SEC's OCA actually provides some guidance on accounting treatment re option dating issues
By Cydney Posner
The SEC's Office of the Chief Accountant today issued a letter providing guidance regarding accounting for stock options in historical financial statements of public companies. This letter discusses the accounting consequences under APB 25 (the accounting rule applicable prior to the adoption of FAS 123R) of various option dating practices, uncertainty as to the validity of prior grants and other related issues. See press release and letter. Although much of the analysis falls back on "fact and circumstances, "the letter still contains a fair amount of very helpful guidance.
Under APB 25, the measurement date is defined as "the first date on which are known both (1) the number of shares that an individual employee is entitled to receive and (2) the option or purchase price, if any." Compensation cost, if any, is measured as the difference between the exercise price and the market price of the underlying stock at the measurement date. The letter provides answers to questions about whether a company’s determination of the measurement date of past stock option awards was appropriate from a financial statement perspective..
The bottom line is that, although OCA believes that many of the issues raised would result in compensation charges and other effects, there is some latitude: "there may also be situations where an at-the-money grant was actually decided with finality, but there were unimportant delays in the completion of administrative procedures to document the grant that did not involve misrepresentation of the option granting actions. In those situations, if compensation cost would not have otherwise been recorded pursuant to Opinion 25, short delays in completing the administrative procedures to finalize the grant would not result in an accounting consequence."
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. Generally, restatements will require amendment of previously filed reports. Companies that believe that amending all of the affected filings is unnecessary should contact Corp Fin. 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.
Although the views in the letter relate to APB 25, they may also be useful in determining the grant date and measurement date under FAS 123 (but, notably, may not be applicable to FAS 123R because of differences in standards). OCA expects that, even if a complete reconsideration of inputs such as volatility and expected term may not be possible under FAS 123, companies should make appropriate adjustments to the input related to the market price of the underlying stock used to determine fair value. If there are material errors in the amount of pro forma compensation cost previously disclosed, the company should correct the footnote disclosures provided for prior periods.
Dating an Option Award to Predate the Actual Award Date.True "backdating" does not change the real measurement date, which is the date the terms of the award and its recipient are actually determined.
Option Grants with Administrative Delays.Where companies use a measurement date that is not the same as the date on which all actions required to effect the granting have been completed (e.g., oral authorization from the board or compensation committee documented at a later date or awards by a member or committee of management under delegated authority within specific parameters previously communicated by the board or committee and appropriate approvals obtained at a later date), the OCA is concerned that there is a delay in completing all required granting actions may mean that the option terms were not final until the completion of those actions. Companies have been taking the position that the difference is only an administrative delay, all option terms and recipients were final and known and the terms of the award do not remain under consideration or subject to change. OCA believes that this position must be considered "carefully" because it may be inconsistent with the "principle that the terms of a stock option cannot be considered known and no longer subject to change until the persons empowered to make grants have determined, with finality, the terms and recipients of those awards." OCA believes that 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." (emphasis in original) 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 granting actions. It is important that all information be considered (such as any other 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). A company may reach different conclusions for different employee groups or award categories.
Validity of Prior Grants. Where companies have made grants that turn out to be invalid (e.g., grants outside the terms of the plan), but the company and employee continue to treat the grant as if made and valid, some companies are taking the position that the option is a fixed option with a measurement date on the date that the terms and recipient of the award were determined. However, issues exist as to whether all required granting actions have been taken (i.e., shareholder approval may be required because the grant is not within the terms of the plan) and whether uncertainty has been created as to the ability of the company to settle the award in stock (i.e., the award my need to be accounted for as a cash-settled SAR). In these instances, where
- the company has historically honored the awards and settled in stock, and
- the company intends to continue to honor outstanding awards and settle them in stock and has a "reasonable basis to conclude that the most likely outcome" is that the awards will be honored and settled in stock (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, and, assuming 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. A legal opinion would help, but is not necessary. If these conditions are not satisfied, additional analysis would be required; 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).
Uncertainty as to Individual Award Recipients. In these instances, the committee may have authorized an aggregate number of shares to be granted, and either management allocates the awards after the approval date or the unallocated options are reserved for future grant. However, under APB 25, no measurement date can occur until "the number of shares that an individual employee is entitled to receive" is known. If management’s role was limited to allocating in accordance with definitive instructions (e.g., the number of shares is based on categories or levels within the organization), the measurement date could appropriately be the date the award was approved. That would not be the case if management had discretion to determine the numbers. As another example, if the list of employee grants is changed after the award approval date, depending upon the facts and circumstances, OCA believes companies should conclude that "either (a) the list that was prepared on the award approval date did not constitute a grant, in which case the measurement date for the entire award would be delayed until a final list has been determined or (b) the list that was prepared on the award approval date constituted a grant, in which case any subsequent changes to the list would be evaluated to determine whether a modification (such as a repricing) or cancellation has occurred. When a company determines that a repricing occurred, variable accounting should be applied to the option from the date of modification to the date the award is exercised, is forfeited, or expires unexercised."
