Walking tightrope on stock options

The value of stock options may be an incentive to staff  but how do they fit in the bottom line. One of the business world’s longest running controversies is almost over. The issue of how to treat stock options — offered to as enhancements to executives, particularly in developed and modern economies — is about to be resolved.

The argument has been raging for at least 30 years, but the International Accounting Standards Board IASB, which issued an exposure draft on Share-Based Payment in November 2002, is about to confirm that these perks must be accounted for as costs in the annual financial reports.  If this were to follow in the Caribbean, especially in Trinidad and Tobago, as is expected in its mentor economy Singapore, this could have a significant impact on the profit and loss accounts of Singapore companies. Even though no cash will actually ever leave the companies, executives are being given something valuable by the company which should be costed. Let us suppose that the companies’ shares are currently trading at TTD$10.  As a reward — and incentive — to increase the companies’ share value, they will offer the executives the chance of buying 50,000 shares at $15 each in three years’ time. It is a ‘no lose’ situation for the executives. If they do well, and as a result the companies’ share prices rise to $25 each, the executives buy 50,000 shares at  $15. If they sell those shares immediately, they will make a profit of $500,000. If they sit on the shares and they continue to increase, the perk improves.

But if things do not go so well and the share price drops to $5, the executive is highly unlikely to exercise the right to buy at $15 and the incentive remains unused. Once it was established that this incentive should appear as a cost to the company granting it, the argument was then about how the cost should be established. The alternatives are either to cost the benefit at the point at which the options were given — the grant date — or else at the date at which the options can be taken up by the employees because their performance targets were met — the vesting date — or the date they buy the shares — exercise date. Currently in Trinidad and Tobago, it is not necessary for companies to recognise the stock options issued as an expense in their profit and loss accounts at the point of grant.  They may recognise them when the employees exercise the options. If the company buys back shares from the market to honour its employee stock option scheme, it must recognise the difference between the prevailing market price and the exercise price as an expense.  However, if the company chooses to issue new shares to meet its employee stock option obligations, there is no impact on its profit and loss account. This is also the approach taken by other jurisdictions.  Based on information from ACCA’s Singapore Office, that country’s accounting requirement is consistent with the existing International Financial Reporting Standards (IFRS), which are set by the International Accounting Standards Board (IASB). But, following the recent corporate governance scandals in the US and elsewhere, the situation is changing. The US Financial Accounting Standards Board (FASB) recently announced that it would review its accounting standard on employee stock options (FASB Statement No. 123), to decide whether to require companies to treat employee stock options as an expense, based on their fair value, at the point of grant. 

A number of US companies, such as Coca-Cola, Amazon, General Electric, the Washington Post Company, Citigroup and Bank One, have already started to account for stock options in this manner. The IASB’s Exposure Draft on ‘Share-based Payment’ proposes that entities should recognise an expense in the profit and loss account, measured at fair value, whenever a share-based payment is made.  In the case of stock options, the Exposure Draft requires the fair value of the stock options issued to be recognised as an expense at or after the point of grant (i.e. grant date). ACCA can see the arguments for costing those options at the time they are exercised, because the cost of the options will be easily measured: it is the difference between the purchase price of the option and the higher value of the shares when they are sold. However, that means that the options might not appear as a cost on the accounts until they have been exercised and, in the post-Enron world where shareholders want more information, that is clearly not acceptable. Therefore, ACCA supports the case for options to be costed at their fair value at   grant date.  That, in itself, involves applying an appropriate model because the market values for these sorts of stock option are not readily available.
 
Examples, such as the Black Scholes or Binomial models, are based on complex set of equations being brought to bear. These take into account such elements as the current price, the price agreed, the volatility of the shares, the time to expiry of the option, interest rate and the likelihood that the executive will meet his targets. Once the calculation is done, there will be a ‘fair value’ for the options which can then appear in the annual accounts. These costs will be spread over the years between the grant date and the exercise date. In the case of our example, that would be three years, so a third of the overall calculated cost is charged each year against the company’s profits. Obviously, if the company has a tough few years and the options are not taken up, the costs which have been allowed for will never be issued as shares. We are calling for the Trinidad and Tobago Stock Exchange to adopt a similar accounting standard to that proposed by IASB which requires companies to expense stock options at the point of grant. While the new standards have been driven by scandals in the US which have not been experienced in Trinidad and Tobago or the Caribbean for that matter, the Round Table called for the accounting standard to be adopted as part of good corporate governance.

It also said that the adoption of the accounting standard will prevent companies from using stock options liberally. Companies will have to grant stock options carefully as their bottom lines will be affected. The implementation of the accounting standard will enable stakeholders to compare the bottom lines of companies which make cash incentive payments and companies which offer  share-based payments. The objective of the accounting standard is to protect investors. Although most unlisted companies have either no private investors, or very few of them, the change will make them more aware of their costs as they are forced to account for them. ACCA also believes that, while the valuation methods proposed by IASB are appropriate, other valuation methods should be allowed provided there is full disclosure and a justification for doing so. It also stressed that disclosure is not an effective alternative to share-based payment accounting. Stock options represent a major cost and companies will not be presenting the true picture if they are not accounted for. Although the accounting app-roach thus far is that disclosure is sufficient, some companies worldwide have already moved towards accounting for share-based payments as they feel that it is a better approach.  I think so too!

ACCA is the largest professional accountancy body operating on an international basis, with almost 300,000 members and students in 160 countries. 
www.accaglobal.com or email emile.valere@accaglobal.com