65 Tax Notes 479

Tax Notes

OCTOBER 24, 1994

LENGTH: 6529 words

DEPARTMENT: Tax Practice and Accounting News (ACC)

CITE: 65 Tax Notes 479

HEADLINE: 65 Tax Notes 479 - STEALING THE COMPANY WITH FREE STOCK OPTIONS: THE FUROR OVER ACCOUNTING STANDARDS.

AUTHOR: Johnson, Calvin H.

SUMMARY:

Calvin H. Johnson is the Andrews & Kurth Centennial Professor of Law, University of Texas Law School.

This is the second part of a two-part series on the Financial Accounting Standards Board's 1993 Exposure Draft on Stock Options. The Exposure Draft would require corporations to report the fair market value of stock options given to executives as a compensation cost on their SEC-required earnings statements when the option is granted. Part I, published in last week's Tax Practice and Accounting News, applauded the proposal and argued that the old rules, treating the options as if they were free, was bad accounting that encouraged excess compensation. Part II, published here, argues that the cost of off-market stock options should be measured more reliably by accruing

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II. Measurement Date

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In 1993 the Financial Accounting Standards Board issued an Exposure Draft proposing an accounting standard that would require corporations to recognize the cost of a compensatory option, in the amount of the fair value of the option at the time the option is granted. /31/ The Exposure Draft is important, foremost, because it requires the corporation to recognize the real market value of the stock option when market data are available. The Exposure Draft moves away from the error in the current standard, which looks only at the bargain the option would give if it were exercised as soon as it is granted.

When it is feasible to measure the value of the option at grant with reasonable accuracy, fair value at grant is relevant information of help to outside investors. When reliable market data are not available, however, the FASB Exposure Draft adopts a measurement of value that materially understates the value of an option on risky stock. FASB is under pressure to undervalue options even further and to extend the privilege of undervaluation to publicly traded stock.

Rather than undervalue options, the FASB standard needs to follow the bargain the option gives as the bargain that would be available on exercise arises and increases. By the time the option is exercised, the full benefit it gives to the holder would be included in the corporation's cost. The bargain on exercise (rather than at grant) reliably measures the future cash costs the corporation will bear in a way that can usually be reliably ascertained and audited and with an accuracy that can survive political controversy.

A. Exposure Draft: Measure at Grant

1. The case for measurement at grant. The 1993 Exposure Draft would improve current standards by abandoning the current rule, which looks only at the bargain the option would give at the time of grant. Both the current standard and the Exposure Draft measure cost, however, when the number of shares and exercise price is set.

Subsequent changes in value of the underlying stock and the value of the bargain have no effect, under both current standards and the Exposure Draft, once the cost is set at grant. The cost, once set, is not reversed into income if the option lapses without exercise and the cost is not increased if the option ultimately gives a bargain far beyond what was anticipated when the option was awarded. The corporate cost so measured would not, however, necessarily be an expense entirely in the year of the award. If, for instance, an executive needs to work for some years before her option rights vest, the option cost becomes an asset, written off to expense over the years as the executive earns her option.

When it is feasible to value an option when granted, the time of grant is a good measurement date under accounting theory. The value of the option at grant is relevant information for investors. The public function of accounting is to provide accurate information so that investors can allocate resources in accord with the real relative value of alternative investments. Investors need to know about future prospects of their stock to invest wisely. Investors also need to know about impending calamities before the calamity strikes.

The Exposure Draft requires a publicly owned corporation, whose stock listed on an established stock exchange or sold with some activity over the counter, to value options when the options are awarded, using an option pricing formula. /32/ Option pricing models require information about how long the option extends before it lapses, the risk-free interest rate, /33/ the corporation's expected dividend yield, and the volatility of the optioned stock. When reasonable accuracy is available as to the inputs, the option pricing model predicts the quoted market value of the option quite well. /34/ Options commonly have a commercially real and ascertainable value when awarded.

