News

SEC Staff Accounting Bulletin 107

News Brief
March 31, 2005

By: Cydney Posner

The SEC has just issued SAB 107, "Share-Based Payment," which expresses the views of the SEC staff regarding the application of SFAS 123R. SFAS 123R is based on the underlying accounting principle that compensation cost resulting from share-based payment transactions, such as employee options, should be recognized in financial statements at fair value. SFAS 123R requires compensation costs to be recognized in the financial statements as services are provided by employees and does not permit those costs to be recognized as deferred compensation on the balance sheet before services are provided. SAB 107 provides interpretive guidance related to the interaction between SFAS 123R and SEC rules, and the staff’s views regarding the valuation of share-based payment arrangements for public companies. The SAB also emphasizes the need for full disclosure, especially during the transition.

In particular, the SAB provides guidance related to the following (not all of which are discussed below):

  • share-based payment transactions with nonemployees,
  • the transition from nonpublic to public entity status,
  • valuation methods (including assumptions such as expected volatility and expected term),
  • the accounting for certain redeemable financial instruments issued under share-based payment arrangements,
  • the classification of compensation expense,
  • non-GAAP financial measures,
  • first-time adoption of SFAS 123R in an interim period,
  • capitalization of compensation cost related to share-based payment arrangements,
  • the accounting for income tax effects of share-based payment arrangements upon adoption of SFAS 123R,
  • the modification of employee options prior to adoption of SFAS 123R and
  • disclosures in MD&A subsequent to adoption of SFAS 123R.
The SAB states that the staff recognizes that there is a range of conduct that a reasonable issuer might select to make estimates and valuations and that the selection of different conduct, conclusions or methodologies by different issuers in a given situation does not of itself

raise an inference that any of those issuers is acting unreasonably. However, the "zone of reasonable conduct is not unlimited," and the staff expects that best practices will emerge over time.

Share-Based Payment Transactions with Nonemployees

Some aspects of nonemployee arrangements are addressed by 123R itself or by other authoritative literature (such as EITF 96-18, which specifies the appropriate measurement date). With respect to questions regarding nonemployee arrangements that are not specifically addressed in other authoritative literature, the staff believes that it would generally be appropriate for entities to apply the guidance in 123R to nonemployee transactions unless other authoritative accounting literature more clearly addresses the appropriate accounting or the application of the guidance in 123R would be inconsistent with the terms of the instrument.

Transition from Nonpublic to Public Entity Status

Prior to becoming public companies, companies are permitted to assign value to options under the calculated value method (but they must be able to provide support for that method). The staff believes that companies should continue to follow that approach for options that were granted prior to the companies' going public (i.e., deemed to occur upon filing with the SEC of their initial registration statement), unless those options are subsequently modified, repurchased or cancelled. In that event, companies should use 123R as applied to public companies.

Nonpublic companies are permitted to value liability awards (such as SARs payable in cash) at intrinsic value, but as public entities, should measure liability awards at their fair value. In the reporting period when the company makes its initial IPO filing, there will be an incremental amount of measured cost for the difference between fair value and intrinsic value.

After becoming a public entity, a company may not retrospectively apply the fair-value-based method to its awards that were granted prior to becoming a public entity because that would require hindsight judgments.

In its initial IPO filing, a company should clearly describe in MD&A the change in accounting policy occasioned by 123R in subsequent periods and the reasonably likely material future effects. In subsequent filings, companies should provide financial statement disclosure of the effects of the changes in accounting policy and should consider the applicability of SEC releases relating to critical accounting policies and estimates in MD&A.

Valuation Methods

Under SFAS 123R, employee equity instruments are to be valued by estimating at the grant date the fair value of the instruments that will be issued when employees have rendered the requisite service and satisfied any other conditions. If available, observable market prices of similar instruments should be used as the basis for the estimate or, if not available, a valuation technique or model should be used that complies with the measurement objective of 123R. In effect, the estimate of fair value represents the measurement of the cost of the employee services to the company.

If a company makes a good faith estimate in accordance with 123R, then, if that estimate turns out not to correspond with the value ultimately realized by the employee, the staff will not view the estimate as materially misleading.

SFAS 123R did not specify a particular valuation technique or model, and the staff follows suit. Rather, the staff reiterates that a company should select a valuation technique or model that

  • is applied in a manner consistent with the fair value measurement objective and other requirements of 123R,
  • is based on established principles of financial economic theory and generally applied in that field and
  • reflects all substantive characteristics of the instrument.
The staff states that it would not object to a company’s choice of a technique or model as long as it meets the fair value measurement objective. For example, a company is not required to use a lattice model "simply because that model was the most complex of the models the company considered."

