Two Step's Private Company Equity Management Blog

Cash v. Equity Compensation: In the early 70’s, stock options were a new form of compensation. The FASB was presented with the question whether compensation in the form of equity should be treated the same as cash compensation.  For instance, if an employee receives a $100 cash bonus, the $100 is clearly recorded as compensation expense. However, what happens, if instead, the company pays the same employee with an option for 100 shares of common stock with an exercise price of $1 per share? Should that be recognized as compensation expense and if so, how do we know how much to record?

APB Opinion 25: In Oct. 1972, the Accounting Principles Board issued Opinion No. 25, Accounting for Stock Issued to Employees, which said that stock options given to employees as part of their compensation would not be recognized as compensation expense.  The primary justification was that there was no reliable method for calculating the value of employee stock options at the time. By coincidence, the Black-Scholes formula would be published the next year.

FAS 123:Due to the increased popularity of employee stock options in the 80’sand 90’s, the FASB revisited the issue of accounting for employee stock options and issued FAS 123 in Oct. 1995, Accounting for Stock-Based Compensation. Under FAS 123, FASB “encourages” all companies to use the fair value method of accounting for employee stock options, but continues to permit the use of the “intrinsic value” based method of Opinion 25 (which generally recognized no compensation expense when an option was granted at fair market value). However, FAS 123 states that if a company uses the intrinsic value method, it must footnote what the compensation cost would have been on a pro forma basis if the fair value method of accounting had been used.  FASB indicated later that it had intended to supersede Opinion 25 when it issued FAS 123 (see Summary of Interpretation 44). However, based on political pressure from a number of powerful industry groups that supported the existing accounting treatment of stock options, FASB did not require the use of the fair value based method.

FAS 123R:However, in the wake of the Enron scandal in 2001 and prior to the effective date of FAS 123R, over 500 public companies voluntarily moved to the fair-value method of accounting for stock options under pressure from investors for more accurate financial disclosures and greater transparency. In addition, FASB notes that there was now increased inconsistency as companies accounted for the same compensation transactions in different ways. There was also inconsistency with the international markets which required fair-value based accounting for employee stock options in Feb. 2004 (see IFRS 2). Despite continued pressure from industry groups that stressed the potential negative effects on US capital markets and potential job loss, in March 2004,FASB released FAS 123R, Share-Based Payment, which requires companies to recognize the compensation expense related to employee stock options based on the grant-date fair value method. It eliminates the alternative to use the intrinsic value based method of Opinion 25 that had been an option under FAS 123. FAS 123R only effects equity compensation provided to employees and applies to public and non-public companies. 

If you’re too busy even to click on the link above, the essence of the change to the accounting treatment for compensatory stock options is that prior to FAS 123R, companies had a choice whether to use the "intrinsic value method” or the “fair-value method” when recognizing the compensation expense related to employee stock options.  As noted in the paper, virtually all companies elected to use the intrinsic value method until at least 2002, if not through 2004 or 2005.  The intrinsic value method measures the difference between the exercise price and the fair market value of the shares on the date of grant. The intrinsic value method normally results in a zero compensation expense since most employee stock options are granted with an exercise price equal to fair market value.  Under the fair-value method, the value would be determined based on an option valuation formula and almost always results in some positive value for a stock option either based on the potential increase in value of the stock at some point during the term or the time value of money since the exercise price does not have to be paid until the end of the term.  Under its predecessor FAS 123, companies were already required to recognize the compensation expense related to an option’s value in the income statement, but if the company used the intrinsic value method, there would normally be no related compensation expense.  Although, if the intrinsic value method was used, the company was required to disclose in a footnote what the compensation expense would have been if the fair value method had been used.

While the popular press has written extensively about the potential catastrophic effect on the profitability of both venture-backed and publicly traded companies, it has been unclear in most articles what was the basis of the new accounting treatment that would have such a deleterious impact.  Usually, it was simply explained that the compensation expense of employee stock options had to now be included in a company’s income statement, but we know that was already the case under FAS 123.  The real change that was never well articulated was that companies could no longer choose to use the “intrinsic value "method for most employee stock options. 

Certainly, explaining the difference between using the intrinsic value method and the fair-value method may be way too esoteric for the average reader, but it is still useful to look back at the three year anniversary of FAS 123R’s initial proposal and make sure that most financial and stock option professionals who are now required to account for stock options under the new regime understand what all the uproar was really about.  Then, you can spend the next three years trying to figure out how to implement the 295 pages of detail.