Under corporate
governance norms, the emphasis is on transparency and disclosure of
decisions that will have impact on the financial statements of a company,
and hence have a bearing on the investment decisions of the shareholders.
Disclosure in relation to compensation to employees of a company assumes
significance in this context.
Employees, especially executives
(CEOs/CFOs) are privy to inside information, gathered as part of daily
work routines. Stock options to such employees provide incentive for their
complicity in manipulating the compilation and presentation of financial
data, resulting in inflated stock prices. Further, to the extent that
stock options are a form of employee compensation and are not reflected in
the books as such, the profits of the company are exaggerated. This
results in an untrue picture of the personnel cost of the company.
Expensing stock options :
What and how
to expense ?
As per the Securities and Exchange Board of India
ESOP Guidelines, 1999, ‘value’ of stock option would be the difference
between the market price on the date of grant and the exercise price of
the option, or the fair value of stock options, computed using the
Black-Scholes Formula or such other binomial function. Listed companies
are required to expense this value over the period of vesting of the stock
options. Currently, there is no such expensing requirement for unlisted
companies.
Why expense ?
Arguments in favour of
expensing stock options :
* Regardless of the scheme, stock
options are a form of ‘employee compensation’ by nature and must be
expensed;
* Such expense erodes the distributable profits and
consequentially affects the company’s earning per share;
* Grant of
stock options results in an opportunity cost to the company which is
equivalent to the discount at which the employees are granted the option,
compared to the market price of the shares;
* Since, stock options are
aimed at aligning the interest of the employees with that of the
shareholders by way of improved performance of the employees resulting in
better stock price performance, cost of such capital appreciation needs to
be accounted for;
* Last but not the least, as experience has shown,
incentive to manipulate accounts can be checked if the company is made to
take a hit on its bottom line.
Arguments against expensing stock options :
* There
is no actual cash outflow to the company at the time of grant or exercise
of stock options — loss cannot be brought on the books merely on
‘opportunity cost’ basis. It cannot accurately be stated that stocks
purchased by the employees would have actually been subscribed to by
general public at the market price and as such the company may not incur a
loss;
* Existing valuation models prove inadequate to quantify the
actual cost to the company;
* Although, stock options may be in the
form of ‘incentive plans’, no asset (i.e. goodwill or human resources) is
brought on the books which in turn is written off over its useful life;
* Quantifying and expensing, even if possible, will not per se address
the imbalance between employee and investor interests.
Accounting treatment of stock options in the US :
Stock options are used most extensively in the US. Ac-cordingly, US
has already introduced standard accounting practice for recording stock
options. Companies are required to expense stock options, using either the
Financial Accounting Standards Board Statement 123 (‘FAS 123’) or the
Accounting Principles Board Opinion 25 (‘APB 25’) read with
Inter-pretation No. 44 on APB 25. Despite these standards, the investors
have been taken for ride by ingenious accounting practices by US
corporates. Thus, it is only natural that we should examine the US
account-ing practices in this regard and its development till date.
APB 25 :
APB 25 establishes the generally
accepted accounting principles for measuring the amount of compensation to
be recorded in a company’s books in relation to employee stock options.
For the purposes of APB 25, stock options are classified as
compensatory or non-compen-satory. Broadly speaking, com-pensatory stock
options are options granted to employees in recognition of past services
of such employees and con-sequently need to be accounted for in the books
as compensa-tion. Non-compensatory stock options would have
characteristics such as grant to non-employees, options linked to future
perfor-mance benchmark et al. Such stock options are not construed to
result in compensation expense. A detailed discussion on the parameters on
which this classification is based is beyond the scope of this article.
Under APB 25, the most significant factor in determining and
recognising compensation cost is the ‘measurement date.’ Measurement date
is the first date on which both the number of shares and the option or
purchase price, if any, are known. Typically, the measurement date in case
of ‘fixed option grant’ would be the date of grant, since on this date,
both the number of shares and the option price are known. On that date,
the compensation is measured as the excess of the fair market value of the
stock on that date over the purchase price. This is referred to as the
‘intrinsic value’. As most options are granted with a purchase price equal
to the then fair market value of the stock, most stock option grants do
not involve any compensation expense under APB 25 even though the stock
may increase in value after grant. Till the components (i.e. number of
shares and purchase price) for determining the compensation cost are
known, the grant of stock options is as good as an ‘off balance sheet’
transaction.