A company can change its valuation model as long as the new model meets the fair value measurement objective in 123R. Changing a technique or model from period to period for the sole purpose of lowering the fair value estimate of an option would not meet the fair value measurement objective. A change used to meet the fair value measurement objective would not be considered a change in accounting principle, but should be disclosed in the footnotes. The staff might get curious about frequently switches in valuation models, particularly in circumstances where there was no significant variation in the form of share-based payments being valued.

Companies do not need to hire an outside consultant to perform the valuation, but it should be performed by someone with the "requisite expertise."

Certain Assumptions Used in Valuation Methods

To satisfy 123R, management will be required to develop estimates regarding the expected volatility of the company’s share price and the exercise behavior of the employees. Changes in these assumptions during the periods presented in the financial statements should be disclosed in the footnotes.

Expected Volatility

SFAS 123R provides that "option-pricing models require an estimate of expected volatility as an assumption because an option’s value is dependent on potential share returns over the option’s term….Because an option’s value is unaffected by expected negative returns on the shares, other things [being] equal, an option on a share with higher volatility is worth more than an option on a share with lower volatility."

There are at least three types of volatility:

  • Historical volatility, which measures the amount by which share price has fluctuated
  • Expected volatility, which measures the amount by which share price is expected to fluctuate
  • Implied volatility, the assumption inherent in the market prices of a company’s traded options, is derived by entering the market price of the instrument, along with assumptions specific to the options being valued, into a model based on a constant volatility estimate (such as Black-Scholes-Merton) and solving for the unknown assumption of volatility. (got it?)
The staff believes that a company with actively traded options generally could place greater (or even exclusive) reliance on implied volatility. The process used to gather and review available information to estimate expected volatility should be applied consistently from period to period, although new or different information should be taken into account when available.

The staff believes that a company could utilize a period of historical data longer than the expected or contractual term, as applicable (expected or contractual term depends on the model used), if it reasonably believes the additional historical information will improve the estimate. A company should use appropriate and regular intervals for price observations, selecting a consistent point in time within each interval. The staff believes using daily, weekly or monthly price observations may provide a sufficient basis to estimate expected volatility if the history provides enough data points on which to base the estimate. The staff believes that, in making the estimate, a company should consider those future events that a marketplace participant would also consider in making the estimation. In some instances, due to a company’s particular business situation, a period of

historical volatility data may not be relevant in evaluating expected volatility. In these instances, that period should be disregarded, but the company should be prepared to support that conclusion.

A company may rely exclusively on implied volatility, using a consistent methodology, if:

  • The company utilizes a valuation model that is based upon a constant volatility assumption to value its employee options;
  • The implied volatility is derived from options that are actively traded;
  • The market prices (trades or quotes) of both the traded options and underlying shares are measured at a similar point in time to each other and on a date reasonably close to the grant date of the employee options;
  • The traded options have exercise prices that are both (a) near-the-money and (b) close to the exercise price of the employee options; and
  • The remaining maturities of the traded options on which the estimate is based are at least one year.
A company may rely exclusively on historical volatility, using a consistent methodology, if:

  • The company has no reason to believe that its future volatility over the expected or contractual term, as applicable, is likely to differ from its past;
  • The computation of historical volatility uses a simple average calculation method;
  • A sequential period of historical data at least equal to the expected or contractual term of the option, as applicable, is used; and
  • A reasonably sufficient number of price observations are used, measured at a consistent point throughout the applicable historical period.
With respect to disclosure, a company should, at a minimum, disclose in a footnote to its financial statements how it determined the expected volatility assumption, i.e., whether it used only implied volatility, historical volatility or a combination of both. The company should also consider the implications of its analysis under critical accounting policies and estimates in MD&A, such as an explanation of the method used to estimate the expected volatility of its share price and the basis for the company's determination to use historical volatility, implied volatility or a combination of both, including a summary of its evaluation of the factors listed above.

Newly public companies may base their estimates of expected volatility on the historical, expected or implied volatility of similar entities whose share or option prices are publicly available, taking into account the industry, stage of life cycle, size and financial leverage of the other entities. A newly public company may look to an industry sector index, such as the Nasdaq Computer Index, that is representative of its industry, and possibly its size, to identify one or more similar entities the volatility of which it could substitute as an assumption in its valuation model. (The company should not use an entire index as a substitute.) The company should use those entities consistently unless circumstances change or until the company has either a sufficient amount of historical information regarding the volatility of its share price or other traded financial instruments are available to derive an implied volatility to support an estimate of expected volatility.