Exercise Price Set by Reference to a Future Market Price. To protect employees against immediate stock price declines, some companies have made grants that, at the award approval date, include a formula for establishing the exercise price, such as the lowest market price of the company’s stock over a 30-day period beginning with the award approval date. Under APB 25, if the original terms of a stock option award provide for a reduction to the award’s exercise price if a specified future event or condition occurs, variable accounting would be required until that uncertainty is resolved. The amount of compensation cost would be the difference between the market price of the underlying stock at the end of the 30-day contingency period and the lowest market price of the stock during the contingency period, which would be the exercise price of the option. However, if the exercise price is reduced after the award date, but the adjustment is not provided for by the original terms of the award, OCA would view it as a repricing requiring variable accounting treatment from the date of modification.
Grants Prior to the Commencement of Employment. Where the terms and conditions of awards to new employees are determined prior to the commencement of employment (e.g., exercise price as of the date of the offer letter), the accounting treatment will depend upon whether the individual performs services in the capacity of a non-employee prior to commencing employment. If the individuals rendered services prior to the commencement of employment, the provisions of FAS 123 and 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" would be applied (generally, measurement date is earlier of date at which a commitment for performance by the individual to earn the equity instruments is reached (as defined) or the date at which the individual's performance is complete). Once the individual becomes an employee, the accounting for the change in grantee status should be evaluated pursuant to FIN 44. (Generally, FIN 44 provides that, if no modification is made to the terms of the award as a result of a change in status, compensation cost would be measured under the appropriate method of accounting (that is, either the intrinsic value method under APB 25 for employees or the fair value method under FAS 123 for nonemployees) as if the outstanding award were newly granted at the date of the change in status. 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 change in status.) If no services are provided prior to commencing employment, generally, the measurement date does not occur until the date that the individual begins employment. APB 25 applies only to employees; as a result, compensation cost would be measured based on the difference between the exercise price of the option and the market price of the underlying stock at the commencement of employment.
Documentation of Option Granting Activities is Incomplete or Cannot be Located. Where companies are unable to locate definitive and complete documentation of past option granting activities (e.g., grant documents do not exist in the company's records, contemporaneous documentation of the date of board or committee meetings was not prepared, written documentation includes only "as of" dates, and not the dates the documentation was actually prepared and approved or the company believes that its documentation may not be accurate) the accounting treatment depends upon (surprise!) the particular facts and circumstances. The lack of documentation or existence of contradictory documentation may mean that the terms of options cannot reasonably be considered fixed, resulting in the application of variable accounting, or that awards do not substantively exist unless and until affirmed by the board. However, OCA does not believe that "the lack of complete documentation being available several years after the activities occurred should necessarily result in a 'default' to variable accounting or to treating the awards as if they had never been granted. Rather, a company must use all available relevant information to form a reasonable conclusion as to the most likely option granting actions that occurred and the dates on which such actions occurred in determining what to account for." If there is a pattern of past option grants using the lowest exercise prices within the period, it may suggest that the grants were backdated or the terms of those grants were otherwise "determined with hindsight." The absence of documentation may also be an indication of fraud. Companies are encouraged to discuss unique facts and circumstances with the staff.
Timing of Option Grants (i.e., springloading and bullet-dodging). 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, the staff believes that compensation cost must be computed on the measurement date by reference to the unadjusted market price of a share of stock of the same class that trades freely in an established market.
Changes to Option Grants Due to the Release of New Information. Lowering the exercise price following the release of new information to the public would be a repricing of the award, resulting in variable accounting treatment from the date of modification.
Income Tax Benefits Related to Options (Including Problems with Exercises). 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 and a corresponding reduction in the income tax benefit received by the company, 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 compensation cost. (Note that one of Enforcement's first cases in this area, against Symbol Technologies, arose out of problems with exercise practices, not grant practices. The SEC charged Symbol and its GC 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 GC. The SEC alleged that, to create the false appearance that these exercises actually occurred on the selected dates, the GC had the transactional documents backdated and used phony exercise dates in the executives' reports to the SEC. The DOJ also filed charges.)
Option dating problems may result in questions regarding the propriety of income tax deductions related to options. Companies are advised to consider FIN 48, "Accounting for Uncertainty in Income Taxes" and, prior to its adoption, FAS 5, "Accounting for Contingencies" and FAS 109, "Accounting for Income Taxes" with respect to these tax contingencies. The determination of the grant date for income tax purposes may differ from the determination of the measurement date pursuant to APB 25.