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September 11, 2002
Stock-Option Expensing Viewed as Inevitable
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. employers hold wide-ranging views on the appropriateness of expensing stock options, but the vast majority (87 percent) believe that option expensing will be mandated in the US within five years.

Despite the potential impact, only 37 percent have formally considered the issue at the executive or board level.

These are among the findings of a new Future of Stock Options Survey from Mercer Human Resource Consulting. The survey, conducted during the first two weeks of August, includes responses from nearly 200 large US employers with median revenues of $4.5 billion.

Under Statement of Financial Accounting Standards 123, companies currently must disclose the fair value cost of stock option grants and the resulting pro forma impact on earnings per share in the footnotes to their annual financial statements, but they do not have to recognize that cost in their income statements.

The Financial Accounting Standards Board (FASB) now is considering a change that would make the expensing of stock options mandatory instead of optional.

"There's a diversity of opinion about what should be done - with everyone from the SEC to Congress weighing in on this issue - but there is strong consensus in corporate America that stock option expensing will happen over the next five years," says Martin Katz, a senior executive compensation consultant in Mercer's San Francisco office and author of the new survey. "So far, however, it's not prompting much action. The majority of the companies we surveyed - 56 percent - say they are considering the implications, but taking a `wait and see' approach at this time."

Other companies say they will begin expensing options when a structured approach or common methodology is approved. One in 10 respondents (9 percent) say they will begin expensing as soon as practical, and just 5 percent plan to lobby actively against expense recognition.

If the accounting rules are changed, some companies clearly would be expensing stock options against their will. Among the companies surveyed, only a small minority (12 percent) say expensing is "the right thing to do," while 28 percent say an accounting charge for option expense is inappropriate. Other companies say options should be expensed only if a consistent manner is used by all companies (25 percent), a reliable valuation method can be found (12 percent), or the company wants a tax deduction (2 percent). One-fifth (21 percent) have not yet taken a position on the issue. (See Figure 3.)

In reaching these positions, respondents say the effect on reported income weighed most heavily on their decisions (cited by 63 percent). The company's philosophical view on option expensing and accounting also was a significant factor (cited by 48 percent).

The companies also were asked to estimate the magnitude of the annual expense they would see if required to expense options. More than one-third (35 percent) say the magnitude would be less than 5 percent of earnings per share (EPS). Another 28 percent say it would be 5 percent-10 percent of EPS.

If option expensing is required, the majority of companies (54 percent) agree that the best valuation methodology would be a Black-Scholes or binomial method with modifications to reflect employee stock option features. One-quarter (25 percent) did not express a preference and 16 percent prefer the "real fair value" approach. However, the issues surrounding the accounting feasibility of this approach remain outstanding, Katz notes.

Of greater concern is the action that companies may take to mitigate the potential impact of stock option expensing on their equity compensation programs. One-third (33 percent) say they would reduce the pool size (the number of options granted to employees). Almost an equal number (31 percent) say they would reduce eligibility (the number of individuals who receive stock options). Others would offset stock options with some other form of equity or nonequity compensation program (23 percent and 22 percent, respectively). Companies estimating a higher EPS impact are considerably more inclined to reduce eligibility or grant size in response to option expensing.

"Option expensing is a complex matter that impacts companies very differently," Mr. Katz says. "For some, the expense would be nominal, but for others, it could cause earnings to go from positive to a substantial loss. It also has broader implications since it alters the accounting for a company's other equity programs, including employee stock purchase plans."

"While they have the time and opportunity now to plan, companies should assess the potential impact of a change in accounting rules on their overall equity strategy, eligibility, and plan design," he adds. "Companies need to be prepared in the event of a change, which most believe is just around the corner."

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