While employee stock option incentives provide a significant benefit for employees, such incentives have been the focus of great controversy and debate, particularly in terms of accounting for such practices. This paper will take an in-depth look at the evolution of stock-based compensation over the last few decades, and how accounting and reporting of such company expenses has changed during that period. As a result, the reader will glean a stronger understanding of this practice.
Keywords: Fair Value-Based Method; Financial Accounting Standards Board (FASB); Intrinsic Value-Based Method; Restricted Stock; Stock Option; Stock Purchase Plan
By the 1990s, the Internet, which only a decade earlier was virtually unknown outside of academic and intergovernmental circles, had become a juggernaut of personal and commercial activity. Entrepreneurs saw the nearly limitless potential for conducting their business. Companies like Amazon.com, eBay and WebMD got their start at this time, along with countless smaller companies offering similar, web-based commerce. These commercial start-up enterprises conducted the latest fad in business known as "e-commerce." Investors shared these companies' faith in web-based business, infusing a great deal of capital into their development, monies which were used for online marketing campaigns, lavish office space and employee perks. In the latter case, many employees of these "dot.coms" were paid not with salaries but with perks such as stock options.
Stock options in those cases helped inflate the perceived value of dot.coms on the open market, where a great many of these companies went public via initial public offerings (IPOs). In 2000, however, such inflation of stock was eventually corrected to account for the true value of these companies, and because of the sheer volume of dot.coms on the market, the NASDAQ technology index quickly fell by about 50 percent in the first few months of that year, leading observers to state that the "dot.com bubble" had burst.
Although it is an extreme example, the leveling of the dot.com industry provides an interesting case of a growing form of employee incentive. Many companies, in order to provide competitive salary and benefits packages to their employees, will offer stock options to their personnel. The rationale for this revenue-sharing concept is simple — in addition to pay and insurance, employees have an opportunity to reap the benefits of the company's success.
While employee stock option incentives provide a significant benefit for employees, such incentives have been the focus of great controversy and debate, particularly in terms of accounting for such practices. This paper will take an in-depth look at the evolution of stock-based compensation over the last few decades, and how accounting and reporting of such company expenses has changed during that period. As a result, the reader will glean a stronger understanding of this stock-based employee compensatory practice.
A Look at the Practice
The practice of offering stock-based compensation to employees centers on giving the employee the option to purchase shares in the company at discounted rates. Also known as "share-based payment," stock options are typically offered to senior-level executives of a company (although the dot.com example above is illustrative of the fact that it may be offered to other employees as well) as a performance incentive or as an employee retention benefit.
The practice of offering stock options to executives has generated controversy for two main reasons. The first is philosophical in nature, centering around the assertion that such practices give even more power and access to wealth for executives, while the profits from a company's market performance could be distributed among all employees on a more equitable level. This philosophical aversion to the practice came to light during the 2008 collapse of the financial markets. Like most personnel strata, senior executives like CEOs lost much of their compensatory benefits and incentives when the recession took root. Even their stock options fell significantly — about 90 percent of the $1.2 billion offered to company CEOs in 2008 fell "under water," which means that they were too low to yield a profit. In partial response, these companies have attempted to retain their high-level personnel by introducing even more stock options, giving them the ability to buy future shares in those companies at current prices ("Recession Takes," 2009). During a period of economic frailty and stagnation, many consumer advocates and activists are railing against such incentives.
The second controversy about the practice of share-based payments is what one industry expert calls "a moral hazard." By design, stock-based compensation acts as an incentive for the executive to foster the success of the company. The underlying principle involved in this venture is shared risk — if the executive succeeds, then the company succeeds, and if he or she fails, then the company falters. The company's failure or success dictates the value of the stock that is part of the executive's benefits package. Hence, he or she has a vested interest in seeing that stock perform well. In this regard, the executive in effect becomes a shareholder of the company as well as an administrator. Some experts argue that shared risk forces the executive into a conflict of interest between the activities of the company's management and the agenda of the shareholders (Chhabra, 2008).
Adding to the above-mentioned issues surrounding stock-based compensation is the fact that a company must account for any expenses and benefits paid to employees. In many ways, accounting for share-based executive payments has become an even more controversial issue than concerns over the morality and equity of such practices. Cannon and Kessel (2013) go so far as to call the accounting rules for stock options "Byzantine" and, as such, provide possible modifications or alternatives to stock option programs.
Korn, Paschke, and Uhrig-Homburg (2011) assert that designing stock-option plans for robustness at the outset is essential for reliable accounting valuations. They explain how robustness can be achieved by combining certain design elements of stock-option plans. They add that robustness of these plans is in itself an element of good corporate governance, in that it could impede managers' ability to understate the values of their compensation packages.
Accounting for Share-Based Benefits: Policy
In the mid-1980s, considerable attention was paid by the Internal Revenue Service to better quantify the income of U.S. businesses. Upon the direction of Congress in 1986, the IRS modified its code pertaining to the income and deductions of publicly-shared corporations to account for "intangible" property transfers. In a one-sentence addition, the IRS code included the statement that, in "the case of any transfer or license of intangible property, the income with respect to the transfer or license shall be commensurate with the income attributable to the intangible(s)" (Internal Revenue Service, 2009a).
The 1986 phraseology in that code was invoked less than a decade later when interest developed in Washington to regulate the practice of stock-based compensation. In 1995, after three years of careful study, a series of regulations were issued that outlined the manner by which cost sharing would be defined. In doing so, the IRS was in effect dictating to companies and taxpayers that stock-based compensation was in fact a component of a company's operating expenses as they pertain to employee benefits.
Still, although the inclusion of stock-based compensation was implied in the 1995 IRS regulations, it was not officially confirmed as such. That lack of clarity led to court challenges that argued that such inclusions were inserted on an arbitrary basis and lacking any uniformity or definition. It was not until 2003 that the IRS offered a further regulation that clarified that stock-based compensation was in fact an "intangible development cost" that, where...
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