By Elizabeth K. Venuti and Richard C. Jones
The International Accounting Standards Board (IASB) has taken a leadership position among accounting standards-setting bodies in the global effort to require the recognition of share-based payments (i.e., equity-based compensation) at fair value. International Financial Reporting Standard 2, Share-based Payment (IFRS 2), was issued February 19, 2004. The related exposure draft (ED2) was issued in November 2002, and comments on the proposals in ED2 were due by March 2003. (Standard, exposure draft, and comment letters are available at www.iasb.org.) Whereas a similar U.S. effort from FASB is suffering heated criticism, including a possible roadblock in the U.S. Congress, the IASB’s proposal proceeded more smoothly.
As in the United States, critics of the IFRS 2 predict that the standard will spell the demise of stock options as a form of compensation. Until recently, the IASB’s project on share-based payments was the most controversial topic to be addressed by the standards-setting body since its inception in 2001. Surprisingly, however, the majority of the 236 respondents to ED2, many of whom are also U.S. investors, users, or preparers, were in favor of expensing share-based payments and felt that doing so would enhance the transparency of financial reports. While there was a fairly reasonable consensus that share-based payments should be expensed, there were wide-ranging opinions on the specific details of how (e.g., valuation method, measurement date, method of allocating cost to benefit periods, subsequent adjustments for forfeitures). After deliberating on the comments and clarifying certain items, the IASB issued a final standard that was substantively the same as the exposure draft.
Interestingly, some of the respondents to ED2 were concerned that an accounting standard that mandated expensing stock-option compensation at fair value would reduce the comparability of U.S. GAAP–based and IAS-based financial statements. This would be contrary to the goals set forth by FASB and the IASB in The Norwalk Agreement, more commonly referred to as ”the Convergence Project.” (For a copy of The Norwalk Agreement, refer to www.fasb.org/news/memorandum.pdf.) In The Norwalk Agreement, FASB and the IASB “pledged to use their best efforts to make their existing financial reporting standards fully compatible as soon as is practicable and to coordinate their future work programs to ensure that once achieved, compatibility is maintained.”
FASB added a project on equity-based compensation to its agenda in March 2003, in large part due to concerns about comparability and convergence. The exposure draft Equity-Based Compensation (EBC) was issued on March 31, 2004, and the public comment period, during which 13,378 letters were received, ended June 30, 2004. At its August 4, 2004, meeting, FASB began redeliberations of the EBC exposure draft and reaffirmed plans to require the expensing of equity-based compensation at fair market value. Specific details of FASB’s plan can be found at www.fasb.org/project/equity-based_comp.shtml. In order to achieve the goal of convergence, it is not necessary for the U.S. standard to be identical to IFRS 2; however, the more substantive requirements should be the same. FASB’s goal is to issue a final standard by the end of 2004.
FASB has stated that its objective is to cooperate with the IASB to achieve convergence to one single, high-quality global accounting standard on equity-based compensation. The majority of respondents that expressed a view on the specific issue of whether EBC gave rise to an expense agreed with FASB’s position, although there were many strong opponents.
The significant strides that the IASB has taken to issue this standard and the rapidity with which FASB has responded have led to an unprecedented backlash from U.S. companies, especially those that stand to be affected the most (e.g., Silicon Valley). These companies have placed significant pressure on their political representatives to prevent any such standard from ever becoming effective. In the first half of 2003, under pressure from lobbyists, senators and representatives responded by proposing bills S. 979/H.R. 1372. (A copy of the house resolution may be found at frwebgate.access.gpo.gov/cgi-bin/
getdoc.cgi?dbname=108_cong_bills&docid=f:h1372ih.txt.pdf.) As far-fetched as it may seem to most CPAs, the bills would prohibit the SEC from recognizing as GAAP any new standards related to the treatment of stock options for a period of up to three years and until after a study is completed on the economic impact of broad-based employee stock option plans. While these bills failed to make it out of committee before summer recess, related actions were taken up again recently in both the House and the Senate. The House passed H.R. 3574, the Stock Option Reform Act, which contains its own method for accounting for stock options and its own scope of application, both unrelated to FASB’s exposure draft.
