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March 19, 2009 NDS 2009-12

New Developments Summary


Share-based payment
FASB Statement 123R

Summary
NDS 2008-7, “Share-based payment: FASB Statement 123R,” was issued in February 2008. This bulletin
updates and supersedes NDS 2008-7. New and revised materials in this bulletin include the following:

• Considerations in accounting for modifications of share-based payment awards. See section H.

• The accounting for the acceleration of deep-out-of-the-money options. See section H.

• SEC staff guidance on the effect of high stock price volatility resulting from the 2008-2009 economic
crisis on the expected volatility input in option-pricing models. See section F.

• Implications of using nonrecourse loans in share-based payment award transactions. See section F.

• The impact of FASB Statement 160 on awards based on subsidiary stock. See section B.

• SEC staff guidance on the estimate of the fair value of awards issued prior to an IPO. See section F.

• An explanation and illustration of the application of FASB Staff Position EITF 03-6-1, “Determining
Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities.”
See section K.

• A discussion of the applicability of EITF Issue 07-5, “Determining Whether an Instrument (or
Embedded Feature) Is Indexed to an Entity’s Own Stock,” to market-based instruments issued to
estimate the grant-date fair value of share-based payment awards. See section F.

• An update of the guidance on the SEC’s executive compensation disclosure rules in Item 402 of
Regulation S-K for the SEC staff’s Compliance and Disclosure Interpretations issued in July 2008 and
a summary of the staff’s comments on companies’ 2008 disclosures in an October 2008 staff speech.
New section K of appendix E describes the executive compensation restrictions of government
financial assistance under TARP. See appendix E.

The FASB issued Statement 123 (revised 2004) in December 2004. The SEC staff subsequently issued
implementing guidance in Staff Accounting Bulletin (SAB) 107 in March 2005 and in SAB 110 in
December 2007. The SEC and PCAOB staffs have provided guidance on entities’ processes, procedures,
controls, and documentation related to granting options, as well as other matters affecting share-based
payment awards. The FASB has issued FASB Staff Positions that amend the guidance in Statement
123R, and the FASB Statement 123R Resource Group reached consensuses on numerous
implementation issues. In December 2007 the FASB issued Statement 141 (revised 2007), Business
Combinations, which provides new guidance on the accounting by acquirers for share-based payment
New Developments Summary 2

awards issued as replacement awards in business combinations. The EITF has reached consensus
opinions on issues that affect the accounting for share-based payment awards and market-based
instruments issued in connection with such awards. This document integrates the implementation
guidance from those sources as of February 28, 2009.

In 2006, the SEC issued revised Item 402, “Executive Compensation,” of Regulation S-K, which
expanded disclosure requirements for executive compensation. In January, February, and August 2007,
and in July 2008, the SEC staff issued Questions and Answers (Q&As) and Interpretive Responses to
clarify certain provisions of Item 402. In October 2007 the SEC staff issued its observations on
approximately 500 registrants’ disclosures under the revised rules. John White, the then-Director of the
Division of Corporation Finance, summarized the staff’s comments on companies’ 2008 disclosures in an
October 2008 speech. Appendix E of this bulletin, “SEC executive compensation disclosure rules,”
summarizes revised Item 402 and the staff’s interpretive guidance through February 28, 2009.
New Developments Summary 3

Contents
A. Introduction ............................................................................................................................................. 5
B. What is the scope of Statement 123R? .................................................................................................. 8
Guidance applicable to awards to employees ........................................................................................ 8
Guidance applicable to awards to nonemployees ................................................................................ 10
C. When is an award considered a liability and how are equity awards presented? ................................ 13
Liability classification ............................................................................................................................ 13
Provisions that may not result in liability classification ......................................................................... 20
Equity awards based on subsidiary stock classified as noncontrolling interest ................................... 21
Awards requiring classification outside of permanent equity ............................................................... 22
Accounting for dividends paid to holders of liability awards ................................................................. 24
D. What is the fair-value-based measurement method?........................................................................... 25
Fair-value-based measurement method .............................................................................................. 25
Exceptions from the requirement to use the fair-value-based measurement method ......................... 27
E. When is fair value measured? .............................................................................................................. 31
Equity awards ....................................................................................................................................... 31
When does the grant date occur? ........................................................................................................ 31
F. How is fair value determined? .............................................................................................................. 37
Fair value hierarchy for share-based payment awards ........................................................................ 37
Option valuation .................................................................................................................................... 39
Observable market price ...................................................................................................................... 39
Requirements for a valuation technique for options ............................................................................. 41
Selecting assumptions for use in option-pricing models ...................................................................... 44
Nonrecourse loans ............................................................................................................................... 58
Other considerations ............................................................................................................................ 60
Calculated value: nonpublic entities unable to estimate volatility......................................................... 61
Intrinsic value: entities unable to reasonably estimate fair value ......................................................... 63
G. How is measured compensation cost recognized? .............................................................................. 64
Recognition principle ............................................................................................................................ 64
Requisite service period ....................................................................................................................... 64
Amount of cost to recognize ................................................................................................................. 71
H. How are modifications accounted for? ................................................................................................. 82
Equity awards ....................................................................................................................................... 82
Liability awards ..................................................................................................................................... 88
Inducements ......................................................................................................................................... 88
Business combinations ......................................................................................................................... 89
Business combinations accounted for under Statement 141R ............................................................ 91
Equity restructurings ............................................................................................................................. 93
Repurchases and cancellations ............................................................................................................ 94
I. How are instruments issued in exchange for employee service accounted for after vesting? ............ 98
J. How are income taxes affected? .......................................................................................................... 99
Recording deferred tax assets.............................................................................................................. 99
Differences between financial reporting costs and income tax deductions .......................................... 99
APIC pool ............................................................................................................................................ 101
Tax effects of awards that are vested or partially vested on adoption ............................................... 107
Tax effects of incentive stock options ................................................................................................. 107
Tax effects of dividends paid on equity awards .................................................................................. 108
Tax effects of nonqualified employee options issued in business combinations ............................... 109
Interim period effects .......................................................................................................................... 109
New Developments Summary 4

K. How are EPS, unvested shares in equity, and the cash flow statement affected? ............................ 111
Earnings per share ............................................................................................................................. 111
Presentation of unvested shares in equity ......................................................................................... 114
Statement of cash flows ..................................................................................................................... 114
L. What are the required disclosures? .................................................................................................... 117
Financial statement disclosures ......................................................................................................... 117
Management’s Discussion and Analysis ............................................................................................ 118
SEC executive compensation disclosure rules .................................................................................. 118
Non-GAAP financial measures ........................................................................................................... 119
M. What are the transition provisions? .................................................................................................... 120
Effective dates .................................................................................................................................... 120
Transition ............................................................................................................................................ 120
Appendix A ................................................................................................................................................ 121
Disclosure requirements ..................................................................................................................... 121
Appendix B ................................................................................................................................................ 126
Comparison of key provisions of Statement 123 and Statement 123R.............................................. 126
Appendix C ................................................................................................................................................ 133
Summary of conditions requiring liability classification....................................................................... 133
Appendix D ................................................................................................................................................ 140
Statement 123R provisions to keep in mind ....................................................................................... 140
Appendix E ................................................................................................................................................ 147
SEC executive compensation disclosure rules .................................................................................. 147
New Developments Summary 5

A. Introduction
FASB Statement 123 (revised 2004), Share-Based Payment, requires all entities to recognize the fair
value of share-based payment awards classified in equity, unless they are unable to reasonably estimate
the fair value of the awards for one of the following reasons:

• A nonpublic entity cannot reasonably estimate the expected volatility of its share price. In this
situation, the entity is required to determine the value of its stock options using the historical volatility
of an appropriate industry sector index (the result is known as calculated value, not fair value).

• A public or nonpublic entity cannot reasonably estimate the fair value of an award because of the
complexity of its terms. In this situation, the award is valued at its intrinsic value until settled (variable
accounting).

Other provisions of Statement 123R impact the accounting for share-based awards granted to employees
as follows:

• More awards are classified as liabilities than under the previous accounting requirements for share-
based payment awards.

• Public companies are required to account for awards classified as liabilities (such as cash-settled
share appreciation rights) at fair value, not at intrinsic value. Nonpublic companies must make a
policy decision to account for all liability awards granted to employees at either fair value or intrinsic
value. Regardless of the valuation method used, compensation cost for awards classified as liabilities
is remeasured each period until settlement and then adjusted to the amount paid to settle the liability.

• All entities are required to estimate the number of awards expected to vest and recognize
compensation cost based on that estimate.

