FASB Makes Changes to Equity Compensation Proposal

The Financial Accounting Standards Board (FASB) has made a number of changes to its exposure draft on equity accounting. The most significant of these are:

Valuation Model Made Optional: In the exposure draft, FASB indicated a clear preference that companies use a binomial lattice model to estimate the fair value of an equity award. In general, these models produce a more accurate and somewhat lower value than the Black-Scholes model favored under FAS 123, the existing accounting standard for companies expensing equity awards. Binomial lattice models are complicated to administer and conceptually challenging, however, and many companies complained that implementing them in 2005 would be unrealistic. In response, FASB decided not to express a preference for any valuation model, as long as the model used incorporates six basic variables (the award price, the term of the award, dividend rates, volatility, the risk-free capital rate, and the stock price at grant). Other models besides Black-Scholes and the lattice model, such as Monte Carlo simulations, may also be used.

Vesting: Another complicated procedure proposed in the exposure draft was that valuations of awards with graded vesting (as opposed to cliff vesting) be done on a tranche-specific basis. In other words, if an employee's 100-option grant vested 25% per year, the valuation would treat the first 25% of the shares as a grant vesting in year one, 50% vesting in year two, etc. This calculation would be made at the time of grant for all the tranches. The effect generally is to push more of the cost to the start of the grant. Now FASB has agreed to revert to the rules of FAS 123, which allow a straight-line approach to vesting, resulting in the cost of the grant being spread out more evenly over the vesting period.

Employee stock purchase plans: The exposure draft essentially required all discounts and look-back periods in ESPPs to be treated as an expense. Initially, FASB ruled that companies could avoid a compensation expense for any broad-based stock purchase plans that offered a discount no more than that required by an underwriter for a stock offering. To simplify matters, however, FASB then decided that the discount could simply be 5% or less. This applies only if the plan does not have a look-back feature, however.

Income Tax Effects: Under the proposal, companies would estimate the income tax effects of options at grant. Thus, if a company expected a deduction on the exercise or grant of an award, it could make an estimate of the value of that at grant and recognize it as a deferred tax asset. If the ultimate deduction were more than expected, the excess would be treated as paid-in capital; if it were less, it would be treated as a tax expense on the income statement. Companies were not happy with that because it would make their future earnings look lower if tax effects were less than expected, while adding to paid-in capital, not income, if they were more. The new ruling reverts to the treatment under FAS 123, which allows the company first to offset any less-than-expected tax deductions against excess benefits previously recognized as paid-in capital. The remainder then would be a tax expense on the income statement. On the cash-flow statement, the excess benefits would be treated as financing cash inflow.

Transitions: Companies can retroactively apply the standards simply by moving their FAS 123 footnote calculations to their income statements.