2. Critique of grant date: Systematic undervaluation for nonpublic entities. It is not always feasible, however, to value an option at grant. Option pricing, for instance, requires data about the volatility of the optioned property and if the stock is not sold on an established market, accurate information about volatility may not be available. The Exposure Draft then generally allows nonpublic entities to omit the expected volatility in its calculation of the stock option value. /35/ Options have value from two sources: the 'interest' element that comes from being able to wait until exercise before paying the purchase price, and the 'risk-protection' element that comes from avoiding loss of the purchase price by not exercising the option if the stock proves unsuccessful. For nonpublic corporations, the Exposure Draft would record the interest element, as if an option were an interest-free loan over its term, but not the loss-protection element.

Ignoring the risk protection element of a stock option is reasonably accurate only for very low risk stocks. For no-risk stock, the only value from the option comes from the ability to defer the exercise price without paying interest. For risky and start-up companies, however, the risk-protection element of an option swamps the interest element and makes the option itself far more valuable. Since nonpublic corporations can be expected to be riskier than publicly traded corporations, the Exposure Draft ignores most of the value of the option, exactly in the cases in which the option is most valuable.

Options on risky stock can have very substantial value derived from risk-protection. In the following example, for instance, the option, exercisable at an exercise price equal to the value of the stock when the option was awarded, is worth over 90 percent of the value of the stock. The risk-protection element in the example is responsible for 98 percent of the value of the option.

Assume a very risky stock of Company A, now worth $10.

Company A owns a potentially breakthrough technology that will

prove to be very successful 10 percent of the time, but will

fail to be commercially feasible 90 percent of the time. Company

A will give no dividends for 10 years. With only a 10-percent

chance of success, the success must make the share worth $127.63

in five years, assuming a 5-percent discount rate, for the stock

of Company A to be worth $10 now. /36/

An option to buy stock A at $10, the current value, will

itself be worth $9.22, that is, over 90 percent of the value of

the stock. In the 10 percent of the cases that the company A

product is successful, the stock will be worth $127.63 in five

years and the holder will exercise the option at its $10

exercise price and achieve a $117.63 bargain. At the assumed 5-

percent discount rate and 10-percent chance of success, the

bargain is like having $9.22 in the bank now. /37/ In 90 percent

of the cases, the option will be worthless, but not an added

cost, so that the $9.22 value from the successful 10 percent of

the cases is the total value of the option.

The $9.22 value of the option can be broken down into a $9

value, attributable to the risk protection element of the

option, and a 22-cent value, attributable to interest saved by

deferred payment of the $10 exercise price. The interest value

arises because the option holder can delay payment for 10 years,

if payment is made at all, without paying interest; the 22 cents

is just the present value of what normal risk-free interest

would be, discounted by time value and the high probability of

nonpayment. /38/ The risk protection value arises because the

owner of stock A, paying $10 immediately for the stock, will

lose the $10 in 90 percent of the cases, for a negative value or

loss of $9. The holder of the option, does not exercise the

option in 90 percent of the cases and thus is left with nothing,

rather than negative $9. For the owner, the positive value of

success is offset by the loss upon commercial failure; for the

option holder, the positive value from success has no loss

offset. The risk protection element is 98 percent of the value

of the option ($9/$9.22). The risk protection value swamps the

interest value whenever the underlying stock is risky. /39/

Had Stock A had no risk, the value of the option to

purchase at $10 in five years would have had a value of only

$2.16, that is, the present value of a no risk return earned

over five years. /40/ The Exposure Draft assumes for nonpublic

companies that exercise of the option is certain, because the

$2.16 present value of risk-free interest is the cost, the

'minimum cost,' which the Exposure Draft would allow nonpublic

companies to use. /41/ The Exposure Draft overstates the

interest element -- there is no interest saved if the price is

never paid. But the error of stating the 'interest' element at

$2.16 instead of 22 cents brings the reported value for the

option a bit closer to the $9.22 true value. The overstatement

of the interest element is not enough, however, to bring the

recognized cost for the option anywhere near the real cost of

the option to the corporation.

