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SEC Issues Guidance on Implementation of New Accounting Rules for Stock Options

William D. Sherman, Patrick McCabe, and Timothy G. Verrall, Morrison & Foerster


On March 29, 2005, the Office of the Chief Accountant ("OCA") of the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin 107 ("SAB 107," available online, pdf format) to provide clarification of the OCA's interpretation of Financial Accounting Standards Statement No. 123R ("FAS 123R," available online, pdf format) as it applies to share-based compensation arrangements for both employees and non-employees.[FN1] Given the administrative complexity associated with FAS 123R's requirements, the relatively flexible approach to compliance adopted by the OCA in SAB 107 is welcome news as companies consider how FAS 123R will affect the accounting for share-based compensation. Although SAB 107 provides detailed interpretive guidance covering a variety of topics relating to share-based compensation, this Client Alert focuses on the OCA's approach to fair value determinations under FAS 123R and related disclosure issues.

Summary of FAS 123R Requirements

In general terms, FAS 123R requires accounting recognition of the costs of a company's own "equity" (broadly defined to include stock, stock options, and other forms of equity such as stock appreciation rights and phantom stock) issued in exchange for the provision of goods or services by either employees or non-employees. Under Accounting Principles Board Opinion No. 25 ("APB 25"), the costs of such equity issuances have historically been valued using an intrinsic value approach that did not require a charge to earnings for most stock options. In 1993, the Financial Accounting Standards Board ("FASB") began to reexamine the basis for APB 25's non-recognition rules and progressively refined its position over the intervening decade, emphasizing its belief that compensatory equity issuances should be recognized at their fair value in company financial statements. Despite the significant amount of controversy generated by this position, FASB has now mandated its adoption in FAS 123R. These new requirements are generally effective as of the first reporting period (quarterly or annual) beginning on or after June 15, 2005 (i.e., July 1, 2005 for calendar year companies) for most public companies; the first reporting period (quarterly or annual) beginning after December 15, 2005 (i.e., January 1, 2006) for "small business issuers"; and the first annual reporting period beginning after December 15, 2005 (i.e., January 1, 2006) for non public companies.

Key Aspects of SAB 107

Cognizant of the significant administrative burdens associated with FAS 123R's requirements, SAB 107 emphasizes that flexibility will be the hallmark of OCA's, and hopefully, the SEC's interpretive approach. Under this approach, companies will be given a substantial amount of latitude - at least initially - to estimate the fair value of share-based compensation, subject to the guidelines provided in SAB 107. Also noteworthy here is the staff's statement that it will not reevaluate reasonable fair value estimates after the fact, even where the ultimate value of share based compensation substantially exceeds a company's initial estimate.

Valuation Methodologies

In general, FAS 123R requires a company to estimate at the grant date the fair value of the shares it will be obligated to issue when a stock option becomes exercisable. Although the preferred evidence of the value of stock options is the value of the same or similar instruments in an observable market, FAS 123R recognizes that the value of many employee stock options cannot be determined in this manner and therefore prescribes a number of criteria for selecting alternate valuation methodologies.

In selecting an appropriate valuation methodology, SAB 107 provides that the chosen method must: (1) be consistent with FAS 123R; (2) be based on established financial economic principles that are generally applicable in the field; and (3) reflect all substantive characteristics of the equity instrument at issue. SAB 107 does not require a company to use any particular valuation methodology as long as the chosen approach satisfies the fair value criterion. The staff observes that in order to comply with these requirements, a valuation methodology must take into account all of the relevant terms of the stock options under consideration. As an example, the staff cites the Black-Scholes-Merton model as a methodology that would not be appropriate for valuing stock options the exercisability of which is conditioned on a specified increase in price in the underlying shares because that model does not take such a term into account. Although the staff does not expand upon this point, our presumption is that Black-Scholes-Merton would not satisfy the foregoing test for any stock options that include performance-based or other terms that are not variables in the Black-Scholes-Merton calculation; for such options, an alternate valuation methodology would be required.

