding awards shall be disclosed. The SEC staff expects companies to make specific disclosures of any modifications to accelerate the vesting of out-of-the money options in anticipation of adopting Statement 123(R), including the reasons why the option terms were modified. The SEC staff noted that boilerplate disclosure (for example, “during fiscal 2004 certain of the company’s stock options were modified to accelerate vesting”) would not be sufficient.

A number of firms (including that of the author) have strongly supported the issuance of Statement 123(R) and a principles-based approach to standard setting as a way to reflect the economic substance of a transaction because, in part, there will be less opportunity for financial engineering. Accordingly, Grant Thornton opposes the practice of entering into transactions that are structured to achieve a particular accounting result.

Gary Illiano is a member of the New York State Society of CPAs and assistant managing partner of professional standards and regional partner in charge of professional standards for Grant Thornton, LLP.