FASB: Options Are Equity

August 18, 2004 (PLANSPONSOR.com) - The Financial Accounting Standards Board (FASB) has reaffirmed its basis that stock option awards should be treated as equity and not a liability.

With the decision, the Norwalk, Connecticut-based accounting standards board has effectively ruled out the possibility that companies would be allowed to adjust options expense to reflect how much employees actually get.   That is because the only way that companies could make such adjustments is through booking options as liabilities on balance sheets, according to a Dow Jones report.

The decision has particular relevance following the release of FASB’s Exposure Draft issued on March 31, in which the rulemarkers proposed all forms of share-based payments to employees would be treated the same as other forms of compensation by recognizing the related cost in the income statement.   In the Exposure Draft, FASB detailed the expense of the award generally would be measured at fair value at the grant date (See  The Bottom Line: Expensing Proposition).  To arrive at this cost, FASB provided several valuation techniques in the Exposure Draft, including a lattice model (an example of which is a binomial model) and a closed-form model (an example of which is the Black-Scholes-Merton formula) that would meet the criteria for estimating the fair values of employee share options.

With today’s decision, FASB has clearly detailed its view that options are “equity,” thus forcing companies to record options on their income statements with a grant-date estimate.   Critics have maintained this type of accounting requires companies to make too much of an educated guess as to the future value of option grants.

Analyst Divergence

However, the decision does not rule out the fact that some analysts may still crunch their numbers using the liability approach.   In the June 14 research paper “The Cost of Employee Stock Options,”Credit Suisse First Boston (CSFB) analysts David Zion and Bill Carcache laid out their alternate view thatemployee stock options should be reported as a liability on corporate financial statements, with changes to the fair value of option grants running through earnings (See  CSFB: Options Should Be Reported As A Liability ).  

The hook of the CSFB research paper is in valuing how employee stock options are exercised.  Under most stock option arrangements, a company is forced to sell shares of stock at less than fair value when employees chooses to exercise their stock options.  Thus, the ultimate cost of the options depends on the stock price at the time of exercise. At that point the cost is simply how much the options are in the money, or put differently, the difference between the stock price and the strike price.

At the time of the option grant, however, a transfer of wealth took place from the shareholders to the employees. Therefore, the employee stock options that are outstanding have a claim on the shareholders’ stake in the company.  “Shareholders can, therefore, view that claim as similar to any other claim on the firm’s future cash flows. We would treat that claim as a liability,” Zion and Carcache say.