Dr. Jensen
Students
may use any reference materials available in the Trinity Library and on the
Web.
Students may not obtain help from any person other than Dr. Jensen. His help is limited to clarification questions regarding what is required for a given question or problem.
Part
1 ESO Tax Benefits
The
starting point for Part 1 is Appendix A of a letter written by Professor Jensen
to Senator Charles E. Schumer. An Appendix C has been added to Professor
Jensen’s original letter, and the letter has not yet been mailed. The purpose of Part 1 of this examination is
to compare how you would write an Appendix C that addresses the tax benefit
controversy of employee stock options (ESOs).
The letter of Walter Schuetze to Senator Schumer, The primary documents useful to this
examination are as follows:
1. “Accounting for Tax Benefits of Employee Stock Options and
Implications for Research,” Accounting Horizons, Vo. 16, No. 1, March
2002, pp. 1-16.
2. Chapter 11 of Business Analysis & Valuation, by K.G. Palepu, P.m. Healy, and V.I. Bernard (South-Western Publishing, 2000, ISBN 0-324-02002-3).
3.
FAS 123 entitled “Accounting for Stock-Based
Compensation.” This standard is
available from the Financial Accounting Standards Board at http://accounting.rutgers.edu/raw/fasb/
Trinity University students may find the document on the path J:\courses\acct5341\ExamHints\Fas123
4. On March 25, 2002, Walter P. Schuetze, former Chief Accountant of the Securities and Exchange Commission, wrote Senator Schumer a letter that leaves no doubt that he opposes booking of employee stock options when they vest. That letter is now on the Web at http://www.trinity.edu/rjensen/theory/sfas123/schuetze01.htm
5.
Bob
Jensen’s reply that points out some opposing arguments. The initial reply is on
the Web at http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm
Initially,
the above document contains an incomplete Appendix C that is Part 1 of this
examination. You are prepare an answer
key for this examination. That key will
complete the Appendix C.
Required:
1.
You are to fill in the cells that have been blanked out
below. Please enter your results in the
Excel spreadsheet that accompanies this examination. That spreadsheet can be downloaded from the
exam02q.xls file on the path http://www.cs.trinity.edu/~rjensen/Exams/5341sp02/exam02/
Warning: Since you will be asked
what happens when the tax rate varies, it is best to derive your spreadsheet
answers in such a way that you can easily derive different outcomes with each
change in the tax rate.
2.
A copy of Hanlon and Shevlon (2002) cited above is provided
in this examination. You are to use
this paper for guidance in completing the spreadsheet required above.
3.
Fill in all the table blanks and answer the questions on
the following pages. Assume that ESO
tax benefits arise only when stock options are exercised. Initially assume that the options in
Appendix C can only be exercised at the end of Year 5.
4.
When you are asked to value these companies at the
beginning of Year 1, pretend that the revenue and expense cash flows are
estimates. For guidance on the
valuation calculations, to the Excel workbook on the path J:\courses\acct5341\ExamHints\FAS123\Appendices.xls
Part
1.1 (40 Points)
Fill in the blanks below after filling in the yellow cells of the Part 1
spreadsheet in the Exam3q.xls file. The
accounting is to proceed according to APB 25 procedures (see Hanlon and Shevlon
(2002)).
Grading Note: Half the points
on Part 1 depended upon the correct accounting for the exercise of the stock
options under APB 25 at the end of Year 5.
In particular, note the top of Page 3 in Hanlon and Shevlon (2002).
The
Excel Workbook Answers to Part 1.1 are in the exam02a.xls file at http://www.cs.trinity.edu/~rjensen/Exams/5341sp02/exam02/
|
Year 5 After Exercise of Options |
Nobel Cash Company |
Nobel Option Company |
|
Operating revenue |
$320,000 |
$320,000 |
|
Interest
revenue |
$12,367 |
$23,424 |
|
Labor
expense |
$160,000 |
$0 |
|
Net
profit before income tax (NBOT) |
$172,367 |
$343,424 |
|
Income
tax expense |
$51,710 |
$103,027 |
|
Net
profit |
$120,657 |
$240,397 |
|
Cash |
$244,329 |
$727,659 |
|
Capital |
($10,000) |
($263,027) |
|
Retained
earnings |
($234,329) |
($464,632) |
|
Number
of shares |
10,000 |
25,000 |
|
Earnings
Per Share |
$12.07 |
$9.62 |
|
Value
of options before exercised |
$0 |
$500,000 |
|
Value of options after exercised |
|
$0 |
|
Book
Value Per Share |
$24.43 |
$29.11 |
|
|
|
|
|
|
Nobel Option Reconciliation of Cash in Year 5 |
|
Appendix
A Cash without interest and taxes = |
$780,000 |
|
Interest
revenue = |
$43,760 |
|
Less
Income Taxes Payable paid in cash = |
($96,101) |
|
Appendix
C Cash With Taxes = |
$727,659 |
|
|
|
|
|
Nobel Option Reconciliation of Capital in Year 5 |
|
Appendix
A Capital without taxes = |
($160,000) |
|
Additional
paid-in capital from ESO tax benefit = |
($103,027) |
|
Appendix
C Capital With Taxes = |
($263,027) |
|
|
|
|
|
Nobel Option Reconciliation of Retained Earnings in Yr 5 |
|
Appendix
A Retained Earnings without interest and taxes = |
($620,000) |
|
Interest
revenue = |
($43,760) |
|
Less
Income Tax Expense in financial statements = |
$199,128 |
|
Appendix
C Retained Earnings With Taxes = |
($464,632) |
|
|
|
|
|
Initial Investment and Net Profits |
Nobel Cash Company |
Nobel Option Company |
|
0 |
$7,700 |
$10,000 |
|
1 |
$7,700 |
$14,700 |
|
2 |
$15,239 |
$29,729 |
|
3 |
$30,306 |
$59,810 |
|
4 |
$60,427 |
$119,997 |
|
5 |
$120,657 |
$240,397 |
|
NPV = |
$166,254 |
$324,096 |
|
Cost of Capital = |
10.00% |
10.00% |
|
Dividend Cash Flow Valuation |
$151,709 |
$451,819 |
|
Residual Income Model Valuation |
$151,709 |
$387,847 |
|
FCF Flow Valuation |
$151,709 |
$451,819 |
|
|
|
|
|
Dividend Cash Flow Valuation |
Nobel Cash Company |
Nobel Option Company |
|
Cost of Capital = |
10.0000% |
10.0000% |
|
Year t |
Dividend Cash Flows |
Dividend Cash Flows |
|
1 |
$0 |
$0 |
|
2 |
$0 |
$0 |
|
3 |
$0 |
$0 |
|
4 |
$0 |
$0 |
|
5 |
$244,329 |
$577,659 |
|
ESO New Equity Investment in Year 5 = |
$0 |
$150,000 |
|
Dividend Est. Value of Firm at Time 0 |
$151,709 |
$451,819 |
|
Dividend Est. Value Per Share at Time 0 |
$15.17 |
$18.07 |
|
|
|
|
|
|
|
|
|
Residual Income Valuation |
|
|
|
|
|
|
|
Residual Income Valuation |
Nobel Cash Company |
Nobel Option Company |
|
Cost of Capital = r = |
10.00% |
10.00% |
|
Year t |
Book Value (0) |
Book Value (0) |
|
0 |
$10,000 |
$10,000 |
|
|
Net Profit (t)-(r)(Book Value (t-1)) |
Net Profit (t)-(r)(Book Value (t-1)) |
|
1 |
$6,700 |
$13,700 |
|
2 |
$13,469 |
$27,259 |
|
3 |
$27,012 |
$54,367 |
|
4 |
$54,103 |
$108,573 |
|
5 |
$108,290 |
$216,973 |
|
ESO New Equity Investment in Year 5 = |
$0 |
$150,000 |
|
RI Estimated Value of Firm at Time 0 |
$151,709 |
$387,847 |
|
RI Est. Value Per Share at Time 0 |
$15.17 |
$15.51 |
|
|
|
|
|
|
|
|
|
Free Cash Flow Valuation |
|
|
|
|
|
|
|
Free Cash Flow Valuation |
Nobel
Cash Company |
Nobel
Option Company |
|
Cost of Capital = |
10.0000% |
10.0000% |
|
Year t |
FCF(t) |
FCF(t) |
|
1 |
$0 |
$0 |
|
2 |
$0 |
$0 |
|
3 |
$0 |
$0 |
|
4 |
$0 |
$0 |
|
5 |
$244,329 |
$577,659 |
|
ESO New Equity Investment in Year 5 = |
$0 |
$150,000 |
|
FCF Estimated Value of Firm at Time 0 |
$151,709 |
$451,819 |
|
FCF Est. Value Per Share at Time 0 |
$15.17 |
$18.07 |
Part
1.2 (10 Points) Abnormal Earnings
Valuation
When
comparing the Dividends versus Abnormal Earnings/Residual Income valuation
outcomes, note that these outcomes are identical ($151,709) for the Nobel Cash
Company. They are not identical for the
Nobel Option Company. What is this
difference and how do you account for the difference. Why is that the case, and what is a fundamental problem with
Abnormal Earnings/Residual Income Model valuation?
