For years employee stock ownership plans (ESOPs) have been like the goose that laid the golden eggs. Cash-poor companies struggling for a method to attract good managerial and technical talent have squeezed the stockholder equity goose to produce options that have little present value but possess potential for significant gain when stock prices increase. This method made everyone happy: the executive stood to gain if his or her performance resulted in increased stock prices, the company got the services of the executive without affecting cash or earnings, and the IRS got its cut if the executive subsequently sold any stock at a gain. Now the Financial Accounting Standards Board (FASB) is planning to kill the goose by requiring that employee stock options (ESOs) be deducted from earnings, a move that is estimated to reduce earnings of emerging businesses by some 30%.
According to an FASB exposure draft issued June 30, 1993, not only will ESOs be considered compensation expense, but the measurement method used to determine the amount of expense (at least for public corporations) will be the Black-Scholes (B-S) or similar option pricing model, previously used mostly for financial research to determine the value of call options for stock actively traded on exchanges. Using this model to determine values for options on infrequently traded over-the-counter issues may be about as accurate as reading the entrails of the goose after it has been killed.
The Executive Compensation Controversy
Counting ESOs as compensation expense is a part of the somewhat larger debate over executive compensation in general, and the FASB was somewhat reluctantly drawn into the debate. Historically, the accounting principles that govern ESOs date back to the old 1972 Accounting Principles Board Opinion 25 (APB No. 25, 1972). Under APB No. 25, compensation expense did not need to be recognized unless the market price of the stock exceeded the exercise price on the date of measurement, which was generally the date of the grant. In the case of emerging firms, the market price was likely to be lower than the exercise price, the presumption being that the value of the stock would increase as the firm grew, and no compensation expense was recorded.
Although the FASB occasionally considered the problem of ESOs, no new pronouncements were issued. As late as 1988, the matter was on the FASB's agenda, but the Board instead turned to a discussion of the difference between liability and equity instruments, believing that making this distinction would assist them in deciding the nature of ESOs.
However, in 1991, Sen. Carl Levin (D-Mich.) introduced the Corporate Pay and Responsibility Act which would have compelled the Securities and Exchange Commission (SEC) to require that ESOs be accounted for in financial statements. Even though the bill did not pass, the SEC issued new proxy statement disclosure rules and also asked the FASB to evaluate its position on ESOs. The FASB responded with a review that subsequently led to the current exposure draft. In its original form, the disclosure provisions would have become effective for years beginning after December 31, 1993, and the recognition provisions for awards granted after December 31, 1996. However, the Board has backed off to the extent that disclosure provisions will not be required in 1994 financial statements. The FASB is currently reviewing the information received during the comment period and is not likely to issue a final pronouncement until the first quarter of 1995.
In the meantime, Congress has not been idle. Sen. Levin along with Rep. John Bryant (D-Tex.) has introduced legislation to require public companies to recognize the fair value of ESOs as expense, while Sens. Joseph Lieberman (D-Conn.), Connie Mack (R-Fla.) and Diane Feinstein (D-Calif.) have a bill that would override the FASB's proposal. Similar measures have been introduced in the House.
Objections To the FASB Proposal: Theoretical
Senate hearings on the FASB proposal before the Securities Subcommittee of the Banking, Housing and Urban Affairs Committee in October, 1993, generated at least as much heat as light with Sen. Phil Gramm (R-Tex.) commenting, "the bottom line here is that this is a stupid proposal" (Cox and Elsea, 1993). Stupidity aside, the objections to the proposal have to do with both theoretical and practical concerns as well as apprehensions about the method of...