ACCOUNTING FOR STOCK-BASED COMPENSATION: AS EASY AS SFAS 123

Granting stock options is one of the most popular, and perhaps controversial, ways of attracting and retaining key employees, especially those of high-tech companies. However, new accounting rules will soon be introduced for Canadian firms. The rules will be similar to those that were recently implemented in the United States. The new guidelines require companies to disclose the fair value of the options and make the popular practice of re-pricing unattractive. As these authors point out, the new rules will force Canadian companies to learn from their counterparts in the United States and become more prudent in their option-granting practices.

Glancing at the proxy statements of the largest Canadian and U.S. companies leads one to realize that stock options are an increasingly popular way of compensating employees. From 1992 to 1996, options grants for U.S. manufacturing firms increased from 27 percent to 36 percent of total CEO compensation with more than 60 percent of CEOs receiving options as part of their pay (Kevin J. Murphy, “Executive Compensation,” working paper, University of Southern California, April 1998). For young, fast-growing companies in the high-tech sector, granting stock options has become crucial for attracting and retaining talent.

The accounting treatment for employee stock options has no doubt contributed to their popularity. Accounting rules in the United States allow companies to grant options to employees and recognize no expense to the business, so long as the options are not already “in-the-money” when granted (i.e., not having an exercise price below the market price of the underlying stock). Not surprisingly, over 96 percent of employee options result in no compensation cost being recorded. (Murphy, page 73). Companies are, however, required to disclose the “fair value” of these options in the footnotes to their financial statements. The Canadian Institute of Chartered Accountants (CICA) is set to adopt the same standards. Also included in the standards are guidelines for accounting for the recently ubiquitous practice of option re-pricing. The new rules make such re-pricing very unattractive, as it will trigger a compensation expense to appear on the income statement as soon as the sagging stock price begins to recover.

GRANTING OPTIONS TO EMPLOYEES: COREL CORPORATION

To illustrate the implication of granting options to employees and subsequently re-pricing these options, we use information from Corel Corporation’s filings for the year 2000.

For fiscal 2000, Corel granted employees options that allowed them to purchase a total of 3.8 million shares of the company. Of these, Corel’s CEO, Derek Burney, received 225,000 options in addition to his $195,385 salary. (all currency in U.S. dollars). Specifically, in March 2000 he received options to purchase 100,000 common shares at an exercise price of $10.17, and in October 2000 re c e i v e d options to purchase another 125,000 shares at an exercise price of $5.47. Both sets of options expire in four years. They also vest immediately, meaning there is no “lock-up” period before he can exercise the options. In this example, we will focus on the $10.17 options.

These options were issued at-the-money (that is, Corel’s stock was trading at $10.17 on the date of the grant) and as such would have no accounting consequences under the traditional accounting rules. However, these rules were introduced in the early 1970s when sophisticated option-pricing models were not yet available. As a result, the simple “intrinsic value” of the options (computed as the stock’s market price less the option’s exercise price) on grant date was used as the basis for determining compensation expense. Yet, options actually have significant value even when issued with zero intrinsic value. This is because options also have a “time value” which reflects—-among other factors—-the volatility of the underlying stock over the lifespan of the options. The longer the lifespan, the more time during which the underlying stock’s price could appreciate beyond the exercise price, and the more valuable the option becomes. With today’s options commonly issued with a lifespan of 10 years, this time value can be significant. And an option’s “fair value” can easily be calculated now using widely available option-pricing models like Black-Scholes.

In the case of Derek Burney, his options have value because Corel’s stock price is quite volatile, and any time the share price rises above $10.17, he can exercise his options and realize a gain. Although this seems unlikely today, with Corel shares hovering around $3, it is quite conceivable they will rise above $10.17 over a four-year horizon. Recall that Corel’s shares hit a high of over $42 just 16 months ago. And if they don’t exceed $10.17 over the next four years, Burney has lost nothing. It is precisely this large upside potential and zero downside risk that gives options their time value.