• There is explicit (and sometimes complex) guidance in numerous areas, including

− The definition of grant date. The grant date is the date on which all of the following have occurred:
The employer and employee have reached a mutual understanding of the key terms and
conditions of the award within the timeframe described in FSP FAS 123R-2, “Practical
Accommodation to the Application of Grant Date as Defined in FASB Statement No. 123(R);” the
employer is obligated to issue the award; all approvals have been obtained; the recipient meets
the definition of an employee; and the employee begins to benefit from (be adversely affected by)
subsequent changes in the price of the employer’s shares.

− The valuation model used to estimate the fair value of share options. Statement 123R provides
guidance on option valuation methods and how an existing option-pricing model (a lattice model)
can be designed to better estimate the fair value of employee options. It requires entities to select
a valuation technique for options and use it consistently for similar option awards granted in the
future and to develop assumptions for the option valuation technique that are reasonable and
supportable and determined in a consistent manner from period to period. If there is a range of
reasonable estimates for a single model input, such as volatility, and no amount within the range
is more likely than the other amounts, the assumption used should be an average of the amounts
in the range (the expected value). To comply with the provisions of Statement 123R, entities
issuing employee options need processes for valuing their options, including documentation of
procedures to be used to estimate assumptions and establishment of controls to assure the
procedures are applied consistently.
New Developments Summary 6

− The determination of the expected share price volatility of options. The estimate of expected
volatility is required to be reasonable and supportable, and the estimation method should be
applied consistently from period to period.

− The determination of the expected term of options. An option or similar instrument’s expected
term should be determined based on, among other factors, the instrument’s contractual term and
the effects of employees’ expected exercise and post-vesting employment termination behavior.
An entity is required to aggregate individual awards into relatively homogeneous groups in terms
of exercise and post-vesting termination behavior. The estimate of the expected term is required
to be reasonable and supportable, and the estimation method should be applied consistently from
period to period.

− The period over which measured cost is recognized. Compensation cost for a share-based
payment award classified in equity is recognized over the award’s requisite service period—the
period over which an employee is required to provide service in exchange for the share-based
payment award. The service required to be provided during that period is referred to as the
requisite service. The requisite service period will usually be the vesting period for an award that
has only a service condition, unless there is clear evidence to the contrary.

• Entities have to make a policy decision about how to recognize compensation cost for awards with
only service conditions that have a graded-vesting schedule. The two methods permitted for
recognizing compensation cost for such awards are

− Straight-line attribution of the cost of the entire award over the vesting period for the entire award

− Graded-vesting attribution, which consists of straight-line attribution over the vesting period for
each separately vesting portion as if the grant consisted of multiple awards, each with the same
service inception date

• Excess tax benefits are classified as financing cash inflows in the statement of cash flows.

• Disclosure requirements are expanded.

Statement 123R also introduces terminology, which this document tries to demystify, such as economic
interest holders; requisite service period; service inception date; explicit, implicit, and derived service
periods; market conditions; short-term inducements; and APIC pools.

The FASB has issued FASB Staff Positions (FSPs) that amend or clarify Statement 123R. They are
posted on the FASB website.

The SEC staff issued implementing guidance in Staff Accounting Bulletin (SAB) 107, Share-Based
Payment, in March 2005 and in SAB 110 in December 2007. The SEC and PCAOB staffs have provided
guidance on entities’ processes, procedures, controls, and documentation related to granting options, as
well as other matters affecting share-based payment awards.

A FASB Statement 123R Resource Group addressed numerous implementation issues.

In December 2007 the FASB issued Statement 141 (revised 2007) (141R), Business Combinations,
which provides new guidance on the accounting by acquirers for share-based payment awards issued as
replacement awards in business combinations.

This document integrates guidance in Statement 123R, including the implementation guidance in
appendix A of Statement 123R, SEC rulings and staff guidance, FSPs, consensus views of the EITF,
implementation issues discussed by the Resource Group, provisions of Statement 141R, and other
relevant guidance issued as of February 28, 2009. However, this document is not a substitute for referral
New Developments Summary 7

to and application of Statement 123R, SEC rulings, SABs 107 and 110, FSPs, and other accounting
pronouncements.
New Developments Summary 8

B. What is the scope of Statement 123R?


Statement 123R applies to share-based payment transactions in which an entity acquires goods or
services by issuing equity instruments or by incurring liabilities that either

• Are settled in an amount based, at least in part, on the price of the entity’s shares or other equity
instruments of the entity. Although many liabilities within the scope of Statement 123R, such as cash-
settled share appreciation rights, are indexed solely to the price of the entity’s equity instruments, a
liability indexed to both the price of an entity’s equity instruments and something else, such as the
price of a commodity, would also be accounted for under Statement 123R.

• Require or may require settlement by issuing the entity’s shares or other equity instruments, for
example, a legal fee payable in shares

There is one type of employee share-based award, however, that is excluded from the scope of
Statement 123R: equity instruments held by an employee share ownership plan (ESOP). ESOPs
continue to be accounted for under AICPA Statement of Position (SOP) 93-6, Employers’ Accounting for
Employee Stock Ownership Plans.

Note that Statement 123R only addresses transactions involving the acquisition of goods or services.
Equity instruments issued in exchange for cash or other financial assets, such as detachable warrants
issued in connection with a debt or preferred share offering, are not subject to this Statement. Other
pronouncements apply, such as AICPA Accounting Principles Board (APB) Opinion 14, Accounting for
Convertible Debt and Debt Issued with Stock Purchase Warrants, FASB Statement 133, Accounting for
Derivative Instruments and Hedging Activities, or EITF Issue 00-19, “Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”

Guidance applicable to awards to employees


The FASB developed the revised and expanded guidance in Statement 123R explicitly for awards to
employees; it may provide expanded guidance for transactions involving persons other than employees in
a later project. Until then, there will be some differences in the accounting for share-based payment
awards, depending on whether the grantee is an employee or a nonemployee. Therefore, determining
whether a grantee is an employee or a nonemployee remains a significant issue.

Definition of employee
Questions about whether certain individuals, such as outsourced employees, nonemployee directors, and
consultants performing management functions, are employees or nonemployees for purposes of share-
based compensation were addressed in FASB Interpretation 44, Accounting for Certain Transactions
involving Stock Compensation (an interpretation of APB Opinion No. 25). Statement 123R’s Glossary
incorporates a definition of employee similar to that included in Interpretation 44. An employee is

An individual over whom the grantor of a share-based compensation award exercises or has the
right to exercise sufficient control to establish an employer-employee relationship based on
common law as illustrated in case law and currently under U.S. Internal Revenue Service
Revenue Ruling 87-41. Accordingly, a grantee meets the definition of an employee if the grantor
consistently represents that individual to be an employee under common law.

In the United States, common law employees are subject to payroll taxes. Therefore, to be an employee
for purposes of Statement 123R, an individual would have to be both an employee under common law,
which would include meeting the criteria under Revenue Ruling 87-41 to be considered an employee, and
an employee for payroll tax purposes. However, being subject to payroll taxes does not, by itself, indicate
New Developments Summary 9

the individual is a common law employee or an employee for purposes of Statement 123R. Case law and
the Revenue Ruling would have to be analyzed, and companies may need to consult legal counsel. In a
jurisdiction outside the United States, whether an employer-employee relationship exists would be
determined under the laws of that jurisdiction.

Owners of pass-through entities


The definition of employee is essentially the same as that in Interpretation 44. The FASB’s Emerging
Issues Task Force (EITF) addressed implementation issues related to Interpretation 44 in EITF Issue 00-
23, “Issues Related to the Accounting for Stock Compensation under APB Opinion No. 25 and FASB
Interpretation No. 44.” Although Interpretation 44 was superseded by Statement 123R, certain
implementation guidance in Interpretation 44, such as that clarifying who is an employee for purposes of
accounting for share-based payment awards, continues to be used in practice, as is certain additional
clarifying guidance in EITF Issue 00-23. For example, Issue 40(a) of EITF Issue 00-23, “Whether a
grantee who provides services to an LLC (or other pass-through entity) should be considered an
employee for purposes of accounting for capital- or equity-based compensation (profits interest awards)
granted by the LLC,” addresses whether an individual providing services to a pass-through entity, such as
a partnership or an LLC, would be considered an employee of the pass-through entity. The issue arises
because if the individual holds ownership interests, the entity would not withhold payroll taxes from
distributions to the individual. The EITF concluded that the individual providing services would be
considered an employee if he or she qualifies as a common law employee. The fact that the individual is
not considered an employee for payroll tax purposes would not be relevant.