The Exposure Draft would ignore the overwhelming source of value of the option -- 98 percent of the value of the option in the high- risk example -- exactly in those cases in which the option is most valuable. Understating value so dramatically is not a material improvement on reporting options as free and reporting so low a value will distort the form and level of compensation, just as do current cost-free standards. The understatement is unfortunate, especially since accounting standards could so reliably measure the corporation's costs by delaying the measurement date.

B. Later, More Reliable Measurement Dates

1. The case for measurement at exercise. The fair market value of the stock issued by a corporation is a reliable measure of the costs that the corporation and other shareholders will bear. Stock has value because it represents the discounted present value of the cash the market expects the corporation to distribute on the stock eventually. Options draw their value from the stock by giving the holder the opportunity to buy the stock in the future at a bargain. But options commonly expire unexercised, especially options for high- risk stock where the option is most valuable. An expired option never becomes a cash cost to the corporation. Conversely, options that are especially hard to value at grant often give extraordinary bargains to a degree not fairly incorporated by the initial valuations. If the ultimate bargain was not fairly anticipated, the ultimate bargain, not the value at grant of the option, is the better measure of the corporation's ultimate cash cost.

Stock is generally a more reliable measure of the corporation's ultimate cash cost than is value of the option at grant. One does not have to estimate volatility of the stock, nor dividend payouts nor discount rates between the award and the exercise of an option. The stock is also closer to the cash.

a. Reliability! If it is feasible to value an option with reasonable accuracy at grant, the value at grant is more relevant to investors because it is a Distant Early Warning line of future costs investors need to know about. When accuracy is not easy, however, then the exercise date is a delayed, but far more reliable, measure of costs.

Stock options well-illustrate the pervasive conflict in accounting standards between requiring reliable information and requiring relevant information. The relevant (early) information (e.g., value at grant) is often so hard to get with accuracy and ease. Financial accounting usually chooses reliability over relevance. Without easily auditable accounts, management can too easily understate costs and inflate earnings. Thus, for instance, investors need to know about the current income-producing value of firm assets, but accounting gives them only the historical cost of the assets.

Certainly, it is better to give reliable information about management compensation than to ignore the costs. All cash that managers get at the expense of shareholders needs to be reflected in books of the corporation because management's benefit from unrecognized costs is too much like theft. Certainly, too, it is terrible to resolve the conflict between relevant information about costs and reliable information about costs by treating the costs as zero, as current accounting standards provide. /42/ Accounting is conservative. Ignoring costs is, for accounting, a mortal sin.

The Financial Accounting Standards Board is under real pressure to relax even its Exposure Draft to allow even publicly held corporations to understate the cost of the money they give to managers. Much of the pressure, /43/ unfortunately, is on the merits, because it is in fact commonly impossible to measure the value of compensatory options when they are granted. Compensatory stock options commonly are subject to an 'earnout,' preventing their being exercised until the executive has performed some years of service, or subject to forfeitures, requiring the executive to return the options or underlying stock if the executive leaves employment. Option pricing theory is of no help in ascertaining how likely it is that an employment-related earnout or forfeiture condition will arise. Black- Scholes option pricing theory, moreover, may be a routine tool relied on by experts in hundred million dollar transactions, but it is not a routine tool for smaller corporations and their humble accountants. Option pricing theory should also not be stretched very far beyond its scope assumptions. Compensatory options, for instance, commonly last for 10 years and volatility measures that are 10 years out of date have nothing to do with the current value of the option and should not be extrapolated so far. FASB needs a more reliable measure of the stock option compensation than it has at grant to be able to resist the pressure for zero cost.

b. Exercise better describes the bargain. The Exposure Draft's stated reason for using grant as the measurement date is that value at grant will measure the bargained-for consideration given for the stock option. The standard for stock options operates within the more general framework that the consideration given for equity, including stock options, measures the credit to equity when equity is issued. /44/

The FASB rationale, however, seems to be letting the credit drive the debit, because it is the corporation's cost that needs to be measured and treated as the expense, not the executive's services or other consideration given for the options. If a corporation wildly underpays for services, at arm's length, for instance, it is still only the corporation's cost that is the expense to the shareholders and not the value the executive gives. The credit, as well as the debit, should be deferred until exercise, moreover, because exercise plausibly best measures the services as well as the option, when the option value at grant cannot be easily ascertained.

