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Don't Stop When You Comply With FASB Options Standard

Paul B. W. Miller and Paul R. Bahnson | May 11, 2004

This is Part One of a two-part series written by Miller and Bahnson. Part Two appeared in the May 18 edition of Compliance Week.

On March 31, amid much fanfare—both cheers and jeers—the FASB finally issued its long-awaited exposure draft of a new standard that would mandate recognizing an expense when stock options are granted. Despite threats from some quarters in Congress and complaints from some managers—and with encouragement from other members of Congress, other managers, and regulators (including the chairs of the SEC and the Federal Reserve)—the board has decided to try to improve the measurement of reported earnings.

Whether you want to or not, you are in all likelihood going to have to start putting this expense on your income statement next year. We have two lines of advice to help you do a better job of communicating with your investors and creditors, and with the capital markets in general.

First: Don't do anything to compromise the quality of your compliance with the new standard. Don't hire experts who will produce minimized measures of the option cost. Just comply and comply well.

And second (and here is where you may be overwhelmed): Don't you dare for one second believe that complying with the new FASB standard will produce high quality financial statements. Nothing could be further from the truth. Although some people will agree with our conclusion, they will probably get there by a different path.

Limitations Of The Method

Our position is that FASB is using an outmoded concept to justify its method that fails to provide the useful information the capital markets need to properly assess your company's profitability, risk, and other factors that affect your securities' market value.

Here is a thumbnail sketch of FASB's method:

  1. It first finds the estimated value of the options on their grant date.
  2. It then spreads that amount uniformly over the vesting period as option expense.
  3. At the same time, the equity section of the balance sheet shows an accumulating balance in an "Outstanding Options" account, finally reaching the full grant date valu—but only years later—on the day that vesting is accomplished.
  4. The balance sheet also reports an accumulating deferred tax asset that anticipates tax savings from assumed future exercise, but only for a deduction equal to that grant date value, not the real value at exercise.

To understand this method's limitations, consider how it reacts to post-grant-date-changes in option value.

Suppose your stock's value goes up after the options are awarded—after all, that's the whole idea. What will happen in your financial statements? Actually, nothing. You will continue to report only the amortization of that old and obsolete grant date value during the vesting period. The balance of the reported options equity account is not affected nor is the deferred tax asset, despite the fact that a much larger future tax deduction is now expected at option exercise.

Not bad, you might think, because that means higher reported earnings. But don't cling to that thought for long.

Instead, suppose the options' value goes south, maybe all the way underwater. Under FASB's coming method, you will continue to amortize that grant date value into earnings during the vesting period and your balance sheet will show outstanding options, even though their market performance has not been (ahem!) very outstanding. You'll also keep showing that deferred tax asset, although the probability of ever using it is greatly diminished.

So, there you have the huge limitation of the coming method—your financial statements will not reflect what has really happened to your options; it will just keep plodding along like a draft horse wearing blinders, oblivious to reality.

Estimates And Tax Issues

You might be asking, "What's so bad about that?"

Well, what do you think happens when your financial statements are incomplete, when financial statement users know they're incomplete, and they want to remedy that incompleteness? They will start estimating the unreported real expense that FASB hasn't required you to broadcast.

And the chances are that they would not systematically underestimate that expense, thereby attributing higher reported earnings to your company. Instead, we believe they will take a protective stance and overestimate the expense, just to be safe.

There is one more defect in FASB's system.

Suppose again that your options increase in value and get exercised when they're worth much more than the old original grant-date value. Say that the options' original value was $5 million but the real value at exercise is a $25 million discount below the stock's market value. You will get to deduct that larger number on your company's tax return and hold onto more cash.

However, the FASB will require your company to report tax expense on the income statement equal only to what you would have had to pay if you had deducted only the initial $5 million cost. If your rate is, say, 40 percent, you will not get to increase your reported earnings by the full $8 million in taxes that you really saved.

Conversely, assume that the options end up lapsing because they're worthless at the end of their term. Remember how you have to reduce tax expense during the vesting period for the anticipated savings? FASB will now make you recapture those past savings and write off those deferred tax assets. That means you will have to write off those accrued savings in the year the options lapse, giving you the opportunity to report higher tax expense and lower after-tax profits, even though your employees never exercised the options.

All in all, we see little resemblance between what FASB will have you report in your financial statements and what is happening with your real financial structure and your real earnings. The noise that will be forced into your statements is probably less disruptive than reporting nothing at all, but it is still quite considerable and likely to frustrate your financial statement users and drive them to discount your company's stock price, simply because they lack solid information about what happens.

The bottom line: Your stock price will be hurt and your cost of capital will be higher.

So, is there something you can do?

Sure, you can complain to FASB and ask them to come up with a different method. However, as seasoned FASB-watchers, we don't think that is going to happen. Far too much has been invested in building a consensus in favor of its current approach; the board simply will not burn political capital to go to a method different from the one it has waited a decade to make mandatory.

Alternatively, you can take steps to fully inform your financial statement users about what numbers have flowed to the income statement, and explain that they aren't reliable because they're incomplete. Then (and here is the big step) you can go beyond the minimum requirements of GAAP and disclose a lot more information that will meet the users' needs.

By doing so, you'll reduce their uncertainty and their risk, pull down your capital costs, and boost your stock price.

In Part Two of our series, which will run in the next edition of Compliance Week on May 18, we will explain what information seems to be useful in addition to FASB's numbers.

The column solely reflects the views of its author, and should not be regarded as legal advice. It is for general information and discussion only, and is not a full analysis of the matters presented.

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