Companies have issued stock options to their employees to supplement compensation for years, but you need to be aware of the implications that come with these options.
New and updated accounting rules have complicated stock option reporting in recent years. For example, Financial Accounting Standards Board (FASB) FAS 123(r) stipulates that costs related to equity-based compensation be recognized in a company’s income statement. Internal Revenue Service 409(a) is a measure that requires companies to report compensation to their employees if stock options were granted to them at prices below fair market value.
“As you can imagine, valuing stock options for financial reporting purposes is not easy,” says Mike Rogers, CPA, CFE, a senior audit manager with Briggs & Veselka Co. “The valuation process must take into account the stock price at the grant date, the exercise price of the option, the expected life of the option, the volatility of the underlying stock, the expected dividends on it and the risk-free interest rate over the expected life of the option.”
Smart Business spoke with Rogers about stock options and what you need to consider from an accounting perspective when issuing them.
Why are stock options such a hot topic in the accounting world right now?
In tough economic times, companies must be creative with the way they reward employees, especially when cash is tight. Some companies issue equity awards like stock options as a reward that doesn’t require cash in the short-term. Stock options permit an employee to purchase shares of company stock at a future date and at a predetermined price. Options also serve as an incentive because employees want the company to do well, thereby increasing the value of the stock underlying the options.
There are different types of options, each having its own tax ramifications to the employee and the company. Some options allow an employee the choice of paying taxes on the option value now or waiting until the options are exercised. Both the company that grants options and the employee who receives them should consult with tax advisers because the rules can be difficult to follow.
What are the financial implications of granting stock options?
Although options do not require an immediate cash outlay, there are financial implications. Current accounting rules require a company that grants options to record expenses based on the value of the options, typically at the time when the company grants the options.
Again, determining the option’s value is a complex process. The primary factor is determining the value of a share of company stock. The stock value establishes the option’s exercise price. This could mean that privately held companies need to obtain a formal appraisal. Alternatively, a company might set the price using a formula or base it on historical transactions.
Accounting rules also require a company to determine the volatility of its stock price. Companies could state zero percent volatility in the past, but this is no longer allowed in the accounting rules. Because volatility is difficult to establish, privately held companies might consider looking to a peer group of publicly held companies in the same industry or to an industry index. In any case, from an accounting standpoint, the volatility must be reasonable and supported.
Finally, the current rules require a company to consider the rate at which employees forfeit the options prior to exercise. This forfeiture rate is ideally based on past employee behavior but can also be formula-driven.
So, how do you determine option value?
The factors we just discussed serve as some of the major inputs into establishing the option’s value. There are two primary models companies use to arrive at the value, the most common being the Black-Scholes-Merton model. The second type is a lattice-based model. There are numerous free online option calculators that use the Black-Scholes-Merton model.
Bottom line, what does a company need to know when issuing stock options?
It is important to remember that granting options or any equity-based compensation has financial reporting implications. Determining the financial impact is a complex process. It is best to communicate with auditors and tax advisers early in the process to gain consensus on the option value and the underlying factors. It is not something that should be considered at the last minute.
MIKE ROGERS, CPA, CFE, is a senior audit manager with Briggs & Veselka Co. Reach him at mrogers@BVCCPA.com or (713) 667-9147.