The FASB rationale, that the bargaining is measured by value at grant, misdescribes the typical bargaining with options, when the option has no readily ascertainable value nor marketability when awarded. Options are a kind of profit-sharing arrangement or earnout. Earnouts and profit-sharing arrangement are adopted in contracts, not to set the liquidated value of the consideration given, but rather because the parties cannot agree on a liquidated value of the consideration when they contract. A buyer of services or other goods will pay a good price if the services or goods turn out to generate good profits, but the buyer is naturally skeptical that the goods or services are really worth what the seller is claiming. The transaction can go forward when the two parties disagree about value, but only because their arrangement sets the cost for the services or goods only after their profitability is measured.

Options, like other profit-sharing arrangements, are also excellent contracts when the value of the services depends on the executive's actions in the future. If asked what services are worth initially, the corporation could only say to the executive, 'as you will it.'

Neither party typically thinks of the grant of a compensatory option as setting the value of services or salary. The Disney Corporation, for instance, did not set compensation for Eisner and Wells in 1984 when their options were negotiated, but the corporation was willing to pay the executives if the executives could make the corporation's stock price rise. The director who negotiated for the corporation in 1984 said in a 1992 interview, 'In no way did I think it would be worth that much to them, but in no way did I think the company would be worth this much either.' /45/ Thus, the exercise date better measures the real bargain between the parties because that is what the parties intended.

c. Follow the lead of tax. Recognizing the cost of an option upon exercise would also simplify the deferred tax accounts, when the option has no readily ascertainable value at grant. Under the Treasury regulations, an executive includes stock options as compensation when they are awarded, only if the options then have a readily ascertainable market value. /46/ 'Readily ascertainable value' generally means that the options are traded on an established market, although some unmarketed options might be shown to have readily ascertainable value. /47/ The corporate deduction follows the executives' compensation, so that the corporate deduction is also allowed only upon exercise of the option. /48/ One critic has relied on the complexity of the deferred tax accounts, reconciling the timing difference between the tax deduction and the accounting recognition, as a reason to abandon recognizing the cost of an option. /49/ There is, of course, another way to avoid the deferred tax accounts, which is for financial accounting to follow the lead of the tax system on the issue and treat the exercise as the measurement date. /50/

As a matter of economics, moreover, there should be no deferred tax accounts with respect to options without readily ascertainable value. The philosophy of deferred tax accounts is that tax savings should be allocated to the period that financial accounting recognizes the pretax expenses. That philosophy overstates the value of the corporation's tax savings from the options because it is blind to the time value of money. The deferred tax account treats the tax savings as accruing as soon as the option is granted (assuming that measurement at grant becomes the final standard), whereas, in fact, the tax savings do not arise until many years later when the option is exercised. Financial accounting would more accurately reflect the economics if it would assume that the tax system knows its own business: tax savings are allocated to the period of exercise by the tax system because that is the period to which they are properly attributed. That would obviate deferred tax accounts. /51/ In any event, the complexity of deferred tax accounts is a separate mistake and not a good reason to ignore real expenses.

2. Critique of exercise date: spasmodic costs. Compensatory options can remain outstanding for 10 years or more and then represent a very major expense, timed for reasons that have nothing to do with corporate operations. The Disney options exercised in 1992, for example, were issued in 1984. Eisner and Wells exercised them in 1992, not because the options were about to expire or the stock had reached its peak, but because individual tax rates were expected to increase starting in 1993. The $187 million bargain the executives got was a fair representation of the discounted present value of the cash the corporation had devoted to the executives in the transaction, but a $187 million expense bundled into a single year can wreak havoc on a corporation's earnings. With such an atypically large cost in a single year, the earnings of the corporation cease to be an indicator of level of operations or future prospects of the corporation.

