Frontline Reaction to FASB 123(R): Companies Are Altering Their Policies, but More Changes Are Likely

EXECUTIVE SUMMARY * The issuance of FASB Statement no. 123(R) forced companies to make several important decisions about their use of stock options as a compensation tool, to select the right valuation model and minimize the impact on financial reporting and public disclosure. * A survey showed companies are decreasing their use of options and increasing their use of restricted shares and restricted stock units since FASB issued Statement no. 123(R). Some 61% of companies eliminated or decreased their use of options at all levels; another 26% did so only for nonexecutives. * While 56% of companies considered using the binomial model to value their stock options, 86% ultimately elected to use the Black-Scholes-Merton model. The former requires more work with binomial model users dedicating an average of 85% more resources to Statement no. 123(R) compliance than Black-Scholes-Merton users. * As expected, nearly 60% of surveyed companies were including in their financial statements pro forma disclosures excluding the Statement no. 123(R) expense or supplemental disclosures explaining the expense amounts. The vast majority-by a nearly 5-to-1 margin--were opting for supplemental disclosures. * Many companies are taking a second look at their compensation strategies to see whether they can provide comparable value at a lower accounting cost. Many over-used fixed options because of the previous advantageous accounting treatment. These companies are now cutting the number of options granted or reducing their statutory life. ********** More than a decade after FASB first proposed mandating the expensing of employee stock options, Statement no. 123(R), Share-Based Payment, became effective for fiscal years beginning after June 15, 2005. It has had a major impact on public companies, as well as on their internal and external accountants and the other professionals who help implement stock option programs. This article describes how affected corporations are reacting to Statement no. 123(R), so readers can benchmark their own actions. Using data from a survey by the Controllers' Leadership Roundtable, the article addresses issues such as Statement no. 123(R)'s effect on compensation structure; valuation models and assumptions; and on public disclosure and reporting. THE IMPACT OF FASB 123(R) Many of the objections companies initially had about expensing stock options related to the effect on their financial statements. High-tech companies in particular have made significant use of options and were concerned about the impact on their stock price and their ability to raise capital and recruit employees. Among the steps businesses might be expected to take to minimize that impact are reducing the number of options granted, reducing the per-option cost or making the direct effect of Statement no. 123(R) more transparent for financial statement readers. (A company can reduce per-option costs by changing the terms of the option or the valuation assumptions.) But companies must take steps to avoid potential abuses. THE EFFECT ON COMPENSATION STRUCTURE The Controllers' Leadership Roundtable survey showed corporations reacted to Statement no. 123(R) by decreasing their use of options and increasing their use of restricted shares and restricted stock units. Some 39% of responding companies said they had changed their use of options as a result of Statement no. 123(R). These companies reduced the use of options, with the majority (61%) eliminating or reducing the use of options at all levels. Another 26% eliminated or decreased options only for nonexecutives. Overall, respondents reported that 15.7% of employees received options before Statement no. 123(R), whereas only 13.2% received them after, a 16% drop. To compensate employees for the decrease in stock options, 44% of companies increased their use of restricted stock. Of the 33% of companies that did not use restricted stock before Statement no. …