Leased employees
Employers sometimes grant share-based compensation to their leased employees and a question arises
about whether those individuals are considered employees for purposes of applying Statement 123R. The
definition of employee in the Glossary of Statement 123R provides the following criteria, which if met,
would indicate the individual is an employee of the lessee for purposes of the Statement:

• The leased individual is a common law employee of the lessee, and the lessor is contractually
obligated to remit payroll taxes for the individual’s services to the lessee.

• The lessee and lessor agree in writing to the following:

− The lessee has the exclusive right to grant stock compensation to the individual for services to
the lessee.

− The lessee has a right to hire, fire, and control the activities of the individual.

− The lessee has the exclusive right to determine the value of the individual’s services.

− The leased individual has the ability to participate in the lessee’s employee benefit plans.

− The lessee is obligated to remit to the lessor funds to cover the leased individual’s entire
compensation cost, including payroll taxes.

Nonemployee directors
An individual whose service to an entity is as a member of the board of directors would not be a common
law employee and therefore would not be an employee for purposes of Statement 123R. Statement 123R
makes an exception for such nonemployee directors.
New Developments Summary 10

“[N]onemployee directors acting in their role as members of a board of directors are


treated as employees if those directors were (a) elected by the employer’s shareholders
or (b) appointed to a board position that will be filled by shareholder election when the
existing term expires” (Statement 123R, paragraph E1)

This is a narrow exception that applies only to services as a director. It would not apply, for example, to
awards granted to an individual appointed to serve on an entity’s advisory board if the individual did not
meet the common law definition of an employee.

Not infrequently, nonemployee directors perform other professional services for the corporation as well as
serve on the board. Individual directors may, for example, perform legal services, investment advisory
services, or marketing services. Share-based payment awards granted for such other services are
accounted for as awards to nonemployees.

Paragraph A76 of Statement 123R contains a further limitation on employee accounting treatment for
awards to nonemployee directors. If a consolidated group has multiple boards of directors, employee
accounting would apply to nonemployee directors of consolidated subsidiaries only if those members are
elected by shareholders that are not controlled directly or indirectly by the parent or other member of the
consolidated group.

Certain transactions with related parties and other economic interest holders
FASB Statement 123, Accounting for Stock-Based Compensation, provided that a share-based payment
award, such as an entity’s shares or options on its shares, awarded to the reporting entity’s employees by
a principal shareholder should be accounted for by the reporting entity as a share-based payment award
to its employees and a contribution of capital by the shareholder, unless the transfer was clearly for a
purpose other than compensation for services to the reporting entity. Statement 123R expands the scope
of that provision by requiring that share-based payment awards to employees made by a related party or
other economic interest holder be accounted for by the employer as compensation cost under Statement
123R, unless the award is clearly for something other than compensation for services to the entity. An
economic interest is broadly defined as any financial interest or arrangement the entity could be a party to
or issue.

The change in the scope of this provision from principal shareholder to related party or other economic
interest holder significantly expands the provision to encompass share-based payment awards
transferred to employees by any related party, shareholder, other holder of an equity instrument, holder of
long-term debt or other debt-financing arrangement, or by a party to a contractual arrangement with the
employer, such as a lease, management contract, service contract, or intellectual property license.

Guidance applicable to awards to nonemployees


As noted at the beginning of this section, Statement 123R applies to transactions in which an entity
acquires goods or services from employees or nonemployees by issuing instruments that are settled in an
amount based on the price of the entity’s equity instruments or require or may require settlement by
issuing the entity’s shares or other equity instruments. However, only paragraphs five through eight
explicitly apply to nonemployee awards. Those paragraphs provide that

• The goods and services should be recognized as they are received.

• The transaction should be accounted for based on its substantive features, with the exception of
certain specified features, such as reload features.
New Developments Summary 11

• The transaction should be measured based on the fair value of the goods or services received or the
fair value of the equity instruments issued, whichever is more reliably measurable.

The Statement does not specify the measurement date if a transaction with a nonemployee is accounted
for based on the fair value of the equity instruments issued. Guidance on that measurement date
continues to be addressed in EITF Issue 96-18, “Accounting for Equity Instruments That Are Issued to
Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.” Although the
measurement date for grants to employees is generally the grant date of the award, under EITF Issue 96-
18, the measurement date for awards to nonemployees is generally the vesting date, unless the award is
fully vested and nonforfeitable on the grant date or performance by the counterparty is probable due to a
sufficiently large disincentive for nonperformance (such as a sufficiently large economic penalty).

Because liability awards issued to nonemployees are within the scope of Statement 123R, they should be
accounted for at fair value, not at intrinsic value. This conclusion was reached by the Statement 123R
Resource Group at its September 13, 2005 meeting and applies regardless of whether the issuing entity
is public or nonpublic.

Statement 123R amends FASB Statement 95, Statement of Cash Flows, to require excess tax benefits
that result from both employee and nonemployee share-based payment awards to be presented as
financing cash flows in the statement of cash flows. Excess tax benefits are the tax benefits the entity
receives for the excess of a tax-deductible amount for a share-based payment award over the
compensation cost recognized for that award in the entity’s financial statements.

The guidance in Statement 123R, other than paragraphs 5 through 8 and the amendment to
Statement 95, applies specifically to employee awards. Nonetheless, the SEC staff stated in SAB Topic
14.A that the guidance in Statement 123R for employee transactions should be applied by analogy to
transactions with nonemployees unless other authoritative literature is more clearly applicable or the
guidance in Statement 123R would be inconsistent with the terms of the nonemployee transaction. The
staff specifically noted that the guidance pertaining to certain transactions with related parties and other
economic interest holders should apply equally to nonemployees. In contrast, use of the expected option
term rather than the contractual term would not be appropriate if a nonemployee option did not have the
specific features common in employee options—nontransferability, nonhedgability, and shortening of the
term of the vested option on termination of service—that make use of the expected term appropriate in
the valuation model for employee options.

Other areas where Statement 123R’s guidance may be relevant for nonemployee awards include

• Determination of the volatility input in an option valuation model

• Accounting for modification of the terms of an equity award

• Accounting for the income tax effects of a share-based payment transaction. As discussed in
section J, accounting for differences between financial reporting compensation costs and amounts
deducted in income tax returns requires an entity to maintain a memo account of its excess tax
benefits pool (also known as its APIC pool). The APIC pool tracks the entity’s cumulative excess tax
benefits and shortfalls. Excess tax benefits arise when the deduction ultimately reported on the
entity’s tax return exceeds compensation cost recognized for financial reporting. Shortfalls result
when the tax deduction is less than the compensation cost recognized. The FASB’s Statement 123R
Resource Group reached a consensus at its July 21, 2005 meeting that excess tax benefits and
shortfalls related to exercise of nonemployee options may be combined in an entity’s APIC pool, with
excess tax benefits and shortfalls resulting from exercise of employee options. Alternatively, an entity
could maintain two separate APIC pools, one for exercise of employee options and the other for
New Developments Summary 12

exercise of nonemployee options. The method chosen is an accounting policy decision that should be
applied consistently and disclosed in the financial statements.

Paragraph 7 of Statement 123R requires that share-based payment awards to nonemployees be based
on the fair value of the awards if their fair value is more reliably measurable than the fair value of the
goods or services received. That same paragraph indicates that employee share-based awards be
measured at fair value, or in some cases at calculated or intrinsic value. It seems clear in that paragraph
that use of calculated value is not intended for share-based payment awards to nonemployees. This was
confirmed by the FASB staff at a Statement 123R Resource Group meeting on September 13, 2005. In
addition, because entities are required to value awards to nonemployees at fair value, there is a
presumption that nonpublic entities that grant options to nonemployees could not use the calculated value
method. Use of that method is permitted only if the nonpublic entity cannot practicably estimate its
expected volatility without undue cost and effort. However, if the entity has issued awards to
nonemployees and is therefore required to estimate its expected volatility to value the nonemployee
options, it would not require undue cost or effort to estimate expected volatility for employee awards.

In SAB Topic 14.E, the staff indicates that redeemable share-based payment arrangements with
nonemployees that are not classified as liabilities under Statement 123R should be subject to the
requirements of SEC Accounting Series Release (ASR) 268, Presentation in Financial Statements of
Redeemable Preferred Stocks, and EITF Topic D-98, “Classification and Measurement of Redeemable
Securities.” In SAB Topic 14.E, questions 2 and 3, the staff indicates that the amount recorded in
temporary equity for a share-based payment arrangement within the scope of ASR 268 should equal the
redemption amount prorated to an amount equal to the vested percentage of the award at the balance
sheet date. That is, if the redemption amount of the unvested shares with a put is $10,000 and the shares
are 75 percent vested, the amount classified in temporary equity should be $7,500.