Hint: Carefully read the introduction to the
Abnormal Earnings Valuation Method introduction on Page 11-3 of Business
Analysis & Valuation, by K.G. Palepu, P.m. Healy, and V.I. Bernard
(South-Western Publishing, 2000, ISBN 0-324-02002-3). Especially note the underlying assumption and Footnote 1 on Page
11-22.. What are some of the reasons
analysts still prefer the Abnormal Earnings Valuation model?
Suggested Answer:
|
|
Nobel Cash Company |
Nobel Option Company |
|
Dividend Cash Flow Valuation |
$151,709 |
$451,819 |
|
Residual Income Model Valuation |
$151,709 |
$387,847 |
|
Valuation
Difference |
$0 |
$63,972 |
The valuations are estimated at the beginning of Year 1. If we
compute the future value of the $63,972 valuation difference five years out
using the Nobel Option's cost of capital rate of 10.00%, that future value is $103,027,
which is exactly equal to the ESO tax benefit. Or put in another way, the
valuation difference of $63,972 is the present value (at Time 0) of the ESO tax
benefit of $103,027 at the end of Year 5.
The reason for the $63,972 lower valuation from the Residual
Income/Abnormal Earnings Model, is that this valuation model assumes a
"clean surplus" in which all equity capital changes other than new
share issuances pass through earnings. Under APB 25, the ESO tax benefit
arising from the intrinsic value of exercised stock options gives rise in this
illustration to a $103,027 tax benefit that wiped out all taxes payable for the
Nobel Option Company in Year 5. The APB 25 required entry for this is a
debit to Cash (or Taxes Payable) and a credit to Capital (or Paid-in
Capital). As a result, Nobel Option Company does not satisfy the required
assumption of a "clean surplus" in Year 5 due to the fact that the
$103,027 did not increase earnings but did increase Capital.
The $150,000 received from the issuance of new shares is not a cause
of any valuation model difference since this does not violate the clean surplus
assumption.
Part
1.3 Market Value at the End of Year 4
Part
A (5 Points)
What are the book values per share at the end of Year 4?
$12.37 in the Nobel Cash
Company
$23.42 in the Nobel Option
Company
Part
B (10 Points)
The book value in both companies at the end of Year 4 maps to the only asset
of each company --- Cash. If each
company went public with an IPO at the end of Year 4, what factors might make
the market value of a Nobel Cash Company’s share of stock worth more
than the market value of Nobel Option Company?
When answering this question, ignore any possible differences in
off-balance sheet items other than ESOs.
Also assume that at the end of Year 4, it is not known that the firm
will liquidate in Year 5.
Suggested Answer:
Astute investors may see the Nobel Option Company ESO obligations
lying in wait. Although Nobel Option
Company has higher earnings performance, higher book value, and more cash, all
of these items are completely due to the fact that in this example, Nobel
Option Company had lower wages.
Before they are exercised, the ESOs are off-balance sheet claims to
the assets of the company. They have
lower priority than creditor claims, and they are contingency claims in the
sense that they must have intrinsic value at the time they are exercised. Intrinsic value is equal to the option value
minus strike price. If intrinsic value
of ESOs exists, there is a dilution impact that will lower the book value and
market value per share if a significant number of such options are exercised.
Part
C (10 Points)
The book value in both companies at the end of Year 4 maps to the only asset of
each company --- Cash. If each company
went public with an IPO at the end of Year 4, what factors might make the
market value of a Nobel Cash Company’s share of stock worth less
than the market value of Nobel Option Company?
When answering this question, ignore any possible differences in
off-balance sheet items other than ESOs.
Also assume that at the end of Year 4, it is not known that the firm
will liquidate in Year 5.
Suggested Answer:
The first reason can be a real economic reason. When employees, such as in the Nobel Option
Company, take ESOs in lieu of higher wages, the company has more cash and lower
labor expense under APB 25 accounting.
If that cash is invested in the future for returns higher than the
firm’s cost of capital, investors should give higher value to the added
earnings.
In some sense, the outcome described above acts like an
interest-free loan from employees to the company. They eventually want some type of cash return on their ESOs, but
they are willing to forego cash now for later returns.
The second reason is that investors may not be as astute as assumed
in Part B above. Investors may not see
the Nobel Option Company ESO obligations lying in wait. Or they may see them, but may not be aware
of the full potential of the dilution impacts.
Part
D (10 Points)
The book value in both companies at the end of Year 4 maps to the only asset of
each company --- Cash. Could the market
value of a Nobel Option Company’s share of stock worth less than
the company’s book value at the end of Year 4?
When answering this question, ignore any possible differences in
off-balance sheet items other than ESOs.
Also assume that at the end of Year 4, it is not known that the firm
will liquidate in Year 5
Suggested Answer:
It is somewhat confusing if investors value each share less than the
cash they would receive if the firm is liquidated. However, if the firm is not being liquidated, investors
anticipate future earnings and cash flows.
Their outlook for the future may assign a higher or lower value
vis-à-vis current exit value.
There are many types of intangibles, contingent liabilities, and
other factors that make book value of dubious importance when estimating market
value.
