The collapse of giants such as Enron,
WorldCom and the brewing troubles at other corporations in the US
which appeared invincible, has brought issues relating to accounting
and corporate governance into prominence.
The emphasis today is on transparency
and disclosure of decisions and actions that will impact the
financial statements of a company, and hence have a bearing on the
investment decisions of e shareholders.
Disclosure in relation to compensation
to the management and employees of a company assumes significance in
this context. Stock options as a means of compensating employees has
been used extensively by companies over the last couple of decades.
Employees stand to gain immensely when
the share prices soar on the bourses. Employees, especially
executives, CEOs, CFOs et al are privy to inside information and are
involved in the day-to-day operations of the company.
Stock options to such employees
provide incentive for their complicity in manipulation in
compilation and presentation of financial data resulting in inflated
stock prices.
To the extent that stock options are a
form of employee compensation and are not reflected in the books as
such, the profits of the company are exaggerated. This gives an
untrue picture of the true cost of employees to the company.
The scandals that have buffeted the
corporate world in recent times have served as an impetus to several
companies to take corrective initiative by expensing stock options
to regain investor confidence. Companies such as Coca Cola and
Citibank have taken the lead and announced their decision to expense
stock options.
The issue is of evolving the
appropriate method of valuation for such expense. This is reflected
in Coca Cola’s appointment of its investment bankers to suggest
the appropriate valuation.
Currently, companies in the US can
expense stock options, using either the Financial Accounting
Standards Board Statement 123 (FAS 123) or the Accounting Principles
Board Opinion 25 (APB 25).
Under APB 25, the intrinsic value of
stock options is to be accounted for as an expense. Generally, there
is no expense recognition under this method when the exercise price
equals the fair market value of the stock on grant date.
Under FAS 123, a company recognizes
compensation expense over the vesting period based on the fair value
of the award on grant date.
Fair value is computed using Black
Scholes formula or any such binomial function. If a company elects
to expense stock options using ABP 25, it is required to disclose in
a footnote the impact on profitability, if FAS 123 were to be
followed.
The technology companies on the West
Coast, which use options very extensively, are reluctant to expense
stock options. The argument of this school is that exercise of stock
options at a price lower than the market value does not result in a
cost or an expense to the company.
At best, it can be considered an
opportunity cost. Such opportunity cost should be brought on the
books and amortized over a reasonable period.
Recognizing the complex issues in the
expensing of stock options, the International Accounting Standards
Board has announced its decision to formulate a suitable framework,
which all companies will have to adhere to from the year ‘04.
Nearer home, in India, the issue of
Esops by listed companies is regulated by the guidelines issued by
the Securities and Exchange Board of India.
The disclosures and the compliance
requirements under these guidelines are quite elaborate. Sebi
requires complete disclosure with respect to the options granted,
including the pricing formula, options vested, options exercised,
the number of shares arising as a result of the exercise of options,
options lapsed, variation of terms of options, money realized by
exercise of options, the employee-wise details of the options
granted and the diluted earnings per share pursuant to the issue of
shares on the exercise of the option calculated in accordance with
the International Accounting Standard 33.
Such disclosures are required to be
made in the Directors’ Report. The Sebi guidelines also require
companies to expense stock options, using the Black Scholes or other
models.
However, there is no provision in the
Sebi guidelines for ensuring the enforceability of these guidelines.
Similarly, there are no transition provisions for unlisted companies
that have issued Esops prior to listing.
The Sarbanes-Oxley Act, which was
enacted to usher better corporate governance requires the
certification of financial reports by CEOs and CFOs. A similar
provision already exists, in terms of the Directors’
Responsibility Statement to be included in the Board’s report
under Section 217(2AA) of the Companies Act, 1956 (the Act).
The ICAI is yet to bring out a
standard for expensing stock options. India already has a strong
framework to ensure better corporate governance in terms of various
requirements under the Act and the listing agreement. We need to
build on this advantage by quickly laying down standards for
expensing of stock options for listed as well as unlisted companies