Accounting for Stock-Based Compensation

While employee stock option incentives provide a significant benefit for employees, such incentives have been the focus of great controversy and debate, particularly in terms of accounting for such practices. This paper will take an in-depth look at the evolution of stock-based compensation over the last few decades, and how accounting and reporting of such company expenses has changed during that period. As a result, the reader will glean a stronger understanding of this practice.

Keywords: Fair Value-Based Method; Financial Accounting Standards Board (FASB); Intrinsic Value-Based Method; Restricted Stock; Stock Option; Stock Purchase Plan

Overview

Dot.coms & Stock Options

By the 1990s, the Internet, which only a decade earlier was virtually unknown outside of academic and intergovernmental circles, had become a juggernaut of personal and commercial activity. Entrepreneurs saw the nearly limitless potential for conducting their business. Companies like Amazon.com, eBay and WebMD got their start at this time, along with countless smaller companies offering similar, web-based commerce. These commercial start-up enterprises conducted the latest fad in business known as "e-commerce." Investors shared these companies' faith in web-based business, infusing a great deal of capital into their development, monies which were used for online marketing campaigns, lavish office space and employee perks. In the latter case, many employees of these "dot.coms" were paid not with salaries but with perks such as stock options.

Stock options in those cases helped inflate the perceived value of dot.coms on the open market, where a great many of these companies went public via initial public offerings (IPOs). In 2000, however, such inflation of stock was eventually corrected to account for the true value of these companies, and because of the sheer volume of dot.coms on the market, the NASDAQ technology index quickly fell by about 50 percent in the first few months of that year, leading observers to state that the "dot.com bubble" had burst.

Although it is an extreme example, the leveling of the dot.com industry provides an interesting case of a growing form of employee incentive. Many companies, in order to provide competitive salary and benefits packages to their employees, will offer stock options to their personnel. The rationale for this revenue-sharing concept is simple — in addition to pay and insurance, employees have an opportunity to reap the benefits of the company's success.

While employee stock option incentives provide a significant benefit for employees, such incentives have been the focus of great controversy and debate, particularly in terms of accounting for such practices. This paper will take an in-depth look at the evolution of stock-based compensation over the last few decades, and how accounting and reporting of such company expenses has changed during that period. As a result, the reader will glean a stronger understanding of this stock-based employee compensatory practice.

A Look at the Practice

The practice of offering stock-based compensation to employees centers on giving the employee the option to purchase shares in the company at discounted rates. Also known as "share-based payment," stock options are typically offered to senior-level executives of a company (although the dot.com example above is illustrative of the fact that it may be offered to other employees as well) as a performance incentive or as an employee retention benefit.

The practice of offering stock options to executives has generated controversy for two main reasons. The first is philosophical in nature, centering around the assertion that such practices give even more power and access to wealth for executives, while the profits from a company's market performance could be distributed among all employees on a more equitable level. This philosophical aversion to the practice came to light during the 2008 collapse of the financial markets. Like most personnel strata, senior executives like CEOs lost much of their compensatory benefits and incentives when the recession took root. Even their stock options fell significantly — about 90 percent of the $1.2 billion offered to company CEOs in 2008 fell "under water," which means that they were too low to yield a profit. In partial response, these companies have attempted to retain their high-level personnel by introducing even more stock options, giving them the ability to buy future shares in those companies at current prices ("Recession Takes," 2009). During a period of economic frailty and stagnation, many consumer advocates and activists are railing against such incentives.

The second controversy about the practice of share-based payments is what one industry expert calls "a moral hazard." By design, stock-based compensation acts as an incentive for the executive to foster the success of the company. The underlying principle involved in this venture is shared risk — if the executive succeeds, then the company succeeds, and if he or she fails, then the company falters. The company's failure or success dictates the value of the stock that is part of the executive's benefits package. Hence, he or she has a vested interest in seeing that stock perform well. In this regard, the executive in effect becomes a shareholder of the company as well as an administrator. Some experts argue that shared risk forces the executive into a conflict of interest between the activities of the company's management and the agenda of the shareholders (Chhabra, 2008).

Adding to the above-mentioned issues surrounding stock-based compensation is the fact that a company must account for any expenses and benefits paid to employees. In many ways, accounting for share-based executive payments has become an even more controversial issue than concerns over the morality and equity of such practices. Cannon and Kessel (2013) go so far as to call the accounting rules for stock options "Byzantine" and, as such, provide possible modifications or alternatives to stock option programs.

