A Vested Present Value Approach to Valuing Employee Stock Options

INTRODUCTION The Financial Accounting Standards Board's (FASB) Stock Compensation project is one of the most controversial projects that the FASB has considered since its inception over two decades ago. In the early 1980's, the FASB was asked by the Securities and Exchange Commission, the AICPA's Accounting Standards Executive Committee, large accounting firms, industry representatives, and others to reconsider accounting for stock-based compensation. In June 1993, the FASB issued an Exposure Draft (ED) on an accounting standard that would have replaced Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) requiring fair value accounting for stock-based compensation. After lengthy debate and considerable controversy, the FASB issued Statement of Financial Accounting Standards No. 123, Accounting of Stock-Based Compensation (FAS 123). FAS 123 encourages, but does not require, companies to recognize compensation expense for stock options and other equity instruments issued to employees based on the fair value techniques recommended in the Exposure Draft. Companies that do not adopt the fair value are required to apply the previously existing accounting rules outlined in APB 25. Although fair value expense recognition for stock-based compensation is not mandatory, FAS 123 does require companies using the APB 25 guidelines to disclose pro forma net income and earnings per share under the fair value method. In addition, all companies with stockbased plans are required to make detailed disclosures about plan terms, exercise prices, and the assumptions used in determining fair value. This paper reviews the issues surrounding accounting for stock-based compensation, and proposes an alternative vested present value method for recognizing stock-based compensation expense during the service period. The first part of the paper discusses the historical development of accounting for stock-based compensation. The next section reviews the authoritative literature to discuss the major theoretical issues surrounding the stock-based compensation debate. Section III presents an alternative for recognizing compensation expense that provides a potentially more reliable measure of total compensation cost than either FAS 123 or APB 25. Finally, section IV summarizes our conclusions and discusses the theoretical benefits that the proposed provides over the other two methods. ACCOUNTING FOR STOCK-BASED COMPENSATION The controversy over accounting for stock based compensation is not a new issue. Many of the same issues that the FASB has debated over the last ten years were originally discussed by the Committee on Accounting Procedure (CAP) in 1953 in Chapter 13B of Accounting Research Bulletin (ARB) No. 43. (These issues were originally considered in ARB No. 37, issued in November 1948. However, ARB No. 37 was revised in 1953 to include consideration of stock purchase plans and recast as Chapter 13B of ARB No. 43.) Chapter 13 considers whether stock option plans are compensation and, if so, when this cost should be measured. The Committee determined that options do have value and should be measured on the date they are granted. However, because these instruments are unique and subject to various restrictions, the Committee recognized that it would be impractical to measure this value. Consequently, it recommended that compensation cost be recorded for the excess of the fair value of the shares over the option price. Realizing that market quotations of stock price were not necessarily conclusive evidence of fair value, the Committee was careful in referring to the fair value of the shares optioned rather than the market quotation of the shares. In the early 1970's, as the use of employee stock options became more prevalent and the compensation plans became more complex, the Accounting Principles Board revisited the question of accounting for stock issued to employees. …