Standards
Expensing Stock Options
Canada is the first major jurisdiction to require expensing for all public company employee stock-based compensation awards.
FROM: MAR-APR 2004 ISSUE | BY STEPHEN SPECTOR
Last issue, I reported on the upcoming changes to Handbook section 5135, entitled The Auditor's Responsibility to Consider Fraud and Error in an Audit of Financial Statements. That column pointed out that despite the fact the section had been updated in March 2001, the goal of international harmonization made additional changes necessary. Moreover, the column concluded that the latest amendments would not be the last.
So it is with section 3870, Stock-based Compensation and other Stock-based Payments . First released in 2001, section 3870 became effective for public enterprises January 1, 2002, and January 1, 2003, for non-public entities. Section 3870 was based on the U.S. Financial Accounting Standards Board (FASB) Statement 123, and the Canadian requirements were deliberately crafted so as not to create a significant U.S./Canadian GAAP conflict. The reason for that approach was to facilitate matters for Canadian firms that were cross-listed on U.S. stock exchanges. Another factor was the business community's reluctance to be offside from the United States so as not to put Canadian firms at what the community called a competitive disadvantage.
As has been recounted in previous columns, the U.S. approach, which Canada adopted, did not require expensing stock options even though there was general agreement that they should be expensed. Consequently, the standard released was not the standard that ought to have been released. The reason was quite straightforward: in an April 19, 2002, Financial Post report, Paul Cherry, chair of the Canadian Accounting Standards Board (AcSB), indicated that he would not have Canada out of step with the United States on stock options. And there the matter might have rested if it wasn't for the tidal wave called Enron.
Enron transformed the thinking of investors and creditors. They argued that truthful accounting mattered and demanded change. And change was not long in coming. For example, Standard and Poor's announced in 2002 that when it computed core earnings, it would deduct stock options as a compensation expense. As more players in the capital markets made similar adjustments, financial executives who continued to hide management compensation by not expensing stock options ran the risk that investors and creditors would take their money elsewhere.
Furthermore, when the Sarbanes-Oxley Act of 2002 was signed into law, one of its provisions required the FASB to explore the implications of moving from a rule-oriented system of GAAP to one that was more principle-based. One aspect of that analysis focused on stock options. In late 2002, the FASB directed its staff to research the implications of a requirement that would fall short of mandating that companies treat stock options as expenses but would force companies to disclose the bottom-line impact of the options on the face of the income statement.
Anticipating the U.S. move (and the soon-to-be-released IASB international standard for stock options), Canada became the first major jurisdiction to require expensing for all public company employee stock-based compensation awards. As of January 1, 2004, public companies are required to expense all stock-based compensation awards (including stock options), including those made to employees, senior executives, and board members.
Interestingly, the AcSB position is, and always has been, that stock-based payments are a form of compensation and should be expensed. It was the over-riding objective of U.S./Canadian GAAP harmonization that caused the AcSB to make section 3870 much the same as FASB Statement 123. But with a revised standard expected to be issued by the FASB in 2004, Canadian standard-setters decided to take the initiative and move ahead of the United States.
So what are the changes? First, section 3870 has been amended to require that all transactions where goods and services are exchanged for stock-based compensation result in expenses that are recognized in financial statements. For public companies, this requirement is effective for fiscal periods beginning on or after January 1, 2004. Enterprises other than public enterprises, co-operative enterprises, deposit-taking institutions, and life insurance enterprises are permitted to defer the expense recognition requirement until fiscal periods beginning on or after January 1, 2005.
Second, all share-based transactions are to be measured on a fair value basis. The use of the intrinsic value method is proscribed.
Third, transitional provisions have been amended to provide the same alternative methods of transition as is provided in the United States for voluntary adoption of the fair value based method of accounting. These provisions permit either retroactive (with or without restatement) or prospective application of the recognition provisions to awards not previously accounted for at fair value. Prospective application is only available to enterprises that elect to apply the fair value based method of accounting to that type of award for fiscal years beginning before January 1, 2004.
Is this the end of the matter? Not by a long shot. As noted, the International Accounting Standards Board is expected to release its financial reporting standard for stock-based compensation in 2004. The FASB is also expected to release revisions to FAS 123, despite the screams of anguish from companies whose bottom lines will be affected by the requirement to expense stock options. It is likely that another round of revisions to Canada's standards will occur. A December 18, 2003, press release regarding the changes to section 3870 notes that "... in order to have a harmonized standard, it may be necessary at a later date for the Canadian board to remove 'nuisance' differences if they exist between our standard and FASB's planned standard, but this should be a relatively simple matter."
So stay tuned. The roller coaster ride is nearly over. When it's finished, the resulting standard will be the standard that should have been issued when the FASB started the process back in 1993.
[ TOP ]
Stephen Spector, MA, FCGA, owns Spector and Associates and teaches Financial and Managerial Accounting at Simon Fraser University. He also serves on CGA-BC’s board of governors. E-mai lshspector@shaw.ca.