Robert
K. Elliott
Challenge and Achievement in Accounting During the Twentieth Century,
edited by Daniel L. Jensen (The Ohio State University and the University of
Florida's Fisher College of Business, 2002, pp. 22-23)
MR. ELLIOTT:
If I could just respond to one point. No one says that GAAP
isn't important or that it doesn't give important information about value
realization. But in the marketplace there's an increasing gap between value
creation, about which we have no good models, and value realization,
the later realization of the value that's created. If we look back to the
Industrial Era, the gap between when value was created and when it was realized
wasn't so great, and we could live with it. But now there is a huge
gap, and we never claimed as accountants that the net worth on the balance
sheet was supposed to equal the value of the company. But 10 or 20 years
ago, the ratio of market value to book value was about 2 to 1. Today it's
about 6 to 1. And for some companies over 100 to 1. What that tells us, I think, is
that what's measured in the balance sheet is seriously lagging what's happening
in the marketplace.
Yes, we have to be concerned with value realization. In the end we have
to make profits and have cash. But our GAAP measures are really not
diagnostic for investors to figure out which companies are actually creating
value. In the absence of disciplined information about those areas,
assured information about those areas, the marketplace runs on rumors.
Those rumors tend to be wrong and that expresses itself in the marketplace in
terms of huge volatility. That volatility then leads to higher cost of
capital, as investors demand to be compensated for that volatility.
Now, I'm not recommending that these assets necessarily be
reduced to debits and credits and put on the balance sheet. I'm not
talking about the necessity to incorporate them all into the existing GAAP
model. What I am saying is that there is objective information that could
be developed about these things, that this could be done in a way that's
similar across enterprises in the same industry, and that assurance could be
given about such information which would make the market estimates in value
creation better than they are today. Perfect? No. I'm not
looking for perfection. I'm looking for better than today.
Part
1.4 (10 Points) ESO Tax Benefits
How
can current APB 25 rules adjusting for the ESO tax benefits lead to misleading
conclusions by analysts about how much management is managing earnings through
the use of its discretionary changes in the FAS 109 valuation allowance?
Hint: See the bottom of Page 7 in the
Hanlon and Shevlon (2002) paper.
Suggested Answer:
Firms are obligated by FAS 109 to provide a valuation allowance when
any part of the deferred tax asset is not likely to be realized. Adjustments to this valuation allowance flow
through income tax expense and affect income on an after-tax basis. Tests searching for evidence of earnings
management often view manipulation of the valuation allowance as a prime
suspect. But when some part of th
evaluation allowance change flows directly to shareholders’ equity, bypassing
income tax expense, the tests may signal unwarranted conclusions.
Studies by Miller and Skinner (1998) and Visvanathan (1998) conclude
that changes in this valuation allowance, after controlling for known economic
determinants of its balance, do not signal earnings management. Both these sutides mignt have concluded
differently had the ESO tax benefits associated with the valuation allowance
changes been properly treated. See
Hanlon and Shevlon (2002, Page 8)
Part
1. 5 ESO Expense Recognition
Paragraph
74 of FAS 123 reads as follows.
Paragraphs 75-117 of this (FAS 123)
appendix discuss the reasons for the Board's principal conclusions on
recognition and measurement issues, which support the Board's belief that
recognition of stock-based employee compensation cost determined according to
the fair value based method is preferable to continued application of Opinion
25 with only pro forma disclosures of the effect of recognizing stock-based
employee compensation cost. That discussion begins with the basic issue of why employee stock
options give rise to recognizable compensation cost.
Part
A (10 Points)
In your own words, briefly summarize in less than 400 words, the arguments for
the FASB conclusions in Paragraph 74 above. Only the first 400 words will be graded.
I think the main argument against APB 45 accounting in which
continues to allow firms not to book ESOs can be found in the following
paragraph from FAS 123:
85.
Some people told the Board that a requirement to recognize compensation cost
might bring additional discipline to the use of employee stock options. Unless
and until the stock price rises sufficiently to result in a dilutive effect on
earnings per share, the current accounting for most fixed stock options treats
them as though they were a "free good." Stock options have
value--employee stock options are granted as consideration for services and
thus are not free.
There are many other arguments for booking of ESOS that are
discussed below.
There is a terrible inconsistency between tax law and APB 25
accounting rules for ESOs. APB 25
allows firms to never book ESO intrinsic value given to employees including
intrinsic value on the date they are exercised. The tax code says that employees receive intrinsic value and
allows companies to charge this intrinsic value to reduce taxes payable. Firms get huge permanent tax benefits for
things of value given to employees that are never recognized assets being given
up by the firms. The amounts involved
are not trivial.
Many large
corporations tend to avoid virtually all taxation. For example, employee
stock options allow enormous permanent reductions in corporate taxes for benefits
that will never cost the corporation anything in terms of corporate
assets. Michele Hanlon and Terry Shevlon, Accounting Horizons,
March 2002, Page 2 state the following:
A recent article in
the Wall Street Journal (August 4, 2002, Page A2) "Cisco, Microsoft, Get
Income Tax Break on Gains from Employee Stock Options" reports that for
its fiscal year ended July 29, 2000, Cisco received a Tax benefit of nearly
$2.5 billion dollars from the exercise of employees' stock options
(ESOs). As a result, the company paid little or no federal income taxes
while reporting $2.67 billion in profits.
The arguments for booking of all employee stock options and counter
arguments against the critics are summarized very well in Appendix A of FAS
123. Several of the most important
paragraphs are quoted below.
|
Excerpts from FAS
123 Appendix A |
|
56. Accounting for stock-based
employee compensation plans is a pervasive subject that affects most public
entities and many nonpublic entities. Opinion 25 continues to be criticized
for producing anomalous results and for lacking an underlying conceptual
rationale that helps in resolving implementation questions or in deciding how
to account for stock-based compensation plans with new features. A frequently
cited anomaly is that the requirements of Opinion 25 typically result in the
recognition of compensation cost for performance options but no cost is
recognized for fixed options that may be more valuable at the grant date than
performance options. Critics of Opinion 25 also note that long-term fixed
options granted to employees are valuable financial instruments, even though
they carry restrictions that usually are not present in other stock options.
Financial statements prepared in accordance with the requirements of Opinion
25 do not recognize that value. The resulting financial statements are less
credible than they could be, and the financial statements of entities that
use fixed employee options extensively are not comparable to those of
entities that do not make significant use of fixed options. Because of the
various criticisms of Opinion 25, in March 1984, the Board added a project to
its agenda to reconsider accounting by employers for stock-based compensation
plans. Why the Board Decided Not to Require
Fair Value Accounting 59. Unlike other highly
controversial topics, the controversy on accounting for stock-based
compensation escalated throughout the exposure process. The main point of
contention was whether compensation cost should be recognized for stock
options with fixed terms that are at-the-money \13/ at the date they are
granted. Constituents gave different reasons for opposing cost recognition,
with many expressing concerns about whether the fair value of employee stock
options at the grant date can be estimated with sufficient reliability. Most
respondents urged the Board to expand disclosures about stock-based employee
compensation arrangements rather than to change the basic accounting method
in Opinion 25. The specific comments of respondents to the Exposure Draft and
later comments made as the Board redeliberated the issues are discussed later
in this appendix. =========================================================================== 60. The debate on accounting for
stock-based compensation unfortunately became so divisive that it threatened
the Board's future working relationship with some of its constituents.
