Every year IR magazine seems to write an article based on the premise that companies are about to be required to expense the cost of stock options in their income statements. And every year what seemed like a done deal is, well, undone.
So here we are again. On December 16 the Financial Accounting Standards Board (Fasb) issued Statement 123R, the long-awaited standard requiring companies to recognize the cost of options in their income statements. Of course, anything can happen. Fasb has been trying to pass a new standard for years, only to see its efforts quashed at the 24th hour. But given how far things have progressed, intervention now seems unlikely.
Without that intervention, companies will have to implement the rule at the beginning of their next fiscal year. Perhaps then the contentious debate will be put to rest, at least for the time being.
Fasb had called for companies to begin applying Statement 123R as of the quarterly or annual reporting period beginning after June 15, 2005. After a furious backlash from lobbyists and companies, the SEC pushed back the deadline to the next fiscal year. The reason: for companies beginning to expense on an interim (rather than an annual) reporting period, results would be skewed.
‘That was one of the confusing things; if you had some companies beginning to expense options in the middle of a fiscal year, the comparables would be lopsided,’ explains Michael Saviage, VP of IR at Adobe Systems.
New beginnings
The SEC’s new deadline should enable everyone to provide full-year results reflecting the cost of options expensing. But Michael Crooch, Fasb board member and collaborator on the expensing project, regrets the SEC intervention. ‘I was disappointed that it saw fit to push back the deadline, but I understand its position,’ he says. ‘Under our original transition period, companies could go back and provide full-year results if they wanted to. Under the new transition, everyone just starts expensing at the beginning of the fiscal year.’
Despite the SEC’s efforts to be accommodating, the transition still promises to be a rocky one. It remains a ‘rolling’ start, with companies expensing based on their fiscal years. For some, that means as soon as this summer.
‘I don’t see how this helps comparability,’ says Joseph Rich, vice chairman at compensation consulting firm Pearl Meyer & Partners. ‘No matter what, it’s going to be a murky year. Maybe investors will have to give companies some breathing room, so they won’t be held to the same standards as when everyone is under the same rule and expensing. Remember, for many companies, these are dramatic charges.’
The SEC extension also gives opponents more time to gather their strength for another round with Congress, or any other body that might intervene. Perhaps that’s why not all companies have taken the situation too seriously. ‘I wasn’t even aware of the new standard,’ comments one IRO from a technology firm that approved an expensing proposal through a non-binding resolution.
Taking stock
On the flip side, several companies, especially outside the tech sector, have been voluntarily expensing options for years. Most firms, however, are reviewing the new standard and determining what needs to be done to comply. And whereas a year ago the response was ‘We’ll wait and see what passes’, now it’s ‘We’re reviewing our strategy’ or ‘We’re putting together our strategy’.
‘We have an informal committee that functions like a disclosure committee – it’s a combination of finance and IR,’ says Randi Paikoff Feigin, VP of IR at Sunnyvale, California-based Juniper Networks. ‘Under the extension, we don’t have to do anything until next year so we’re still evaluating several things. Much of what we do is going to be based on what we see from our peers. Cisco Systems has to comply before us, given its financial year, so we can see how it’s affected.’
Companies are generally providing detailed information on the cost of their options programs in the footnotes of their financials. But given that the cost associated with options will begin hitting their income statements – and their results – few companies plan to simply use the same inputs and models without review.
‘We’ll look at what our peers are doing with inputs such as turnover and volatility, for example,’ points out Patrick Lee, IR manager at jewelry retailer Zale Corporation. ‘We have already begun to benchmark against the industry to ensure consistency. Equity compensation has always been relatively moderate for us, and I would expect our option expense to be so, too.’
Room to maneuver
One of the most contentious issues surrounding option expensing is the imprecision of the pricing models available. Critics point out that the binomial and Black-Scholes models are unpredictable because they try to assign a value today, even though the option hasn’t yet been traded – so comparability suffers, given the myriad of assumptions. Fasb didn’t take on the issue of which valuation method is best. Instead, Statement 123R gives companies the latitude to choose.
