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Tax News: Accounting for Stock Options

Summer 1995

The long and sometimes bitter battle between the Financial Accounting Standards Board ("FASB") and various United States corporations and lobbying groups on the proposed rules on accounting for stock options appears to be coming to a close. Based upon recent statements from both the FASB and the Securities and Exchange Commission, it appears that the FASB will adopt the originally proposed rules on an "optional" basis. Although the change should not affect the income taxation of stock options (aside from any impact on alternative minimum tax for the difference between book and tax income), the change is very important from a financial reporting standpoint. Some experts have estimated that many public companies pay between 20% and 30% of their top executive compensation in the form of stock options.

Under existing rules, if a company grants an option to an executive to purchase shares at a price equal to the then prevailing market rate for the stock, the company generally does not recognize compensation expense on the date of grant. Moreover, the company generally does not recognize compensation expense at the time the executive exercises the option. These rules allow a company with appreciating stock to generously compensate its top executives without recognizing any expense on its books.

In June 1993, the FASB proposed new rules regarding accounting for stock-based compensation. The proposed rules would require companies to estimate the fair value of stock options on the date of grant and to recognize the expense over the service period, which is generally the vesting period. The important and difficult variable in this proposal is the "fair value" of the option. In order to estimate the fair value of an option, a company must make certain subjective assumptions about its stock and the timing of the option's exercise. The proposed rules would require that a company consider all of the following:

- Current price of underlying stock
- Exercise price of option
- Anticipated dividend yield
- Expected volatility of the stock
- Expected term of option
- Risk-free interest rate
- The company would use these assumptions, and several others, in a pricing model designed to determine the option's fair value. The FASB has specifically sanctioned the use of the Black-Scholes and Binomial Models but permits companies to use other methods. The proposed rules would require disclosure of the pricing method and the assumptions used by the company.

The proposed rules were met with harsh criticism. After extensive hearings, discussions, and other methods of persuasion (including proposed legislation that would have removed the FASB as the accounting profession's private rulemaking body), a compromise appears to have been reached. The FASB has indicated that it will substantially adopt the proposed rules. However, the proposed rules will constitute only the FASB's "preferred" method of accounting. Because the method will be the only preferred method of accounting, companies will have the option of adopting it. Significantly, if a company does not adopt the preferred method, the company will be required to make extensive disclosure of its earnings, including earnings per share, as if it had adopted the preferred method of accounting. The Securities and Exchange Commission recently endorsed the FASB's most recent proposal, and this endorsement likely will help persuade opponents of the proposal to accept it.

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