Stock-based compensation is a wonderful way to reward employees for their hard work, meeting company goals and helping a company achieve financial prosperity. However, this method of paying employees may present problems for accountants trying to ascertain the health of a company's bottom line. Professors Paul B.W. Miller and Paul R. Bahnson have laid out a case for accounting reform regarding how this compensation works.
The Financial Accounting Standards Board, or FASB, examined stock-based compensation rules as they related to financial reporting in 1995. One side of the divisive issue felt companies should list stocks as compensation as an expense on financial sheets, while the other aimed simply for disclosure as a footnote to financial reports.
In 2004, the FASB backtracked and eliminated the rule about disclosing noncash executive pay as a footnote to financial statements. That's because the Sarbanes-Oxley Act, passed in 2002, made it mandatory for companies to disclose the compensation of executives as part of quarterly financial reports. However, those disclosures still didn't solve the basic problem of how much stock compensation costs a company in its balance sheets. The difficulty with stock-based compensation is that stocks received by executives are tied to a company's future value. No one knows the precise cost of this compensation until the executive cashes them out.
Miller and Bahnson note that paying out stock options to an executive changes the stock's value simply by existing. Companies cannot fully know how much stock-based compensation costs them until the executive cashes in the stocks, yet investors need to know this to ascertain the financial health of the company. When the executive cashes in the stock, it alters the value of the company based on supply and demand. Selling stock means there is more stock for others to buy, and it indicates the company must pay out for those shares. Until then, the expenses don't show up on the financial reports because no money actually changes hands.
This presents problems if a company faces financial uncertainty. It fuels insider trading concerns and makes investors jittery as to the reason why executives suddenly made this type of move.
One solution is for a company to list the value of the derivatives at the time it issues the stock-based compensation to employees. These show up as costs and expenses. Rather than saying CEO Jim Smith received 1,000 shares of common stock, the company can list expenses of $10,000 if it issued those shares at $10 per share. It should also list when the stock options will expire in the future.
Following that, the company can issue financial statements every quarter based on the stock's market value at the time of the report. This way, it makes a rolling count of the potential cost of the stock if the executive exercises those options. Financial reporting for stocks puts generally accepted accounting practices, or GAAP, in line with 2017 tax code where companies can take tax deductions for doling out this kind of benefit to employees.
Stock-based compensation was controversial in the past, and the FASB is leery of changing GAAP protocols without a major paradigm shift in accounting reform. Eventually, the FASB must weigh the needs of investors over those of balance sheets that make companies look better.
Photo courtesy of GotCredit at Flickr.com
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