When an entity issues awards to nonemployees in exchange for goods or services, it continues to
account for the awards under Statement 123R and EITF Issue 96-18 until the nonemployees’ rights
conveyed by the awards are no longer dependent on providing goods or services. Thus, after the
requisite services required to earn the awards have occurred—services performed, purchases of the
entity’s products made, or products delivered to the entity—and the nonemployee’s rights to transfer
shares or exercise options are no longer contingent on performing continuing services, the awards should
be accounted for under other applicable generally accepted accounting principles (GAAP), such as
Statement 133, FASB Statement 150, Accounting for Certain Financial Instruments with Characteristics of
both Liabilities and Equity, or EITF Issue 00-19.
New Developments Summary 13

C. When is an award considered a liability and how are equity awards


presented?
A share-based payment award is classified in equity unless it is required under one or more of the factors
described below to be classified as a liability. Share-based payment awards classified as liabilities are
accounted for under Statement 123R’s measurement and recognition provisions for liabilities, which
require variable accounting until the award is settled or expires unexercised.

Liability classification
Application of Statement 150
Although Statement 150 excludes share-based payment awards from its scope, the FASB decided to
require entities to apply the classification requirements in paragraphs 8 to 14 of Statement 150, with
certain modifications discussed below, to freestanding financial instruments granted to employees in a
share-based payment transaction accounted for under Statement 123R. The FASB is currently working
on phase 2 of Statement 150. Completion of that project may ultimately lead to changes in the
classification of liabilities under Statement 123R.

Statement 150 should be applied to awards at each reporting date, which means, for example, taking into
account the deferrals in FASB Staff Position (FSP) FAS 150-3, “Effective Date, Disclosures, and
Transition for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain
Mandatorily Redeemable Noncontrolling Interests under FASB Statement No. 150, Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity,” during each period in which
those deferrals are in effect. FSP FAS 150-3 is expected to remain in effect until the completion of
phase 2 of Statement 150.

Under Statement 150, the following instruments are classified as liabilities:

• A mandatorily redeemable share (paragraph 9), unless this provision is subject to deferral under FSP
FAS 150-3, which is discussed below. Under Statement 150, mandatorily redeemable has a more
limited meaning than it does in some other accounting literature. It applies to instruments whose
terms unconditionally obligate the issuing entity to redeem the instrument at a specified or
determinable date or on an event certain to occur and unconditionally obligate the holder to tender
the instrument in redemption. If redemption is not unconditionally required, the award is not
mandatorily redeemable. For example, a puttable share is not considered mandatorily redeemable,
because the holder has a choice of whether to redeem the instrument and the entity is required to
redeem the instrument only if the holder exercises the put. Mandatorily redeemable employee awards
seen in practice include shares required to be redeemed on the employee’s termination or death. The
obligation to redeem may be in the share-based award document or in a separate buy/sell or
shareholders’ rights agreement.

• A financial instrument other than a share that obligates the issuer to repurchase its shares or is
indexed to such an obligation (paragraph 11). Instruments within the scope of this category include a
freestanding put that is net-cash or physically settled.

• Certain obligations to issue a variable number of shares (paragraph 12). Instruments are within the
scope of this provision if their value is based predominantly on any of the following:

− A fixed monetary amount known at inception, for example, a grant of $500,000 payable in a
variable number of shares in 36 months
New Developments Summary 14

− Variations in something other than the fair value of the issuer’s equity shares, for example, a
grant of an amount indexed to changes in the price of gold and payable in a variable number of
shares in 36 months

− Variations inversely related to changes in the fair value of the issuer’s equity shares, for example,
a written put option settled net in shares

Deferral of effective date of mandatorily redeemable share provision in certain situations

FSP FAS 150-3 defers the effective date of the mandatorily redeemable share provision (paragraph 9 of
Statement 150), but only for certain entities and certain mandatorily redeemable shares. Under FSP FAS
150-3, entities that are not SEC filers (that is, they have no requirement to file financial statements with
the SEC) are not required to apply liability classification to a mandatorily redeemable share unless it is
redeemable on a fixed date for an amount that is either fixed or determined by reference to an external
index.

A nonpublic entity that is not required to file its financial statements with the SEC is
required to classify as a liability an employee share-based award that is mandatorily
redeemable on a fixed date for a fixed amount. However, that nonpublic entity would not
be required to classify as a liability a share that is mandatorily redeemable on the
employee’s termination or death if both of the following apply:

• The share has no other feature that would require liability classification under
Statement 123R.

• FSP FAS 150-3 remains in effect at the end of the financial reporting period.

Classification of the award would be reviewed at each subsequent reporting date, based
on the provisions of Statement 150 and related guidance then in effect.

FSP FAS 150-3 indefinitely defers the effective of Statement 150 for all entities for the following interests:

• A noncontrolling interest in a subsidiary that is mandatorily redeemable only on liquidation would not
be classified as a liability in the consolidated financial statements.

• A mandatorily redeemable noncontrolling interest that was issued before November 5, 2003 would
not be subject to the measurement provisions of Statement 150 in the financial statements of either
the subsidiary or the consolidated entity.

Book value awards

Nonpublic entities sometimes issue employees book value shares. Book value shares are typically a
separate class of equity having a purchase price that is a formula price based on the entity’s book value.
The terms of book value shares generally require the employee, on termination of employment, to sell the
shares back to the entity using the same formula price. The mandatory redemption provision of book
value shares would cause them to be a liability under Statement 150, except during the indefinite deferral
period of FSP FAS 150-3. However, if the terms of the book value shares include a put or other provision
that could result in the employee putting the shares back to the entity before the shares had been fully
vested for six months, the shares would be classified as liabilities as long as that condition exists.
New Developments Summary 15

An entity that does not file with the SEC issues book value shares as a separate class of
equity held exclusively by employees. Their purchase price is determined by a formula
based on the entity’s book value. On termination, employees are required to sell the
shares back to the entity for an amount based on the same book value formula. The
shares do not contain a provision that could result in the shares being sold back to the
nonpublic entity before they have been fully vested for six months. Under these specific
facts, the formula price is deemed to represent the fair value of the book value class of
shares. While the indefinite deferral provisions of FSP FAS 150-3 apply, the shares
would be classified in equity if they otherwise qualify for equity classification. They would
be measured at the formula price on the grant date. Compensation cost equal to the
difference between the formula price on the grant date and the amount paid by the
employee would be recognized over the requisite service period. Subsequent changes in
the formula price would not be compensatory.

If a public entity issued book value shares, the shares would generally not be indexed to the entity’s share
price and would therefore be classified as liabilities. In addition, for a public entity, a mandatory
redemption provision would require the shares to be classified as liabilities under the classification criteria
of Statement 150.

Options subject to liability classification


Statement 123R modifies the application of liability classification under paragraph 11 of Statement 150 for
share-based payment awards in the form of options or similar instruments. These instruments are
classified as liabilities if either of the following applies (this is a more limited provision than paragraph 11):

• The shares underlying the options or similar instruments would be classified as liabilities.

• The entity can be required under any circumstances to settle the option or similar instrument by
transferring cash or other assets.

FSP FAS 123R-4, “Classification of Options and Similar Instruments Issued as Employee
Compensation That Allow for Cash Settlement upon the Occurrence of a Contingent Event,”
amended the “under any circumstances” provision in Statement 123R to provide that if a cash
settlement feature in an option or similar instrument issued to an employee is contingent on the
occurrence of an event outside the employee’s control (such as a change of control), the contingent
cash settlement feature does not cause the option or similar instrument to be classified as a liability
until the occurrence of the contingent event becomes probable. For example, if an option award
provides that the employee can require the entity to net-cash settle his or her vested option if a
change of control occurs, that contingent net-cash settlement provision would not cause the option to
be classified as a liability unless the occurrence of a change of control becomes probable. Other
contingent cash settlement provisions sometimes found in employee options include contingencies
related to the occurrence of a significant change in ownership (say, more than 20 percent), an initial
public offering or other liquidity event, or the death or disability of the employee. Under current
practice, the occurrence of a liquidity event is generally not considered probable until it occurs. An
instrument similar to an option that could be affected by this FSP would be a stock settled share
appreciation right that can be net-cash settled only in the event of a specified contingency outside of
the employee’s control. The exception to liability classification provided by FSP FAS 123R-4 applies
only to employee awards. A contingent cash-settlement provision in an option issued to a
nonemployee would cause the option to be classified as a liability.
New Developments Summary 16

The probability of a contingent cash settlement event occurring should be continually reassessed. If
an instrument classified in equity subsequently becomes a liability because it is probable that a
contingent net-cash settlement event will occur, the accounting to reclassify the award as a liability is
similar to the accounting for a modification that results in an award being reclassified from an equity
to a liability award. Under that accounting, to the extent the amount reclassified to a liability (the
portion of the current fair value attributable to past service) does not exceed the amount previously
recorded in equity for the award, the offsetting debit is a charge to equity. If the reclassified amount
exceeds the amount previously recorded in equity, the excess is recognized as compensation cost.
Illustration 14(a) in appendix A of Statement 123R provides detailed guidance on the accounting for
such a reclassification resulting from a modification. The total recognized compensation cost for an
award with a contingent cash settlement feature should at least equal the fair value of the award at
the grant date.

