FAS 123R

What Is FAS 123R?

FAS 123R is the 2006 financial accounting standard introduced by the Financial Accounting Standards Board (FASB) that requires companies to deduct the amount of share-based (equity) payment granted to their employees on an annual basis.

• FAS 123R was introduced in 2006 and requires companies to share-based equity distributions to be recorded as deductions. 
• The basic idea behind FAS 123R is that the costs associated with equity payment for employee services are to be expensed on financial statements. 
• Equity compensation was previously not expensed because it’s not a real monetary expense. However, equity compensation is a direct expense to a company's shareholders. 
• Opponents of employee stock option (ESO) expensing say that option grants help companies attract key employees and align their interests with shareholder interests.
• Supporters of ESO expensing say that equity compensation transfers stockholders' equity to grantees—they get the money that otherwise would have been left with the company. 

How FAS 123R Works 

Many employees receive equity compensation as a supplement to their salaries. Traditionally, this compensation comes in the form of stock option grants, which can be exchanged for shares of the company's stock. The basic idea behind FAS 123R is that the costs associated with equity payment for employee services are to be expensed on financial statements in order to reflect the economic transaction taking place between a company and its employees.

Equity compensation was not expensed previously because it is not a real monetary expense to a company. However, equity compensation is a direct expense to a company's shareholders. Shareholders are the owners of publicly-traded companies and, therefore, they are the ones who ultimately pay for the issue of extra shares through dilution. When additional shares are issued by a company or convertible securities are converted, dilution occurs. If there were 10 shares in a given company, issuing five more shares for equity compensation would mean that the previous owners of the 10 shares would see their stake in the company reduced to only two-thirds.

Special Considerations

In the face of FAS 123R, equity compensation has changed—options are no longer the preferred means of rewarding executives, and new ways to reward good corporate performance have emerged. Some of these, such as reload options, have been dug up from the 1990s—the heyday of bull market fever and ESO granting. From the point of view of the investor, these newer vehicles for compensation are not only intimidating and complicated but hard to value.

Before FAS 123R, options did not explicitly take away from a company's balance sheet earnings; so, despite their flaws, they were inherently more attractive than other compensation vehicles. Now, granting common stock, stock appreciation rights (SARs), dividends, options, or other derivatives of stock-based incentives are all equally expensive approaches to employee compensation, making the best incentives the ones that have the most motivational power.

From the investor's standpoint, equity compensation should not unduly dilute shareholders' ownership, should pay executives for market capitalization appreciation instead of stock price appreciation (which can be easily manipulated by using share buybacks), and should be simple enough to dissect without having to spend days plowing through the legalese of a mandatory filing. From the executive's standpoint, equity compensation should be highly levered to provide exponentially high compensation for exceptional performance, and it should not expose them to potentially punitive income taxes.

Advantages and Disadvantages of FAS 123R

Opponents of employee stock option (ESO) expensing say that option grants help companies attract and motivate key employees and that they align shareholder interests (such as increasing the stock price) with the interests of grantees (i.e. increasing the option value). They also argue that if companies are required to expense options, they will likely use other forms of compensation instead—ones that do not align the goals of shareholders with those of grantees.

On the other hand, those that support ESO expensing say that equity compensation transfers stockholders' equity to grantees—they get the money that otherwise would have been left with the company. Proponents of these rules maintain that if the salary is expensed as an exchange for employee services, then it follows that equity-based compensation for the same employee services should also be expensed.

Example of FAS 123R

Why should this matter to you as an investor? Well, if you have a lot of money tied up in stocks, FAS 123R has the potential to take a substantial bite out of your portfolio's value. In the past, a company that issued stock options to its employees did not have to expense those options; for example, a grant of 500,000 options to an executive would cost the company nothing on paper. Now, the FASB requires companies to charge the option grant multiplied by the fair value of the grant. Continuing with our example, let's assume that the grant is $10 per option, for a total of $5 million (500,000 options x $10 per option) in equity compensation expense. To be in compliance with FAS 123R, the company now would have to expense this $5 million, thus affecting its financial performance.

As you can see, this new way of doing things could greatly affect the profitability of some companies. If you have many companies in your portfolio that rely on options to keep their executives happy, you should be aware that the stocks of these companies may be on their way to a price correction based on the news that their earnings have decreased substantially as a result of options expensing.