How to spread? The costs of large options outstanding for many years should be spread by the corporation over the years. The Disney options grew more valuable because of events, including the executives' endeavors, over the nine-year period 1984-1992. Stock options are a kind of profit-sharing agreement contingent on stock price increase. The stock price increase, realized by the executive by exercise in 1992, accrued annually over the full period. If the options are treated as a cost at grant, the costs could be capitalized as an asset and amortized over the expected period they are outstanding. /52/

One might match costs, measured at exercise, backward by treating most of the value-at-exercise cost of a multiyear option as a prior period adjustment. Prior period adjustments, however, are not a very good solution to the need to spread costs, because posting costs directly to a balance sheet account means the costs bypass the income statement and tend to get lost. The income statement is now the most important accounting statement; the balance sheet has diminished so much in importance that it is not sufficient reflection of costs to debit only balance sheets accounts. The dominant philosophy of accounting calls for comprehensive income statement, meaning that all changes in balance sheet worth are to be reflected in the income statement. /53/ Under the current definitions of prior period adjustments, /54/ option costs would be current losses and not be prior period adjustments, notwithstanding that they are best matched with income of prior periods.

C. Accrue Costs as Bargain Increases

The obvious solution to the problem of spreading the expense from the corporation's cost is to accrue the expense as the bargain on the stock option arises and increases. If a stock increases steadily for 10 years of the option period, for instance, the corporation would recognize a cost per period equal to the increase in the cost since the last period. At exercise, the only cost the corporation would have would be the incremental increase in the bargain since the end of the last accounting period.

1. Exercise is the verification. Overall, over the course of the option period, the corporation would recognize as a cost the full bargain that it gives to the executive on its stock when the executive exercises the option. Since stock is a fair proxy for the discounted present value of the cash the corporation will have to pay in the future on the stock, the corporation will, under the system, recognize all of the future cash devoted to the option holder by the time the option is exercised. None of the executives gain on exercise can be attributed to executive capital because prior to exercise of the option the executive contributes no capital. The bargain at the real exercise of the option would verify the actual compensation cost to the corporation.

The bargain finally given to the executives verifies the corporation's total costs. If FASB settles on some measure of the cost at granting or vesting of an option as an approximate solution, it should nonetheless check the results by looking to the bargain ultimately given. If, for example, managers succeed in getting a valuation for an option that is far below the value that is given on exercise, the standards need to increase the total cost, using hindsight, to reflect the final bargain. Earlier valuations might even be treated as standards or estimates of cost, but the exercise needs then to be treated as a variance or as the actual cost that is reflected in the accounts after final reconciliation.

2. Reversing into income. A drop in the price of the stock, subject to the option, would mean that the corporation would reverse prior expenses into income, so as to measure a reduction in the bargain available on the stock at the end of the current accounting period. The corporation's costs could not drop below zero, by reversing into income, however, since a holder will not exercise an option to give the corporation a negative cost or gain.

3. Contra-indicating? The reversal into income when stock goes down in value would generally run counter to how well the corporation is doing overall. The corporation's expenses would be higher when its stock is appreciating and lower when its stock is decreasing in value. That accounting, however, would describe the real economics. A stock option behaves like a profit-sharing arrangement. When a corporation has a lot of profits, its costs under its profit-sharing arrangements are very high. When a corporation has shrinking or negative profits, its costs under a profit-sharing arrangement are shrinking or zero. Losing companies have no expense and no loss from their stock options because their holders do not exercise the options. Stock options and profit-sharing arrangements are, in fact, costs that run contrary to the overall trend of the corporation and they need to be reported as such.