FAS 123 :
FAS 123 deals with accounting of
grant of stock options to employees as well as to non-employees. The
definition of measurement date under FAS 123 is the earlier of (i) the
date of a ‘performance commitment,’ or (ii) the date at which the
non-employee service provider’s performance is complete. A measurement
date will occur on the earlier of these dates, notwithstanding the fact
that on such date the terms of an equity instrument may depend on other
events that have not yet occurred. Prior to the occurrence of a
measurement date, compen-sation expense should be measured at the then
current ‘fair value’ of an equity instru-ment on each interim financial
reporting date until the measurement date.
Under FAS 123, ‘fair value’
of an option is estimated using an option pricing model (such as the
Black-Scholes or binomial model) that takes into account the following
factors :
* Exercise price;
* Expected life of the option;
*
Current price of the underlying stock and its expected volatility;
*
Expected dividends on the stock; and
* Risk-free interest rate for the
expected term of the option.
A company may elect to apply FAS 123
to its employee stock options, in addition to its non-employee stock
options. Once a company elects to apply FAS 123, it is not permitted to
switch back to APB 25. Even when a company elects to account for stock
options under APB 25, it is required to compute and disclose in its
financial state-ments, by way of a footnote, the compensation cost of its
stock options (whether employee or non-employee) as calculated under FAS
123. Such footnote should include income statement disclosure and earnings
per share.
Recent developments :
In July 2002, Coca Cola
an-nounced its decision to expense all stock options as per the fair value
method as envisaged under FAS 123 so as to bring its earnings in parity
with economic realities. In the past, Coca Cola had applied APB 25 read
with Interpretation 44 for accounting of its stock option plans.
Accordingly, no compen-sation cost had been recognised, as discussed
earlier under APB 25 analysis. Amazon and General Motors have also
voluntarily decided to charge their stock options to the profit and loss
accounts. The recently enacted Sarbanes-Oxley Act addresses the issue
indirectly by requiring the certification of financial reports by CEOs and
CFOs for their accuracy.
The Financial Accounting Standards Board in
the US has issued an exposure draft on ‘Accounting for stock-based
compensation — transition and disclosure, an amendment to FAS 123’. This
proposed statement seeks to amend FAS 123 to provide for alternative
methods of transition for a voluntary change to the ‘fair value’ method of
accounting for stock options. Additionally, it seeks to amend the
disclosure requirements of FAS 123 to include disclosures about method of
accounting used and the ef-fect of the method on the re-ported results.
The new amended standard would be mandatory from the accounting year 2004.
Indian scenario :
In India, stock options
issued by listed companies are regulated by the SEBI ESOP Guidelines,
which was expected to usher better corporate governance. The disclosures
and the compliance requirements under the SEBI ESOP Guidelines are quite
elaborate. They require complete disclosure with respect to the options
granted, including the pricing formula, options vested, options exercised,
the number of shares arising as a result of the exercise of options,
options lapsed, variation of terms of options, money realised by exercise
of options, the employee-wise details of the options granted and the
diluted earnings per share pursuant to the issue of shares on the exercise
of the option calculated in accordance with the International Account-ing
Standard 33.
Such disclosures are required to be made in the
Directors’ Report. Companies like Infosys, Wipro and Satyam state, by way
of a note to the accounts, the possible impact on the company’s earn-ing
per share if the stock options were expensed out.
However, there are
no provisions in the SEBI ESOP Guidelines for ensuring their
enforceability, nor any transition provisions for unlisted companies in
regard to stock options issued prior to listing. Further, as far as
‘non-variable’ plans, (i.e. plans in which both the number of shares and
the purchase price are known at the grant date) are concerned, the
intrinsic value method as laid down by the SEBI ESOP Guidelines may be
sufficient. However, when ‘vari-able’ plans (subject to performance
vesting) are issued by the company, then the intrinsic value method may be
inadequate since at the date of grant the number of shares to which the
employee will be entitled will not be known. Black-Scholes formula or
other binomial function has also been pre-scribed as an alternative for
determining ‘fair value’ for accounting. Issues like granting stock
options through a trust route too need to be addressed so that there is no
possibility of not accounting for stock options expense.
Conclusion :
The relationship of stock options
and corporate governance is much beyond the accounting of stock options.
It is certainly a starting point and the Institute of Chartered
Accountants of India needs to bring out a standard for expensing stock
options so as to complement and achieve the effectiveness of the elaborate
disclosure require-ments under the SEBI ESOP Guidelines.
To conclude,
the following statement of Warren Buffet aptly summarises the debate on
expensing of stock options : “If options aren’t a form of compensation,
what are they ? If compensation isn’t an expense, what is it ? And, if
expenses shouldn’t go under calculations of earnings, where in the world
should they go ?”