Stock-Based Compensation

Aligning management's goals with those of the company's stockholders

The primary objective of stock-based compensation arrangements is to achieve alignment between the goals of management and a company's stockholders. The intention is to encourage management to act in a manner that will increase the stock's market value. In addition, as stock options generally vest over a number of years, stock compensation also serves as a mechanism to retain and reward top employees. However, while this arrangement would appear to be in the best interest of management and shareholders alike, it is evident that management of some companies is focused on the short-term performance of the company's stock rather than the long term.

Accounting for employee stock compensation had been a controversial area of GAAP for many years.

Historically, the vast majority of public companies accounted for stock based compensation using "the intrinsic value method" rather than "the fair value based method." Recently, many companies switched, or indicated their intention to switch, to using the fair value based method, which results primarily from the push in the market toward transparency in financial reporting.

The "fair value" method of accounting for employee stock options and other stock-based compensation was introduced into the CICA Handbook, and thus into Canadian generally accepted accounting principles (GAAP), in late 2001.

The fair value method records compensation for stock option transactions with employees at the fair value of the option instrument granted – the value that would generally be received when a similar option was issued in any other arm's length transaction, such as in an options market. Fair value is generally determined at the date the employer grants the option to the employee and the employee understands the terms of the grant.

Accounting for stock-based compensation plans requires management to make several complex assumptions. Management is responsible for making the estimates required in the preparation of the financial statement captions and footnotes. It is the audit committee's role to understand and evaluate the most significant accounting estimates. To do so, the audit committee must understand the methodology used in making the estimates, the major assumptions used, the sensitivity of the outcome (e.g., how would the accounting estimate change if changes were made in the assumptions), and the overall reasonableness of the result.

In assessing the overall reasonableness of the estimates, audit committees should understand whether the policies or estimates are too conservative, too aggressive, or appropriate.

The evaluation of these policies and estimates involves a high degree of judgment. Management and the external auditor should provide the audit committee with information to enable it to assess whether the accounting policies and estimates used in the preparation of the stock-based compensation information were consistent with those used in prior periods, those used by other companies in the same industry or other similar businesses, and whether they were more conservative or more aggressive.