An employee option that can be net-cash settled, but only on the occurrence of a change
of control, requires liability classification if a change of control becomes probable.
However, such an award issued to a nonemployee would require liability classification
regardless of whether the contingent event is probable.
An employee option on a mandatorily redeemable share issued by a nonpublic entity not
required to file with the SEC is not classified as a liability assuming the shares underlying
the option, although mandatorily redeemable, are not subject to liability classification
because of the deferral provided in FSP FAS 150-3. This applies as long as the deferral
under FSP FAS 150-3 remains in effect, assuming no other conditions requiring liability
classification apply to the option.
An employee option on a mandatorily redeemable share issued by a nonpublic
broker/dealer in securities would require liability classification, because broker/dealers
are required to file with the SEC even if their shares are not publicly traded. The shares
underlying the option would be subject to liability classification when issued.
Entities sometimes issue employee call options and guarantee that the options will have
a specific amount of intrinsic value by a specified date. Under the guarantee, if the
amount of intrinsic value is not achieved by the specified date, the employer will make a
cash payment to the employee equal to the guaranteed amount less the intrinsic value of
the options on that date. If the options have a term that extends beyond the specified
guarantee date and are not required to be exercised on the specified date (that is, the call
options are freestanding instruments whose exercise is independent of the guarantee of
their intrinsic value on a certain date), the award is accounted for as a combination plan
consisting of call options and a net-cash settled put option with an exercise price equal to
the guarantee amount. The call options would be accounted for as equity instruments.
The put (the guarantee), however, would be classified as a liability because the entity can
be required to settle the put by transferring cash.

An option may permit settlement in net shares, that is, the holder exercises the option without paying the
exercise price and receives shares equal to the intrinsic value of the options. This is sometimes referred
to as cashless exercise. A net-share settlement provision would not cause an option (or an option-like
instrument such as a stock appreciation right) to be classified as a liability.
New Developments Summary 17

Shares with repurchase features


Shares with embedded puts or calls are not within the scope of Statement 150. However, under
paragraph 31 of Statement 123R, a puttable (or callable) share (that is, a share with an embedded put
exercisable by the employee or an embedded call exercisable by the employer) awarded to an employee
as compensation is classified as a liability if the employee may be able to avoid bearing the risks and
rewards of ownership for a reasonable period of time. A reasonable period of time is defined as six
months. An employee holding shares with embedded puts is deemed able to avoid the risks and rewards
of ownership for a reasonable period of time, and the award would be classified as a liability, if any of the
following conditions apply:

• The employee can exercise the put before the share has been fully vested for six months. If the put
right is contingent on an event that is outside the control of the employee (such as a change of
control), however, the puttable share is not required to be classified as a liability until it becomes
probable the contingent event will occur within six months.

• It is probable the employer would call the share or permit the employee to exercise the put before the
share has been fully vested for six months.

• The shares are required to be held for at least six months before being put to the employer, but the
repurchase price is fixed. The employee can avoid bearing the risks and rewards of ownership for a
reasonable period of time because of the fixed (in effect, guaranteed) repurchase price.

Shares with fair value repurchase features that are subject to classification as liabilities because the
repurchase feature enables the employee to avoid bearing the risks and rewards of ownership for at least
six months would continue to be classified as liabilities until six months after option exercise or the vesting
date of awards of unvested shares. After six months, the employee has been exposed to the risks and
rewards of share ownership for a reasonable period of time, and the shares would be reclassified to
equity at their then fair value. However, see below in this section under the heading “Awards requiring
classification outside of permanent equity” for requirements for SEC registrants to reclassify the
redemption amount of such awards outside of permanent equity.

Awards indexed to conditions other than market, performance, or service conditions


An award is classified as a liability if it is indexed to a factor in addition to the entity’s share price that is
not a market, performance, or service condition.

A market condition relates to the achievement of a specified price of the issuer’s shares, a specified
amount of intrinsic value indexed solely to the issuer’s shares, or a specified price of the issuer’s share in
terms of a similar (or index of similar) equity security. An example of an award with a market condition
would be an award that vests if the entity’s share price increases at least 10 percent more than the
average increase of the share prices of three specific companies in the entity’s industry at the end of a
three-year period.

A performance condition relates to achievement of a specified target defined by reference to the


employer’s own operations or activities, such as an option that vests if the employer’s growth rate
increases a certain amount or regulatory approval is obtained for a product. A performance condition may
also be in reference to the same performance measure of another entity or group of entities, such as a
vesting requirement that the company attain an increase in earnings per share that exceeds the average
growth rate in earnings per share of other entities in the same industry.
New Developments Summary 18

A share-based payment award that vests based on achievement of inflation-adjusted


growth in either earnings per share (sometimes referred to as “real growth in EPS”) or
EBITDA (earnings before interest, taxes, depreciation, and amortization) is classified as
a liability, because it is indexed to a factor (inflation) in addition to the entity’s share
price that is not a market, performance, or service condition.
An option whose exercise price is indexed to changes in the price of gold or that
becomes vested based on appreciation in the price of gold is classified as a liability,
because it is indexed to a factor in addition to the entity’s share price that is not a
market, performance, or service condition.

Exercise price denominated in a foreign currency

An exception applies to the above provision related to an award indexed to a factor in addition to the
entity’s share price that is not a market, performance, or service condition, for employees of an entity’s
foreign operations. An option with a fixed exercise price denominated in a foreign currency awarded to an
employee of an entity’s foreign operation is not required to be classified as a liability if both of the
following apply:

• The award otherwise qualifies for equity classification.

• The foreign currency is either the functional currency of the foreign operation or the currency in which
the employee’s pay is denominated.

Options with a fixed exercise price denominated in euros issued to employees of a U.S.
entity’s foreign subsidiary whose functional currency is euros would be classified in equity
if the options otherwise qualified for equity classification. Those options would be
classified in equity even if the subsidiary’s functional currency was dollars, if the
employees granted the options were paid in euros.

Applicability of EITF Issue 07-5 to share-based payment awards


As discussed above, Statement 123R provides guidance on when a share-based payment award indexed
to a factor other than the entity’s share price is classified as a liability rather than as equity. EITF Issue
07-5, “Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock,”
provides a two-step method for determining whether an equity-linked financial instrument is considered to
be indexed to the entity’s own stock. This guidance is significant in determining whether an equity-linked
financial instrument is within the scope of either FASB Statement 133, Accounting for Derivative
Instruments and Hedging Activities, or EITF Issue 00-19, “Accounting for Derivative Financial Instruments
Indexed to, and Potentially Settled in, a Company’s Own Stock.” EITF Issue 07-5 is effective for fiscal
years beginning after December 15, 2008, including interim periods within those fiscal years.

The guidance in EITF Issue 07-5 does not apply to share-based payment awards subject to Statement
123R for purposes of determining whether the awards should be classified as liabilities or in equity.
However, some entities issue specially structured equity-linked financial instruments to investors to
establish a market-based measure of the grant-date fair value of their employee stock options. Those
equity-linked financial instruments are not within the scope of Statement 123R and are subject to the
New Developments Summary 19

classification guidance in EITF Issue 07-5. See the discussion of EITF Issue 07-5 in section F under the
heading “Market-based instrument to measure grant-date of fair value.”

Classification based on substantive terms of award


Share-based payment awards are accounted for based on their substantive terms.

