Introduction
On September 19, 2006, the SEC’s Office of the Chief Accountant (OCA) issued a letter that provides guidance regarding accounting for stock options in historical financial statements of public companies. OCA’s guidance relates to accounting for options under Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25), which all public companies could apply in fiscal years beginning prior to June 15, 2005. APB 25 therefore governs the accounting treatment for many of the option grants now under investigation.
General Summary of Applicable Accounting Rules
Under APB 25, any compensation cost for options is measured as the excess of the fair market value of the underlying stock over the exercise price (i.e., the "intrinsic value") on the "measurement date." The measurement date is the first date when both (1) the number of shares an individual employee is entitled to receive and (2) the exercise price, are fixed and determinable. If the measurement date occurs on the date of grant, the option is entitled to "fixed" accounting treatment and the compensation expense is fixed on that date. Accordingly, the grant of a "plain vanilla" stock option with a fixed number of shares and a fixed exercise price equal to the fair market value of the underlying stock on the grant date has no intrinsic value and, therefore, results in no compensation cost under APB 25. Certain option grant practices now under scrutiny may produce a measurement date that is different from the purported grant date of the option. These options may have accounting consequences if they had an intrinsic value on their measurement date and thereby produce a compensation cost for what was originally accounted for as a "plain vanilla" stock option.
Under APB 25, if either the number of shares or the exercise price is not fixed and determinable on the grant date, the option receives "variable" accounting treatment. For an option subject to variable accounting, the compensation cost is remeasured on each reporting date until the measurement date occurs, or the option is exercised, forfeited or expires unexercised. This "mark-to-market" accounting causes an increased compensation expense each reporting period if the underlying stock price has increased. Finally, if a company directly or indirectly reduces the exercise price of an option subject to fixed accounting (e.g., conducts a "repricing"), the option will receive variable accounting for the life of the award. Most companies considered variable accounting to be less favorable because they preferred to avoid the resulting earnings volatility.
Issues in OCA Letter
The OCA letter provides answers to frequently asked questions about whether a company’s determination of the measurement date for past stock option awards was appropriate from a financial statement perspective. In OCA’s view, some practices and conduct may result in compensation charges, but still entitle companies to use fixed accounting. Other practices and conduct may result in even more unfavorable variable accounting for the life of the awards. Other conduct, such as unimportant delays in completing administrative procedures to document option grants, may have no accounting consequences. Nonetheless, OCA warns that any analysis of accounting consequences is heavily dependent upon the particular facts and circumstances of each company. Different or additional analysis may be required where there is evidence of fraudulent or manipulative conduct.
Following are some of the issues discussed in OCA’s letter:
1. Unfortunately, one of our former officers changed the dates of some of our compensation committee’s actions to an earlier date when our stock price was lower so that his options would have a lower exercise price. Is there any hope that we could avoid a compensation charge related to these options?
No. True "backdating" does not change the measurement date, which is the date the number of shares and exercise price are established. Here, the measurement date is the actual date of the compensation committee’s actions. Unless a pattern of conduct suggests otherwise, the options will be entitled to fixed accounting treatment, and the compensation cost to be recognized will be the excess of the fair market value of the underlying stock on the measurement date over the exercise price of the options.
2. On occasion, our compensation committee members will have a series of telephone calls during which they authorize the grant of certain employee options. Because these calls do not constitute a formal meeting, we always follow up with documentation of the approval at a later point, but treat the date of the telephone calls as the grant and measurement date. How does OCA view this type of "administrative delay"?
The resolution of this issue will depend heavily upon individual facts and circumstances. Where companies use a measurement date that is not the same as the date upon which all actions necessary to effect the grant have been completed, delays in completing the necessary actions may suggest that the option terms were not final until the completion of those actions. OCA believes that the contention that a delay is "administrative" must be considered "carefully" because it may be inconsistent with the principle that the terms of a stock option cannot be considered final until the persons authorized to make grants have determined, with finality, the terms and recipients of those awards. In other words, the measurement date does not occur, and fixed accounting does not begin, until there is "finality" in the option terms.
3. Sometimes, our awards are made by a member or committee of management under delegated authority within specific parameters previously communicated by the board or committee, and appropriate approvals are then obtained at a later date. Would OCA also consider this practice to be a type of "administrative delay"?
The analysis described above also applies in this circumstance.
4. What kind of evidence should we consider to determine "finality"?
Relevant evidence might include evidence indicating that the terms were not final, the company’s pattern of historical stock option grants, the presence or absence of documentation of past stock option granting actions and evidence of fraudulent or manipulative conduct. If "a company operated as if the terms of its awards were not final prior to the completion of all required granting actions (such as by retracting awards or changing their terms), the staff believes the company should conclude that the measurement date for all of its awards (including those awards that were not changed) would be delayed until the completion of all required granting actions." Such conduct suggests variable accounting is appropriate for all awards by the company. However, if the facts, circumstances and pattern of conduct "make clear that the company considered the terms and recipients of the awards to be fixed and unchangeable at the earlier date," it may be possible to conclude that the measurement date occurred prior to completion of all actions necessary to effect the grant, and, therefore, fixed accounting may be appropriate.
