Employee stock options: things to watch

Senior manager, Global Risk Management Solutions, PricewaterhouseCoopers, on the pros and cons of issuing employee stock options under US GAAP.

PwC's Craig PowellThe accounting for employee stock options under US Generally Accepted Accounting Practice (GAAP) is particularly complex … companies need to carefully plan their stock options schemes otherwise they could end up with a significant and unintended charge to earnings.

With the use of employee stock options becoming more widespread, and a greater number of Asian companies tapping into the US capital markets, (which then usually requires them to prepare their accounting information under US GAAP), this issue is becoming increasingly important. This article sets out some of the basic considerations for accounting for employee stock options under US GAAP.

One of the main reasons for the widespread use of employee stock options is the favourable accounting treatment, even under US GAAP, that is typically afforded their use. For example, if an employer gives an employee a cash bonus then this would be accounted for as compensation expense, which in turn lowers reported earnings.

On the other hand, under current US GAAP, usually no compensation cost needs to be recorded if a company gives the employee stock options under “typical, fixed” stock option plans, even though the options could prove to be far more valuable than the cash bonus. However, things are not always that simple. Employee stock options plans that don’t have the features of a “typical, fixed” stock option plan may result in a significantly higher compensation expense.

In 1972, the US accounting standards authority released Accounting Principles Board No. 25, “Accounting for Stock Issued to Employees” ("APB 25”). Under APB 25, most standard plans where the number of shares each employee is entitled to, and the exercise price, are established at the time the options are granted to the employee, usually qualify as fixed plans. For fixed plan options the difference between the exercise price of the option and the stock price at the time of the grant, (i.e. the intrinsic value), is recognised as a compensation expense over the vesting period of the options. As employee stock options are typically granted at an exercise price equal to the stock price at the time of the grant, usually no compensation expense has to be recognised and earnings is not affected.

If, on the other hand, either the exercise price or the number of shares that the employee is entitled to cannot be determined at the time the options are granted, then APB 25 considers the plan to be a variable plan. Under a variable plan the difference between the stock price and the exercise price must be recognised as a compensation expense in each accounting period until such time as the exercise price or the number of shares becomes known. Clearly, as the market value of the company’s stock increases, variable plan accounting could lead to a substantially larger compensation cost under APB 25.

In 1995, in an attempt to address the generous accounting treatment allowed to fixed plans under APB 25, the US accounting authorities, currently known as the Financial Accounting Standards Board, or FASB, released Financial Accounting Standard 123, “Accounting for Stock Based Compensation” (“FAS 123"). Under FAS 123, compensation cost is based on the fair value of the options granted, with fair value measured using an option pricing model such as Black-Scholes.

Therefore, for most fixed plans, the compensation cost of granting employee stock options would increase dramatically as the cost would based on fair value which includes not just the intrinsic value of the options but the time value as well. In other words, even options granted “at the money” would result in a compensation cost. (Although, some stock option plans that qualify as variable plans under APB 25 may result in a lower compensation cost under FAS 123).

Understandably the proposals contemplated by the original version of FAS 123 met with strong resistance from industry with some calling the fair value approach as “a threat to rob emerging growth companies of one of their most vital tools for success”. The result was that FASB backed down and the final version of FAS 123 now “encourages” companies to adopt the fair value approach for determining compensation cost but allows them to continue to use APB 25 as long as the difference between the impact of FAS 123 and APB 25 is disclosed. Not surprisingly, most companies with fixed stock option plans elect to account for their employee stock options under APB 25 with the impact on earnings of adopting a fair value approach buried in the notes to the financial statements.

In addition to APB 25 and FAS 123, the US accounting authorities have issued a number guidelines and commentaries to assist with the implementation and interpretation of these standards. Recently, FASB issued a document known as Interpretation No. 44 “Accounting for Certain Transactions Involving Stock”, which is an interpretation of some of the requirements of APB 25. This document, amongst other things, severely restricts the flexibility afforded companies for varying the terms of options already granted to employees.

One common practice of companies when faced with a sharp down turn in the stock market is to reprice the “underwater” employee stock options at a lower strike price, or alternatively, to extend the option period. Repricing employee stock options is not without controversy. While many companies argue that repricing is needed to prevent employees fleeing to other companies with fresh options, shareholders often view repricing as “changing the rules after the games has begun” as, after all, they cannot reprice their depreciated shares. Well-known US companies that have taken the repricing route in the past include Apple Computer, 3 Com and Oracle.

However, with the introduction of Interpretation No. 44, companies that choose to reprice or extend the option period will have to take it on the chin. Under Interpretation No. 44 a repricing or extension of the option period will usually turn a fixed plan into a variable plan. As a result, the stock option award would have to be accounted for as a variable plan from the date of modification to the date of exercise.

For example, if a company originally grants employees options with an exercise price of $30 when the stock price is at $30, then, if the plan qualifies as a fixed plan under APB 25, no compensation is recognised, even if the stock price subsequently increases to, say, $100. However, if the stock price drops to $20 and the company decides to reset the exercise price at $20 then the stock option plan is converted from a fixed plan to a variable plan, effective from the repricing date. Should the stock then recover to $45, the company would have to recognise $25 as compensation expense, i.e. the difference between the reset exercise price of $20, and the market price of $45.

Therefore, although US GAAP permits the relatively favourable accounting treatment for most employee stock option plans, companies still need to consider their schemes carefully. An ill-considered plan, or one that requires tinkering with at a later stage, could result in a significant and unintended compensation cost. Some of the steps that management needs to take are as follows:

  • Understand the accounting rules and alternatives available;  
  • Collect specific information about the company’s past stock prices, past and expected dividends, and if applicable, history of stock option grants, exercise patterns, option terms, vesting and forfeitures experience;  
  • Evaluate alternative valuation models, assumptions and stratification approaches required for estimating the fair value of employee stock options under FAS 123;  
  • Calculate compensation expense and the impact on earnings and earnings per share of the alternate stock options plans under the existing employee stock option accounting policies. If applying employee stock option accounting for the first time, consider the impact under both APB 25 and FAS 123. Also, analyse the sensitivity of each alternative on earnings under different assumptions and conditions;  
  • Consider the impact of alternate stock option plans on taxation, shareholder reaction and employee motivation and retention;  
  • Evaluate the alternate stock option plans and accounting policy options. Select the most appropriate plan and accounting policy (if applicable); and  
  • Monitor ongoing impact of the stock options plans, including impact on earnings and reaction of employees and shareholders.

Craig Howell is senior manager, Global Risk Management Solutions, PricewaterhouseCoopers. E-mail: [email protected]

Mohan Kohli is partner, Global Risk Management Solutions, PricewaterhouseCoopers. E-mail: [email protected]