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Compensation committees must pay close attention to new rules and legal considerations for setting executive compensation.
Keywords: executive; director; compensation; stock; deferred
In 2005, executive compensation decision makers will need to respond to a few recent developments, including new expense recognition for stock options, enhanced Securities and Exchange Committee (SEC) disclosure rules, an overhaul of the tax laws applicable to deferred and stock-based compensation and ever stricter accountability to shareholders as the result of a landmark judicial decision in the high-profile Disney case. The discussion that follows reviews each of these developments and concludes with a note about why their combined effect is likely to involve a shift away from stock options and cash bonuses and toward restricted stock and deferred compensation. For the reasons explained below, the decision-making environment is right for awards that are formula driven, that vest based on future performance and that impose postemployment risks of forfeiture for disloyal actions, such as joining a competitor or soliciting customers or employees.
Expensing Stock Options
Effective for the first interim or annual reporting period that begins after June 15, 2005, the Financial Accounting Standards Board (FASB) will require that public companies that do not file as small business issuers recognize financial expense for the fair value of stock options that are granted or vested after that date. Public companies that do file as small business issuers become subject to the same requirement for the first interim or annual reporting period that begins after December 15, 2005. Private companies become subject to the same requirement for fiscal years beginning on or after December 15, 2005. FASB set forth these rules in Statement No. 123(R), which became final December 16, 2004.
Before Statement No. 123(R), FASB's accounting rules for stock-based compensation basically differentiated between those subject to fixed and variable accounting.1 Fixed awards of stock options resulted in financial expense only to the extent of their in-the-money value on the grant date.2 The most dramatic change made by Statement No. 123(R) requires that issuers attribute a value to these awards and recognize that expense over the vesting period.
FASB did not go so far as to dictate the valuation method for stock options. Two of the most common valuation models are the Black-Scholes...