Expected Term

When valuing an employee option under the Black-Scholes-Merton framework, companies should use the option's expected term rather than the contractual term, based upon the facts and circumstances available in each particular case. No discount should be provided for non-hedgeability and nontransferability: these aspects instead have the effect of increasing the likelihood that an employee option will be exercised before the end of its term. Forfeitures or terms that stem from possibility of forfeiture should not be factored into the determination of expected term because these prevesting restrictions or other terms are taken into account by ultimately recognizing compensation cost only for awards for which employees render the requisite service. A company’s estimate of the expected term should never be shorter than the vesting period.

Companies should aggregate individual awards into relatively homogenous groups with respect to exercise and post-vesting employment termination behaviors (for e.g., executives and non-executives) for the purpose of determining expected term, regardless of the valuation technique or model used to estimate the fair value. An entity may generally make a reasonable fair value estimate with as few as one or two groupings.

A company's approach should be reasonable and supportable and may or may not be based on historical experience, depending upon the life of the company and its relative stage of development, past or expected structural changes in the business, differences in terms of past option grants or a lack of variety of price paths that the company may have experienced. For example, if a company had historically granted options that were always "in the money" and will grant at-the-money options prospectively, the exercise behavior related to the in-the-money options may not be sufficient as the sole basis to form the estimate of expected term for the at-the-money grants. Similarly, if a company had a history of previous option grants and exercises only in periods in which the company’s share price was rising, the exercise behavior related to those options may not be sufficient as the sole basis to form the estimate of expected term for current option grants. Alternatives to historical experience include the lattice model, industry averages and other pertinent evidence, such as published academic research.

For plain vanilla options (granted at-the-money, service time-vesting as condition to exercise, forfeiture of non-vested options upon termination, limited time to exercise vested options post-termination, nontransferable, non-hedgeable), the staff states that it will accept, on a temporary basis, the following "simplified" method: expected term = ((vesting term +original contractual term) / 2). Assuming a ten-year original contractual term and graded vesting over four years (25% of the options in each grant vest annually), the resultant expected term would be 6.25 years. (For non-math geniuses, this is actually calculated as follows: [[[1 year vesting term (for the first 25% vested) plus 2 year vesting term (for the second 25% vested) plus 3 year vesting term (for the third 25% vested) plus 4 year vesting term (for the last 25% vested)] divided by 4 total years of vesting] plus 10 year contractual life] divided by 2; that is, (((1+2+3+4)/4) + 10) /2 = 6.25 years.) If a company elects to use this method, it should be applied consistently to all "plain vanilla" employee options, and the company should disclose the use of the method in the notes to its financial statements. The staff does not expect that this simplified method would be used after December 31, 2007.

Classification of Compensation Expense Associated with Share-Based Payment Arrangements

The staff express the view that expense related to options and other share-based payment arrangements should be presented in the same line or lines as cash compensation paid to the same employees. If a company desired to indicate that some of this expense was not really cash, it could consider disclosing the amount of expense related to options in a parenthetical note to the appropriate income statement line items, on the cash flow statement, in the footnotes to the financial statements or in MD&A.

Non-GAAP Financial Measures

"Net income before option charges" or an equivalent measure is a non-GAAP financial measure and may even be a prohibited Reg S-K, Item 10(e) NGFM under certain circumstances. It is not appropriate to eliminate an item to smooth earnings that is identified as recurring. However, the staff believes that if this type of measure is used by management internally to evaluate performance, it may be relevant disclosure for investors. Companies would have the burden of demonstrating usefulness and would be required to disclose, among other things, the following:

  • The reasons that the company's management believes that presentation of the NGFM provides useful information to investors regarding the company's financial condition and results of operations; and
  • To the extent material, the additional purposes, if any, for which the company’s management uses the NGFM that are not otherwise disclosed.
In addition, as indicated in earlier releases, inclusion of a NGFM may be misleading without the following disclosures:

  • The manner in which management uses the NGFM to conduct or evaluate its business;
  • The economic substance behind management's decision to use such a measure;
  • The material limitations associated with use of the NGFM as compared to the use of the most directly comparable GAAP financial measure;
  • The manner in which management compensates for these limitations when using the NGFM; and
  • The substantive reasons why management believes the NGFM provides useful information to investors.
Because expenses from options might vary in different ways and for different reasons than other expenses, the staff believes it would be a good idea to identify in MD&A the amount of expenses associated with these share-based payment transactions and to discuss the reasons why such amounts have fluctuated from period to period. For a variety of reasons, however, the staff would object to inclusion in SEC filings of a pro-forma income statement removing from net income the effects of the accounting for share-based payment arrangements.

