Accounting for employee stock options to change

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Stock options, once a perk reserved for top executives, have filtered down to mid-management-level and technical employees, particularly in high-tech companies that have adopted stock option programs to attract top talent.

About 13 percent of the private sector workforce now holds stock options, according to one estimate. Now, under a revision to accounting rules by the Financial Accounting Standards Board, all companies that issues options, from the largest publicly traded companies companies to the smallest start-ups, will be required to estimate the value of those options and account for them as an expense.

The Biotechnology Industry Organization, a Washington, D.C., trade group, opposes the new rule, FASB 123R, saying it will be detrimental to small biotechnology companies trying to attract scientists while cash flows are tight and products are still under development. One of the difficulties is that the rule will require the use of valuation models that aren’t designed for determining the value of employee options, according to a statement by Morrie Ruffin, BIO’s vice president of business development and emerging companies.

“This will divert much needed money away from research toward the development of extraordinarily complex and highly subjective stock option value exercises that none of the experienced investors in the industry will even consider in their investment decisions,” Ruffin said.

It’s an issue that’s been around a long time, said Jeff Baker, a partner at McGladrey & Pullen LLP in Des Moines.

“There have been proposals in the past to do this, and there was always fierce lobbying by the high-tech companies that kept it out,” he said. “I don’t think it’s exactly because of (accounting and auditing reforms under) Sarbanes-Oxley, but in light of the all the corporate misdeeds, (the FASB) thought this was the way to go and they stuck to their guns.”

Under the old rule, companies may opt to expense options, but are not required to. However, public companies are required to state in the notes of their accounting statements what the effect on earnings would be if they did expense their options. The diluted earnings per share figures are an attempt to show the difference in values if all the companies’ options were exercised.

Under the new rule, the company must estimate what the value of the options would be, and record that value as an expense. If there is a vesting period, the expense would be spread over the vesting period.

The change will affect most companies, “but not very dramatically,” Baker said, acknowledging that the biggest effect will be on high-techs and start-ups that use options as a compensation tool.

“Most companies here are more mature, and they don’t use options to the extent that other companies might,” he said.

Doug Jacobson, founder and chief technology officer of Palisade Systems Inc., an Ames-based Internet security technology company, said the use of options is prevalent among companies such as his that are housed at the Iowa State University Research Park.

“It’s a common practice, particularly among software companies, so I think some of the larger ones are going to find this more burdensome,” he said.

For Palisade, which has provided options to its employees since its founding, the new rule probably won’t have much impact because the options’ valuation will be relatively small, he said. Under the company’s plan, employees vest 20 percent per year in the options until they’re fully vested in five years. The options wouldn’t be exercised until the company makes a public stock offering, which isn’t yet on the horizon, Jacobson said.

For publicly traded companies, “it is a big deal,” said Paul Juffer, a partner with LWBJ LLP in West Des Moines.

“The unfortunate thing is, (the Black Shoals options valuation model) wasn’t meant for these kind of options; it was meant for options that are traded on an exchange,” he said. “What companies like the Coca-Cola Co. are doing is actually having people come in and do a valuation, rather than use a model that really doesn’t fit.”

As for their firm, “we would take a look at whether Black Shoals will work, and you really don’t know until financial analysts begin looking at price-earnings ratios and have to decide what number to use.”

Meanwhile, a bill that was proposed in Congress last year, the Stock Option Accounting Reform Act, would limit the expensing of options for top executives of established companies, but not for rank-and-file workers.

For now, accountants are operating under the assumption that the rule change will proceed.

“We’re not really advising clients one way or the other at this point,” Baker said. “We’re just still trying to figure out how to proceed.”

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