Know your options for share based compensation
By Jeffrey D. Solomon, CPA, CVA

There are many issues to evaluate if you are contemplating the issuance of stock compensation to your employees in 2006, but one option no longer available to public or nonpublic companies is the complete avoidance of compensation expense. FAS 123(R), “Accounting for Share Based Compensation,” is effective for non-publicly held companies for fiscal years beginning after December 15, 2005. For public companies, the rules are effective for years ending after June 15, 2005. The rules related to FAS 123(R) are complex. However, in certain situations, FAS 123(R) might offer new opportunities for companies to restructure stock based plans and enhance employee compensation at a reasonable cost to the company.

Under FAS 123 (R), your Company must calculate the expense using an option-pricing model, usually the Black Scholes-Merton or Binomial (Lattice) models. While the lattice model is more complex, time consuming and expensive to implement, it could actually result in less expense being recorded than the Black Scholes formula. It is our experience to date that most nonpublic companies are using the Black Scholes model due to its simplicity. Both methods force management to make certain assumptions about volatility, dividend rates and the life of the options in the valuation calculations. Volatility is especially hard for nonpublic companies to determine and many companies are likely to struggle to find a reasonable methodology and basis for this key assumption.

For nonpublic companies that had previously used the minimum value method to calculate pro forma expense, the new measurement provisions only apply to new options (those granted after 12/31/05), or to options modified after the effective date. However, for nonpublic companies that had previously calculated their pro forma expense using the Black Scholes model, all non-vested options granted prior to January 1, 2006 must be expensed as they vest

The use of restricted stock to compensate employees has become quite popular, particularly with public companies, because of this new standard. Companies do not have to issue as many shares to their employees, resulting in less dilution. In addition, depending on the vesting schedule, employees will see an immediate bonus, since they receive the actual value of the shares, versus a benefit only if the stock price appreciates.

Under the old rules, management tried to avoid variable stock plans (i.e. incentive or goal based plans) since these plans created compensation expense that had to be recorded and re-measured each year. However, under FAS123(R), if the plan is performance based but the future event is not probable; the expense is not recorded until it becomes probable. In addition, the expense will only be measured at one date and will not have to be continuously re-measured. This is a huge benefit to companies that want to create plans that are based on performance versus simply the passage of time.

Prior to the issuance of FAS 123(R), if a company wanted to re-price their “under water” options or cancel old options and issue new options at the current fair value of the stock, there were certain financial consequences. Typically, we would instruct our clients to cancel the old shares and then wait for at least 6 months to issue new options to avoid a charge to the P&L. With the new standard, a company can generally issue new options and take the change in price between the old and the new options over the remaining life of the new options. This may make it easier for some companies to revise their option plans.

Finally, nonpublic companies may want to consider fully vesting all of their below market price options prior to the implementation of FAS123(R). By doing this, the shares may not have to be expensed in their financial statements. For this and other reasons, some of our clients have decided to early adopt FAS 123(R).

The new share based compensation standard is complex, and there are many judgments and assumptions that management will need to make. Obviously, all companies that offer share based compensation will need to carefully assess the implications that FAS 123(R) will have on employee compensation and the financial position of the company.

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