First Time Adoption of SFAS 123R in an Interim Period

Companies applying the "modified retrospective method" in other than the first interim period of a fiscal year (which will be the timing for most calendar-year companies since the new standard is effective for periods after June 30), should disclose in the Form 10-Q for the period of adoption the effects of the adoption of 123R on previously reported interim periods. Companies applying the modified prospective method will not reflect any restated amounts and should disclose this fact.

Modification of Employee Share Options Prior to Adoption of SFAS 123R

If a company accelerates vesting ofoptions prior to adoption of SFAS 123R, compensation expense is not required to be recognized in the period of the modification under the provisions of APB 25. Companies may reflect the compensation cost related to the modification in their fair value pro forma disclosures in the period the modification is made. The staff believes that an acceptable interpretation of SFAS 123 is that the modification to accelerate the vesting of the options would result in the recognition of the remaining amount of compensation cost in the period the modification is made, so long as the acceleration of vesting permits employees to exercise when they would not otherwise have been able to do so absent the modification. That is, after the modification, the options will be vested pursuant to the awards’ terms; therefore, there is no remaining service period and any remaining unrecognized service cost for those options should be recognized at the date of the modification; no compensation cost would be recognized for these modified options in the periods after adoption of 123R, absent any further modifications. Companies should disclose any modifications to accelerate the vesting of out-of-the-money options in anticipation of adoption, including the reasons for the modifications.

Application of the Measurement Provisions to Foreign Private Issuers

The staff believes that 123R’s measurement guidance would not generally result in a reconciling item required to be reported by a foreign private issuer that has complied with the provisions of IFRS 2 for share-based payment transactions with employees, although there are some differences that may require reconciliation.

Disclosures in MD&A Subsequent to Adoption

The staff believes that companies should consider including in MD&A material qualitative and quantitative information about any of the following, as well as other information that could affect comparability of financial statements from period to period:

  • Transition method selected (e.g., modified prospective application or modified retrospective application) and the resulting financial statement impact in current and future reporting periods;
  • Method utilized by the company to account for share-based payment arrangements in periods prior to the adoption of SFAS 123R and the impact, or lack thereof, on the prior period financial statements;
  • Modifications made to outstanding options prior to the adoption of SFAS 123R and the reason(s) for the modification;
  • Differences in valuation methodologies or assumptions compared to those that were used in estimating the fair value of options under SFAS 123;
  • Changes in the quantity or type of instruments used in share-based payment programs, such as a shift from options to restricted stock;
  • Changes in the terms of share-based payment arrangements, such as the addition of performance conditions;
  • A discussion of the one-time effect, if any, of the adoption of 123R, such as any cumulative adjustments recorded in the financial statements; and
  • Total compensation cost related to unvested awards not yet recognized and the weighted average period over which it is expected to be recognized.
Receivables From Sale Of Stock

Receivables from the sale of capital to officers or employees should be presented in the balance sheet as a deduction from stockholders' equity and not as assets. All amounts receivable from officers and directors resulting from sales of stock or from other transactions (other than

expense advances or sales on normal trade terms) should be separately stated in the balance sheet irrespective of whether such amounts may be shown as assets or are required to be reported as deductions from stockholders' equity. However, a receivable from an officer or director need not be deducted from stockholders' equity if the receivable was paid in cash prior to the publication of the financial statements and the payment date is stated in a note to the financial statements. (However, the staff would consider the subsequent return

of such cash payment to the officer or director to be part of a scheme or plan to evade the registration or reporting requirements of the securities laws.)

Accounting for Expenses or Liabilities Paid by Principal Stockholders

Where a principal stockholder pays an expense for the company through the transfer of the stockholder's shares, unless the stockholder's action is caused by a relationship or obligation completely unrelated to his position as a stockholder or the action clearly does not benefit the company, the value of the shares transferred should be reflected as an expense in the company's financial statements with a corresponding credit to contributed (paid-in) capital.

This content is provided for general informational purposes only, and your access or use of the content does not create an attorney-client relationship between you or your organization and Cooley LLP, Cooley (UK) LLP, or any other affiliated practice or entity (collectively referred to as “Cooley”). By accessing this content, you agree that the information provided does not constitute legal or other professional advice. This content is not a substitute for obtaining legal advice from a qualified attorney licensed in your jurisdiction and you should not act or refrain from acting based on this content. This content may be changed without notice. It is not guaranteed to be complete, correct or up to date, and it may not reflect the most current legal developments. Prior results do not guarantee a similar outcome. Do not send any confidential information to Cooley, as we do not have any duty to keep any information you provide to us confidential. This content may be considered Attorney Advertising and is subject to our legal notices.