The Impact of FAS 123 on Stock-Based Compensation Plans

ACA Journal, Spring 1998, Volume 7, Number 1

Please note: The graphics contained in this article are available in a separate pdf file. Click here.

The Impact of FAS 123 on Stock-Based Compensation Plans

By James A. Hatch
Arthur Andersen LLP

The increased use of stock-based compensation and, more noteworthy, the extension of participation further down the corporate ranks and across borders has made it increasingly important for HR professionals to understand the impact of Financial Accounting Standard (FAS) 123 on plan design. An understanding of FAS 123 enhances the HR professional's effectiveness in addressing and meeting the objectives of equity participation. This article provides a high-level review of FAS 123 and is intended to contribute to the knowledge base of HR professionals so they can fully participate as strategic business partners in the arena of stock-based compensation design alternatives.

FAS 123 Purpose

FAS 123 was developed in response to criticism of Accounting Principles Board Opinion (APB 25), which produces anomalous results with respect to various stock plans and measures the cost of stock options using only the intrinsic value. (See "FAS 123 vs. APB 25" on page 56.) FAS 123 is based on the precept that a stock option has an inherent value that can and should be measured to better reflect what the Financial Accounting Standards Board (FASB) calls the "fair value." Thus, a stock option grant with an initial intrinsic value of zero has a fair value because of its potential, at some point over the life of the option, to be "in the money" and to result in stock appreciation for the option holder. The issue is how to determine and report this fair value.

As a result of the controversies surrounding accounting for stock issued to employees and whether APB 25 is a valid methodology, FASB issued a compromise standard. FAS 123 provides companies with the flexibility to continue to report their financial statements using APB 25 or by adopting FAS 123. By choosing to use APB 25, companies are able to continue to grant stock options that, if structured properly, will not result in compensation expense. It should be noted that companies are required to select one accounting methodology for all stock-based compensation programs. Companies are not permitted to select APB 25 for one stock-based program and FAS 123 for another stock-based program. Additionally, once a company adopts FAS 123, it is not permitted to reverse methodologies and resume accounts under APB 25.

Companies electing to continue reporting under APB 25 are required to disclose in a footnote in the annual report what the pro forma impact on net income and earnings per share (EPS) would have been had they applied the fair-value methodology prescribed by FAS 123. Additionally, all companies, whether they follow APB 25 or FAS 123 accounting, will have expanded disclosure requirements. These disclosure requirements include but are not limited to:

A description of the method used to account for all stock-based employee compensation arrangements.
A thorough description of stock-based plans.
The number and weighted-average exercise prices for all stock option events (e.g., grant, exercise, forfeit) that occurred during the year.
A description of the method and significant assumptions used to estimate the fair values of options.
The pro forma net income and, for public entities, the pro forma EPS as if the fair-value-based accounting method prescribed by Statement 123 had been used to account for stock-based compensation costs.

An Initial Look at the Impact of FAS 123

There was much controversy surrounding FAS 123, particularly for high-technology and biotechnology organizations due to their common practice of offering large stock option grants instead of cash compensation to employees. FAS 123 was effective for fiscal years commencing after Dec. 15, 1995. Companies that are on a calendar-year reporting basis are now in their second year-end audit process. This allows observers to better understand these organizations' position on FAS 123.

The reaction thus far -- probably not surprising -- is that the vast majority of companies have continued to report their financial statements under APB 25 and to conform to FAS 123 by disclosing the pro forma net income and EPS impact in footnote statements in the annual report. Of the minority of companies that adopted FAS 123, the typical company has long-term incentive programs that are partially or fully performance-based. Under certain circumstances, performance-based plans can yield better accounting results than APB 25 results.

At this point, the impact on pro forma results if companies had adopted FAS 123 is under some scrutiny. Universities, accounting firms and consulting organizations have conducted several studies with consistent results. Nearly all companies surveyed continued to report financial statements under APB 25 with insignificant pro forma earnings impact and few outliers. The fair value of options did not create a significant decrease in net income and EPS (other than for some companies in the high-technology industry).

Design Considerations

What does this mean for the HR professional charged with designing stock-based compensation plans? There are several types of stock-based programs that may not produce adverse accounting results under FAS 123 and, in some cases, may yield favorable accounting treatment. This section provides comparisons of the stock option accounting alternatives for a traditional stock option program and a performance-based stock option program. FAS 123 covers all forms of stock-based compensation and has a significant impact on stock option accounting. The examples that follow are for stock options only.

