As the effective date approaches for the controversial new accounting rule requiring companies to expense stock options, a handful of companies are accelerating vesting to get stock options off the books before they become a drain on earnings.
Donaldson
The Securities & Exchange Commission has been quiet on whether it would approve or disapprove of such a strategy, except to say it expects full disclosure. After testifying before a Senate committee on another initiative, SEC Chairman William Donaldson faced questions about how he intended to address lingering questions about implementation of the new rule, especially regarding valuation of stock options. Donaldson responded only by promising that his staff would issue new guidance by the end of March.
The Financial Accounting Standards Board finalized its long-pondered rule requiring companies to expense stock options at the end of 2004 but, under intense pressure on a variety of fronts, delayed the effective date until June 15, 2005. The SEC, which oversees FASB, has faced its share of pressure as well to overturn or dilute the new rule.
Opponents, consisting largely of technology companies that have made heavy use of stock options to compensate and motivate employees, took the six-month delay as a window of opportunity to lobby Congress for pre-emptive legislation. A bill currently is under consideration in the House Financial Services Committee.
No Prohibition
R.G. Associates, an investment research and portfolio management firm in Baltimore, has counted 63 companies through late February that have chosen to accelerate the vesting of stock options to declare their value as a footnote in financial statements instead of a reduction in income when the new accounting rule takes effect June 15.
Ciesielski
Jack Ciesielski, owner of R.G. Associates, is critical of the practice because it enables employees to exercise their options much sooner than originally scheduled. “If companies called it for what it is—a gift to employees—and recognized it in the income statement when they give the gift, it would be slightly more palatable,” he said. “Instead, they bury it in the footnote disclosures because they can. There’s no prohibition on this treatment.”
Ciesielski said his firm counted seven companies in the third quarter of 2004 who accelerated vesting on employee stock options, 18 more in the fourth quarter, and 38 by late February in the first quarter of 2005. “That’s probably a drop in the bucket compared to what we’ll be seeing by June, the month before [the new rule] becomes effective.”
In a December speech at an accounting conference, Chad Kokenge, a professional accounting fellow with the SEC’s Office of the Chief Accountant, reminded accountants of the disclosure requirement attached to the new stock option rule. “For each year an income statement is provided, the terms of significant modifications of outstanding [stock option] awards shall be disclosed,” he said.
If a company is changing the terms of options it has already granted to avoid recognizing an expense in future financial statements, “disclosure of this underlying reasoning is needed to inform investors as to how and why management makes decisions regarding the company,” Kokenge said. “If you have engaged in this type of transaction or are planning to, be prepared to explain your actions to your investors in your SEC filings.”
A former SEC staffer said the SEC wants to see FASB’s rule go into effect, but is holding its tongue because of the intense political pressure. “While I suspect the staff are not real enthused about the accelerations, they are not going to take exception to them as that would only further stoke the political fire they find themselves in,” the former staffer said.
No Hiding
Brian Bronson, chief accounting officer and treasurer for RadiSys Corp., which disclosed its acceleration plans last November, said the company reported a $6 million expense via footnote in 2004 and will accelerate more options by mid-year, before the rule takes effect.
“It results in a more accurate reflection of our earnings and losses in periods going forward,” Bronson said. “There’s no avoiding or hiding from the rule. This makes our reporting as clean and as transparent as possible. It’s a much better representation of what our shareholders want.”
John Wirtshafter, an attorney with McDonald Hopkins who focuses on executive compensation, said he’s only aware of companies accelerating options when the options are under water, meaning the exercise price is higher than the current trading price. With big swings in stock values over the past several years, it’s not an uncommon scenario for companies to face.
Underwater options serve no incentive benefit to motivate employees, he said, and so companies are cutting back or eliminating stock options in favor of other forms of compensation. “If the present fair market value is considerably lower than the grant date, why take an accounting charge for an option that has no value to employees?” he said. “It doesn’t strike me as unfair or inappropriate,” for companies to accelerate vesting to get underwater options off the books.
Wirtshafter acknowledged the SEC might take exception. “I’m sure the SEC would not think highly of the practice of making a compensation decision solely on how it is treated in the books,” he said. He thinks there’s a strong case for companies to accelerate vesting of underwater options, however, because the new rule “creates an unintended, unnecessary large accounting impact that is unfair to employees.”
Kaiser
Gordon Kaiser, a partner with Squire, Sanders & Dempsey, who leads the firm’s corporate practice, said the decision to accelerate vesting represents a legitimate business strategy based on a change in accounting treatment.
“With the change in rules, [stock options] are not as attractive as incentive compensation as when they were issued,” he said. “If companies have decided to alter their incentive compensation in light of new accounting rules, we shouldn’t punish executives for that change in direction.”
Bronson said the new accounting treatment in part is causing RadiSys to rethink its compensation strategies.
“We used to grant options to all employees,” he said. “Now, more are beginning to receive restricted stock because it’s more predictive in terms of profit and loss. It has a different retentive element for employees.”
No comments yet