Eventually, the nature of the debate threatened the future of accounting
standards setting in the private sector. 61. The Board continues to believe
that financial statements would be more relevant and representationally
faithful if the estimated fair value of employee stock options was included
in determining an entity's net income, just as all other forms of
compensation are included. To do so would be consistent with accounting for
the cost of all other goods and services received as consideration for equity
instruments. The Board also believes that financial reporting would be
improved if all equity instruments granted to employees, including
instruments with variable features such as options with performance criteria
for vesting, were accounted for on a consistent basis. However, in December 1994,
the Board decided that the extent of improvement in financial reporting that
was envisioned when this project was added to its technical agenda and when
the Exposure Draft was issued was not attainable because the deliberate,
logical consideration of issues that usually leads to improvement in
financial reporting was no longer present. Therefore, the Board decided to
specify as preferable and to encourage but not to require recognition of
compensation cost for all stock-based employee compensation, with required
disclosure of the pro forma effects of such recognition by entities that
continue to apply Opinion 25. Why Stock-Based Employee
Compensation Is a Cost That Should Be Recognized in Financial Statements 74. Paragraphs 75-117 of this appendix
discuss the reasons for the Board's principal conclusions on recognition and
measurement issues, which support the Board's belief that recognition of
stock-based employee compensation cost determined according to the fair value
based method is preferable to continued application of Opinion 25 with only
pro forma disclosures of the effect of recognizing stock-based employee
compensation cost. That discussion begins with the basic issue of why
employee stock options give rise to recognizable compensation cost. 75. The Board's conclusion that
recognizing the costs of all stock-based employee compensation, including
fixed, at-the-money stock options, is the preferable accounting method stems
from the following premises: a. Employee stock options have value. b. Valuable financial instruments
given to employees give rise to compensation cost that is properly included
in measuring an entity's net income. c. The value of employee stock
options can be estimated within acceptable limits for recognition in financial
statements. Employee Stock Options Have Value 76. An option or warrant to buy an
entity's stock for a fixed price during an extended future time period is a
valuable right, even if the ways in which the holder can exercise the right
are limited. Investors pay cash to buy stock options and warrants that
generally have fewer restrictions than employee stock options, and
unrestricted options and warrants are traded daily in financial markets. The
additional restrictions inherent in employee stock options, such as the
inability to transfer the option to a third party for cash, cause the value
of an employee stock option to be less than the value of an otherwise
identical tradable option at any time before the expiration date, but the
restrictions do not render employee stock options valueless. 77. Employees rarely pay cash to
acquire their employee stock options. Instead, employees provide services to
their employer in exchange for cash, stock options, and other employee
benefits. Even if employees are required to pay a nominal amount of cash for
their options, it usually is far less than the fair value of the options
received. The majority of the consideration an employer receives for employee
stock options is employee services. Nonrecognition of compensation cost
implies either that employee stock options are free to employees or that the
options have no value--neither of which is true. 78. Some respondents argued that an
employee stock option has value only if the employee ultimately realizes a
gain from it. The Board does not agree. Many traded options ultimately expire
worthless; that does not mean that the options had no value either when they
were written or at any other time before they expired. An employee stock
option has value when it is granted regardless of whether, ultimately, (a)
the employee exercises the option and purchases stock worth more than the
employee pays for it or (b) the option expires worthless at the end of the
option period. The grant date value of a stock option is the value at that
date of the right to purchase an entity's stock at a fixed price for an
extended time period. Investors pay cash to acquire that right--employees
provide services to acquire it. Valuable Financial Instruments Given
to Employees Give Rise to Compensation Cost That Is Properly Included in
Measuring an Entity's Net Income 79. Employees provide services for
which employers pay compensation. The components of an employee's total
compensation package are, to some extent, flexible. The compensation package,
for example, might include more cash and less health insurance, or the
package might include stock options and less cash. Some employers even offer
employees a choice between predetermined amounts of cash and stock options. 80. Large employers have included stock
options in the compensation packages of upper echelon management for many
years, and some employers recently have adopted broad-based plans that cover
most of their full-time employees. A stated objective of issuing stock
options is to align employee interests with those of shareholders and thereby
motivate employees to work to maximize shareholder value. In addition, many
start-up and other cash-poor entities provide stock options to make up for
cash wages and other benefits that are less than those available elsewhere.
Many respondents from younger, rapidly growing entities said that their
success was attributable in large part to their extensive use of stock
options; without stock options, they could not have attracted and retained
the employees they needed. 81. Some respondents said that stock
options are not direct compensation for services rendered and thus are not
comparable to cash salaries and wages. Rather, stock options usually have
other objectives, such as to attract valuable employees and to encourage them
to stay with the employer by requiring a period of service before their
options vest and become exercisable. Stock options, like other forms of
incentive compensation, also are intended to motivate employees to perform
better than they might have without the incentive. Stock-based compensation
awards often are intended to compensate employees for incremental efforts
beyond the basic performance required to earn their salaries or wages.
Respondents that made those points generally said that the value of stock
options is not a compensation cost that should be recognized in the entity's
financial statements. 82. The Board acknowledges that
employee stock options, as well as other forms of stock-based compensation,
usually are not direct substitutes for a stated amount of cash salaries. That
does not, however, imply that the value of options issued to employees is not
a recognizable cost. Group medical and life insurance, disability insurance,
employer-paid memberships in health clubs, and the like also are not direct
compensation like cash salaries because the amount of benefit that an
individual employee may receive does not necessarily vary directly with
either the amount or the quality of the services rendered. However, virtually
everyone agrees that the costs of those benefits are properly deducted in
determining the entity's net income. Like employee stock options, benefits
such as medical insurance and pensions are compensation in the broad sense of
costs incurred to attract, retain, and motivate employees. It has long been
an established practice that, even if employee benefits are paid--directly or
indirectly--with shares of the employer's stock, the value of the stock
issued to the employee or the service provider is a cost to be reported in
the employer's income statement. 83. Some opponents of recognizing
compensation cost for stock options acknowledge that stock options are
recognizable compensation, but they say that a requirement to recognize that
compensation would have adverse economic consequences because many entities
would reduce or eliminate their stock option programs. However, some of the
same respondents also said that Opinion 25's bias in favor of fixed awards at
the expense of awards with performance conditions, options with indexed
exercise prices, and the like should be eliminated because that bias has
undesirable economic consequences. It deters employers from using more
performance-based awards, which those respondents consider preferable to
fixed options in many situations. 84. The Board's operating precepts
require it to consider issues in an even-handed manner, without intentionally
attempting to encourage or to discourage specific economic actions. That does
not imply that improved financial reporting should not have economic
consequences; a change in accounting standards that makes available more
relevant and representationally faithful financial information often will
have economic consequences. For example, the availability of the new
information resulting from application of this Statement may lead an entity
to reassess the costs and benefits of its existing stock option plans. If a
reassessment reveals that the expected benefits of a stock option plan do not
justify its costs, a rational response would be to revise or eliminate the
plan. However, an entity presumably would not restrict or eliminate a stock
option program whose motivational effect on employees is expected to make a
net contribution to reported results of operations. To do so would not be
rational because continuing the plan would be expected to increase revenues
(or to decrease other expenses) more than enough to offset the reported
compensation cost. In addition, many small, emerging entities told the Board
that stock options often substitute for higher cash wages or other benefits,
such as pensions. Significantly reducing those option programs would not make
economic sense if employees would demand equal or greater cash wages or other
benefits to replace the lost stock options. 85. Some people told the Board that
a requirement to recognize compensation cost might bring additional
discipline to the use of employee stock options. Unless and until the stock
price rises sufficiently to result in a dilutive effect on earnings per
share, the current accounting for most fixed stock options treats them as
though they were a "free good." Stock options have value--employee
stock options are granted as consideration for services and thus are not
free. 86. Some respondents said that
recognizing the compensation cost stemming from stock options would, by
itself, raise the cost of capital of all entities that use options
extensively. An individual entity's cost of capital would rise only if its
lenders or buyers and sellers of its stock had previously been misled by the
accounting under Opinion 25 to believe that fixed, at-the-money employee
stock options have no value and thus impose no cost on the entity. If that
were the situation for an individual entity or a group of entities, any
increase in cost of capital would result from new, relevant information.