5. Is it acceptable to reach different conclusions for different employee groups or award categories?
Yes, if the evidence so indicates.
6. We granted some options that turned out to be outside the terms of our option plan and may even be invalid. How does OCA treat options that may technically be invalid?
Where companies have made grants that turn out to be invalid, two significant issues arise. First, all required actions to effect the grant may not have been taken (e.g., shareholder approval may be required because the grant is below market and not permitted by the terms of the plan). Second, there may be uncertainty regarding the ability of the company to settle the award in stock and, as a result, the award may need to be accounted for as a cash-settled stock appreciation right (SAR). Such an award is subject to variable accounting until it is exercised, forfeited or expires unexercised.
In the circumstance where the company and the employee have continued to treat the grants as if made and valid, and the company has historically settled the awards in stock, intends to continue to do so, and has a "reasonable basis" for doing so (even if settlement in stock is not entirely within the company’s control), OCA believes that the mutually understood "substantive arrangement" represents the "underlying economic substance" of the option grants. Assuming that all other conditions have been satisfied, OCA believes it would be appropriate to account for the awards as fixed options with a measurement date on the date that the terms and recipients were determined with finality. If these conditions are not satisfied, however, additional analysis would be required. Moreover, there may be even greater uncertainty as to a company’s ability to honor options for grants that were made to senior officers (particularly officers who were involved in the option granting process).
7. Our compensation committee authorized the grant of an aggregate number of shares subject to awards to be allocated by our management in its discretion, with the remainder reserved for future grant. How does OCA view those grants?
Under APB 25, the measurement date for an individual’s grant cannot occur until the number of shares the individual employee is entitled to receive is known. If management’s role was limited to allocating a pool in accordance with definitive instructions (e.g., the number of shares is based on categories or levels within the organization), the measurement date might appropriately be the date the overall award was approved. On the other hand, if management had discretion to determine the number of shares to be awarded to each individual, the measurement date would not occur until management had finalized the terms of the awards.
8. We had to make some changes to our list of employee option grants after our compensation committee approved the grants at its last meeting. What accounting treatment would OCA apply in that circumstance?
Depending upon the facts and circumstances, there are two possible outcomes. Either (1) the list that was prepared on the award approval date did not constitute a grant of options, in which case the measurement date for all awards on the list would be delayed until a final list has been determined; or (2) the original list constituted a grant of options, in which case subsequent changes to the list must be evaluated to determine whether a modification (such as a repricing) or cancellation has occurred. When a company determines that a repricing has occurred, variable accounting is required for the life of the option.
9. To protect our employees against immediate stock price declines, our committee made grants which provided by their terms that the exercise price be set at the lowest market price of our stock in the 30-day period following the approval of the award, a practice that was common in our community. Our accountants are telling us that we need to apply variable accounting treatment for the life of the awards. Are they right?
Not necessarily. Under APB 25, if the original terms of a stock option provide for a reduction in the award’s exercise price if a specified future event or condition occurs, variable accounting would be required until that uncertainty is resolved. Here, the terms of the awards suggest that the measurement date would be delayed until the end of the 30-day contingency period. Accordingly, the compensation cost would be the excess of the fair market value of the underlying stock at the end of the 30-day contingency period over the exercise price of the option. Thereafter, the option would be subject to fixed accounting.
However, if the original terms of the award do not suggest such a limited contingency period and the exercise price is reduced after the award date, OCA would view it as a repricing, which would require variable accounting treatment from the date of modification for the life of the option.
10. In our offer letters to new employees, we include the terms of their compensation, including option grants and exercise prices. Typically, we determine the exercise prices on the dates of the offer letters. What accounting treatment would OCA require?
Where the terms and conditions of awards to new employees are determined prior to the commencement of employment, the accounting treatment will depend upon whether or not the individual performs services in the capacity of a non-employee prior to commencing employment. APB 25 applies only to employees. If no services are provided prior to an individual’s start date, the measurement date will generally coincide with the start date, and compensation cost would be measured based on the excess of the fair market value of the underlying stock at the start date over the exercise price of the option.
11. Would the answer to question 10 change if the prospective employee provided consulting services before his or her actual start date?
Yes. APB 25 generally only applies to stock compensation granted to employees. Options granted to consultants must be accounted for under the "fair value" provisions of Financial Accounting Standards Board (FASB) Statement No. 123, "Accounting for Stock-Based Compensation" (FAS 123) and Emerging Issues Task Force (EITF) Issue No. 96-18, "Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services." Accordingly, the compensation cost for grants to consultants is based upon the Black-Scholes or binomial value of the option as remeasured on the vesting date of each installment. Such cost includes the appreciation in the fair value of the option from the date of grant until the vesting date of each installment.
Here, if the prospective employee commences providing services as a consultant, compensation cost must be determined under FAS 123 based on the "fair value" of the option on the date of grant, with such cost measured on the vesting date of each installment during the consulting period.
