Hi Ron:
We have been looking for an accountant well versed in the employee stock option compensation subject to weigh in. Ask and you shall receive. In Thursday’s Wall Street Journal, the following story appeared. I found this article extremely helpful. It looks like I was incorrect on some of my interpretions, but nevertheless, this accountant is in favor of expensing stock option compensation using a fair value (Black Scholes) approach. I personally side with those who think that a fair-value approach should be used in recording compensation expense for stock-option grants. Whether the assumptions employed by the Black-Scholes model are appropriate for such options is open to debate. Though it would seem that even if the model were not perfect for estimating the values of stock options it is better than assigning no value to those options.
online.wsj.com
More Accounting Answers For Confounded Investors
[Editor's note: Understanding accounting has become an important issue for investors. In an effort give investors a better handle on the complex financial statements, we're asking experts to explain how companies can use gimmickry to improve their reported financial results.
This is the second of two-part question-and-answer session with Charles Mulford, Professor of Accounting at the Georgia Institute of Technology in Atlanta. Last week's installment is here.
In this week's installment, Mr. Mulford discusses questions about stock-option accounting, earnings restatement and gimmickry to watch for in the future.]
WSJ.com: There has been a great deal of chatter about stock options and accounting. Do you think that compensation expense should be recorded for stock options or do you think that footnote disclosure is sufficient?
Mr. Mulford: Companies presently have a choice in how they account for compensation expense associated with stock-option grants -- an intrinsic-value approach or a fair-value approach. Under the intrinsic-value approach compensation expense is recorded for the option's intrinsic value. This is the amount by which the exercise price of an option granted is exceeded by the market price of the underlying stock on the measurement date, typically the date of grant. With the fair-value approach compensation expense is recorded for the estimated fair value of the options granted using an established valuation model such as the Black-Scholes option-pricing model. With both approaches any compensation expense recorded is spread over the estimated service period of the recipient, usually the vesting period.
Most option grants entail qualified options that afford certain tax benefits to the recipient, mainly that no income tax is due on shares obtained through stock-option exercise until the acquired shares are sold. At that point capital-gains treatment is applied. However, qualified plans require that an option's exercise price cannot be less than the market price of the underlying stock on the date of grant. Thus, such options have no intrinsic value. Accordingly, under the intrinsic-value approach there is no compensation expense to be recorded.
The vast majority of all companies use the intrinsic-value approach. While companies choosing this method will not, in most cases, record compensation expense, they still must disclose in a footnote to their financial statements an estimate of the cost of the options granted using the fair-value approach.
Thus, as long as options are granted with no intrinsic value on the date of grant, generally no compensation expense is recorded. This is not to say that the options do not have value. Recipients certainly do not consider options to worthless or they would not be inclined to accept what in many instances is a below-market cash-based rate of pay.
In the early 1990s the Financial Accounting Standards Board proposed requiring companies to use a fair-value approach to recording compensation expense for stock options. Companies, especially technology firms that had been generous in their stock-option grants, argued forcefully against such a measure. Their argument held that requiring expense recognition for stock options would affect the viability of many technology firms by significantly reducing their ability to use options as compensation and in the process would threaten our nation's technology edge. In Congress they found a sympathetic ear and pressure mounted on the FASB to back down. The compromise solution reached is our present practice of permitting a choice in the method used to account for stock options but requiring footnote disclosure of the effects on earnings of the fair-value approach if it were not used in recording compensation expense.
In the past year, as serious questions about accounting generally in the U.S. have been raised, the option-accounting issue resurfaced. The use of options as a form of compensation soared in the late 1990s and into the new decade, all without the recording of compensation expense. Were earnings being properly measured? Also putting pressure on our regulators to reconsider the issue is talk that the International Accounting Standards Board, a board that is gaining stature in its pursuit of a body of common accounting standards internationally, is considering adopting a fair-value approach. In addition, very recently Standard & Poor's announced that it would incorporate estimated compensation expense for stock options in its calculations of operating earnings.