A tandem award may give an employee a choice of exercising a fixed option or a cash-settled share
appreciation right. Exercise of one instrument cancels the other. Such an award may be structured by
giving the employee the choice of settlement methods: physical settlement by paying the exercise price
and receiving a share or net-cash settlement by receiving the intrinsic value of the award in cash
(equivalent to a share appreciation right). Such awards are classified as liabilities because the entity may
have to settle the award in cash. Note that a share option that provides a choice of settlement methods—
physical settlement or net-cash settlement—is, in substance, a similar tandem award that would require
liability classification.

If a tandem award gives the entity the choice of settling in shares or in cash, the terms of the award would
appear to permit equity classification for the award. However, an entity’s past practice may indicate that
the substantive terms of the award differ from the written terms.

If an entity that has a choice of settling awards in shares or cash predominately settles in
cash or it usually settles in cash when requested to do so by an employee, the award is a
substantive liability.

In considering whether an entity that can choose to settle awards in shares has a substantive liability, the
entity must consider whether it has the ability to deliver shares. To the extent an entity does not have
enough authorized and unissued shares to settle its share-based awards in shares, the awards should be
classified as liabilities. Delivery of registered shares may be required under federal securities law, in
which case an entity has to determine whether it has the ability to deliver registered shares. However,
entities are not required to apply the provisions in paragraphs 14 to 18 of EITF Issue 00-19 that presume
a contract with a requirement to settle in registered shares would be net-cash settled and therefore
require liability classification. Statement 123R does not require entities to classify employee share-based
awards as liabilities based solely on that provision in EITF Issue 00-19.

If an entity makes a short-term, limited time offer to settle employee awards for cash, the short-term offer
would not affect the classification of the awards (for example, from an equity instrument to a liability
instrument for the period the award remains outstanding during the offer) under FSP FAS 123R-6,
“Technical Corrections of FASB Statement No. 123(R).” If the employee accepts the settlement offer, the
entity accounts for the repurchase of the award as discussed in section H under the heading
“Repurchases and cancellations.” In contrast, as noted above, if the entity has a history of settling awards
for cash, it should evaluate at inception whether it has a substantive liability.

Special classes of stock, LLC profits interests, and similar instruments

At the 2006 AICPA National Conference on SEC and PCAOB Developments, the SEC staff described
two types of special classes of stock that entities in a variety of industries have created specifically for
employees. In one type, the employees are granted instruments whose value is based on a subset of the
parent’s operations, such as a particular subsidiary, with which the employees are involved. The other
special class of stock is issued by some pre-IPO companies to allow employees to participate in
appreciation realized through a liquidity event. A similar instrument addressed by the EITF in Issue 40 of
New Developments Summary 20

EITF Issue 00-23 is a profits interest in an LLC or other pass-through entity. Such interests are often
structured to provide holders with distributions after other interest holders recover their investment plus a
specified return.

In accounting for such instruments, entities should look through the legal form and evaluate all relevant
features to determine whether the instrument is (1) a substantive class of equity that should be accounted
for under Statement 123R or (2) more similar to a performance bonus or profit-sharing arrangement. In
Issue 40(b), the EITF noted that, depending on its terms, an award may be similar to

• An equity interest, for example, restricted stock that is subordinate to existing equity

• A stock option, such as the right to purchase an interest in the future at a specified price

• A share appreciation right

• A profit-sharing arrangement

Characteristics that may be indicative of equity include substantive voting rights and dividend rights
similar to those of other shareholders. To qualify for equity classification, an instrument should be legal
equity and have a residual interest in net assets. Features that may indicate the substance is similar to a
bonus or profit-sharing arrangement include few, if any, assets underlying the class of stock or profits
interest, the holders’ claim on the assets being significantly subordinated, and liquidation or repayment
provisions or provisions for realization of value, including put and call rights that limit the employees’
downside risk or provide for cash settlement. If the instruments are, in substance, performance bonus or
profit-sharing plans, they should be accounted for as liabilities. All facts and circumstances should be
considered in evaluating whether the interest is, in substance, equity or a liability.

If the special class of stock or profits interest is, in substance, equity, valuation questions arise. The SEC
staff has rejected valuation methodologies based primarily on current liquidation value because it believes
that approach would not capture the stock’s significant upside potential.

The SEC staff noted that other accounting issues to consider for such instruments include the applicability
of EITF Issue 03-6, “Participating Securities and the Two-Class Method under FASB Statement No. 128,”
FSP EITF 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions Are
Participating Securities,” and whether temporary equity classification would be required under EITF Topic
D-98.

Other applicable GAAP


To determine if an award not specifically addressed in Statement 150 or the above provisions is a liability,
an entity should apply GAAP applicable to financial instruments issued in transactions other than share-
based payment awards.

Provisions that may not result in liability classification


Broker-assisted cashless exercise
Some public entities enter into arrangements with a broker to enable employees to carry out cashless
exercise of their employee options. The arrangement usually consists of a simultaneous exercise of the
option and sale of the shares by the broker. Such broker-assisted cashless exercise arrangements do not
result in liability classification if the award would otherwise qualify as equity and the following conditions
are satisfied:

• The arrangement requires a valid exercise of the option.


New Developments Summary 21

• The employee is the legal owner of the shares subject to the option.

For the award to qualify for equity classification if the broker is a related party of the entity that issued the
awards, the broker has to sell the shares in the public market within a normal settlement period, which is
generally three days in the United States.

The Glossary of Statement 123R outlines the usual structure of these arrangements:

• The employee authorizes the exercise of specified options and the immediate sale of the option
shares in the open market.

• The entity notifies the broker of the sale order the same day.

• The broker executes the sale and notifies the entity of the sales price.

• The entity determines the minimum required statutory tax-withholding amount.

• The entity delivers the stock certificates to the broker prior to the settlement day.

• On settlement, the broker pays the entity the exercise price and the minimum statutory tax
withholding (or a higher withholding amount specified by the employee) and pays the remaining
proceeds to the employee.

Tax withholding provisions


An immediate share repurchase feature for tax withholding purposes does not result in liability
classification if the award would otherwise qualify as equity and the withholding is limited to the
employer’s minimum statutory withholding requirements resulting from option exercise (or vesting of
nonvested shares). Minimum statutory withholding rates for such supplemental taxable income pertain to
income and payroll taxes required to be withheld by the relevant tax authorities, such as federal, state,
and local authorities.

If an amount in excess of the minimum statutory tax withholding amount is withheld by the entity, or may
be withheld at the employee’s discretion, the entire award is classified as a liability.

Equity awards based on subsidiary stock classified as noncontrolling interest


Some consolidated entities, or their subsidiaries, issue share-based payment awards whose settlement
amount is based on the stock of a consolidated subsidiary. Such awards include grants of subsidiary
stock, as well as options on subsidiary stock. If these awards qualify for equity classification under
Statement 123R, they must be presented in the financial statements as noncontrolling interests under
FASB Statement 160, Noncontrolling Interests in Consolidated Financial Statements. A noncontrolling
interest is the portion of equity in a subsidiary that is not directly or indirectly attributable to the parent.
Awards of equity-classified subsidiary stock and options on subsidiary stock meet Statement 160’s
definition of a noncontrolling interest regardless of whether the award was issued by the parent or the
subsidiary. However, if an award granted by the parent company expires unexercised, the entity should
reclassify the carrying amount of the award from noncontrolling interest to controlling interest on the
expiration date.

Under Statement 160, a noncontrolling interest is reported in equity in the consolidated financial
statements, but separately from the parent’s equity. It must be clearly identified and labeled, for example,
as a “noncontrolling interest in subsidiaries.” An entity with noncontrolling interests in more than one
subsidiary may present those interests in aggregate.

Previously, how entities have presented awards based on a subsidiary’s stock in their financial
statements has varied. However, with the issuance of Statement 160, consolidated entities must adopt
New Developments Summary 22

the noncontrolling interest presentation requirement on its effective date, which is for fiscal years, and for
interim periods within those fiscal years, beginning on or after December 15, 2008. Earlier adoption is
prohibited. Therefore, entities with a calendar year-end must initially apply Statement 160 in their quarter
ending March 31, 2009.

Awards requiring classification outside of permanent equity


To determine whether share-based payment awards not accounted for as liabilities can be classified in
permanent equity, public companies need to consider the SEC’s guidance in ASR 268, EITF Topic D-98,
and SAB Topic 14.E.

ASR 268 requires instruments to be classified outside of permanent equity if they are redeemable (a) at a
fixed or determinable price on a fixed or determinable date, (b) at the option of the holder, or (c) on the
occurrence of an event not solely within the control of the issuer.