Determining the Accounting Treatment of a Stock Option

Following are the steps required to determine the accounting treatment of a stock option:

Determine if the option is compensatory (e.g., nonqualified stock option, incentive stock option) or noncompensatory (e.g., employee stock purchase plan -- §423). The examples presented will be based on stock options used in long-term incentive programs that would be deemed to be compensatory.
Determine the measurement date. Under APB 25, the expense is measured at the date that both the number of shares and the exercise price are determinable.

From these two steps, it can be determined whether to use fixed or variable accounting. Under a fixed plan, the expense is fixed at the date of grant when both the number of shares and exercise price are determinable. Under a variable plan, the expense is not determined until both the number of shares and price per share are determinable. If it is not possible to determine these plan aspects, the plan needs to be accounted for using variable accounting. Fixed accounting is almost always preferable to variable accounting.

Impact of APB 25 on Fixed-Plan Stock Option Accounting

To understand the APB 25 impact, assume:

The number of shares and price per share are fixed at the date of grant.
The stock price on June 30 is $15 per share.
On June 30, a total of 10,000 options are granted at $15 per share.
Compensation expense will be reported as zero.

The company measures the intrinsic value between fair value and the exercise price on the date of grant because the number of shares and the exercise price are fixed. In this case and in most traditional stock option programs, the resulting compensation expense is zero.

Impact of APB 25 on Variable-Plan Stock Option Accounting

Under a variable accounting plan, compensation expense varies until the number of shares and price per share are fixed. Examples of these plans could include performance-based plans and stock appreciation rights (SARs).

The compensation expense is measured the same way as with fixed plans. However, as the market value of the underlying stock changes, the amount of compensation expense will change accordingly -- but it will never be below zero.

Compensation Cost and FAS 123

Compensation cost is measured based on the estimated fair value of the equity instruments awarded. The estimated fair value of stock options is measured using a pricing model (e.g., the Black-Scholes or Binomial model). Under APB 25, compensation cost is determined by the intrinsic value at the measurement date (when both number of shares and the exercise price are known). Again, this may be different from the value at the date of grant. Also, under APB 25, there is no need to use a valuation model because the intrinsic value is simply the difference between the exercise price and fair value of the underlying stock at the measurement date.

The Adoption of FAS 123

Figures 1 and 2 show that the only companies that may benefit from adopting FAS 123 are those with performance-based stock option plans that expect the stock price performance to exceed the valuation-model projections. Other plans that might be appropriate could include formula-based plans where the accounting treatment is largely the same under APB 25 and FAS 123. Note that the examples apply for publicly traded companies. The accounting treatment may be different for privately held companies.

Going forward, it is likely that companies will continue to elect reporting stock-based compensation under APB 25 and to disclose the financial impact in the footnote in the financial statements required by FAS 123. For most companies, continuing to grant stock options with no financial statement expense is too enticing to consider adopting FAS 123, especially under these favorable economic conditions.

Sidebar:
FAS 123 vs. APB 25

In 1995, the Financial Accounting Standards Board issued FASB Statement No. 123, "Accounting for Stock-Based Compensation." This brought to closure FASB's 11-year project on stock compensation accounting. The statement:

Requires all companies to change what they currently disclose about their employee stock-based compensation plans.
Recommends that companies change how they account for these plans.
Requires those companies that do not change their accounting method to disclose what their earnings and earnings per share (EPS) would have been if they had adopted the recommended accounting changes.

The underlying concepts of FAS 123 are that:

Stock-based instruments issued to employees have value.
The value of such stock-based instruments can be estimated.

Historically, companies have reported stock-based compensation under Accounting Principles Board Opinion 25 (APB 25), which requires companies to measure compensation cost using the "intrinsic value method." This method -- assuming a typical stock option -- measures compensation cost at the time that the exercise price and the number of shares are fixed. Thus, at the date of grant -- if the exercise price equals the fair market value -- the resulting compensation charge to the income statement is zero.

The significant difference between APB 25 and FAS 123 is the measurement date. Under FAS 123, the fair value of stock-based compensation awards is measured at the date of grant.

The Author:

James A. Hatch is an Andersen Worldwide Partner at Arthur Andersen LLP and is Director of the Northeast Region Human Capital Services Practice. He is also the Global Director of Arthur Andersen LLP Human Resource Strategy Consulting.

Author's Note: Gregory M. Kopp, Manager, and Solange Charas, Senior Manager, of the Metro New York Human Capital Services Consulting Practice made substantial contributions to this article.