I personally side with those who think that a fair-value approach should be used in recording compensation expense for stock-option grants. The options have value, they are being used as a form of currency to pay for services and accordingly, there is an accompanying expense to be recorded. While measuring the value of options is based on an estimate, we use estimates for many items reported in financial statements.
There are other valid arguments against the fair-value approach. In estimating the value of stock options, the Black-Scholes model incorporates assumptions for such factors as the exercise price of the option, the market price of the underlying share and the volatility of that price, the level of interest rates, the underlying share's dividend yield, and the option's term to expiration. It was developed more for publicly traded options with relatively short expiration periods. Stock options granted to employees and others are not publicly traded and carry expiration dates that often extend out as far as ten years. Whether the assumptions employed by the Black-Scholes model are appropriate for such options is open to debate. Though it would seem that even if the model were not perfect for estimating the values of stock options it is better than assigning no value to those options.
Others note that the granting of options involves no cash payment and indeed results in cash inflows for the amount of any exercise price received plus, in some instances, a tax benefit. How can there be expense with no ultimate cash payment? Many companies that issue options will use cash to repurchase their own stock in order to avoid the dilutive effects of stock-option exercises. Others may use treasury shares, purchased earlier for cash, to satisfy exercises of stock options. However, even without using cash to repurchase shares there is a foregone cash inflow for the excess of the market price of the stock over the exercise price on the date of exercise. In fact, it is roughly the present value of this excess that a valuation model such as the Black-Scholes model attempts to estimate when assigning a value to stock options on the date of grant.
Another argument against the fair-value approach is that the effects of options are seen in the dilutive effects caused by an increase in the number of shares outstanding used in the calculation of earnings per share. That is, the inclusion of the effect of options on earnings and on shares outstanding would result in a double counting of their impact. It should be noted that dilution reflects a division of equity ownership and of earnings and does not affect the absolute amount of that equity or those earnings. Stated differently, the dilutive effect of options does not appear in reported net income or shareholders' equity. Also, there is no debate about the need to record expense when shares are granted outright for services. Yet even here there is an expense effect and a dilution effect.
These are all valid arguments, but I think that they can be addressed in a satisfactory manner. Unfortunately, the issue of whether or not to record compensation expense remains a political one subject to pressure from lobbyists and political rhetoric. In such a politically charged environment it is difficult to get objective discourse. If we can move the debate away from politics, something that is important if there is to be more trust in our accounting standards, I think that there would be an excellent opportunity to make meaningful change to our accounting practices for options. Unfortunately, this may be a tall order to fill.
WSJ.com: We have seen a rash of restatements in the past six months, almost all of them downward. Will this trend continue or do you believe that accounting practices have become more conservative in the past two quarters?
Mr. Mulford: Certainly it is difficult and possibly foolhardy not to be conservative in this environment.
I personally think that during the bull market of the 1990s and into 2000, the power pendulum in discussions on accounting issues between managers and their auditors swung solidly to the side of management. High and rising share prices led to a general feeling of success on the part of managers. With this success also came the pressure to perform. Financial results were being carefully scrutinized by investors. Given this intense scrutiny and the high level of share prices at the time, there was no room for unpleasant surprises. Emboldened by their success but under pressure from investors to perform, managers pressed their auditors to agree to more aggressive accounting practices. In this environment, auditors felt more pressure to abide by managers' wishes and did so. Financial reporting became more aggressive.
Since the demise of Enron Corp. and the ensuing problems at Arthur Andersen, the power pendulum has swung back to the auditor's side. Both sides -- managers and auditors -- now see clearly the negative consequences of overly aggressive financing reporting. In addition, there is a general consensus that investors now require compensation for aggressive accounting and a lack of reporting transparency. They are exacting this charge through lower debt and equity prices for firms that are not forthcoming. As a result, managers now see that conservative accounting and full disclosure are good for business, helping to reduce the cost of capital.
The recession has also helped lead to more conservative reporting. It has lowered earnings expectations and with them, share prices. Accordingly, there is less pressure on managers to meet optimistic and ever-growing earnings forecasts.
