The Issues Related to Stock Options and How They Should Be Accounted For

The purpose of this case study is to discuss the issues related to stock options and how they should be accounted for.

Introduction

In the early 1990s, FASB proposed an accounting rule calling for corporations to recognize compensation expense for certain stock options when they were granted to executives and employees. This proposal was met with strong opposition from many different sources including: Congress who passed a resolution by vote urging FASB to drop the proposed standard, business executives who stood to lose the most, and even the accounting firms who were accused of lobbying for their largest clients. New issues were raised over the controversy. Among these issues was whether accounting firms undermined the integrity and credibility of the independent audit function when they lobbied on behalf of controversial positions supported by their audit clients and whether the authority for issuing accounting rules should remain in the private sector or be assumed by a governmental agency.

Stock Options as Compensation Expense

Stock options have become an important part of compensation for key executives and employees. In 1978, Chrysler hired Lee Iacocca to turn around the company was having financial troubles. Iacocca was given $1 annual salary and 400,000 stock options. He was able to turn the company around and cashed in $40 million in profit with his stock options. It was a gamble for Iacocca and would only pay off if he succeeded in turning the company around. For newly emerging companies especially in the high-technology industries, stock options are an important corporate strategy. It allows these companies to hire executives with stock options that normally command large salaries.

The APB Opinion No. 5 said that companies were not required to recognize compensation expense when they issued stock options to executives and employees if those options had an exercise price equal to or higher then the stock’s market price on the date the options were granted. FASB decided this was unreasonable and wanted to change it because the stock still has an economic value on the date options were granted. The economic value arises when the opportunity the holders of the options may have to purchase the company’s common stock at less than market value at some point of their term. This economic value is a component of an entity’s compensation expense and should therefore be recognized in the financial statements. The FASB suggested that companies use the option-pricing model to determine the economic value of the stock options. This model is used by sophisticated investors to determine the economic value of publicly traded stock options. Several assumptions must be made when using this model.

FASB Backs Off

FASB rescinded its controversial stock option proposal in 1994. It was replaced with Statement of Financial Accounting Standards No. 123 which only encouraged companies to recognize compensation expense for compensatory