Making available at an acceptable cost information that is helpful in making
investment, credit, and similar decisions is the overriding objective of
financial reporting. 87. Some respondents that agreed
with the Board's conclusion that accounting standards, by themselves, are
highly unlikely to have negative economic consequences noted that the market
abhors uncertainty. Reducing uncertainty can reduce the cost of capital.
Therefore, recognizing in financial statements the cost of all stock-based
compensation measured in a reasonable and internally consistent manner might
lower rather than raise an entity's cost of capital. Financial statement
users no longer would have to decide how to consider the cost of stock options
in their analysis of an entity, knowing that whatever method they chose would
be based on inadequate information. With amounts recognized and measured on a
reasonable and consistent basis that takes into account detailed information
generally available only to the entity, users might still choose to modify or
use the available information in different ways, but they would have a
reasonable starting point for their analysis. Expenses and Capital Transactions 88. Some respondents pointed out
that the definition of expenses in FASB Concepts Statement No. 6, Elements of
Financial Statements, says that expenses result from outflows or using up of
assets or incurring of liabilities (or both). They asserted that because the
issuance of stock options does not result in the incurrence of a liability,
no expense should be recognized. The Board agrees that employee stock options
are not a liability--like stock purchase warrants, employee stock options are
equity instruments of the issuer. However, equity instruments, including
employee stock options, are valuable financial instruments and thus are
issued for valuable consideration, which often is cash or other financial
instruments but for employee stock options is employee services. Using in the
entity's operations the benefits embodied in the asset received results in an
expense, regardless of whether the consideration is cash or other financial
instruments, goods, or services. \14/ Moreover, even if shares of stock or
other equity instruments are donated to a charity, the fair value of the
instruments issued is recognized together with other charitable contributions
in determining the issuer's net income. The Board recently reaffirmed that
general principle in FASB Statement No. 116, Accounting for Contributions Received
and Contributions Made. ===========================================================================
89. Others noted that the issuance
of an employee stock option is a capital transaction. They contended that
capital transactions do not give rise to expenses. As discussed in paragraph
88, however, issuances of equity instruments result in the receipt of cash,
other financial instruments, goods, or services, which give rise to expenses
as they are used in an entity's operations. Accounting for the consideration
received for issuing equity instruments has long been fundamental to the
accounting for all free-standing equity instruments except one--fixed stock
options subject to the requirements of Opinion 25. 90. Some respondents also asserted
that the issuance of an employee stock option is a transaction directly
between the recipient and the preexisting stockholders in which the
stockholders agree to share future equity appreciation with employees. The
Board disagrees. Employees provide services to the entity--not directly to
the individual stockholders--as consideration for their options. Carried to
its logical conclusion, that view would imply that the issuance of virtually
any equity instrument, at least those issued for goods or services rather
than cash or other financial instruments, should not affect the issuer's
financial statements. For example, no asset or related cost would be reported
if shares of stock were issued to acquire legal or consulting services,
tangible assets, or an entire business in a business combination. Moreover,
in practice today, even if a stockholder directly pays part of an employee's
cash compensation (or other corporate expenses), the transaction and the
related costs are reflected in the entity's financial statements, together
with the stockholder's contribution to paid-in capital. To omit such costs
would give a misleading picture of the entity's financial performance. 91. The Board sees no conceptual
basis that justifies different accounting for the issuance of employee stock
options than for all other transactions involving either equity instruments
or employee services. As explained in paragraphs 57-62, the Board's decision
not to require recognition of compensation expense based on the fair value of
options issued to employees was not based on conceptual considerations. Prepaid Compensation 92. The Exposure Draft proposed that
an asset, prepaid compensation, be recognized at the date stock-based
employee compensation awards are granted; the prepaid compensation would
represent the value already conveyed to employees for services to be received
in the future. Later, compensation cost would have been incurred as the
benefits embodied in that asset were used up; that is, as the employees
rendered service during the vesting period. 93. Many respondents objected to the
recognition of prepaid compensation at the grant date. They said that, unlike
most other amounts paid to suppliers before services are received, the proposed
prepaid compensation for nonvested stock-based employee compensation did not
meet the definition of an asset in ñparagraph 25 of Concepts Statement 6,
which defines assets as "probable future economic benefits obtained or
controlled by a particular entity as a result of past transactions or
events" (footnote reference omitted). Prepaid fees for legal services,
consulting services, insurance services, and the like represent probable
future economic benefits that are controlled by the entity because the other
party to the transaction has entered into a contract to provide services to
earn the fees. The service provider is not entitled to walk away from its
obligation to render the services that are the subject of the contract by
merely foregoing collection of the fee for services not rendered. Although
courts rarely enforce specific performance under a service contract, a
construction contractor, for example, cannot decide unilaterally not to
finish a building after digging the foundation without being subject to legal
action for monetary damages by the other party to the contract. Contracts
sometimes specify the damages to be paid if the contract is broken. In other
circumstances, such as prepaid rent or insurance, the purchaser of the
service may be able to successfully sue for specific performance--the right
to occupy an office or to be reimbursed for fire damage, for example. 94. Those respondents said that
employee stock options do not represent probable future benefits that are controlled
by the employer at the date the options are granted because employees are not
obligated to render the services required to earn their options. The contract
is unilateral--not bilateral--because the entity has only conditionally
transferred forfeitable equity instruments and is obligated to issue the
instruments if and when the employee has rendered the specified service or
satisfied other conditions. However, the employee is not obligated to perform
the services and may leave the employer's service without being subject to
damages beyond the loss of the compensation that would have been paid had the
services been rendered. 95. The Board agreed that an entity
does not obtain an asset for future service to be rendered at the date
employee stock options are granted. Therefore, this Statement does not
require recognition of prepaid compensation at the grant date. Rather, the
cost of the related services is accrued and charged to compensation cost only
in the period or periods in which the related services are received. At the
grant date, awards of stock-based employee compensation are fully executory
contracts. Once employees begin to render the services necessary to earn the
compensation, execution of the contracts has begun, and recognition of the services
already received is appropriate. The Board's conclusions on how to attribute
compensation cost to the periods in which the entity receives the related
employee services are discussed further in paragraphs 196-203. 96. An equity instrument may be conditionally
transferred to another party under an agreement that allows that party to
choose at a later date whether to deliver the agreed consideration for it,
which may be goods or services rather than cash or financial instruments, or
to forfeit the right to the instrument conditionally transferred, with no
further obligation. In that situation, the equity instrument is not issued
for accounting purposes until the issuing entity has received consideration
for it and the condition is thus satisfied. The grant of an employee stock
option subject to vesting conditions is an example of such a conditional
transfer. For that reason, this Statement does not use the term issued to
refer to the grant of a stock option or other equity instrument that is
subject to service or performance conditions for vesting. The Board's
conclusion that the entity receives no asset at the date employee stock
options are granted is consistent with that use of the term issued. That
conclusion about the issuance date of employee stock options, in turn, has
implications for the appropriate date at which to measure the value of the
equity instruments issued. This Statement requires a measurement method that
combines attributes of both grant date and vesting date measurement. The
Board's conclusions on measurement date and method are discussed in
paragraphs 149-154. Disclosure Is Not a Substitute for
Recognition 102. FASB Concepts Statement No. 5,
Recognition and Measurement in Financial Statements of Business Enterprises,
says: Since recognition means depiction of
an item in both words and numbers, with the amount included in the totals of
the financial statements, disclosure by other means is not recognition.
