Question

CA16-4 WRITING (Stock Compensation Plans) The following two items appeared on the Internet concerning the GAAP requirement to expense stock options.

WASHINGTON, D.C.—February 17, 2005 Congressman David Dreier (R–CA), Chairman of the House Rules Committee, and Congresswoman Anna Eshoo (D–CA) reintroduced legislation today that will preserve broad-based employee stock option plans and give investors critical information they need to understand how employee stock options impact the value of their shares.

“Last year, the U.S. House of Representatives overwhelmingly voted for legislation that would have ensured the continued ability of innovative companies to offer stock options to rank-and-file employees,” Dreier stated. “Both the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) continue to ignore our calls to address legitimate concerns about the impact of FASB’s new standard on workers’ ability to have an ownership stake in the New Economy, and its failure to address the real need of shareholders: accurate and meaningful information about a company’s use of stock options.”

In December 2004, FASB issued a stock option expensing standard that will render a huge blow to the 21st century economy,” Dreier said. “Their action and the SEC’s apparent lack of concern for protecting shareholders, requires us to once again take a firm stand on the side of investors and economic growth. Giving investors the ability to understand how stock options impact the value of their shares is critical. And equally important is preserving the ability of companies to use this innovative tool to attract talented employees.”

“Here We Go Again!” by Jack Ciesielski (2/21/2005, http://www.accountingobserver.com/blog/2005/02/here-we-go-again) On February 17, Congressman David Dreier (R–CA), and Congresswoman Anna Eshoo (D–CA), officially entered Silicon Valley’s bid to gum up the launch of honest reporting of stock option compensation: They co-sponsored a bill to “preserve broad-based employee stock option plans and give investors critical information they need to understand how employee stock options impact the value of their shares.” You know what “critical information” they mean: stuff like the stock compensation for the top five officers in a company, with a rigged value set as close to zero as possible. Investors crave this kind of information. Other ways the good Congresspersons want to “help” investors: The bill “also requires the SEC to study the effectiveness of those disclosures over three years, during which time, no new accounting standard related to the treatment of stock options could be recognized. Finally, the bill requires the Secretary of Commerce to conduct a study and report to Congress on the impact of broad-based employee stock option plans on expanding employee corporate ownership, skilled worker recruitment and retention, research and innovation, economic growth, and international competitiveness.”

It’s the old “four corners” basketball strategy: stall, stall, stall. In the meantime, hope for regime change at your opponent, the FASB.

Instructions

(a) What are the major recommendations of the stock-based compensation pronouncement?

(b) How do the provisions of GAAP in this area differ from the bill introduced by members of Congress (Dreier and Eshoo), which would require expensing for options issued to only the top five officers in a company? Which approach do you think would result in more useful information? (Focus on comparability.)

(c) The bill in Congress urges the FASB to develop a rule that preserves “the ability of companies to use this innovative tool to attract talented employees.” Write a response to these Congress-people explaining the importance of neutrality in financial accounting and reporting.

Short answer

1. Stock-based compensation is reported as a general compensation expense.
2. U.S. GAAP requiresto report all stock-based compensation as non-cash expenses under operating expenses.
3. Neutrality ensures that the financial statement is free from biasness.

Step-by-step solution

Definition of Stock-Based Compensation

Stock-based compensation is the method of rewarding employees using shares and options rather than using cash. Such compensation is also reported in the financial statements of the business entity.

Recommendation for stock-based compensation pronouncement

The stock-based compensation must be accounted for as general compensation. It must be reflected in the financial statement of the business entity as the cost paid for employee services. All the shares of the stock-based compensation must be recognized at the fair value of the options. The option pricing model is used to determine the fair value of the government company’s option. After granting the option, no adjustment will be made to the share price.

The value of the award will be included as an expense in the financial statement of the period in which the employees provide the services. Such a period is considered as vesting period.

Business entities made adjustments for the options that employees did not vest.

Difference in the approaches to exercising the option

The bill introduced by the member of congress reflects that the company must record only those options provided to the top five executives of the company. Under U.S. GAAP, all stock-based compensation is reported as non-cash operating expenses.

Based on comparability, recording stock-based compensation for some shares only will not provide useful information to the users of the financial statement and analysts. It will become difficult for the analyst to compare the compensation cost of the companies where one is paying through the share option, and another is paying in cash.

Importance of neutrality in the financial statement

The financial statement users are best served when the financial statement is prepared using neutral accounting standards. It means that all accounting information must be true and fair. Neutrality is not concerned with influencing human behaviour. At the same time, neutrality means that accounting information of the business entity is free from biasness and reflects the true picture of the business entity. Neutrality is one of the characteristics of the international financial reporting standards.