Rambus lost money - under SFAS 123R

Did you know that Rambus lost money two out of the last three years? Yup, welcome to financial statements SFAS 123R style – scheduled to arrive June 15, 2005.

Turning in your hymnals, err, Rambus’ 2005 Form 10-K at page 54, you will find that when using the Black-Scholes option valuation model, Rambus lost 12 cents a share in 2002, 5 cents in 2003 and basically broke even in 2004.

What us SFAS 123R?
SFAS 123R is SFAS 123 on steroids. SFAS was an attempt by the Financial Accounting Standards Board (FASB) to change accounting methods so that corporate income statements reflected the cost of options - what everybody knows: namely, that stock options compensate employees and dilute other shareholder interests. FASB wilted to pressure from Congress and SFAS (1995) ultimately required only footnote disclosure of options. Further, companies were required to expense only the intrinsic value of the option – which when issued was almost always zero

The debate continued and in December 2004, the FASB approved revision to the 1995 pronouncement, and issued SFAS 123(R).

Fulcrum Financial Inquiry describes SFAS 123R as follows:

“The new accounting considers future possibilities, so even if the stock’s market price is equal to the option’s strike price, the option still has a positive fair value. This fair value is recognized as a compensation cost in the income statement over the vesting period. Companies are also required to recognize a compensation cost for unvested stock options outstanding on July 1, 2005. This transition cost is equal to fair value of those options at the original grant date, amortized over the vesting period. The income difference between the old and new accounting is often
substantial.” (Emphasis added.)

What is the Black-Scholes?
It is an option valuation method (approved for use under SFAS 123R) which is named after the 1997 Nobel Peace Prize winning authors Robert Merton and Myron Scholes who worked with Fischer Black (who died in 1995) in developing a model for option valuation. It is the option pricing model that is the most widely taught and best known. It is a complex mathematical formula that takes into account the following inputs: strike price, time to expiration, volatility and the risk-free rate of return.

Despite being complex, it is highly subjective and thus subject to criticism as an unreliable and inaccurate method for determining option expense.

For example, under Black-Scholes, option exercise only occurs at the end of the contractual term. In the employment setting that may not in fact be the most opportune time for the employee to exercise the option. Most options expire upon termination of the employment relationship. Thus, as employee with “above-water” vested options must exercise her options before leaving employment, regardless of how many years the options remain open. Also, an employee may choose to exercise options years prior to the expiration for a variety of reasons, including financial need, diverisification or simply to lock-in some profit.

Further, Black-Scholes assumes that volatility, dividends and risk-free interest rates are all constant over the option’s term. Reality does not often reflect these assumptions.

The 1997 press release for the Nobel Prize in Economic Sciences includes a depiction of the Black-Scholes formula.

How are companies reacting to SFAS 123R?
Some are accelerating the vesting of their options in advance to June 15, 2005. Reportedly, over 130 companies have taken this approach already. By doing this they dump the “expense” in bulk into the current footnotes where it will not be noticed by most when looking for the “earnings”. Some announce they are accelerating vesting for employee morale, etc. Others are more brazen (forthcoming?) and simply inform their shareholders they are doing so to avoid the SFAS 123R expense. (See Micron.)

Stay tuned.