Disclosure of information about the items in financial statements and their
measures that may be provided by notes or parenthetically on the face of
financial statements, by supplementary information, or by other means of
financial reporting is not a substitute for recognition in financial
statements for items that meet recognition criteria. [paragraph 9] 103. Many respondents contended that
improved disclosures about employee stock options in the notes to financial
statements would be as useful as recognition of compensation cost in the
income statement. A specific disclosure proposal submitted by a group of
providers and users of financial statements and endorsed by the largest
accounting firms was illustrated in Appendix E of the Exposure Draft. Most
respondents, including some that had previously endorsed that proposal,
agreed that the proposed disclosures were too extensive and included some
items that more properly belong in a proxy statement. The Board received
several other proposals for disclosures in lieu of recognition during the
exposure period and during its redeliberations of the conclusions in the
Exposure Draft. Some of those proposals included a measure of the value of
options granted during the year, but most focused largely on greatly
expanding the detailed data disclosed about stock-based employee compensation
plans. 104. As discussed in paragraphs
57-62, the Board's decision to encourage but not to require recognition of
compensation cost for the fair value of stock-based employee compensation was
not based on acceptance of the view that disclosure is an adequate substitute
for recognition in the financial statements. If disclosure and recognition
were equal alternatives, the arguments for only disclosing either detailed
information about stock-based employee compensation awards or the amount of
unrecognized cost would apply equally to other costs such as depreciation,
warranties, pensions, and other postretirement benefits. 105. The Board believes that the pro
forma disclosures required by this Statement will mitigate to some extent the
disadvantages of permitting disclosure in lieu of recognition. To disclose
only additional details about options granted, vested, forfeited, exercised,
expired, and the like would permit only the most sophisticated users of
financial statements to estimate the income statement impact of recognizing
all compensation costs. Many individual investors and other users of
financial statements could not, and even the more sophisticated users would
have available less information than the entity itself has on which to base
estimates of value and related compensation cost related to employee stock
options. The Board's continuing belief that disclosure is not an adequate
substitute for recognition of items that qualify for recognition in financial
statements is the reason for this Statement's establishment of the fair value
based accounting method as preferable for purposes of justifying an
accounting change and for encouraging entities to adopt it. 106. The Board did not specifically
address during its formal deliberations whether pro forma disclosures of the
effects on net income and earnings per share of applying the fair value based
method should be included in summarized interim financial data required by
APB Opinion No. 28, Interim Financial Reporting. That question arose late in
the process of drafting this Statement when some Board members noted that
comparable information about earnings and earnings per share presented on a
quarterly basis would be important to financial analysis. Other Board members
agreed but thought that it was too late in this extraordinarily controversial
project to add a requirement for pro forma disclosures in summarized interim
financial data. Therefore, this Statement does not require those disclosures.
If a need for pro forma disclosures on a quarterly basis becomes apparent,
the Board will consider at a later date whether to require those disclosures. The Value of Employee Stock Options
Can Be Estimated within Acceptable Limits for Recognition in Financial
Statements 107. The value of employee services
rendered is almost always impossible to measure directly. For that reason,
accounting for the cost of employee services is based on the value of
compensation paid, which is presumed to be an adequate measure of the value
of the services received. Compensation cost resulting from employee stock
options is measured based on the value of stock options granted rather than
on the value of the services rendered by the employee, which is consistent
with the accounting for other forms of employee compensation. 108. Trading of options in the
financial markets has increased significantly in the last 20 years. During
that time, mathematical models to estimate the fair value of options have
been developed to meet the needs of investors. Some employers and
compensation consultants have used variations of those models in considering
how much of a compensation package should consist of employee stock options
and in determining the total value of a compensation package that includes
stock options. Many that have been using option-pricing models for those
purposes said that the existing models are not sufficiently accurate for
accounting purposes, although they are adequate for comparing the value of
compensation packages across entities and for estimating the value of options
in designing compensation packages. Those respondents generally said that a
more precise measure is needed for measuring compensation cost in the income
statement than for comparing the value of total compensation, including
options, paid by various entities or in determining how many options to grant
an employee. 109. The Board disagrees with the
distinction made by those respondents. One important use of financial
statements is to compare the relative attractiveness of investment and
lending opportunities available in different entities. Therefore, increasing
the comparability of financial statements is a worthy goal, even if all
entities use a measurement method that is less precise than the Board or its
constituents might prefer. 110. The derivative markets have
developed rapidly with the introduction of new kinds of options and
option-like instruments, many of which are long term and nontraded--or even
nontransferable. For example, interest rate caps and floors, both of which
are forms of options, are now common. Often, option components are embedded
in other instruments, and both the seller and the purchaser of the instrument
need to evaluate the value added by each component of a compound instrument.