Although a company is permitted to change its valuation methodology from time to time, the OCA states that it does not expect to see frequent changes. In addition, the OCA confirms that such a change is not deemed to be a "change in accounting principle" and as a result may be set forth in a footnote disclosure and does not even require a "preferability" letter from outside auditors.

In addition, SAB 107 clarifies that companies need not hire outside valuation experts to make the determinations required by FAS 123R, although valuations should be performed by persons with the requisite expertise.

Assumptions for Valuation Methodologies

In order to satisfy FAS 123R, a company must make estimates regarding two key aspects of its stock options: their expected volatility and their term. FAS 123R does not specify a particular method for making these estimates but it does supply a list of factors for consideration by the company. If, after initially selecting appropriate assumptions for these determinations, a company subsequently opts to make changes, it must disclose the new assumptions in its financial statement footnotes.

Volatility

SAB 107 indicates that a company should make a good faith estimate of the volatility of its stock options, taking into account both historical and implied volatility (or a combination of the two), as appropriate. For companies with actively-traded options or other financial instruments with embedded options, the staff notes that implied volatility could be the predominant or even exclusive measure of volatility for purposes of FAS 123R. The approach to data collection and analysis relating to share volatility should generally remain consistent over time, absent changed circumstances.

To determine historical volatility, the OCA suggests that a company estimate the expected future volatility of its stock options, consider applicable historical data, make regular price observations, and consider the potential impact of future events. In addition, the OCA notes that in certain rare circumstances, a company could reasonably exclude anomalous periods of time from consideration, although if it chooses to do so, the company must be prepared to justify the exclusion.

When considering its reliance on implied volatility based on traded options, a company should evaluate the volume of market activity; its ability to match the material characteristics of the traded options and employee stock options as closely as possible (i.e., through the selection of near-the-money or at-the-money options and the use of recent trading data); and the similarity between the exercise price and terms of its traded options and employee stock options.

Once a company has determined the assumptions upon which it will base its volatility determination, FAS 123R obligates it to disclose the expected volatility and the method used to estimate it. Under SAB 107, the OCA expects companies to include this information in footnote disclosure and to indicate whether the company has used historical volatility, implied volatility, or some combination of the two. The OCA also expects an explanation of the method used to estimate volatility.

For companies with limited historical data, FAS 123R permits the use of comparable alternative data. SAB 107 expands upon this by permitting a company to use volatility data for similar companies in the same or a similar industry until it has at least two years of daily or weekly historical data to draw upon. A company opting to use this approach must apply it consistently.

Expected Term

In addition to estimating share volatility, a company must also estimate the expected term for its stock options. According to SAB 107, because employee stock options are nontransferable and often subject to other limitations, their value is inherently less than traded options. To account for this, a fair value estimate of employee stock options must be based on their expected term rather than their contractual term. Under SAB 107, the expected term of a stock option must be determined on the basis of the relevant facts and circumstances and, pursuant to FAS 123R, must be disclosed in the financial statement footnotes.

Because the expected term determination already reflects the limited transfer and hedging opportunities available to option holders, no additional discounting is permitted to account for an expected term that is less than a contractual term. Forfeitures and terms relating to forfeitability should not be taken into account for purposes of determining an expected term. In no event can the expected term for an employee stock option be less than the applicable vesting period.

The determination of expected terms must be made using a reasonable and supportable approach consistent with likely marketplace behavior. In appropriate circumstances, historical experience regarding option exercises could be used as a reasonable basis for this determination. Under FAS 123R, in determining the expected term of stock options, a company must generally group individual awards by expected behavior; despite FAS 123R's implication that several such groups may be required, the staff believes that no more than one or two groups may be necessary to comply with this requirement.

SAB 107 provides a simplified formula[FN2] that can be used to determine the expected term of "plain vanilla" stock options.[FN3] Note that companies that have more detailed data regarding the terms of stock options are not required to use this simplified formula, and the simplified formula is not intended for use as a benchmark for more detailed analyses. Moreover, the OCA expressed its belief that the simplified formula will not generally be appropriate for use for option grants made after December 31, 2007.