12. Does the accounting treatment described in response to question 11 change once the individual becomes an employee?
Yes. Once the prospective employee changes status from a consultant to an employee, the compensation cost must be remeasured on the date of the status change under APB 25 pursuant to FASB Interpretation No. 44, "Accounting for Certain Transactions Involving Stock Compensation" (FIN 44). Accordingly, the compensation cost will be based on the intrinsic value of the option on the date the individual commences employment. However, only that portion of the newly measured cost attributable to the remaining vesting period would be recognized as compensation cost prospectively from the date of the commencement of employment.
13. We moved our offices recently and now we are unable to locate some of our records regarding option grants. In addition, most of our option grants were made using unanimous written consents that stated the date "as of" which they were supposed to be effective, but were not actually signed until, in some cases, weeks after the "as of" date. What will that mean from an accounting perspective?
Considering the prevalence of grants affected by documentation gaps or inconsistencies, the OCA’s response is, unfortunately, far from definitive. OCA believes that the accounting treatment in these cases will depend upon the particular facts and circumstances. On one hand, OCA believes that the unavailability of complete documentation several years after the activities occurred should not necessarily result in a default to unfavorable variable accounting or in treating the awards as if they had never been granted. On the other hand, evidence suggesting that options had exercise prices equal to or near the lowest price of the underlying stock when combined with documentation gaps during such periods may suggest fraudulent conduct. These facts and circumstances may result in the application of variable accounting or may suggest that awards do not substantively exist unless and until affirmed by the board. Companies are encouraged to discuss unique facts and circumstances with OCA staff.
14. Our committee has a practice of granting awards during open window periods, immediately after release of quarterly earnings, which may, in some cases, be negative. In addition, on one occasion, the committee granted options the night we learned that the FDA had approved our product candidate, but before a public announcement had been made. Now, we hear that these practices have names like "bullet-dodging" and "spring-loading" and that they present accounting issues. Is there any validity to that?
Not according to OCA. Consistent with prior indications of guidance, OCA believes that selection of award dates in coordination with the disclosure of information to the public is not an accounting issue. Pursuant to APB 25, OCA believes that compensation cost must be computed on the measurement date by reference to the actual market price of the stock freely trading on an established market. The market price does not need to be adjusted to reflect the committee’s knowledge of material non-public information. There may, however, be legal or other issues involved.
15. We released material unfavorable information to the public which caused our stock price to decline. What if we reduced the exercise price of our options after our stock price declined?
Under APB 25, reducing the exercise price of an option following the release of new information to the public constitutes a repricing of the option, thereby resulting in variable accounting of the option from the date of modification through the life of the option.
16. One of our employees asked if we would change the date of his exercise to a date when the market price was lower so that he could lower his tax liability. What issues are presented?
Where companies document option exercises as of a date other than the actual date of exercise, resulting in a reduction in income taxes payable by the employee, there will be a corresponding reduction in the income tax benefit received by the company. In that event, the company should record the excess tax benefit it otherwise would have been entitled to receive as an addition to paid-in capital (per APB 25). The amount of lost tax benefit, as well as any other tax obligations of the employee paid by the company, should be recorded as additional compensation cost.
Note that one of the first cases in this area, brought by the SEC’s Division of Enforcement against Symbol Technologies in 2004, arose out of problems with exercise practices, not grant practices. The SEC charged Symbol and its general counsel with fraud and other violations in connection the practice of using a more advantageous exercise date chosen from a 30-day "look-back" period so as to reduce the tax liability of the exercise to the executives, including the general counsel. The SEC alleged that, to create the false appearance that these exercises actually occurred on the selected dates, the general counsel had the transactional documents backdated and used these incorrect exercise dates in the executives’ reports to the SEC. The use of the fraudulent "look-back" practice was also alleged to have caused Symbol to misstate its stock option expenses by material amounts in its financial statements. The Department of Justice also filed charges in that case.
17. Is the determination of the grant date for income tax purposes the same as the determination of the measurement date for accounting purposes under APB 25?
No.
Final Words
OCA believes that companies that determine that their prior accounting contains material errors (based on both quantitative and qualitative factors, such as intentional errors), will need to restate their financial statements. Disclosure should include the circumstances that gave rise to the errors. As a general matter, restatements will require amendment of previously filed reports. However, it has been reported that the SEC’s Division of Corporation Finance may issue guidance "fairly soon" that would indicate when companies that have improperly accounted for stock options may make the required disclosures and restatements on an amended, or future, Form 10-K and avoid the need to revise all prior filings that contained the inaccurate accounting information. Unless and until further guidance is available, companies that believe that they should not be required to amend all of their affected filings are advised to contact the Division of Corporation Finance. No amendment of previously filed reports is necessary to correct prior financial statements for immaterial errors, which may be corrected, if necessary, the next time the prior financial statements are filed.
If you have any questions about the subject matter of this Alert, please contact a member of your Cooley team or one of the individuals identified at the beginning of this Alert. However, you should note that we are not accountants, but, in the interest of passing along important information to our clients, we have attempted to summarize the substance of the OCA letter. Questions of a technical, accounting nature should be presented to your accounting professional.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
