`Death Wish 3' Stars FASB in Stock-Option Redux: Jonathan Weil
 

By Jonathan Weil

Oct. 10 (Bloomberg) -- The first time the accounting mandarins tried to fix the rules for employee stock-option compensation, it almost killed them. The second time, they barely escaped with all their teeth. Now, they're coming back for more.

The U.S. Financial Accounting Standards Board is preparing to rewrite its rules for stock-option pay, in a move evoking the 1985 movie ``Death Wish 3.'' Except Charles Bronson's character, architect-turned-vigilante Paul Kersey, had it easy, battling street gangs and muggers. He never had to take on Cisco Systems Inc., Intel Corp. and Congress -- all at once.

Now in its early stages, the board's plan is part of a broader project to redefine the difference between liabilities and equity on corporate financial statements. As it happens, rewriting those definitions would turn the underpinnings of the board's fledgling rules for stock-option accounting upside down. And that's bound to upset a lot of high-technology companies that depend heavily on stock options to pay employees.

The upshot: Stock options would be treated as a liability once they are granted, rather than as equity. And they would stay that way until they are exercised or expire.

That means companies might report much higher or much lower expenses for stock-option pay, depending on how much their share prices go up or down after employees are granted their options. Conceivably, a company might announce a big loss one quarter because its stock price had soared -- or vice versa.

Not long ago, stock-option compensation was the third rail of accounting politics. Touch it and you die, the tech lobby used to tell the FASB, as did anyone in Congress who wanted a steady flow of campaign checks from Silicon Valley.

Backing Down

Faced with that prospect, the board in 1994 withdrew its original proposal to start treating options as an expense, rather than a zero-cost item. As a result, many companies' earnings looked much better than they should have during the 1990s and after.

In 2004, riding the wave of accounting scandals that began with Enron Corp., the board defied its bashers and finally passed a standard to begin expensing options. The result was a 286-page tome full of political kowtows, including loose rules for how to value the options. FASB supporters rallied behind the board nonetheless, figuring any expense would be more accurate than none. When the new rules started taking effect in 2005, it was inconceivable the board would revisit them so soon.

Yet if the board is going to redefine the boundaries of equity and liabilities, it may have little choice.

Stock options are ``a very important instrument and one that's politically charged,'' says Robert Herz, the board's chairman. ``But it is only one form. The project is much broader than this.''

Simple Structures

The difference between debt and equity used to be simple, when capital structures were less complex. Today, companies routinely issue financial instruments that are designed to look like equity and raise money like debt -- everything from ``callable convertible bonds'' and ``putable preferred shares'' to derivatives on their own stock.

At a June meeting, the board decided only ``direct ownership instruments'' should be classified as equity. That means options on common stock -- which lack voting rights -- would bounce to the liabilities side of the ledger, including the kind used to pay employees. The board expects to publish its preliminary views on the project later this year.

Currently, companies record an expense when an employee's right to own an option vests, rather than when the option is granted or exercised. The size of the expense is based on the option's estimated grant-date value. Once recorded, the expense amount is never revised, even if the option later soars in value or expires worthless.

Day of Reckoning

If stock options were treated as a liability on the balance sheet, the liability's value would be recalculated each quarter. One possible approach would be to record a corresponding expense when an option is first granted, and then run subsequent changes in the option's fair value through quarterly earnings until the option is exercised or expires.

Another approach would be to wait until the option is exercised or expires before running the fair-value changes through earnings. Still another question would be whether the fair-value changes should be classified as operating items or financing items on corporate income statements.

Whatever the approach, there would be a final day of reckoning. Figuring the cost of an exercised option, for example, would be as simple as subtracting the strike price from the price of the underlying stock at the time of exercise -- which is how the Internal Revenue Service does it for tax purposes.

`Closer to Reality'

``A lot of investors at the time of the stock-option project felt that what we did was closer to reality, but would have preferred an exercise-date approach,'' Herz says.

Treating options as liabilities also would eliminate double-counting in earnings per share. Currently, options are treated as both an expense and an addition to diluted shares outstanding. If treated as liabilities, unexercised options wouldn't count toward diluted shares because they wouldn't be classified as equity.

There is, of course, another possible path. To avoid the political klieg lights, the board could exclude employee stock- option pay from its project's scope and leave the current rules in place. Herz says that's not a good option, though.

``If you come up with a model that seems to be economically better and produces better reporting,'' Herz says, ``it's not a good idea to try to make political carve-outs.''

To contact the writer of this column: Jonathan Weil in Boulder, Colorado, at Or jweil6@bloomberg.net

Last Updated: October 10, 2007 00:00 EDT