4. Just like phantom stock. The Exposure Draft gives a model for the proper treatment of stock options in its mandate governing plans that are settled in cash. 'Phantom stock' and 'stock appreciation rights' plans are incentive compensation plans that mimic the market value of the corporation's stock, but never make nor promise to make the executive a shareholder. The executive is paid under the plan according to how well the corporation's stock performs, but all payments are made in cash. The Exposure Draft provides that if settlement of the compensation plan is to be made in cash, the recognized expense per period is the amount that would be paid at the end of the period under the plan had the executive exercised her rights to settlement. /55/ Having created that standard for cash plans, FASB needs to conform the standard for stock plans. There is no economic or accounting distinction between settlement in cash and settlement in stock. For the issuing corporation, stock is just an expensive way to pay future cash. /56/

D. Unvested Options

1. Unvested options under an annual accrual standard. Options sometimes are unvested when awarded, that is, they are forfeitable if the executive leaves the corporation or else exercise is subject to an earnout under which the executive must stay with the corporationfor some years before the option may be exercised. Corporations rarely have a track record as to how often vesting requirements come into play and even when they do, the record does not apply to the CEO and other top managers.

Under a standard in which options are accrued as the bargain increases, employment contingencies might be accounted for under a systematic, but possibly arbitrary, convention as to how likely it is for the option to vest. As the bargain increases, it is predictable that it would be more likely that the executive would meet the conditions of vesting under her control. If so, the discount in cost attributed to lapse of an option with a large bargain will not usually be very material. Under a standard requiring annual accrual of option costs, errors could be corrected in the following year. The standards might reasonably call for a systematic convention, even if arbitrary, rather than for estimates of likelihood of vesting, to prevent management from shifting earnings from one year to another by changing its estimates of liklihood of vesting.

An alternative would be to ignore the vesting requirements, if the executive is more likely than not to exercise the option. The general standard for loss contingencies requires the corporation to recognize costs that are more likely than not to occur. /57/ Under the general loss standard, contingencies that would prevent the corporation's cost from arising would be ignored, so long as the option is more likely than not to vest and be exercised. If the option then lapses, the previously accrued cost would be reversed into income.

2. Shift from grant to vesting date. Accounting for unvested stock becomes more difficult under a standard that allows only one crack at the whip to assess costs. Published reports suggest that the FASB staff is considering shifting the time to value unvested options from grant date to the vesting of an option (without however any consideration of accruing the costs annually by following the bargain upward). /58/

Moving measurement from the award to the vesting of an option seems likely to cause some quite peculiar results, especially if valuation at grant continues to give management the opportunity to undervalue the costs. Management will inevitably strive to minimize the reported expense for their compensatory options and in the endeavor they seem likely to drop vesting requirements altogether.

Under current standards, management can give valuable options without any reduction of earnings by setting the option price at the value of the stock as of the date of the grant. Management then can seize the valuable options from executives it fires or executives who move on to other jobs, by attaching a forfeiture or earnout restriction. If vesting becomes the measurement date under new standards, however, then management will not be able to recapture the value of the stock options from departed executives without causing the value given to nonforfeiting executives, measured at vesting, to be a large debit to expense. Good compensation policy might well imply hard vesting requirements. If the past is any indication, however, management will choose reported-expense minimization over compensation policy and will drop the vesting requirements from its options so as to maintain the privilege of reporting their options at zero or low cost.

Vesting conditions are impossible to value with real accuracy. Under a one-crack-at-the-whip measurement standard, it is tempting to delay the all-important measurement date until the vesting conditions disappear. Still, if management has access to zero or low cost standards for fully vested options, a standard delaying measurement until vesting will induce management to strip vesting requirements from their options.

Under an accrue-increases-in-the-bargain standard, vesting conditions are less hard to handle. Such a standard could try to assess the likelihood of forfeitures and then make corrections in the following year. The final cost to the corporation would not be set until the option is exercised or forfeited. The greater ease of handling employment conditions under a measure at exercise or accrue the bargain standard is, in fact, another good reason for accruing the bargain on an option as it rises in lieu of the Exposure Draft framework.