Korn, Paschke, and Uhrig-Homburg (2011) assert that designing stock-option plans for robustness at the outset is essential for reliable accounting valuations. They explain how robustness can be achieved by combining certain design elements of stock-option plans. They add that robustness of these plans is in itself an element of good corporate governance, in that it could impede managers' ability to understate the values of their compensation packages.

Further Insights

Accounting for Share-Based Benefits: Policy & Guidelines

In the mid-1980s, considerable attention was paid by the Internal Revenue Service to better quantify the income of U.S. businesses. Upon the direction of Congress in 1986, the IRS modified its code pertaining to the income and deductions of publicly-shared corporations to account for "intangible" property transfers. In a one-sentence addition, the IRS code included the statement that, in "the case of any transfer or license of intangible property, the income with respect to the transfer or license shall be commensurate with the income attributable to the intangible(s)" (Internal Revenue Service, 2009a).

The 1986 phraseology in that code was invoked less than a decade later when interest developed in Washington to regulate the practice of stock-based compensation. In 1995, after three years of careful study, a series of regulations were issued that outlined the manner by which cost sharing would be defined. In doing so, the IRS was in effect dictating to companies and taxpayers that stock-based compensation was in fact a component of a company's operating expenses as they pertain to employee benefits.

Still, although the inclusion of stock-based compensation was implied in the 1995 IRS regulations, it was not officially confirmed as such. That lack of clarity led to court challenges that argued that such inclusions were inserted on an arbitrary basis and lacking any uniformity or definition. It was not until 2003 that the IRS offered a further regulation that clarified that stock-based compensation was in fact an "intangible development cost" that, where applicable, should be included in any expense reports.

The Sarbanes-Oxley Act of 2002 may have influenced stock-option accounting practices as well. A 2011 study compared the accruals-based earnings-management patterns for a group of firms that were implicated by the Securities and Exchange Commission for backdating stock options with a matched control group of nonimplicated firms during the enactment of the Sarbanes-Oxley Act. The results suggest that the Sarbanes-Oxley Act had effects on management's reporting choices beyond those resulting from improvements in governance and internal control over financial reporting (Hossain, Mitra, Rezaee & Sarath, 2011).

Fair Value Method

In March of 2004, the Financial Accounting Standards Board (FASB), the organization charged with establishing standards of accounting, issued a set of proposals geared toward accounting for such expenses. In language that would immediately meet with controversy, the FASB recommended that stock-based compensation costs would be based on the fair value of the employee's right to purchase stock at a set price. Fair value in this case was determined by existing market prices or relevant option pricing models.

Within three months of the proposal's promulgation, the FASB received over 4,000 comment letters from businesses and taxpayers. One of the most prominent arguments was that while market prices and stable models give some indication of a stock option's value, stock options contain an element of depth and fluidity that could not be quantified under this framework. One expert suggests that rather than reliance on market and modeling systems, the accounting measures should instead operate from a more simple basis — the ultimate cost to the company of the stock options is equal to the amount of cash proceeds forgone at the date the employee exercises those options (Dyson, 2004).

The proposal was handed other criticisms as well. Some simply disagreed with the idea that employee stock options were expenses — in their view, stock options were merely pieces of paper that stated that an individual could purchase such stock, and that as a result, cost nothing for the company while giving a benefit to the employee. Other critics complained that there was a wide range of variables, such as the time at which the employee purchases the stock, which added an air of complexity to stock options for which simply valuating at market value could not account.

One of the most common criticisms, however, came from those who felt the policy would adversely impact business. After all, this school of thought professed, expensing stock options meant reporting lower net earnings. In the case of small business, lower earnings could put a startup business at risk to lose venture capital dollars. Additionally, expensing stock-based compensation could, in critics' eyes, give larger companies a competitive advantage over smaller businesses in terms of attracting high-quality employees (Carruth, 2003).

Still years after the proposals were released, criticism continued. Howe and Lippitt (2013) put forth that disparities between accounting expenses and actual exercise-date economic effects reflect a substantial wealth transfer that is not recognized or disclosed. Even within the context of the equity approach, they wrote, one can argue that the expenses, as currently measured, significantly understate the value of the services rendered. They offered an alternative "expected value approach."

Intrinsic Value Method

Since the release of the 1995 FASB statements, that organization has also allowed for other methods for equity valuation. One such method is intrinsic value-based, which focuses not on the market value but on the actual value of the share in question. Under the intrinsic value-based method, the cost of employee compensation is the difference between the quoted market price at the time the stock is granted and the amount the employee must pay to acquire the shares. The FASB leans against intrinsic value methodologies, however, as the most common type of stock option plan, the fixed stock option, does not have an intrinsic value by the date at which the option is exercised. Absent this intrinsic value, accounting for compensation in this arena is extremely difficult (Financial Accounting Standards Board, 2009).