Awards classified in equity under Statement 123R that may be subject to temporary equity classification
include

• Shares with a repurchase feature exercisable by the employee after the shares have been vested for
at least six months, as well as options on such shares

• Shares that have a contingent repurchase feature that is outside the control of the employee and the
entity if it is currently probable that the contingency would not occur. Examples include shares
redeemable only on the occurrence of a liquidity event, such as a change of control or an initial public
offering.

• Options that have a contingent cash-settlement provision not within the control of the employee or the
entity, if it is not currently probable that the contingency would occur

SAB Topic 14.E clarifies that, for purposes of classification outside of permanent equity under ASR 268,
share-based payment awards classified as equity under Statement 123R that are not redeemable for
cash or other assets would not be presumed to require net-cash settlement (under paragraphs 14 to 18 of
EITF 00-19) solely because the terms of the award require settlement in registered shares.

Statement 123R does not require an employee award to be classified as a liability if it contains provisions
for either direct or indirect repurchase of shares on exercise of an employee option solely to meet the
employer’s minimum statutory tax withholding requirements resulting from exercise. EITF Topic D-98
notes that the SEC staff would not expect SEC registrants to classify such employee awards outside of
permanent equity.

SAB Topic 14.E addresses how to determine the amount of a share-based payment award that should be
reported in temporary equity. A registrant “should present as temporary equity at each balance sheet date
an amount that is based on the redemption amount of the instrument, but takes into account the
proportion of consideration received in the form of employee services” at that date. In other words, the
amount reported as temporary equity for an award of common shares that is not fully vested is based on
the redemption amount determined at the balance sheet date, prorated for the cumulative vesting
percentage of the award at that date. When awards are fully vested, the amount reported in temporary
equity should be adjusted to the redemption amount in the period a change in the redemption amount
occurs.
New Developments Summary 23

Two years ago an entity awarded 100,000 common shares to employees. The grant date
fair value of the shares was $25. The shares have a four-year vesting provision and are
puttable to the entity at fair value anytime after the shares have been vested for six
months. The current share price is $30. The entity should report the redeemable shares
in temporary equity with a carrying amount of $1,500,000 (100,000 x $30 x 0.5), because
the cumulative vesting percentage at the balance sheet date was 50 percent.

The required adjustments to temporary equity at each balance sheet date are recorded as a
reclassification between permanent equity and temporary equity. Although there is not explicit guidance
on the equity accounts affected by the reclassification, retained earnings would generally not be charged
unless there is an insufficient amount of additional paid-in capital. The reclassification does not affect the
amount of recognized compensation cost and therefore would not affect the income statement.

SAB Topic 14.E and EITF Topic D-98 provide guidance on the amount to be classified as temporary
equity if the redeemable instrument is an option or similar instrument. For such instruments, the initial
amount to be reported in temporary equity should be based on the redemption provisions of the
instrument and prorated for the vested percentage of the instrument on that date. If the instrument is an
option on a share that is redeemable at fair value, the amount reported in temporary equity should be the
vested percentage of the intrinsic value of the option on the balance sheet date, rather than the vested
percentage of the redeemable amount. This is because the option holder will pay the entity the exercise
price when the option is exercised. Therefore, although the entity will pay the redemption price when the
holder redeems the shares, the net cash outflow for the entity is the option’s intrinsic value. If the
instrument is a fully vested option redeemable at its intrinsic value on a change of control, and a change
in control is not probable, an amount representing the grant-date intrinsic value of the option should be
reported in temporary equity.

EITF Topic D-98 provides general guidance on determining the amount that should be reported outside of
permanent equity if an award is not redeemable currently because a contingency has not been met and it
is not probable at the balance sheet date that the instrument will become redeemable. (This would apply,
for example, to a share that is redeemable on a change of control before the occurrence of a change of
control is probable, but only if the share is not otherwise subject to classification as a liability under the
guidance of Statement 123R). If the award is a share that is contingently redeemable at fair value, the
amount reported in temporary equity would be the share’s grant-date fair value (or the vested percentage
of the share’s grant-date fair value if the share is not fully vested). The amount reported in temporary
equity would continue to be the grant-date fair value (or the grant-date fair value prorated for the vested
percentage) of the award as long as it is not probable that the contingent will occur. However, if the award
with the contingent feature is an option that is redeemable for its intrinsic value if a specified contingency
occurs, only the grant-date intrinsic value of the option (or the grant-date intrinsic value prorated for the
vested percentage) should be reported in temporary equity if the contingency is not probable of occurring
on the balance sheet date. Therefore, no amount would be reported in temporary equity if an equity-
classified option can be cash settled for its intrinsic value on a change of control and the option had no
intrinsic value on the grant date. An entity should reassess the probability of a contingent event occurring
each reporting period. If the contingent event becomes probable, the award becomes a liability and the
temporary equity provisions no longer apply.

The following table summarizes the SEC staff’s requirements for reclassifying an amount from permanent
equity to temporary equity when an instrument accounted for under Statement 123R that is classified in
equity has redemption features.
New Developments Summary 24

Instrument classified in Amount required to be classified outside


equity of permanent equity

Fully vested award Partially vested award

Share with redemption Redemption amount at Redemption amount at


features (that apply only after balance sheet date balance sheet date multiplied
share has been fully vested for by the vested percentage of
six months) the award

Option on a share redeemable Intrinsic value of the option at Intrinsic value of the option at
at fair value (redemption the balance sheet date the balance sheet date
feature applies only after multiplied by the vested
option has been exercised and percentage of the award
share held six months)

Contingently redeemable Redemption amount at grant Redemption amount at grant


share if contingent event is date date multiplied by the vested
outside the employee’s control percentage of the award
and if it is not probable at the
balance sheet date that the
event will occur

Option redeemable at intrinsic Grant date intrinsic value Grant date intrinsic value
value on occurrence of (which would be $0 if the multiplied by the vested
contingent event not within the award was at-the-money when percentage of the award
employee’s control, provided it granted)
is not probable at the balance
sheet date that the event will
occur

Accounting for dividends paid to holders of liability awards


Because the fair value (or intrinsic value for certain nonpublic entities) of liability awards is remeasured
each reporting period, the payment of dividends on share-based payment awards is reflected in the fair
value (or intrinsic value, as applicable) of those awards as dividend payments are made. If dividends are
paid to holders of share-based liability awards (such as a share with an embedded put exercisable within
six months of vesting), the dividends are accounted for as compensation cost.
New Developments Summary 25

D. What is the fair-value-based measurement method?


All entities are required to recognize in their financial statements the cost of share-based payment
transactions with employees. The measurement objective in determining that cost is to estimate the fair
value of the share-based instruments an entity is obligated to issue to its employees when the employees
have satisfied the requisite service period (the period over which an employee is required to provide
service in exchange for a share-based payment award) and any other conditions necessary to earn the
instruments. For transactions with employees, therefore, cost is determined based on an estimate of the
fair value of the share-based instruments that will be issued rather than on a direct measure of the fair
value of the employee services the entity will receive in exchange for the share-based instruments. The
portion of the fair value of an instrument attributable to employee service is the fair value net of any
amount the employee pays for the instrument (for example, the option or the share) on the grant date.
Employees are often not required to pay any of the share price or the option premium when granted a
restricted share or an option. In that situation, the cost attributable to employee service is the entire fair
value of the award.

The fair value of share-based payment awards is not determined under the provisions of FASB Statement
157, Fair Value Measurements, because Statement 123R and related interpretive pronouncements are
excluded from the scope of Statement 157. The fair value of share-based payment awards is determined
under the measurement guidance in Statement 123R and related pronouncements, which is discussed in
this section and in section E and section F.

Fair-value-based measurement method


Although the measurement objective in Statement 123R is fair value, the Statement specifies a fair-value-
based measurement method that entities are required to follow to estimate the value of employee awards.
That method differs in some respects from a normal fair value method because, as described below,
some features and conditions of the awards are excluded from the estimation of the fair value of
employee awards. However, for convenience, this document (and Statement 123R) uses the term fair
value to refer to the fair-value-based measurement method required for employee awards. The fair-value-
based measurement method requires the use of a fair value hierarchy described in section F and fair
value measurement techniques, such as the use of appropriate valuation models for options. However, it
also specifies the following requirements, some of which differ from a pure fair value approach:

• Fair value is determined based on the substance of an award, regardless of how it is structured. For
example, if shares are transferred to an employee in exchange for a nonrecourse note secured only
by the shares, the transaction is the same as granting the employee an option to purchase the shares
and should therefore be accounted for as an option grant.