Mathematical models that extend or adapt traditional option-pricing models to
take into account new features of options and other derivative securities
also continue to be developed. Sometimes decisions have been made based on
inadequate analysis or incomplete models, resulting in large and highly
publicized losses for one party to a contract. Those instances usually lead
to additional analysis of the instruments in question and further refinement
of the models. However, market participants--whether they consider themselves
to be traders, investors, or hedgers--continue to commit billions of dollars
to positions in options and other derivatives, based at least in part on
analysis using mathematical pricing models that are not perfect. 111. The Exposure Draft noted that
uncertainties inherent in estimates of the fair value of employee stock
options are generally no more significant than the uncertainties inherent in
measurements of, for example, loan loss reserves, valuation allowances for
deferred tax assets, and pension and other postretirement benefit
obligations. All estimates, because they are estimates, are imprecise. Few
accrual-based accounting measurements can claim absolute reliability, but
most parties agree that financial statement recognition of estimated amounts
that are approximately right is preferable to the alternative--recognizing
nothing--which is what Opinion 25 accounting recognizes for most employee
stock options. Zero is not within the range of reasonable estimates of the
value of employee stock options at the date they are granted, the date they
vest, or at other dates before they expire, with the possible exception of
deep-out-of-the-money options that are near expiration. Even those latter
options generally have a nominal value until very shortly before expiration. 112. Many respondents said that the
Exposure Draft inappropriately compared the imprecision in estimating the
value of employee stock options with similar imprecisions inherent in
estimating, for example, the amount of an entity's obligation to provide
postretirement health care benefits. They said that because postretirement
health care benefits eventually result in cash payments by the entity, the
total obligation and related cost are "trued up" over the entity's
life. In contrast, the value of employee stock options estimated at the grant
date is not trued up to reflect the actual gain, if any, that an employee
realizes from an award of employee stock options. Those respondents asserted
that the lack of true-up makes it necessary for the estimated value of
employee stock options that forms the basis for recognizing the related
compensation cost to be more precise than an estimate of the value of the
same entity's obligation for postretirement health care benefits. 113. The Board questions that
perceived distinction between the relative importance of the precision of
estimates of the value of employee stock options and the precision of other
estimates inherent in financial statements. Although the total amount of any
expense that is ultimately paid in cash will necessarily equal the total of
the amounts attributed to each of a series of years, the appropriate amount
to attribute to any individual year is never trued up. Nor can the precision
of the reported total obligation be determined at any date while it is being
incurred. For example, the total cost of a postretirement health care plan
will be trued up only if the plan is terminated. Investors, creditors, and
other users of financial statements must make decisions based on a series of
individual years' financial statements that covers less than the entire life
of the entity. For costs such as postretirement health care benefits, the
true-up period for an individual employee (or group of similar employees) may
be decades, and even then the total amount cannot be separated from amounts
attributed to other employees. Concern about the reliability of estimates of
the value of employee stock options and the related cost seem equally
applicable to annual estimates of, for example, obligations for
postretirement benefits and the related cost. 114. The respondents that emphasized
the importance of truing up the total cost of a stock-based employee
compensation award generally were adamantly opposed to exercise date
accounting--the only accounting method for employee stock options that would
true up interim cost estimates to equal the total gain, if any, an employee
realizes. The Board rejected exercise date accounting for conceptual reasons,
as discussed in paragraph 149. However, deferring final measurement of a
transaction until enough of the related uncertainties have been resolved to
make reasonably reliable measurement possible is the usual accounting
response to measurement difficulties for virtually all other transactions
except an award to an employee of fixed stock options. 115. The standard Black-Scholes and
binomial option-pricing models were designed to estimate the value of
transferable stock options. The value of transferable stock options is more
than the value of employee stock options at the date they are granted
primarily for two reasons. First, transferable stock options can be sold,
while employee stock options are not transferable and can only be exercised.
Second, an employee can neither sell nor exercise nonvested options.
Nonvested employee options cannot be exercised because the employee has not
yet fully paid for them and is not obligated to do so. Options other than
employee options rarely include a lengthy period during which the holder may
choose to walk away from the right to the options. 116. The measurement method in this
Statement reduces the estimated value of employee stock options below that
produced by an option-pricing model for nonforfeitable, transferable options.
Under the method in this Statement, the recognized value of an employee stock
option that does not vest--and thus is never issued to the employee--is zero.
In addition, the estimated value of an employee stock option is based on its
expected life rather than its maximum term, which may be considerably longer.
Paragraphs 155-173 explain why the Board believes those adjustments are
appropriate and sufficient to deal with the forfeitability and
nontransferability of employee stock options. 117. The Board continues to believe
that use of option-pricing models, as modified in this Statement, will
produce estimates of the fair value of stock options that are sufficiently
reliable to justify recognition in financial statements. Imprecision in those
estimates does not justify failure to recognize compensation cost stemming
from employee stock options. That belief underlies the Board's encouragement
to entities to adopt the fair value based method of recognizing stock-based
employee compensation cost in their financial statements. . |
Part
B (10 Points)
In your own words, briefly summarize in less than 400 words, the arguments against
the FASB conclusions in Paragraph 74 of FAS 123.
The
major argument against booking of ESOs is that the firm itself never sacrifices
assets for value received by employees holding ESOs, including intrinsic value
of the options at the time they are exercised.
Assets given up ultimately route to the existing shareholders in the
form of dilution of their shares in the assets as is illustrated in Appendix A
and B at http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm
The
second major argument is that a new requirement to book ESOs when they vest
would add heavily to the burden of having to fully expense R&D expenses
under FAS 2. Many firms, especially
high technology firms, are thrown into reporting of net losses for R&D even
though R&D expenditures generally have future benefits. Booking ESOs at fair value would further
lower reported earnings, creating enormous reported losses for many firms and
raising their cost of capital.
The FASB lists the major arguments in Appendix A of FAS 123 and then counters these arguments.
|
Excerpts from FAS
123 Appendix A |
|
83. Some opponents of recognizing compensation cost for stock options acknowledge that stock options are recognizable compensation, but they say that a requirement to recognize that compensation would have adverse economic consequences because many entities would reduce or eliminate their stock option programs. However, some of the same respondents also said that Opinion 25's bias in favor of fixed awards at the expense of awards with performance conditions, options with indexed exercise prices, and the like should be eliminated because that bias has undesirable economic consequences. It deters employers from using more performance-based awards, which those respondents consider preferable to fixed options in many situations. 84. The Board's operating precepts require it to consider issues in an even-handed manner, without intentionally attempting to encourage or to discourage specific economic actions. That does not imply that improved financial reporting should not have economic consequences; a change in accounting standards that makes available more relevant and representationally faithful financial information often will have economic consequences. For example, the availability of the new information resulting from application of this Statement may lead an entity to reassess the costs and benefits of its existing stock option plans. If a reassessment reveals that the expected benefits of a stock option plan do not justify its costs, a rational response would be to revise or eliminate the plan. However, an entity presumably would not restrict or eliminate a stock option program whose motivational effect on employees is expected to make a net contribution to reported results of operations. To do so would not be rational because continuing the plan would be expected to increase revenues (or to decrease other expenses) more than enough to offset the reported compensation cost. In addition, many small, emerging entities told the Board that stock options often substitute for higher cash wages or other benefits, such as pensions. Significantly reducing those option programs would not make economic sense if employees would demand equal or greater cash wages or other benefits to replace the lost stock options. 85. Some people told the Board that a requirement to recognize compensation cost might bring additional discipline to the use of employee stock options. Unless and until the stock price rises sufficiently to result in a dilutive effect on earnings per share, the current accounting for most fixed stock options treats them as though they were a "free good." Stock options have value--employee stock options are granted as consideration for services and thus are not free.