Restricted Stock

Another form of share-based compensation is restricted stock. In this form, the stock has any number of limitations in terms of how and when the stock is exercised. Accounting for such restricted stock (also known as "nonvested stock") is conducted using the fair market value method, taking into account any restrictions that are imposed.

Stock purchase plans entail a group of employees who are allowed to purchase stock at a discounted price from the market rate. However, such plans are generally not considered compensation in accounting terms, due to the fact that most of them are relatively small and limited in terms of their dividend-generating capabilities.

Stock-based compensation appears in a number of manifestations. The stock option, which is extremely common among executives, offers the employee the option to purchase shares at a specified price within a certain period of time. Valuating stock option expenses entails accounting for the stock price at the time it is granted, the exercise price, the life of the option, the stock's volatility and the expected dividends.

Accounting for these types of stock options has been enmeshed in controversy since the FASB and IRS statements and policies pertaining thereto. Assertions that the parameters surrounding the inclusion of stock-based compensation present an incomplete image of the value of such stocks have been paralleled by the overall philosophical opposition to such inclusion. In general, however, the recommendations of the FASB and IRS have largely been adhered to, although begrudgingly among some.

Issues

Public Perception of Stock-Based Compensation

The use of stock options as an employee benefit and/or incentive was highly popular during the latter 20th century. The practice was particularly of use for high-level executives, although in the case of the dot.coms, was offered to all levels of staff (and in high quantities in this business arena). However, in the early 21st century, the practice had been so widespread among executives that it caught the attention of both lawmakers and the general public when these executives' respective companies began to falter.

In one case, French investment giant Societe Generale had offered its highest-level executives stock options, a benefit France's third-largest bank had also offered 5,000 of its employees. In 2009, the company received about $2.3 billion in government support after the collapse of the financial markets. After considerable public backlash against large corporations around the world who had received state "bailout" money yet continued the practice of offering executives stock options and bonuses, Societe Generale made a policy move. In March of 2009, the company's chairman announced that four of its upper-level executives would return their stock options to the company. The change in policy was a clear attempt to quell mounting criticism not only from the general public but from the French Parliament, which was threatening to levy sanctions against companies that offer stock options and bonuses to employees after receiving government aid (Frost, 2009).

From an accounting perspective, the Societe Generale move had minimal fiscal impact on the company. Rather, it was seen as an effort to mitigate public dissent over high-level benefits. The company continued to receive state funds; its upper management simply opted to decline any stock options. The policy therefore cost Societe Generale very little financially, since such options have no value until they are exercised, an action from which these targets of controversy would refrain.

The Societe Generale example provides an illustration of two important points. First, public opinion presently holds that stock-based compensation offers executives great returns even if the company is failing. This view is not entirely accurate, as the practice of offering stock options is not limited to upper-level executives (the 5,000 employees of the bank held stock options that amounted to about 98 percent of the program's total value). Still, public opinion, especially during times of recession, remains high in the eyes of lawmakers who act upon it with restrictive regulations and laws.

Second, this case underscores the latent nebulousness about the value of stock-based compensation for accounting purposes. Placing a value on stock options depends on when the employee exercises them — if they do not take advantage of such benefits, such options are not worth the price of the paper on which they are printed.

Conclusions

The British lawyer and novelist John Mortimer once said, "The freedom to make a fortune on the stock exchange has been made to sound more alluring than freedom of speech" (www.nonstopenglish.com). Words of the sort uttered by Mortimer are illustrative of the value people place in the potential for return on investments in the markets. It is for this reason that, among the items in many employees' benefits packages, stock options are highly prevalent. In cases like the dot.coms of the 1990s, they are often seen as potentially more valuable than cash, especially when the company shows signs that they will continue to grow in profits.

However, the government and the FASB have collectively deemed such policies as similar to other employee payroll expenses. This mandate was initially met with a number of different criticisms. Some of the objections were philosophical in nature, speaking against regulation of an important employment incentive. Others were with the fair value approach, offering alternatives to such a formula. The latter of these criticisms resulted in some flexibility in accounting guidelines among the IRS and FASB, and also spurred more diversity in the types of stock-based compensation created for employees.

