SEC Says Option Grant Rescissions Require Variable Accounting

The Securities and Exchange Commission has issued new guidance stating that if a company allows employees with options to turn in shares obtained through the exercise of stock options in exchange for new options, then this will trigger variable accounting procedures. For the rescission to be effective, the shares have be turned in during the same tax year the employee exercised the option.

The policy of allowing "rescissions" on options is controversial. It's easiest to understand how a rescission works through an example. Assume Bill gets an option at $20 per share in 1995. In January 2000, he exercises the option. The share price is now $45. It doesn't matter whether the option is an incentive stock option (ISO) or non-qualified option. An incentive option will become a non-qualified option if the employee turns in the shares because they will not have been held long enough to qualify as an ISO. By December, the share price has tumbled to $15. The company allows Bill to turn in the shares and get new options with the same price and terms as the old ones. The price Bill paid to exercise the options is returned to him, and Bill returns any dividends paid during the period he held the shares. From an income tax standpoint, the argument is that nothing has happened -- the old options have been canceled, the employee has no tax due, and the company does not get a tax deduction.

The SEC has issued guidance on rescissions saying that the practice creates a variable accounting requirement, meaning that, unlike with conventional stock option practices, the cost of option must be reflected on the company financial statements. The SEC has allowed a transition period, however, saying that the treatment will apply only to rescissions granted after January 1, 2001.

For rescissions prior to 2001, the company must record a charge to earnings equal to any tax deduction it lost as a result of the rescission (the $25 spread between the $20 exercise price and the $45 share price, in our example), plus any additional cost represented by the excess of the share price over the option price at the time of the rescission (in this example). It is not clear whether the company will still have to take a charge to earnings for lost deductions under the new procedures as well.

For rescissions after January 1, 2001, the company must use "marked-to-market" variable accounting, meaning it records an expense each quarter representing the current difference between the option price ($20) and the market price of the shares, a process that can result in a substantial accounting charge. This goes on until the options are no longer in effect, either because they have been exercised, they have lapsed, or are forfeited. In addition, the company has to disclose the terms of the rescission in its financial statements. In its stockholder equity section, the company must show the initial exercise and subsequent rescission. Rescinded shares must be included in the calculation of "basic" earnings per share while the shares are outstanding, and any cash flow results need to be discussed in management's "discussion and analysis."

It is not known just how common the rescission practice has become, but it has generated considerable controversy about whether it is just another way to eliminate the risk associated with options, one that could, in some cases, cost a company valuable tax deductions. The SEC's guidance is apparently at odds with FASB staff recommendations, and FASB has not yet issued any guidance of its own on the subject other than to release the SEC guidance.