On June 5th, John W. White, Director, Division of Corporation Finance, U.S. Securities & Exchange Commission, testified before the U.S. Senate Permanent Subcommittee on Investigations. He covered a wide range of issues concerning stock options, executive compensation disclosure, option backdating, and FAS 123R.
In his testimony, White candidly admitted two areas of failure. First, he stated that while Section 162(m) (added to the IRS Code by the Omnibus Reconciliation Tax Act in 1993) had been intended to curtail excessive compensation (in excess of $1 million) to top executives, instead it simply moved compensation from cash to stock options which were exempt from Section 162(m). He quoted SEC Chairman Christopher Cox from his testimony to the Senate in 2006 when Cox admitted: “the stated purpose[of Section 162(m)] was to control the rate of growth in CEO pay. With complete hindsight, we can now all agree that this purpose was not achieved.”
And second, he acknowledged that the changes to the executive disclosure requirements for proxy statements added at the end of 2006 were the first “significant revisions of its rules for executive and director compensation disclosure in more than thirteen years.” He summed up by stating: “Simply put, the disclosure required of companies in their public reports failed to keep pace with changes in the marketplace.”
After these admissions, he went on in a good natured way to discuss some of the ways in which the disparity between the accounting treatment for tax and financial reporting of options, while potentially reduced, continues to exist even after the changes introduced by FAS123R which requires expensing of stock options. A few segments from this part of his testimony follow:
“… comparing the financial reporting and tax systems is a bit like comparing apples to oranges, it is more complicated than that. For the years prior to 2006, before FAS 123R was effective for most companies, the comparison was more like apples to automobiles. How a company calculated stock option compensation costs was based on a set of rules that differ significantly from those in place today. Before FAS 123R, most companies expensed options in accordance with Opinion 25, which in most cases meant that no expense was recognized because the option was granted at-the-money … Comparing how a company calculates stock option compensation costs and tax deductions for those costs after FAS 123Rtakes us back to the apples to oranges analogy.
“The compensation expense a company recognizes in its financial statements is tied to the fair market value of the option at the time of grant, whereas the tax deduction is tied to an option’s intrinsic value at the exercise date….
“The adoption of FAS 123R by most companies in 2006 will no doubt reduce the book-to-tax differential, but the magnitude and timing of this impact is difficult to predict. That is because, under FAS 123R, companies will recognize the expense associated with an option grant in the financial statements (amortized over the vesting period) prior to any tax deduction being reflected on exercise of that option. If the tax system for companies was changed to bring it into conformity with the financial reporting system, one effect would be to accelerate the timing of a company’s tax deductions.”
His full June 5th testimony can be read at: www.sec.gov/news/testimony/2007/ts060507jww.htm
I highly recommend reading his testimony. It’s like a primer covering historical aspects of stock options, current stock option backdating issues, new executive compensation disclosures, FAS 123R, and tax and financial reporting. Whether you’re a novice or an expert, looking to learn more about options or just learn the SEC’s latest thinking, you can get through it in one cup of coffee.