‘Companies just have to show the methodology they choose is an economically acceptable one,’ observes Gill Eapen, principal of Decision Options of Groton, Connecticut, which is selling a lattice-based binomial method called ‘decision options’ for $5,000 per copy. ‘Of the Fortune 500, about a third are expensing voluntarily, and most use Black-Scholes. But if you put in constraints, such as vesting periods or blackout periods, you get a number that is less than the Black-Scholes number, as there are no constraints with Black-Scholes. It’s a static equation.’
For many companies, however, the less complex Black-Scholes remains the method of choice. ‘We use Black-Scholes and most likely will continue to do so because of the way our options program is structured – it covers the top 150 or so employees,’ says Lee. ‘The lattice method would not make much of a difference in terms of results, yet it is more complicated to implement.’
At Adobe Systems, the company uses a variety of sources to come up with the inputs it uses, including third-party data. ‘The volatility factor is currently a combination of third-party information, historical and peer data; under FAS 123R, we will likely move to a third-party only factor for volatility,’ says Saviage. ‘As for which method we will use under FAS 123R, we are still evaluating.’
Ultimately, time will be the most important factor in deciding which model is best. That’s why the CFA Centre for Financial Market Integrity – part of the CFA Institute that administers the chartered financial analyst® curriculum and examination program – is pleased Fasb did not constrain the models that companies can use.
‘We hope the development of option expensing models will continue,’ says Rebecca McEnally, director of the capital markets policy group for the CFA Centre for Financial Market Integrity. ‘We said companies should disclose the model and inputs they’re using, and Fasb did require that. That way investors can compare companies. For example, we want to be able to know if a specific company is low-balling the estimates so we can adjust accordingly. It’s the inputs disclosure that is critical. And again, we want to see continued development of the modeling processes.’
Pro forma blinders?
One question that remains to be answered is how investors will react to expensing. Will they just ignore the expense and, in response, will companies provide pro forma results that exclude these costs?
The SEC was concerned enough to forbid companies from reporting the options expense as a separate line item on the income statement. ‘The commission said it should be regarded as compensation and put with compensation, not broken out,’ notes McEnally. ‘That way investors won’t ignore it. The SEC wants it treated as what it is – compensation, which is very important.’
Companies and IROs in particular are using this transition time to gauge what investors want to see. ‘The IR department provides qualitative research collected from shareholder discussions,’ observes Maria Tagliaferro, director of corporate communications at semiconductor giant Analog Devices. ‘These discussions are to help us understand how the expensing of stock options will be viewed in terms of using pro forma EPS, adjusting to cash flow per share, and sticking to Gaap EPS. So far, there is no consensus.’
Tagliaferro doubts Analog Devices will issue pro forma results as it prefers one set of financials in Gaap. But the firm has not made a final decision. Others are leaning toward pro forma earnings releases. ‘Our conversations with investors tell us they’ll pro forma it out, so we’ll probably look at doing a non-Gaap and a Gaap version,’ notes Saviage. ‘We already provide the reconciliation to Gaap, so everyone can see what we’ve done.’
‘We probably will do non-Gaap and Gaap, and this will be one more thing we’ll pro forma with reconciliation,’ agrees Feigin. ‘That’s how our peers and analysts are looking at it.’
One practice that has raised eyebrows is the accelerated vesting of underwater options. To critics, this is a reprehensible act that rewards employees for poor performance. But some companies contest they’ll be unfairly penalized, especially if their peers are following suit. The SEC has not weighed in definitively on the subject.
‘We are aware of this and in fact have some direct competitors who have taken these steps,’ says Tagliaferro. ‘We have not made any decisions but this practice does seem counter to our primary objective for granting options: long-term employee retention.’
As for the prospects of another article – say, a year from now – claiming that this is really the last time we write about the prospect of a final rule being implemented – well, as McNally says: ‘I would hope this is it.‘