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III. Conclusion

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A corporation giving stock options to management incurs a corporate cost that needs to be recognized in full in the corporation's income statements. Stock is a proxy for the future cash which the corporation must divert from existing shareholders and distribute to the executive who acquires the stock at a bargain. A stock option has value because it may ultimately turn into corporate cash distributions. If the full fair value of the option can be easily and reliably ascertained when the option is granted, then recognizing the corporation's cost at grant is reliable information that is relevant to investor needs. But if the option cannot be reliably valued at grant, then the value at grant is not a fair proxy for the cash the corporation will ultimately pay. The corporation then should accrue its cost, as the bargain increases, between the grant of the option and its exercise. By the time the executive exercises such an option (if she does exercise the option), the corporation needs to recognize all of the bargain that it has given to the executive.

Stock options have a material value and are not free, even when it is difficult to assess their value. Managers who take stock from the corporation without recording the full value as a cost to their corporation are engaging in a kind of self-dealing to the detriment of shareholders, which is too much like theft.

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FOOTNOTES:

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/31/ Exposure Draft of Proposed Statement of Financial Accounting Standards No. 127-C, Accounting for Stock-Based Compensation, (June 30, 1993), par. 20.

/32/ The seminal article on option pricing is Black & Scholes, 'The Pricing of Options and Corporate Liabilities,' 81 J. Pol. Econ. 637 (1973). Clear explanations of option valuation, include Richard Brearly & Stewart Myers, Principles of Corporate Finance 480-515 (3d ed. 1988); Craig McCann, 'Why (and How) to Value Employee Stock Options,' in Stock Options Hearings at 167 (October 21, 1993).

/33/ The Exposure Draft requires use of the interest rate paid on federal bonds that pay interest only upon maturity with a remaining life equal to the expected term of the option. Exposure Draft, supra note 31, par. 16.

/34/ See, e.g., Beni Lauterback and Paul Schultz, 'Pricing Warrants: An Empirical Study of the Black-Scholes Model and Its Alternatives,' 45 J. Finance 4 (1990).

/35/ Exposure Draft, supra note 31, par. 17. The exception to the general rule is the unusual case of a well-established nonpublic entity that has enough transactions in its stock to reasonably estimate expected volatility. If a reasonable estimate of expected volatility is available, it must be used.

/36/ A 1-in-10 chance of achieving $127.63 is worth $12.76. Discounting the $12.76 by the 5-percent discount rate yields $10 because $12.76/(1+5%) /5/ =$10.

/37/ $117.63/(1+5%) /5/ = $92.17 and $92.17/10 = $9.22

/38/ To borrow $10 now, one would have to pay $12.76 in five years when interest at 5 percent is compounded, because $10*(1+5%) /5/ is $12.76. The extra $2.76, above the $10 borrowed, is interest. The present value of the interest is $2.76/(1+5 %) /5/ or $2.16. Since there is only a one-tenth chance of paying the exercise price, the $2.16 value of deferring payment of the exercise will come into play only 10 percent of the time, for a total value of only 22 cents.

/39/ The interest value of an option is only [(1+i) /n-l]/(1+i) /n or 4.8 percent for one year, or 21.6 percent for five years. For any start-up company, risk of loss is far higher.

/40/ A risk-free stock worth $10 now will be worth $12.76 in 5 years at 5 percent. [10*(1+5%) /5/ = $12.76]. The present value of the $2.76 profit on exercise is $2.76/(1+5%) /5/ or $2.16.

/41/ Exposure Draft, supra note 31, par. 104-106. In the hypothetical, Stock A gives no dividends during the five-year option period. Options are less valuable than the ownership of stock by the amount of the dividends given, as the exposure draft provides. An option on a risk-free stock that pays all its return as dividends would have no value or cost.