Recognizing this fact, in 1995 the U.S. Financial Accounting Standards Board (FASB) proposed SFAS No. 123, Accounting for Stock-Based Compensation, that called for the fair value of stock options to be included as a compensation cost in the income statement. However, under intense pressure from the business community, the FASB backed down and now requires only disclosure of the fair value of options. The recently released CICA Exposure Draft entitled, “Stock-based Compensation,” largely mirrors SFAS 123. The new rules recommend but do not require recognizing a compensation expense equal to the fair value of the options on grant date, amortized over the vesting period of the options. If a company opts not to recognize this expense (something nearly every public U.S. corporation has opted for) it must still disclose what the total expense would have been, in the footnotes to the financial statements.

For Corel, using a Black-Scholes (or similar) model, and applying Core l ’s publicly disclosed assumptions for Burney’s $10.17 options (3.07 years expected life of option, 105 percent volatility of Corel stock, 6.13 percent risk-free interest rate, and 0 percent dividend yield), results in an estimated “fair value” of $6.87 per option. Therefore, his 100,000 options have an estimated value of over $660,000! Under SFAS 123, it is recommended this cost be amortized over the vesting period. Since Corel’s options vest immediately, the entire cost would be recognized as compensation expense in 2000. For the various employee stock options granted in fiscal 2000, Corel would have recorded a related expense of over $21 million if it opted to recognize it as an expense instead of simply noting it in the statement footnotes.

IMPLICATIONS FOR CANADIAN COMPANIES

With the new standard on stock-based compensation forthcoming, all Canadian companies will be required to make pro forma disclosures in the notes to their financial statements that reflect what net income would have been had they used fair-value accounting. A number of Canadian companies listed on U.S. exchanges, including Corel, already disclose this information to comply with U.S. accounting rules. Exhibit 1 reports the impact of fair-value accounting on Canadian firms in the technology sector; firms that tend to be heavy users of employee stock options. It shows the average Canadian technology firm’s earnings per share would be lower by a startling 48.7 percent in 2000, and 35.4 percent in 1999, if fair-value accounting for compensation expense was mandatory.

However, for many other Canadian companies, these disc l o s u res will be new when they are first adopted. For example, prominent Canadian companies like Bombardier, BCE Emergis and Bank of Nova Scotia do not currently disclose the fair value of their option grants. Given that Bombardier granted over 11 million options in fiscal year 2000, the effects of disclosure could be enlightening to investors.

REPRICING OPTIONS UNDER THE NEW ACCOUNTING RULES

More relevant to reported net income for Canadian companies are the new rules on accounting for option re-pricing. (These new rules mirror FASB Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation, issued in March 2000.) The new guidelines state that any modifications to existing employee options which reduce the options’ exercise price will trigger what is known as “variable plan accounting.” Under variable-plan accounting, a company must record a compensation expense each period over the remaining vesting time of the option, if the stock’s market price climbs above the revised exercise price. This time, companies do not have a choice to simply disclose the information but leave its effect off their income statement. The compensation expense will be computed as the difference between the stock’s market price at the end of each accounting period and the revised exercise price, amortized over the remaining vesting period (or recognized immediately if the award is fully vested). Thus, once an option is re-priced, companies enter the precarious situation of having future earnings influenced by changes in their stock price (i.e., compensation expense increases when the stock price goes up and decreases when the stock price goes down).

