I dug this out of one of my old ToolBook lectures
Bob Jensen

Arthur Andersen Accounting News Briefs, August 1993 FASB Exposure Draft "Accounting for Stock-based Compensation"

1. In 1972, the Accounting Principles Board issued APB 25 that became the foundation of subsequent FASB interpretations. The main thrust of APB 25 is that most stock compensation plans are compensatory .

2. Under APB 25, there seldom is compensation expense at the time of issuance since the expense at the time of issuance was required to be intrinsic value rather than market value. Whenever the exercise price equals or exceeds the market price of the stock at the date options are issued are deemed to have zero intrinsic value even though employees view them has having, possibly, significant market value.

3. In 1984, the FASB concluded that that employee stock options having zero intrinsic value were compensation expenses at the date of issuance. However, they deferred a decision on how to measure the expense and when to book the expense until 1992 legislation was introduced in Congress to have the SEC take action on this item.

4. In 1993, the FASB issued the exposure draft proposing that market value of stock-based compensation be measured at the date of issuance. This ED resulted in heated controversy and was criticised by corporations and large accounting firms.

Arthur Andersen Accounting News Briefs, August 1993 FASB Exposure Draft "Accounting for Stock-based Compensation"

1. In January 1993, Senator Carl Levin (D-Michigan) introduced legislation to require the SEC to expense executive stock options at fair market value rather than intrinsic value.

2. In June 1993, several legislators sponsored even more restrictive legislation.

3. In 1993, business lobbying accelerated to fend off both the proposed legislation and to require the SEC to override any FASB standard requiring fair valuation of employee stock options at the date of issuance.

Scope

The ED applies to the following:

1. Transactions in which shares of an employer's common stock, stock options, or other equityinstruments are granted or issued to employees.

2. Cash payments made to employees in amounts based on the price of the employer's stock or other equity instruments.

3. Equity instruments issued to other suppliers of goods and services, such as independent contractors or vendors, and outside members of an entity's board of directors.

4. Equity instruments granted to an employee by a principal stockholder unless the grant clearly is for a purpose other than compensation.

Arthur Andersen Accounting News Briefs, August 1993 FASB Exposure Draft "Accounting for Stock-based Compensation"

Option-Pricing Theory (A Sidebar to the Discussion)

The FASB's conclusions on the accounting for grants of stock options have been strongly influenced by option-pricing theory. This sidebar presents a simplified discussion of current option-pricing theory. A more thorough discussion can be found in Appendices A, B and C of the FASB Discussion Memorandum, "Recognition and Measurement of Financial Instruments"

Traditionally, option values (premiums) are divided into two parts--intrinsic value and time value. Intrinsic value represents the amount of advantage, if any, that the holder of an option would realize by exercising the option rather than buying the underlying stock directly. For example, an option to buy a share of stock for $5 when the market price of the stock is $8 has $3 of intrinsic value. An option whose exercise (strike) price equals the market price of the underlying stock is referred to as "at the money." An option whose exercise price exceeds the market price of the underlying stock is referred to as "out of the money."

Click here to see a call option graph Click here to see a put option graph

The excess of the total value of an option over its intrinsic value is referred to as time value. For "at the money" and "out of the money" options , the time value is the same as total value, because they have no intrinsic value . All options have time value as long as significant time remains before expiration. All other things being equal, the longer the time until expiration, the higher the time value. This is readily apparent in the price quotations for exchange-traded stock options, where options with the same strike price but different expiration dates trade side-by-side.

Time value can be subdivided into two components -- the effects of time value of money (interest) and volatility value. The time value of money component arises because the holder of an option does not have to pay the exercise price until the option is exercised. Instead, the holder can invest funds elsewhere while waiting to exercise the option. The time value of money component is computed using the rate of return available on risk-free U.S. Treasury securities. The higher the available rate of return on U.S. Treasury securities, the higher the value of being able to delay payment of the exercise price and, therefore, the higher the time value of money component. If the stock pays no dividends and is not expected to pay a dividend during the life of the option, the time value of money component is the difference between the discounted present value of the exercise price and the exercise price. That is, if the exercise price is $10 and the discounted present value of the exercise price based on the assumed exercise date is $7, the time value of money component is $3. If the stock pays a dividend, or is expected to pay a dividend during the life of the option, however, the time value of money component is lower. In this situation, the value to the holder of the option from delaying payment of the exercise price is only the excess (if any) of the return available on U.S. Treasury securities over the return available from exercising the option today and owning the shares. The time value of money component for a dividend-paying stock equals the exercise price less the discounted present value of the exercise price less the discounted present value of the expected dividends during the expected life of the option. Thus, if the discounted present value of the expected dividends were $1, the time value of money component in the previous example would be reduced from $3 to $2.

