New Rules for the Treatment of Stock Options: Caveats for Management

Abstract

appreciation rights, and performance shares. Fixed awards do not create open-ended compensation expense. Because most companies set the option price equal to the market price on the grant date, compensation expense is never recorded. Consequently, fixed award treatment is preferable to variable treatment. However, if a fixed stock option is reclassified as a variable stock option, then compensation expense must be recorded. INTERPRETATION 44The FASB's stated purpose in releasing Interpretation 44 was to "interpret rather than amend" Opinion 25. Thus, the Interpretation is intended to provide additional clarification and guidance, within the existing framework of Opinion 25, in several areas of accounting for stock compensation where "questionable application and diversity in practice" have evolved over the years. Most of the guidance in Interpretation 44 became effective on July 1, 2000; however, provisions concerning who is an employee for purposes of Opinion 25 and repricing of stock options became effective for transactions occurring after December 15, 1998.Interpretation 44 mandates that two conditions must exist before Opinion 25 applies to stock compensation. First, the stock compensation must be granted by a company based solely on the stock of the grantor company. Second, the stock compensation must be granted only to "employees" of the grantor company. By definition, an individual is an employee of a grantor company if the grantor exercises or has the right to exercise sufficient control over that individual to establish an employer-employee relationship.Interpretation 44, however, does not apply to stock compensation that may be • Granted to independent contractors, non-elected nonemployee directors, such as members of an "advisory board," and other nonemployee service providers; MODIFICATIONS UNDER INTER-PRETATION 44One of the most significant areas of change involves the Interpretation's additional clarification and guidance in regard to the types of modifications to outstanding stock options or awards that can result in either a "new" measurement date or, potentially more punitive, in variable award accounting treatment.Three possible changes may cause fixed awards to be reclassified as variable awards, thus necessitating the recording of compensation expense:• A reduction in the exercise price; • An increase in the number of shares awarded; and • An extension of the option term.Any of these changes will serve to discourage the repricing of stock options. Since a traditional repricing would reduce the exercise price of the award, the award would have to be accounted for as variable from the date of the modification until the award is exercised, forfeited, or has expired. However, there are provisions within the Interpretation that provide additional clarification with little or no change from current practice. Examples of provisions that do not require a change from current practice include• Permissible provisions in broad-based employee stock purchase plans; • Adjustments to outstanding awards in c...