Currently Acceptable Accounting Methods sample essay

Accounting for employee stock options has been recognized as contemporary most controversial accounting issue. Practically, over 90% of United States public companies offer stock options to top executives. Corporations are concerned that changes in stock option accounting could impact net income adversely, making options less attractive as employee incentives. Some assert that the granting of stock options should be reflected in a company's income statement. The debate over accounting for stock options is developed on 3 key questions: 1. Should granting stock options result in expense recognition? 2. If so, how should the expense be recognized? 3. When should it be measured? An important concern in stock option accounting is the difficulty of valuing employee options.

In the end of 2004 the FASB developed Statement 123(R), Share-Based Payments, which included important changes for stock options and other forms of equity-based employee grants. Practically, it requires all public companies to report compensation expense for stock options based on fair value as estimated using an option-pricing model. It also would require expanded disclosures about options and other equity-based grants. Moreover, Statement 123(R) replaces both existing accounting standards: APB Opinion No. 25, Accounting for Stock Issued to Employees, and FASB Statement No. 123, Accounting for Stock-Based Compensation. Most employers follow the intrinsic value model of Opinion 25, under which they report no compensation expense for stock options with an exercise price equal to market price on date of grant, although they present a foot-note with proforma earnings and earnings per share as if they estimated the fair value of options using an option-pricing model (Kunkel, 28).

All employee plans are considered compensatory unless the benefit to employees is no greater than the benefit available to shareholders generally. The benefit to employees is assessed based both on the discount from market price and the number of shares they are eligible to buy. As a result, virtually all plans will be considered compensatory for accounting purposes, including employee stock purchase plans that are non-compensatory for US Federal income tax purposes under Section 423 of the Internal Revenue Code. For example, if the employee plan provides a discount from quoted market price that is not available to shareholders generally, the plan would be compensatory. If the employee plan provides a discount that is equivalent to the discount available to shareholders generally, for example, through a dividend reinvestment plan, but employees are eligible to buy more shares than a typical shareholder, the plan would be compensatory. The FASB adopted this approach as part of its effort to make standards more consistent with underlying principles by minimizing exceptions.

Under Statement 123(R), an employer assesses the employees' rights under the plan in accordance with FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, to determine whether those rights constitute equity interests or liabilities. After making that assessment, Statement 123(R) governs recognition and measurement of compensation expense, and liabilities are accounted for differently from equity interests. Generally, plans that are settled by issuing shares to employees, including "cashless exercise" (net share settled) options, would create equity interests, and plans that are settled by issuing cash to employees would create liabilities (Kunkel, 28). Compensation for equity interests is measured at date of grant and generally is not adjusted subsequently unless the employee forfeits the award by failing to complete the required period of employee service (Acharya, 34). Private companies are permitted to measure compensation for options at exercise date instead of grant date. Compensation for liabilities is measured at the exercise or settlement date, but compensation is estimated at each reporting date from grant date to exercise or settlement date, much like variable accounting under Opinion 25 (Acharya, 34).

Under Opinion 25, compensation for some plans is measured at grant date and compensation for other plans is measured at a later date, typically either vesting date or exercise or settlement date, with compensation estimated at each reporting date. However, the dividing line in Opinion 25 relates to when the amount the employee must pay and the number of shares the employee is entitled to be known. If both factors are known at grant date, and vesting is not dependent on anything other than continued employment, compensation is measured at the grant date. Absent these conditions, compensation is measured at a later date when these factors become known, with interim estimates beginning at grant date. If the number of shares is not known solely because of uncertainty about whether the employee will render service for a stated period, the factors are known at grant date. If any other uncertainty exists about the number of shares, final measurement of compensation is delayed until that uncertainty is resolved. Situations involving delayed measurement often are referred to as variable accounting, because the amount of compensation expense varies from period to period as the price of the company's shares changes.

Compensation is measured based on the fair value of the instruments issued to employees. For shares, fair value is the quoted market price of the shares if they are traded (Wolosky, 41). For options, fair value is estimated using a recognized option-pricing model that incorporates all of the following assumptions: current fair value of underlying shares, option exercise price, expected term of option, expected dividend yield over the expected term of the option, risk-free interest rate over the expected term of the option, expected volatility of the stock price over the expected term of the option (Wolosky, 40).

Compensation is accrued ratably over the vesting period. Ultimately, compensation is recorded only for awards that vest, that is, awards for which the employees fulfill any service requirements and meet any performance conditions. If an employee forfeits an award because he fails to fulfill a service requirement or fails to achieve a performance condition, no compensation cost is recorded for the forfeited award. If compensation was accrued in earlier periods, it is reversed in the period of forfeiture. If an employee fulfills all of the conditions and vests in an award but does not exercise it, because the stock price falls and makes exercise uneconomic, compensation cost is not reversed.

Opinion 25 has similar concepts that compensation is accrued over the service period and that zero compensation is recorded for forfeited awards. However, Opinion 25 has no specific requirement to estimate vesting or for how or when to reflect forfeitures. For awards with graded vesting, Opinion 25 requires separate accounting by tranche only for variable awards (those for which either the price the employee must pay or the number of shares is not known at date of grant). For fixed awards (those for which both the price the employee must pay and the number of shares are known at date of grant), practice predominantly treats the entire award as a unit and amortizes compensation expense over the period to the last vesting date.

Bibliography

1. Howard W. Wolosky. Mandatory Fair-Value Accounting for Options. The Practical Accountant. Boston: Feb 2005. Vol. 38, Iss. 2; p. 40

2. J. Gregory Kunkel. Compensation Plans and the New Stock Option Accounting Rules. The CPA Journal. New York: Jan 2005. Vol. 75, Iss. 1; p. 28

3. Narendra Acharya. Recent Equity Compensation Developments. Corporate Taxation. New York, N.Y.: Nov/Dec 2004. Vol. 31, Iss. 6; p. 34
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