Disclosure Issues

MD&A Disclosures

As part of its focus on critical accounting policies and its desire to encourage companies to better advise investors and other users of financial statements, the OCA believes that companies should include certain disclosures relating to their adoption of FAS 123R in its MD&A. More specifically, the staff notes that a company should consider disclosing material qualitative and quantitative information regarding the following:

  • The selected transition method and resulting financial statement impact
  • The method used to account for stock options in prior periods
  • Any modifications made to outstanding stock options prior to the adoption of FAS 123R and the reason for such modifications
  • Any differences in valuation methodology or assumptions between the disclosed information and the fair value estimate made under FAS 123R
  • Any changes to the type or quantity of instruments used in the stock option program
  • Any changes to the terms of stock options
  • A description of the effects of adopting FAS 123R

The total compensation costs of nonvested stock options that have not been recognized and the weighted average period over which they are expected to be recognized.

Modification of Existing Options

As noted above, the OCA suggests that companies disclose and explain any modifications made to outstanding stock options prior to the adoption of FAS 123R. Beyond this suggestion, the OCA importantly notes that it will have no objection if a company that has previously accounted for stock option grants in accordance with APB 25 opts to accelerate vesting on outstanding stock options prior to adopting Statement 123R. In other words, a company's choice to accelerate vesting for underwater stock options prior to adopting FAS 123R will not result in subsequent accounting charges relating to those options. However, the OCA points out that any such modifications must be disclosed and accompanied by an explanation of the business justification for accelerating vesting for the affected stock options.

Non-GAAP Financial Measures

SAB 107 indicates that it may be possible for a company to include a separate measure in its financial statements footnotes to show net income before taking into account the effects of share-based payments even though such a measure is a non-GAAP measure for purposes of SEC Regulation G and Item 10(e) of Regulation S-K. The OCA references its prior statement that the elimination of a recurring expense for the purpose of smoothing earnings is impermissible and that a company proposing to remove such an expense for other reasons bears the burden of establishing the usefulness of the elimination. The OCA notes that the use of such a measure could be permissible if the company were to determine that the measure does not violate any of the prohibitions set forth in Item 10(e) of Regulation S-K and disclose the basis for the use of the measure and the extent to which the measure is used for purposes that are not otherwise disclosed. According to the OCA, the use of a non-GAAP measure relating to share-based compensation could be misleading unless certain specified disclosures are made. The staff believes that a company should disclose information in its MD&A regarding each component of its expenses, including any material information about expenses associated with share-based payments. Moreover, a company may not remove the net effects of share based payment expenses from its pro forma income statements filed with the SEC.

Classification of Compensation Expenses

SAB 107 indicates that it may be appropriate for a company to distinguish between cash and share-based compensation in a parenthetical note to an income statement line item, on the cash flow statement, in the financial statement footnotes, or in MD&A. The staff notes that both cash and share-based compensation should be combined for disclosure as an expense in a company's income and financial statements.

Other Issues

In addition to focusing on fair value and related disclosure issues, SAB 107 addresses a number of ancillary issues. More specifically, the OCA provides guidance for share-based compensation provided to non-employees; the transition from non-public to public status and its related effects on existing share-based compensation arrangements; redeemable financial instruments; the adoption of FAS 123R during an interim period; the capitalization of costs relating to share based compensation; income tax accounting issues relating to share-based compensation; and modifications of employee share options.

Conclusion

SAB 107 provides important guidance for both public and non-public companies as they implement measures to comply with FAS 123R and offers some degree of reassurance that the SEC does not intend to impose a "one size fits all" approach to determining the fair value of share-based compensation. Time will tell.


Footnotes:

1. Note that the guidance provided in SAB 107 is not regarded as an official interpretation or regulation of the SEC nor does it modify or supersede the requirements set forth in FAS 123R. Instead, SAB 107 describes the interpretations and practices that will be followed by the OCA in administering disclosure requirements under Federal securities laws.

2. Under this simplified formula, a stock option's expected term is equal to the sum of its vesting term and original contractual term divided by 2.

3. The example cited in SAB 107 involves at-the-money option grants that are subject to a standard employment based vesting schedule, exerciseable for a limited period of time after termination of employment, and non-transferable and non-hedgeable.