Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: the fair value method of accounting for stock-based compensation (which results in an income statement expense) as a preferable method and encourages companies to adopt it instead of the intrinsic value method (which typically results in no expense in the income statement) allowed by APB 25. However, only a small fraction of companies follow FASB’s suggestion. Despite the fact that SFAS 123 was issued in 1995, which encourages but does not require expensing of stock options, the controversy over accounting methods for stock-based compensation is still ongoing. (See Section 3.6 for a summary of SFAS 123). Some c ompanies b elieve t hat t he f air v alue m ethod p rovides g reater transparency of financial statements to investors. However, some financial analysts state that if compensation expense is recognised using the fair value method they will add the stock-based compensation expense back to net income since it is a non-cash expense, which does not affect their valuation analysis (Pippolo, 2002). 3.4.1 Arguments Supporting the Recognition of Expense One of the arguments presented to support the fair value method of accounting for stock-based compensation plans is related to tax consequences for both the company and the recipient. When stock options are sold after satisfying the holding period rules, the difference between the received amount and the option price is taxed at a rate considerably lower than the ordinary income is taxed at (Shnider, 2002). However, the company gets a tax deduction at ordinary corporate tax rates for the difference between the option price and the current market value of the stock. Some of the U.S. Congress members proposed to require companies granting top executives stock options and taking tax 25 deductions, to charge stock-based compensation expense in their income statements as well. It is believed to be unfair to allow companies to claim options as tax deductions while not reporting them as an expense (Newell & Kreuze, 1997). U.S. Congressman, Pete Stark, in his Introduction of a bill to “End the Double Standard for Stock Options Act,” calls options “…a corporate tax loophole that allows companies to hide stock option expenses from their Securities and Exchange Commission earnings reports, but allows those same companies to take the deduction on their Internal Revenue Service tax filings” ( According to Statement of Financial Accounting Concepts (SFAC) No. 6, “Elements of Financial Statements,” expenses are defined as “outflows or other using up of assets or incurrence of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations.” Stock-based compensations do not always result in outflows of assets or incurrence of liabilities. However, FASB argues in SFAS 123 that stock-based compensation plans are valuable considerations given to employees for their services. The benefits stock options hold for employees result in an expense regardless of whether consideration is cash or other goods or services. Moreover, stock-based compensations can in fact result in actual cash outflows or into significant opportunity costs for all companies. Below we explain these possibilities. According to Newell and Kreuze (1997) many companies tend to keep a fixed number of shares outstanding. When employees exercise their stock options, companies in fact are selling their shares to employees at a discount. In order to hold a fixed number of shares outstanding companies then turn to the stock market and buy shares at a higher market price. When the price of the stock is going up there is a real cost to companies. That is when stock options cost the most. Microsoft, for instance, states the following in its Annual Report 2002 in the Notes to Financial Statements (Note 15 “Employee Stock and Savings Plans”): “The Company has an employee stock purchase plan for all eligible employees. Under the plan, shares of the Company’s common stock may be purchased at six-month intervals at 85% of the lower of the market value…” ( In Note 13 “Stockholders’ Equity” it is written: “The Company repurchases its common shares in the open market to provide shares for issuance to employees under stock option and stock purchase plans” ( As we see, companies do purchase their shares in the stock market at higher prices when stock options are exercised. These options are not recognised as an expense unless companies voluntarily choose to a pply t he f air v alue b ased m ethod f or a ccounting f or s tock-based 26 compensation. However, eventually these options result in a real cash expense for companies. As noted above, there is also an opportunity cost for companies. When employees exercise stock options, the company is selling its stock to them at a discount. That discount is the difference between the hig...
View Full Document

This document was uploaded on 10/31/2013.

Ask a homework question - tutors are online