A Conversation About Equity Incentives with Jonathan Miller
“There was an initial impression that stock options were going to disappear, but we haven’t noticed that," Miller told AccountingWEB.com. "People are doing smaller plans and being more responsible about giving their options out. All the other plans have to be expensed as well.”
FAS 123 sets standards for financial accounting and reporting for stock-based employee compensation plans, according to the Financial Accounting Standards Board (FASB). An equity plan is any arrangement by which an employee receives shares of equity instruments, including stock shares from the employer. The employer may also incur liabilities to employees in amounts based on the stock of the employer. Transactions involving the acquisition of goods and services from nonemployees using equity instruments issued by an entity are also included.
“It used to be that stock-based compensation plans were footnoted and weren’t put into the actual profit & loss (P&L) statement of the public companies when they did their filings and now it has to be in a company’s P&L statement," Miller told AccountingWEB. "There has been almost a whole new industry that’s grown up for people who provide administration services, people who have developed software for the companies to use themselves and companies like us, in partnership with accounting firms. If accounting firms don’t have accurate information about the option plans, they can’t do proper expensing for their clients.”
Summarizing how accounting methods have changed, Miller told AccountingWEB that basically “the transition has really gone from footnoting without as strict a requirement for accuracy, to the actual expensing on the income statement,” that requires attestable accuracy. Miller continued, “The usual method of accounting for options before FAS 123, was to run the option plans on an Excel spreadsheet. So the process was fraught with opportunities for mistakes.”
Auditors and accountants must attest to the accuracy of the numbers that the CEOs must sign off on, as required by SOX. Auditors are also ensuring that the financial controls are in place. The auditors also have to give a judgment on the assumptions that the company and consultants have made that they use to get a precise value of the options.
Each of the different equity incentives is accounted for differently, adding to the complexity of their software, according to Miller. For example, stock option grants are accounted for differently than Stock Appreciation Rights (SARs), that are accounted for differently from stock performance plans.
The accounting provisions of FAS 123  apply to transactions entered into in fiscal years beginning after December 15, 1995, according to FASB. The provisions of FAS 123 may be adopted on issuance, as well.
The disclosure provisions of FAS 123 apply to financial statements for fiscal years beginning December 15, 1995. FAS 123 may also extend back to financials if an earlier fiscal year is adopted for recognizing compensation costs.
For those entities continuing to use APB Opinion No. 25,  Accounting for Stock Issued to Employees, the effects of all awards granted in fiscal years following December 15, 1994, must be disclosed in pro forma statements, according to FASB.
Further, any pro forma disclosures in that first fiscal year after December 15, 1994, do not need to be included in the that year’s financials but should be included in all subsequent fiscal years’ financial statements, according to FASB.
FAS 123 encourages companies to use a fair value based method of accounting to be adopted for all employee stock compensation plans, according to FASB. This statement allows an entity to continue measuring compensation cost for plans using the intrinsic value based accounting method as prescribed by Opinion 25, although the fair value based method of accounting is encouraged.
According to FASB, compensation cost is measured at the grant date based on the value of the equity incentive awarded and is recognized over the service period using the fair value-based accounting method. This service period is usually the vesting period. Using the intrinsic value-based method, compensation cost is any excess of the quoted market price of the stock on the grant or other measurement date.
Calculating fair market value for stock options involves several factors, according to FASB. The option-pricing model considers the following items:
- The stock price at the grant date
- The exercise price
- The expected life of the option
- The volatility of the underlying stock
- The expected dividends on that stock
- The risk-free interest rate over the expected life of the option.
Nonpublic entities are entitled to exclude volatility in calculating the value of their stock option, resulting in a minimum value, according to FASB. The fair value of nonvested or restricted stock is the same as the market price of a share of a nonrestricted stock on its grant date. The imposition of any restriction, especially after the employee has a right to it, just takes that restriction into account in the value calculation.
FASB states that employee stock purchase plans (ESPPs) are not considered compensatory if the following three conditions are met:
- The discount on shares is small, although a discount of 5 percent or less automatically satisfies this condition. A greater discount might also be considered as noncompensatory in some cases.
- All full-time employees may substantially participate in the ESPP on an equitable basis.
- The ESPP does not allow the employee purchasing shares at a fixed discount from the lesser of the market price at grant date or the date of purchase.
Certain disclosures about all stock-based employee compensation arrangements must be included in employer’s financial statements for compliance with FAS 123, according to FASB. These disclosed pro forma amounts must reflect the difference between any compensation cost included in net income and the resulting cost of the fair value based calculation, as defined in FAS 123, including any tax effects for those employers applying the provisions of Opinion 25.
“There are other systems out there for companies to use, but our system is easier to use," Miller told AccountingWEB. "We started doing administration of plans nine or ten years ago ourselves. At that time, we had to use other methods and gained experience with a variety of plans. When we decided on a program for our own use, we would start developing a program that was much easier to use and more intuitive to the non-computer or IT person.
“The people who get thrown into this [process] are the data entry types and human resource staff … so we decided that we wanted to handle all the big cap companies and needed to come up with an intuitive, user-friendly system,” where it was easy to track and follow resulting values, Miller concluded.
Miller has seen that brokerage firms and other companies have developed plan management software that is less user-friendly than their own system. Plan Management Corporation gleans information from their clients to help keep their system user friendly and provide what clients need to maintain their plans as easily as before, as client requirements change.
More information about Plan Management’s web-based software and services is available at www.optiontrax.com. 
Written by Tom Broughton, AccountingWEB Staff Writer. firstname.lastname@example.org