Let us return to Derek Burney’s $10.17 stock options. Shortly after these options were granted in March 2000, Corel’s stock declined significantly. In an effort to mitigate the effect of the price decline, the board passed a resolution on Nov. 16, 2000, to re-price these options. The new exercise price was set at $3.80 (Corel’s closing price at the time). So long as it closes below $3.80 by the end of fiscal 2001, Corel will not be required to record any compensation expense for the re-priced options in 2001. However, assume that by the end of fiscal 2002 the stock price rises to $6.17 (the average monthly closing price over the last two years). For Burney’s options, the intrinsic value of $2.37 per option or $237,000 overall ($6.17 less the revised exercise price of $3.80, multiplied by the number of options) must now be recorded as a compensation expense in the income statement. And as the stock price fluctuates in future periods, compensation expense will move with equal volatility. Imagine, if by the end of fiscal 2002 Corel’s stock price returned to its all-time high of $42, Corel would be forced to recognize an expense of $3.8 million on Burney’s 100,000 options alone!

COMPANIES NEED TO RECONSIDER THEIR OPTIONS CAREFULLY

Corel is not alone. With the Nasdaq down nearly 60 percent from its high, about 80 percent of employee options granted during the market euphoria are now “under water,” with exercise prices well below where the stock is currently trading (CFO Magazine, “Keeping Options Afloat,” March 1, 2001). Employees and executives who had dreams of riches when they signed on with a high-flying tech firm and were given lucrative stock option plans are now beginning to reconsider their employment opportunities. Their underwater options no longer act as a set of golden handcuffs. Until the new accounting rules for re-pricing came into place, the recipe for a company facing this situation was straightforward: 1. Simply re-price the options to a level in line with today’s stock market prices. 2. Repeat as necessary to prevent key employees from departing. 3. Deal sensitively with shareholder groups who complain they do not have the privilege of re-pricing their shares when the company’s stock tanks, so why should company executives? But now, with the new accounting implications of re-pricing, companies have reason to think twice before reducing the exercise price on their options.

The alternative some companies have chosen to re-pricing options is even less palatable to shareholders: They simply issue a new set of options with more realistic exercise prices, to supplement the existing underwater options. Not only does this still send a signal to managers of lowered expectations, it also creates a dangerous double-dilution effect. That is, with two sets of options now floating around, there is the potential for them to eventually both be exercised. While it currently seems impossible that tech stocks will recover to their old highs, many of these options have lives of 10 years. For a volatile tech stock down only 50 percent from its peak, it is quite conceivable that the existing underwater options will see dry land before they expire. If and when this occurs, companies will be forced to spend huge amounts of cash to buy back shares from the open market, or else allow for a massive dilution in shareholder equity.

To avoid this possible double dilution, companies would much prefer to cancel the existing options before replacing them with a new set of options. However, the new accounting rules view such action as tantamount to a re-pricing, and thus the new options would be subject to variable plan accounting. Thus, to retain top talent in this tight labour market, companies are forced to choose whether they want to suffer the expensing implications of re-pricing, or the risk of double dilution from issuing a supplementary set of options.

Changes in the way that options are granted may be needed. A tight labour market and favourable accounting rules have distorted stock options from their intended purpose of rewarding superior performance, into a cost-free recruiting and retention tool. Employees now view options as a fundamental entitlement, and companies have appeased them by offering large stock option plans as part of signing-bonus packages. Such practices put the fate of companies at the whim of equity market conditions. If the company happens to sign an employee when equity markets are peaking, they are likely to lose that employee when equity markets hit a trough and the options are underwater. Instead of putting all the employee’s eggs in one basket, companies could grant options in more frequent, smaller packages, perhaps monthly or quarterly. (CFO Magazine, “Gasping for Air,” June 1, 1998). Like a dollar-cost-averaging technique, this will smooth out fluctuations in the exercise price on employees’ options.

Do options truly have value or are they a cost-free way of compensating employees? Does option re-pricing reward management incompetence, or is it a reasonable reaction to volatile equity markets? Regardless of the answer to these questions, Canadian companies will now find employee stock options more costly from a financial-reporting perspective, either with new fair value amounts being disclosed in the notes, or compensation cost for re-priced options being recorded on the income statement. As the new CICA rules come into effect, Canadian corporations must learn from their U.S. counterparts, and be more prudent in their option-granting practices.

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