88. Some respondents pointed out that the definition of expenses in FASB Concepts Statement No. 6, Elements of Financial Statements, says that expenses result from outflows or using up of assets or incurring of liabilities (or both). They asserted that because the issuance of stock options does not result in the incurrence of a liability, no expense should be recognized. The Board agrees that employee stock options are not a liability--like stock purchase warrants, employee stock options are equity instruments of the issuer. However, equity instruments, including employee stock options, are valuable financial instruments and thus are issued for valuable consideration, which often is cash or other financial instruments but for employee stock options is employee services. Using in the entity's operations the benefits embodied in the asset received results in an expense, regardless of whether the consideration is cash or other financial instruments, goods, or services. \14/ Moreover, even if shares of stock or other equity instruments are donated to a charity, the fair value of the instruments issued is recognized together with other charitable contributions in determining the issuer's net income. The Board recently reaffirmed that general principle in FASB Statement No. 116, Accounting for Contributions Received and Contributions Made. ===========================================================================
96. An equity instrument may be conditionally transferred to another party under an agreement that allows that party to choose at a later date whether to deliver the agreed consideration for it, which may be goods or services rather than cash or financial instruments, or to forfeit the right to the instrument conditionally transferred, with no further obligation. In that situation, the equity instrument is not issued for accounting purposes until the issuing entity has received consideration for it and the condition is thus satisfied. The grant of an employee stock option subject to vesting conditions is an example of such a conditional transfer. For that reason, this Statement does not use the term issued to refer to the grant of a stock option or other equity instrument that is subject to service or performance conditions for vesting. The Board's conclusion that the entity receives no asset at the date employee stock options are granted is consistent with that use of the term issued. That conclusion about the issuance date of employee stock options, in turn, has implications for the appropriate date at which to measure the value of the equity instruments issued. This Statement requires a measurement method that combines attributes of both grant date and vesting date measurement. The Board's conclusions on measurement date and method are discussed in paragraphs 149-154 |
Some of the major arguments against booking ESOs are given by Walter
Schuetz at at
http://www.trinity.edu/rjensen/theory/sfas123/schuetze01.htm
His
main argument reads as follows:
|
Excerpts From Accounting for Stock Options
Issued to Employees |
|
At the hearing of the Senate Committee on Banking,
Housing, and Urban Affairs on Tuesday, February 26, 2002, in response to your
question, I said that, for technical accounting reasons, I would not charge
expense for stock options issued to employees. I said that I would explain why. First, I will define a term. The word “expense” means (1) a decline in the value of an owned
asset, as for example when an account receivable, which was thought to be
collectible, goes bad, or (2) the using up of an owned asset, as for example,
using cash to pay for advertising.
(Technically, an expense arises when an obligation to transfer assets
(to use up assets) arises, for example, on the receipt of goods or services
where payment of cash in satisfaction of the obligation is delayed in
accordance with normal business terms.) The Financial Accounting Standards Board, in one of
its Concepts Statements, defines assets as “…probable future economic
benefits obtained or controlled by a particular entity as a result of past
transactions or events.” (That
definition is followed by six paragraphs of more than 600 words explaining
the definition.) The International
Accounting Standards Board’s definition of assets is similar to the FASB’s in
that it is based on “economic benefits.”
Under that definition of assets, the receipt of services from
employees is an economic benefit, and the using up of that economic benefit
is an expense. (For FASB mavens, see
paragraphs 25—31 of Statement of Financial Accounting Concepts No. 6,
“Elements of Financial Statements,” especially paragraph 31, and paragraph 88
of Statement of Financial Accounting Standards No. 123, “Accounting
for Stock-Based Compensation.”) The
value of that economic benefit is hard if not impossible to measure directly,
so it is measured indirectly by reference to the cash paid to the employee by
the employer, state and Federal taxes paid by the employer on account of the
employee/employer relationship, and the cost of medical insurance, maternity
leave, child care, vacation, sick leave, and other benefits furnished to the
employee by the employer. Defining assets as probable future economic benefits,
as the FASB does, results in an expense on the receipt and use of services
from employees in exchange for stock or stock options. The value of the economic benefit received
is measured indirectly by reference to the fair value of the stock or stock
options issued to the employees. If,
as is generally the case, the stock is restricted stock or if restricted
options are issued, the measurement of the fair value of the stock or the
options generally is done by formula because reference cannot be made to a
market price of the stock or option. So, if you like the FASB’s definition of assets, that
is, economic benefits, you get an expense when stock or stock options are
issued to employees as the FASB recommended in its Statement 123 issued in
1995 unless you think that it results in “double counting,” which I will
explain later on. I do not like the FASB’s and IASB’s definition of
assets; “economic benefits” is too ambiguous, amorphous, and
indeterminate. It is not
workable. Only FASB and IASB accountants
know what the term “economic benefits” means, but they cannot explain the
term in words that ordinary folk and investors and creditors understand. When I was on staff at the Securities and
Exchange Commission as Chief Accountant and as Chief Accountant of the
Commission’s Division of Enforcement, I found “economic benefits” to be so
pliable that almost any expenditure, cost, or debit can be said to qualify as
an asset, or at least so it is asserted by registrants and their auditors,
lawyers, and expert witnesses when challenged by the Commission’s staff or
the Commission itself, either informally or in court. (For proof, I can show you the court
filings by respondents and their very distinguished expert witnesses.) Moreover, using that definition of assets
allows junk—rusty junk--to get onto corporate balance sheets—junk that cannot
be sold to anyone and therefore has no market value whatsoever—for example,
goodwill, deferred income taxes, income tax benefits of operating loss
carryforwards, development costs, direct-response advertising costs, debt
issue costs, and capitalized interest cost said to relate to the acquisition
of fixed assets. The FASB and IASB
say that junk has probable future economic benefits. I say nonsense. That junk does not and cannot earn a penny. When it comes time to pay bills or make
contributions to employees’ pension plans, that junk is worthless. Showing that junk as assets on corporate
balance sheets misleads investors.
Showing that junk as assets allows stock prices to soar when the
corporate balance sheet is bloated with hot air. In my accounting model, which I have recommended to
the FASB and IASB, I define assets as follows: CASH, claims to CASH (for example, accounts and notes
receivable), and things that can be sold for CASH (for example, securities,
inventory, trucks, buildings, oil and gas reserves, and patents). Ordinary folk and investors and creditors
understand my definition of assets.
Nothing ambiguous about it.
There are no rusty junk assets on balance sheets prepared using my
definition of assets. And, when
assets, as I define assets (and liabilities, as I define liabilities), are
shown on corporate balance sheets at their market prices as I have recommended
to the FASB and IASB, the balance sheet presents the corporation’s true
economic financial condition, not financial position that is determined by
reference to the FASB’s mountain of rules and formulas for computing or
determining asset and liability amounts, the result of which is not understandable
by investors, creditors, and other users of financial statements. In my accounting, I do not get an expense for the issuance of stock options (or stock for that matter) to employees in return for their services. No asset, as I define assets, is used up and no asset, as I define assets, declines in value as the result of the issuance of a stock option—thus, no expense Continued at http://www.trinity.edu/rjensen/theory/sfas123/schuetze01.htm |
Bob Jensen’s counter
arguments are provided http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm
Especially note Appendix B of the above document.
Parts
2 and 3 solutions are provided in a separate handout.