The SEC's role in encouraging more conservative financial reporting has also been a significant one. The Commission increased resources devoted to its enforcement division and has stated that it will more carefully review public filings made with it. As part of changes being made the filings of larger companies will now be more carefully scrutinized than in the past. Adding weight to the SEC's moves has been the never-ending litany of enforcement actions taken by the Commission against errant companies and their managers. The SEC publishes enforcement actions against companies, individual managers and auditors in what are referred to as Accounting and Auditing Enforcement Releases. Many of these actions, but not all, lead to restatements of financial reports. Often more than one enforcement action is filed for an individual reporting violation. For example, a company, one or more key managers and the company's auditor might be named in separate enforcement actions involving a single event. Nonetheless, given the high volume of enforcement actions being filed recently, it is clear that the SEC has been very active. For example, between 1990 and 1999 the Commission filed on average a little over 100 enforcement actions per year. That number increased to approximately 144 in 2000 and was 126 in 2001. Given the prominence it is placing on enforcing the securities laws many more such filings are expected for 2002.
Given all of these factors it is not surprising that managers and their auditors have taken a more conservative reporting bias. Returning to the question, I think that we will continue to see a higher than average number of restatements as the excesses of recent years are worked off. However, as the storm subsides, and it will, I think that the number of restatements will decline markedly reflecting a new and more conservative financial reporting environment.
WSJ.com: Are there other accounting issues that might emerge in the coming weeks and months that we should be aware of?
Mr. Mulford: I think that we will continue to see examples of many of the same issues we have seen recently. Companies will be reprimanded for overstating revenues and understating expenses, for off-balance sheet liabilities and for insufficient disclosure of related-party transactions. That said, I do have a few thoughts on other items that may surface in the near to mid-term.
Last week I provided a few thoughts about how companies might manage operating cash flow within the boundaries of generally accepted accounting principles. If the SEC's move against Dynegy Inc. to reclassify $300 million from operating to financing cash flow is any indication, that agency is starting to think more seriously about how companies report cash flows. I would not be surprised to see the SEC require other companies to reclassify their cash flow statements.
While we are in this mode of forward-looking, let's look at the supplemental reporting of EBITDA or earnings before interest, taxes, depreciation and amortization. This is a big topic and one that could easily be dealt with as a stand-alone subject. But here are a few observations. Because EBITDA, which is often used as a pro-forma measure of earnings, is calculated before key expense measures such as interest and income taxes, depreciation and amortization, it obviously provides a more positive view of financial performance. Many proponents of EBITDA would also remove certain nonrecurring items, typically charges, in calculating EBITDA. Thus companies just look better when measured on an EBITDA basis. I think that this fascination with the metric will decline as a more conservative reporting environment takes hold and investors begin to make more sober assessments of financial performance. EBITDA gained its popularity during the 1990s and I think will lose its luster during this new decade. EBITDA will become a metric for companies that cannot generate normal shareholder earnings. Lenders, I believe, will continue to use EBITDA as such earnings are available for debt service. It is shareholders who I think will begin to more forcefully question the reporting of EBITDA as a supplemental earnings statistic. EBITDA are simply not earnings that are available for shareholders.
Some recently released Statements from the Emerging Issues Task Force (EITF) of the FASB are changing how manufacturers account for certain promotion and marketing expenses. Consider, for example, a consumer packaged goods company that sells to a grocery chain. Historically, any promotional payments made by the manufacturer to the grocery chain would be accounted for as part of selling, general and administrative expense (SG&A). Beginning this year those same payments must now be netted against revenue. This appears to me to be a significant issue to watch. While it will not alter reported net income it does affect amounts reported as revenue.
The FASB is presently working on the definition of control. That is, when does an entity "control" another one requiring consolidation of financial reporting. Historically, control was defined as an ownership interest of over 50% of the voting shares. However, it is not difficult to identify situations where one entity does not own over 50% of the voting shares but through a large minority ownership interest and other arrangements, including significant board representation, the entity has effective control. Prior to all of the discussions about off-balance sheet obligations surrounding Enron Corp.'s restatements, the FASB had tabled this topic. After Enron, it is easy to see the need for a clearer definition of what constitutes control. I think that we will see something from the FASB on this before too long.
Updated June 13, 2002 4:33 p.m. EDT |
