The Employee Ownership Update
November 7, 2002
IASB Issues Exposure Draft on Options ExpensingThe International Accounting Standards Board (IASB) has an exposure draft on how companies should account for stock options and other forms of equity compensation. "ED 2 Share-based Payment " is now available for public comment. The electronic text will be available free November 18. Until then, those interested can obtain paper copies at £15 each (€24/US$23) including postage, from IASB Publications Department, 30 Cannon Street, London EC4M 6XH, United Kingdom (Tel: +44 (0)20 7246 6410, Fax: +44 (0)20 7332 2749, email: email@example.com; Web: www.iasb.org.uk).
The proposal is similar to that now used by U.S. companies under Financial Accounting Standards Board Statement 123, which requires companies to calculate option value using a Black-Scholes or binomial model. These models calculate the current cost of an option based primarily on several factors:
Currently, US companies have to show this amount either on their income statements or in the footnotes. Accounting rules for other kinds of equity compensation, such as employee stock ownership plans or direct grants of stock to employees, follow different rules. The IASB proposal differs from the FASB proposal in that it would cover all forms of equity compensation. It also would make some changes in the approach used to calculate the value of the equity award. It could become effective as soon as the end of 2003 as a voluntary standard, and will be adopted by rule in Europe in 2005.
- Volatility (the higher the volatility, the higher option's current cost)
- The expected life of the option (the longer the term, the higher option's current cost)
- The dividend rate of the stock (the higher the divined, the lower the option's current cost)
- The risk free investment rate (the higher the rate, the higher option's current cost)
- The grant price (the higher the grant price, the higher option's current cost)
IASB chair Sir David Tweedle said that the proposal would not be as costly as some fear because it would allow companies to calculate the expected life of an option, not its full term. An option's expected life is how long the option is held before exercise, not how long it could be held. The original IASB discussion would have used the full term. FASB rules already allow an expected life calculation.
The proposed rules would allow companies to assume that volatility will be lower in the future than it has in the past, provided the company can justify why that will be the case. This is a somewhat more liberal interpretation than currently followed under FASB rules, which are based on calculations of previous volatility.
In the U.S. model, however, private companies do not factor volatility into their formulas. The IASB model would require this, increasing the option's impact on accounting statements.
Finally, the IASB rule would allow companies to estimate the percentage of shares that would not vest, and adjust current costs accordingly. Under current FASB procedures, expected unvested shares are not considered, but can be credited back if and when they do not vest.
Department of Labor Issues Field Assistance Bulletin on Refinancing ESOP LoansThe Department of Labor (DOL) has issued the first of what will be periodic Field Assistance Bulletin (FAB) on the operation of qualified plans. The advisories are meant to give DOL field officials guidance on how to respond to various plan operational issues. The inaugural FAB is on refinancing leveraged ESOPs.
The bulletin does not address situations in which an ESOP loan is refinanced with the same or shorter terms, usually to obtain a lower rate of interest. That kind of refinancing would clearly be beneficial to plan participants. Instead, it looks at a practice that grew in the 1990s, especially among public companies, of refinancing existing ESOPs to extend the term of the loan. The usual purpose was to spread out ESOP contributions over a longer period of time so that the amount released from the plan was lower on an annual basis. Many of these plans were linked to 401(k) plans. The company set up the ESOP so that the projected amount released annually from the ESOP suspense account as the loan was repaid would be similar to the amount the company would have otherwise contributed as a match to the 401(k) plan. In the 1990s, however, stock values went up faster than companies anticipated, meaning the amounts released from the suspense account were also much larger than anticipated (in a leveraged ESOP, as the loan is repaid, an equivalent number of shares is released each year, so the value of those shares will go up and down with share price). Some companies decided they were overcompensating employees and decided to refinance their loans to spread the release out over a longer period of time. Many ESOP experts (as well as the NCEO) argued that this was improper, that the employees were simply getting the upside of the risk ownership entails, just as they would get less if the stock went down. The new FAB concurs with his view, directing DOL agents to examine these refinancings to assure that if loans are refinanced, the refinancing is for the benefit of the employees, not the company.
Other refinancings, however, could present very different issues. For instance, a company may want to extend the terms of a loan because its cash flow is not as high as projected. In other cases, a loan may be refinanced because the company's payroll has shrunk. and repaying the loan on its original terms could cause violations of contribution limit rules. In these cases, refinancings may be in the interest of employees. Nonetheless, they should still be evaluated in light of the new directive.
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