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Observations on Employee Ownership
FASB Issues Final Accounting Rules
Corey Rosen
February 2005
The Financial Accounting Standards Board (FASB) has ended the suspense about expensing by issuing its final revision to FAS 123. Statement of Financial Accounting Standards No. 123 (Revised 2004), or FAS 123(R), was released December 16, 2004. Unlike its predecessor, FAS 123(R) will be mandatory. In the eight and a half months between FASB's release of its exposure draft and mid-December, the accounting board made several announcements about revisions it planned to make to the exposure draft's proposals, leaving few surprises for FAS 123(R).Beginning in 2005, companies will have to show the fair value of their stock option awards on their income statements. That value will be determined using an option-pricing model. In the past, under FAS 123, companies have shown the Black-Scholes value of their stock options in the footnotes to their income statements, but not reflected them as a line item. Most other kinds of equity compensation already show up as an expense on companies' income statements.
FAS 123(R) allows companies to choose among lattice models, the Black- Scholes model, and Monte Carlo simulation models to put a dollar value on their unvested equity awards. Unlike the exposure draft, which expressed a preference for a binomial lattice model, the final statement does not express a preference. Acceptable models must, at a minimum, take into account: the exercise price of the option; the expected term of the option; the current price of the underlying shares; the expected volatility of the price of the underlying shares for the expected term of the option; the expected dividends on the underlying shares; and the risk-free interest rate. The new standard goes into effect for reporting periods that start after June 15 for public companies, with the exception of small business with revenue of less than $25 million, which have until December 15. Nonpublic companies must begin using the standard in fiscal years that begin after December 15, but unlike public companies do not have to use the standard for interim reporting periods before that.
Other changes from the exposure draft include:
- Graded vesting. While the exposure draft sought to have companies recognize awards with graded vesting by counting each vesting tranche as a separate award, FAS 123(R) allows for the less administratively onerous method of allowing companies to account for the award on a straight-line basis over the service period covered by the entire award.
- Employee stock purchase plans (ESPPs). While the exposure draft sought to require the expensing of any ESPP shares offered at a discount, the final standard will allow companies to offer up to a 5% discount without expensing— as long as the plan is offered to all employees who meet service terms, the purchase price is based on the market price on the purchase date, and employees are allowed no more than 31 days after the purchase price has been fixed to enroll in the plan.
- Retrospective restatement of financial statements. The exposure draft would have prohibited retroactive restatement of earlier periods, but that was when FAS 123(R) was expected to go into effect in late 2004. Because the effective date was pushed back, companies will be allowed to restate earlier quarters. This will allow companies that operate on a calendar-year basis to account for their equity compensation awards the same way throughout 2005, rather than showing equity compensation without an expense for the first two quarters of the year and with the expense for the second two quarters.
- Tax recognition. FAS 123(R) revokes a provision in the exposure draft that would have required excess tax benefits (the difference between taxes recognized for accounting purposes and taxes actually paid) that are attributable to equity compensation plans to be recorded in a different place than tax benefit shortfalls. FAS 123(R) will allow companies to recognize excess tax benefits as an addition to paid-in capital.
- Performance-based awards. Like FAS 123, FAS 123(R) puts performance- based awards on an even footing with other forms of equity compensation as long as they don't vest based on increases in a company's stock price. Performance-based awards based on length of service or general financial goals can be "trued up" at the end of the vesting period, meaning the company ultimately must expense only the shares that actually vest. A company whose performance awards vest based on the company stock price must show the cost of all awards as an expense and can't go back later to adjust for awards that never vested.
- Repricing. Like its accounting predecessors, FAS 123(R) views repricings as modifications. But because all options will be expensed, companies will no longer be able to avoid recognizing any expense by waiting six months and a day to replace canceled options. Instead, companies will have to expense any difference in incremental value between the canceled award and the replacement award. "In many cases, the new standard allows companies to place a higher 'before' value on the award than under FAS 123, enabling them to provide more replacement value to employees without incurring an additional earnings charge," according to "A New Accounting Standard for Stock- Based Compensation," published by Mercer Human Resource Consulting in December.