The virtual collapse of several of the world's largest financial institutions in 2008 created a firestorm of public sentiment against the practice of offering stock options, particularly to high-level employees of financially distressed institutions that received government "bailout" monies. From an accounting standpoint, however, this issue has underscored the prevalence of this practice from upper management to rank-and-file employees, at minimal cost to employers. Indeed, share-based compensatory benefits remain an important tool in employee recruitment and retention, in strong and even weak economic times.

Terms & Concepts

Fair Value-based Method: Accounting measure preferred by FASB for determining share-based compensation benefit value using existing market prices or relevant option pricing models.

Financial Accounting Standards Board (FASB): A quasi-public organization that oversees the management and policies of accounting practices.

Intrinsic Value-based Method: Accounting principle for determining value of shares which focuses not on the market value but on the actual value of the share in question.

Restricted Stock: Stock-based compensation with limits on when and how the individual may exercise the option.

Stock Option: Employee benefit offered in lieu of or in addition to cash benefits as an incentive for employee recruitment and retention.

Stock Purchase Plan: Share-based compensatory program in which a group of employees are able to exercise stock options at a reduced or discounted rate.

Bibliography

Carruth, P. (2003). Accounting for stock options: a historical perspective. Journal of Business and Economics Research, 1, 9-14. Retrieved September 11, 2009 from Clute Institute http://www.cluteinstituteonlinejournals.com/PDFs/200351.pdf.

Chhabra, A. B. (2008). Executive stock options: Moral hazard or just compensation? The Journal of Wealth Management, 11, 20-35. Retrieved September 12, 2009 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=32153280&site=ehost-live

Dyson, R. (2004). Accounting for stock-based compensation: A simple proposal. The CPA Journal, 74, 6-10. Retrieved September 10, 2009 from EBSCO Online Database Business Source Complete http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=14009197&site=ehost-live

Financial Accounting Standards Board. (2009). Summary of Statement 123. Retrieved September 10, 2009 from http://www.fasb.org/summary/stsum123.shtml.

Frost, L. (2009, March 22). Societe Generale executives bow to pressure, drop stock options. Retrieved September 12, 2009 from Bloomberg.com. http://www.bloomberg.com/apps/news?pid=20601087&sid=a%5f5Kz231f7ac&refer=home.

Hossain, M., Mitra, S., Rezaee, Z., & Sarath, B. (2011). Corporate governance and earnings management in the pre- and post-Sarbanes-Oxley Act regimes: evidence from implicated option backdating firms. Journal of Accounting, Auditing & Finance, 26, 279-315. Retrieved November 7, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=67004289&site=ehost-live

Howe, H., & Lippitt, J.W. (2012). An evaluation of fair value accounting for employee stock options. International Business & Economics Research Journal, 11, 821-826. Retrieved November 7, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=79567430&site=ehost-live

Internal Revenue Service. (2009a). Stock based compensation audit techniques guide (02-2005). Retrieved September 10, 2009 from http://www.irs.gov/businesses/corporations/article/0,,id=134892,00.html.

Internal Revenue Service. (2009b). Cost sharing stock based compensation. Retrieved September 11, 2009 from http://www.irs.gov/businesses/article/0,,id=180309,00.html.

Korn, O., Paschke, C., & Uhrig-Homburg, M. (2012). Robust stock option plans. Review of Quantitative Finance & Accounting, 39, 77-103. Retrieved November 7, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=76607255&site=ehost-live

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Suggested Reading

Balsam, S. (1994). Extending the method of accounting for stock appreciation rights to employee stock options. Accounting Horizons, 8, 52-60. Retrieved September 14, 2009 from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=9503010821&site=ehost-live.

Barth, M., Bell, T., Collins, D. et al. (1994). Response to the FASB exposure draft "Accounting for Stock-Based Compensation." Accounting Horizons, 8, 114-116. Retrieved September 14, 2009 from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=9409140255&site=ehost-live.

Canada: Stock-based compensation. (2000). Accountancy, 126(1288), 107.

Dechow, P., Hutton, A. & Sloan, R. (1996). Economic consequences of accounting for stock-based compensation. Journal of Accounting Research, 34, 1-20. Retrieved September 14, 2009 from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=9708134799&site=ehost-live.

Simon, R. (2003, September 4). Popular stock perk faces cutbacks. Wall Street Journal — Eastern Edition, 242, D1-D2.

Talmor, E. & Wallace, J. (1998). Computer industry executives: An analysis of the new barons' compensation. Information Systems Research, 9, 398-414. Retrieved September 14, 2009 from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=1595115&site=ehost-live.