The future of employee stock options after
Statement of Financial Accounting Standards No. 123

March 14, 2005

© 2005 by Michael C. Gray

High technology companies and their employees are justifiably concerned about the impact of the revised statement of financial standards for share-based payments issued by the Financial Accounting Standards Board (FASB) during December, 2004.

As an observer of employee stock options, I studied this statement of standards with interest. I am not an auditor, so I won’t be involved in implementing the rules. As an advisor to employees in how to work with employee stock options, I am deeply concerned with how they will be used in the future. It will have a direct impact on my business.

Why should we be concerned about the future of employee stock options? During the 1990s, employee stock options were a great example of the American Dream. Rank and file employees were able to convert brain power (busting their butts working) into money. I have seen and counseled many people who weren’t “fat cats” that received millions of dollars that they were able to use to create financial security for themselves, including being able to buy homes they would otherwise never have been able to afford. It would be a shame to kill this goose that lays golden eggs.

Public companies have been required to make most of the computations under this standard since 1996 for footnote disclosures. Many of these companies have responded to public pressure after recent major accounting scandals, including Enron and Worldcom, by reporting expenses of granting employee stock options on their income statements. Revised Statement 123 will require all public companies to report an expense for granting employee stock options for periods beginning after June 15, 2005. For the first time, non-public companies will also have to report the expense for the first year beginning after December 15, 2005.

I’m not going to try to explain how the expense amount is determined. The FASB has made it clear it favors the “lattice method” of computing the value. This is a complex computation requiring computer software given certain assumptions and economic models. The formulas were developed by economists for pricing publicly-traded options. The purpose of the “lattice” appears to be to incorporate more variables in determining the value. Software companies will presumably be submitting their products to the FASB for approval.

The FASB is justified in defending determining a financial statement item based on estimates. There are many estimates used in assembling financial statements, most notably useful lives for depreciation. Even “cash” is an estimate for outstanding checks and deposits in transit.

I still have some concerns about valuing options this way. Financial statements for similar companies should be comparable. Since the valuation models depend on many assumptions, it is unlikely two people computing the value of the same options would reach the same result. Most estimated items eventually “settle out” in cash. These computations will never settle in cash, and any cash adjustments for income tax results, etc. will not be reported in the income statement, but as capital adjustments.

Since the computations are dependent on people using software, computation errors, including software “bugs”, may be hard to detect. The people who use the software should be a highly trained specialist group within the public accounting firms or specialized consulting firms who provide outsourcing for the work. Students who graduate as accounting majors and eventually pass the CPA exam will not be able to make the computations without further training. Every grant of options requires these computations, and some may need to be tracked for several years. This means that granting these options will require significant expenses beyond the stock itself. There will be legal expenses for drafting the plans, accounting expenses of tracking for financial and tax reporting, and advisors for tax planning and business financial reporting to project the results of the plans. These costs should also be estimated when deciding when and to whom stock option grants should be made.

In the heyday of stock options, start up companies could literally print their own money by issuing stock options. Some were even paying their rent using options. Those days will probably be gone when these new reporting rules are effective.

Some companies will decide, as Microsoft has already, that it’s just too expensive and complicated to continue this practice. These companies may decide to just make stock grants to employees instead of issuing stock options. Accounting for stock grants is much easier for the employer, but stock grants are much more risky than stock options for the employee. The employee doesn’t have to pay any cash when awarded a stock option until it is exercised. The employee must pay income taxes when a stock grant is received. Employees who are granted stock of privately-held companies will be especially unhappy about reporting taxable income for grants of stock they can’t sell.

Again in the heyday of stock options in Silicon Valley, there was very wide participation. The secretaries of some high technology companies became millionaires. With the increased administration costs and the financial statement impact of options under the new rules, only key executives are likely to be granted employee stock options in the future.

Employee stock purchase plans can be designed to be exempt from the new reporting requirements. In order to qualify for exemption, the discount can’t exceed 5% (compared to 15% under the Internal Revenue Code) and the price can only be based on the fair market value on the grant date (compared to the lesser of the grant date or the exercise date under the Internal Revenue Code.) This will significantly curtail the benefits to employees under these plans.

Although financial statements may be more “fairly stated” under the new standards, nobody will really understand or be able to explain this adjustment.

Smaller public companies are already under siege because of the new compliance requirements for internal control certification under Sarbannes Oxley. The smaller companies traditionally are the heaviest users of employee stock options, because they have more limited resources to compensate their employees. They are having trouble even finding a national CPA firm to audit their financial statements. Adding these additional costs and the need for specialists to account for employee stock options may be the straw that breaks the camel’s back, forcing even more companies to de-list their stock with the resulting loss of liquidity and loss of value for their shareholders.

Under the same reasoning, the size threshold for companies to make initial public offerings is growing significantly.

Unless opponents are successful in blocking FASB Statement 123 with legislation in Congress, grants of employee stock options to rank and file employees will be severely curtailed in the future. Although some opportunities for specialists, usually with training in economics, will remain after the new rules are implemented, it appears to me that most of the future work for tax advisors like me will probably be serving employees who were granted stock options in the past.

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