The implications of Congress’ actions reach far beyond the accounting for stock options. The acts indicate that Congress is again attempting to intervene in the standards-setting process and to impair FASB’s ability to carry out its mission “to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial information.” And it would, as the respondents to ED2 feared, reduce comparability and impede progress on convergence.
Despite the ongoing controversy in the United States, the IASB issued the final standard in February 2004. IFRS 2 is effective for periods beginning on or after January 1, 2005. The controversy, however, was likely one reason that the IASB postponed its original plans to issue the standard in late 2003, pushing implementation back a year. The delay in the effective date realigns the IASB and FASB timetables. The final standard provides the following guidance:
- Scope. Applies to all share-based payment transactions, including:
- Equity-settled, share-based payment transactions:
- Cash-settled share-based payment transactions: and
- Transactions in which the entity or the supplier of goods or services has the choice of how the transaction will be settled.
- Recognition and measurement basis. For transactions with parties other than employees, the valuation should be based on the value of the goods or services received, if readily determinable. For transactions with employees, and for transactions with parties other than employees where the value of the goods or services received is not readily determinable, the entity should measure the value of the equity instruments granted.
- Fair value. Fair value should be based on an observable market price, if available, or otherwise estimated. In the case of options, an option-pricing model should be utilized that incorporates common features of options (such as the exercise price of the option, the expected life of the option, the current price of underlying shares, volatility in the share price, dividends expected, and risk-free interest rate over the life of the option). The Black-Scholes option-pricing model is suggested, but not prescribed, as one example of an acceptable model.
- Measurement date. If a share-based payment transaction is measured by reference to the value of the goods and services received, that fair value should be measured on the date of receipt. If the share-based payment is measured by reference to the fair value of equity instruments granted, that fair value should be measured at the grant date.
- Accounting for employee services. If the options are granted for services that have already been performed, then they should be expensed at the grant date. If the options are granted for services that have not yet been performed, then the value of the options that are expected to vest should be recognized over the vesting period. Companies will be required to estimate, at the grant date, the number of shares or options that are expected to vest. Companies should revise this estimate if subsequent information indicates that actual forfeitures differ from initial estimates.
- Modifications to terms and conditions. The measurement of the value of the services received should include the incremental value from repricing subsequent to the grant of the options. The incremental value should be recognized prospectively, by allocating the cost over the remaining options expected to vest.
- Subsequent adjustment for forfeitures. Because the amount expensed already takes into account estimated forfeitures, no adjustment should be necessary. As stated earlier, if actual forfeitures differ from expected forfeitures, then the initial valuation should be revised and the difference recognized prospectively.
- Disclosures. Entities with share-based payments must disclose the following:
- The nature and extent of share-based payment arrangements that existed during the period;
- How the fair value of the goods or services received, or the fair value of the equity instruments granted, was determined; and
- The effect of share-based payment transactions on the entity’s profit or loss for the period and on its financial position.
Details on other projects on which the IASB is working may be found on its website or on IAS Plus, a website hosted by Deloitte Touche Tohmatsu that is updated daily with news about international financial reporting (www.iasplus.com). The following is a partial list of projects on which the IASB is currently working:
- Business combinations
- Consolidation and special purpose entities
- Financial instruments and hedging
- Insurance contracts
- Convergence issues
- Lease accounting
- Revenue recognition, liabilities, and equity
- Reporting performance and comprehensive income.
Elizabeth K. Venuti, PhD, CPA, is an assistant professor in the department of accounting, taxation, and legal studies in business at the Zarb School of Business, Hofstra University, Hempstead, N.Y., and a member of the NYSSCPA’s International Accounting and Auditing Committee.
Richard C. Jones, PhD, CPA, is an associate professor in the department of accounting, taxation, and legal studies in business at the Zarb School of Business, Hofstra University.