/42/ I have a similar conflict between relevance and reliability in figuring out now how to finance the college tuition costs for my son, now in third grade. I do not have reliable information as to how much to set aside now for his college and by the time I have reliable bills, the information will come too late to be relevant. May I thus treat his college tuition as cost-free to me?

/43/ See, e.g., Senator Lieberman, D-Conn., 'But They Do Create Jobs,' Los Angeles Times, Apr. 8, 1994, at E7, (accurately estimating the current value of an employee's stock option is nearly impossible); Carter Beese Jr. (SEC Commissioner), 'A Rule That Stunts Growth,' Wall St. J., Feb. 8, 1994, at 19, (finding the true value of a stock option is an impossible task); Dane Miller, Statement on behalf of Association of Publicly Traded Corporations, in Stock Options Hearings 130, 132 (Oct. 21, 1993).

/44/ Exposure Draft, supra note 31, par. 7,17,81,82.

/45/ David J. Jefferson, 'Disney Officials Get $187 Million From Stock Sale.' Wall St. J., Dec. 2, 1992, at A3.

/46/ Treas. reg. section 1.83-7(a)(1978)

/47/ Treas. reg. section 1.83-7(b)(1978). If the option is itself not readily traded on an established market, the 'option privilege' must be measurable with reasonable accuracy. The 'option privilege' is the right to benefit from an increase in the value of the underlying property without risking any capital. Treas. reg. section 1.83-7(b)(2). The option must also be transferable and exercisable immediately and the stock acquired on exercise must have no value-affecting restrictions on it. Treas. reg. section 1.83- 7(b)(1).

/48/ Section 83(h); Treas. reg. section 1.83-7 (1978).

/49/ Samuel A. Derieux, 'Stock Compensation Revisited,' 177 J. of Accountancy 39 (Feb. 1994).

/50/ Tax accounting law and financial accounting standards usually have opposite purposes -- tax law is tying to prevent understatement of income and financial standards are trying to prevent overstatement of income -- but here tax and financial accounting have the same goal. Tax is trying to prevent understatement of compensation income by the executive and accounting is trying to prevent understatement of compensation cost by the corporation.

/51/ The criticism of deferred tax accounts that they are blind to the time value of money and allocate the costs and savings of tax without discounting is a valid general criticism. See, e.g., J. Alex Milburn, 'Comprehensive Tax Allocation,' CAMagazine 40 (Apr., 1982) reprinted in Stephen Zeff & Thomas Keller, Financial Accounting Theory 445, 447 (3d. ed. 1985).

/52/ The Exposure Draft, supra note 31, par. 17, anticipates that the value-at-grant cost will sometimes be capitalized and amortized over the period until the lapse of the option.

/53/ Accounting Principles Board, Opinion No. 9, Reporting the Results of Operations par. 17 (1966) (net income should reflect all items of profit and loss recognized during the period, but extraordinary items should be shown separately within the income statement).

/54/ Under FASB Statement No. 16, Prior Period Adjustsments, par. 11, 12: (1977) (prior period adjustments are used for correction of previous errors (but not for changed estimates), for adjustment of pre-acquistion tax net operating losses and for retroactive changes in standards).

/55/ Exposure Draft, supra note 31, par. 19.

/56/ Calvin Johnson, 'The Legitimacy of Basis From a Corporation's Own Stock,' 9 Amer. J. of Tax Policy 155, 199-203 (1991), argues that stock is an especially expensive way for a corporation to give out cash to executives because the discount rate applicable to stock is a very high risk, reflecting the risks arising because outsiders cannot control distributions and have not received a promise of distributions. The discount rate is also high because it represents nondeductible interest, because dividends are not deductible.

/57/ FASB Statement No. 5, Accounting for Contingencies par. 8 (1975).

/58/ Amy Adler, 'FASB Meets With Members of Financial Accounting Advisory Council,' Tax Notes, Aug. 1, 1994, p. 647.

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