The other component--volatility value--represents the ability of the holder to profit from appreciation of the underlying stock while being exposed to the loss of only the option premium, not the full current value of the stock. Volatility is a measure of the amount by which a price has fluctuated or is expected to fluctuate during a period. Volatility is usually measured by one standard deviation of a statistical (or probability) distribution. The larger the standard deviation in relation to the average price level, the more variable the price. An expected annualized volatility of 30 percent means that the probability that the year-end stock price will fall within roughly plus or minus 30 percent of the beginning-of-year stock price is approximately 67%. There is approximately a 33% probability that the year-end stock price will fall outside that range. Effectively, option-pricing models make an assumption about the probability distribution of future stock prices that reflects the expected volatility of the stock price. Option-pricing models do not predict a specific future stock price, but they make assumptions about the likelihood of different future stock prices. The Black-Scholes model , for example, assumes a log-normal distribution, meaning that the stock price is as likely to double as it is to fall by half and that small price movements are more likely than large price movements. The probability distribution of future stock prices converts into a probability distribution of payoffs from the option at exercise. A highly volatile stock has a higher probability of big increases or decreases in price. As a result, an option on a highly volatile stock has a higher probability of a big pay-off than an option on a less volatile stock and so has a higher volatility value component.

To summarize the effects of the variables used in option-pricing models, as noted above, all other factors being equal, a longer term of the option results in a higher value; a higher rate of return results in a higher value; a higher dividend rate results in a lower value; and a higher stock volatility results in a higher value. The two other factors which affect option values are the exercise price of the option and the current market price of the stock. A higher exercise price results in a lower option value and a higher stock price results in a higher option value.

APB 25 uses the intrinsic value of an option as the measure of compensation. The ED proposes to use the fair value of an option ( intrinsic value plus time value of money component plus volatility component ) as the measure of compensation for public companies or for the rare private company with enough trading activity to estimate expected volatility. A third possibility is to use the sum of intrinsic value plus the time value of money component as the measure of compensation. This approach sometimes is referred to as the "minimum value" of an option, because it represents the smallest premium that the writer of an option would accept. The minimum value would be computed as the market price of the stock less the discounted present value of the exercise price and less the discounted present value of the expected dividends on the stock. The ED proposes that most private companies use this approach as the measure of compensation. Using the preceding option example and assuming that the market price of the stock is $10, the "minimum value" would be $2 (market price of $10 less discounted present value of exercise price of $7 less discounted present value of dividends of $1). Because this option has no intrinsic value, the "minimum value" equals the time value of money component.

Arthur Andersen Accounting News Briefs, August 1993 FASB Exposure Draft "Accounting for Stock-based Compensation"

1. Due to the deferred effective date, companies may issue as many options as they wish prior to 1997 with no change to today's accounting.

2. The use of performance plans may increase since, generally, they will result in less compensation expense or volatility in earnings than under today's accounting and many believe that performance options more closely align employees' interests with those of the company and its shareholders than do straight options.

3. "Cashless" exercise features may become more prevalent because the accounting penalty that exists under today's accounting will disappear.

3. To reduce compensation expense compared to traditional options, options can be issued with exercise prices in excess of current market price.

4. A shift to cash compensation may occur.

5. Broad-based employee stock purchase plans may be amended to reduce or eliminate the typical 15% discount and to eliminate the look-back feature (exercise or purchase price is the lesser of the stock price at the beginning or end of the period).

6. Option lives may be shortened, which would result in lower fair values. Also, the vesting period may be extended in order to reduce the annual compensation charge (i.e., spread the compensation charge over a longer period).

7. In certain circumstances, the use of discounted options (exercise price less than the current fair market value of the stock) or restricted stock rather than "at the money" options may increase. As compared to today's accounting, the incremental compensation expense for a discounted option over an "at the money" option will be smaller. For example, assume an option is issued with an exercise price of $5 when the fair market value of the stock is $10. Under today's accounting, compensation expense would be $5 based on the intrinsic value of the option. Compared to an option with an exercise price of $10, the incremental expense is $5. Under the ED, the fair value of the option with an exercise price of $5 will be higher than the fair value of the option with an exercise price of $10, but not by a full $5.

Arthur Andersen Accounting News Briefs, August 1993 FASB Exposure Draft "Accounting for Stock-based Compensation"

The next twelve months are expected to be a difficult time for employers with respect to which direction to take on employee compensation matters. It will be a period of great uncertainty, awaiting a final decision from the FASB, and seeing what effects the proposed legislation will have on both employer's accounting for and tax treatment of stock compensation plans.

Arthur Andersen Accounting News Briefs, August 1993 FASB Exposure Draft "Accounting for Stock-based Compensation"

Argument: The FASB's conclusions will reduce earnings, which will inevitably reduce stock prices and raise the cost of capital for U.S. companies, making them less competitive with international competitors. The reduction in earnings will discourage companies from granting options, especially to rank and file employees, even though options are the best incentive to make employees think like shareholders and work to maximize the stock price. The dilemma is especially acute for start-up and high technology companies, because they tend to grant options broadly to most employees and because their generally higher stock price volatility and lower dividends make their options more valuable.

Argument: The FASB should retain today's accounting but require expanded disclosure of option grants, including estimated values. The disclosures would provide the same information as the proposed accounting without the negative economic consequences.