• Restrictions on share-based instruments issued to employees affect the estimate of fair value only if
the restrictions remain in effect after the requisite service period. Restrictions that remain in effect,
such as the nontransferability of vested options or a prohibition on the sale of vested shares for a
period of time, are taken into account in estimating an award’s fair value as follows:

− The effect on fair value of the nontransferability (and the nonhedgability) of vested options is
taken into account by a requirement to use the expected life in the valuation of the option rather
than the option’s contractual life. Determination of the expected life is based on consideration of
the employee’s expected exercise and post-vesting employment termination behavior.

− A share the employee is contractually or governmentally prohibited from selling after having a
vested right to it (for example, the employee is not permitted to sell the share until a year after it
becomes vested) should be measured at the same amount as similarly restricted shares issued
New Developments Summary 26

to third parties (see section F, under the heading “Fair value hierarchy,” for implementation
guidance on discounts on such shares).

• Restrictions on the transferability of unvested options and a prohibition on the sale of unvested
shares are not taken into account in determining the award’s fair value.

• Service conditions and performance conditions affecting vesting or exercisability, which are often
embedded in employee awards, are ignored in determining the fair value of the awards. Instead, no
cost is recognized for awards that are forfeited because the required service or performance
conditions are not met. Because entities ultimately recognize cost only for awards for which the
service and performance conditions are met, the cost recognized for those awards is not reduced to
reflect their service and/or performance conditions.

• Some employee awards contain market conditions that affect the exercise price, exercisability, or
other factor related to the award. A market condition relates to the achievement of a specified price of
the issuer’s shares, a specified amount of intrinsic value indexed solely to the issuer’s shares, or a
specified price of the issuer’s shares relative to the price of a similar (or index of a similar) equity
security. Compensation cost is recognized for employee awards with market conditions, provided the
employee satisfies the requisite service period, regardless of whether the market condition is ever
satisfied. Therefore, a market condition is included in the estimation of an award’s fair value. Inclusion
of the market condition reduces the fair value of the award, because it is a contingency that must be
attained, for example, for the award to become exercisable, as illustrated in the following example.

An option becomes exercisable if the entity’s share price increases at least as much as a
competitor’s (on a percentage basis) over a two-year period. The market condition needs
to be considered in the estimation of fair value. Compensation cost is recognized if the
employee provides service for two years, even if the entity’s share price did not increase
as much as its competitor’s during that period and the option is therefore never
exercisable.

• The fair value of employee share-based payment awards excludes

− Reload features: Employee options sometimes have an embedded reload feature that provides
for an automatic grant of additional options if the employee exercises the original option using
previously acquired employer shares. A reload feature in an award is not included in estimating
the award’s grant-date fair value. Instead, reload options issued on exercise of an option with a
reload feature are accounted for as separate awards.

− Clawbacks and other contingent features: Employee awards may have a contingent feature that
requires the employee to return to the employer equity instruments earned or realized gains from
the sale of equity instruments acquired in a share-based payment arrangement. An example is a
clawback feature included in a grant of fully vested shares that requires the employee to return
the equity shares to the employer if the employee terminates employment and begins to work for
a competitor. Such contingent features are not included in the grant-date fair value of the award.
Instead, they are accounted for if and when the contingent event occurs by recognizing the
consideration received in the appropriate balance sheet account and a credit in the income
statement equal to the lesser of the compensation cost previously recognized for the award and
the fair value of the consideration received.
New Developments Summary 27

Exceptions from the requirement to use the fair-value-based measurement


method
Statement 123R recognizes that, in certain situations, entities may not be able to determine the fair value
of an option award. It makes an exception from the requirement to value options at fair value in the
following two limited circumstances, neither of which is optional:

• Use of calculated value—applicable only to certain nonpublic entities: If it is not practicable for a
nonpublic entity to reasonably estimate the expected volatility of its share price (presumably this
would occur, for example, if the nonpublic company could not identify similar public entities whose
average volatilities the entity could use as a surrogate for its own share price volatility), the entity is
required to use the calculated value method to estimate the value of its options and similar
instruments. The calculated value method consists of substituting the historical volatility of an
appropriate industry sector index for the entity’s own expected volatility in the valuation model it uses
to estimate the value of its options.

• Use of variable intrinsic value—applicable to all entities, but only in rare circumstances: There is a
strong presumption in Statement 123R that fair value can be determined for option awards, including
those with complex provisions. Relevant implementation guidance can be found in appendix A of the
Statement. Paragraph 24 provides, however, that “in rare circumstances, it may not be possible to
reasonably estimate the fair value of an equity share option or other equity instrument at grant date
because of the complexity of its terms.” If an entity, public or nonpublic, is not able to reasonably
estimate an option’s fair value (or calculated value) on the grant date because of the complexity of the
option’s provisions, the option should initially be accounted for based on its grant-date intrinsic value,
and then be remeasured and reported at current intrinsic value as of each reporting date. An entity is
required to continue using the variable intrinsic value method for these awards even if it subsequently
determines it can reasonably estimate their fair value. An award subject to variable intrinsic value is
remeasured each period until it is exercised or settled or expires unexercised. The final cost will
therefore be the option’s intrinsic value on the date it is exercised, settled, or expires.

Liability awards: nonpublic entities have accounting policy choice


Nonpublic entities have a choice of methods for accounting for their share-based payment awards that
require classification as liabilities. They can account for them at fair value (or calculated value, if
applicable) or intrinsic value. Therefore, a nonpublic entity that has awards that require liability
classification has to make a policy decision about its accounting method for awards classified as liabilities
and apply the policy selected consistently to all share-based payment liability awards it issues. Intrinsic
value measurement is similar to the variable accounting method required for repriced options under APB
Opinion 25.

A nonpublic entity using calculated value for equity-classified awards should choose either calculated
value or intrinsic value measurement for employee awards classified as liabilities. Even if the entity is later
able to reasonably estimate its fair value, a liability award originally measured at calculated value must
continue to be (1) accounted for at either calculated value or intrinsic value, whichever the entity has
elected, and (2) remeasured each reporting date until settlement (or until the award no longer requires
classification as a liability).

For purposes of justifying a change in accounting principle, Statement 123R specifies that the fair-value-
based method is preferable. Regardless of the method selected for valuation of a liability award, the
amount is remeasured each period until settlement, at which time it is adjusted to the amount paid to
settle the liability.
New Developments Summary 28

Definition of nonpublic entity


For purposes of applying Statement 123R, a nonpublic entity is any entity other than one to which any of
the following apply: (a) its equity securities trade in a public market either on a stock exchange (domestic
or foreign) or in the over-the-counter market, including securities quoted only locally or regionally, (b) it
makes a filing with a regulatory agency in preparation for the sale of any class of equity securities in a
public market, or (c) it is controlled by an entity covered by (a) or (b). “An entity that has only debt
securities trading in a public market (or that has made a filing with a regulatory agency in preparation to
trade only debt securities) is a nonpublic entity for purposes of this Statement” (paragraph E1).

An entity that does not have publicly traded equity would therefore be considered a public entity under
Statement 123R if it is a subsidiary of an entity that has publicly traded equity. In addition, an entity loses
its nonpublic status when it initially files in preparation for a public offering of equity securities.

At its meeting on September 13, 2005, the FASB’s Statement 123R Resource Group reached a
consensus that the following two types of entities would not qualify as nonpublic entities under the above
definition and would therefore be considered public entities:

• An entity that does not have publicly traded equity securities but is controlled by a private equity fund
if the parent of the private equity fund is a public company. This situation is not uncommon. It often
requires careful evaluation to determine whether the private equity fund is a subsidiary of a public
entity. This is because both the private equity fund and the parent of the private equity fund may not
consolidate their respective subsidiaries, but rather account for them at fair value under the guidance
in the AICPA Audit and Accounting Guide, Investment Companies.

• A U.S. subsidiary whose parent has equity securities that trade publicly in a foreign jurisdiction

Because subsidiaries of public companies are considered public companies for purposes of Statement
123R, many entities that do not have publicly traded equity securities will not meet the definition of a
nonpublic entity and therefore will not be able to use the calculated value method or to elect to use the
intrinsic value method to account for liability awards.

Employee share purchase plans


Employee share purchase plans are typically broad-based plans that permit employees to purchase their
employer’s shares, generally at a discount, through payroll deductions. If they meet the requirements of
Internal Revenue Code section 423, such plans receive special tax benefits. Section 423 plans were
noncompensatory (no cost required to be recognized) under APB Opinion 25. Under Statement 123R
(and under Statement 123, except as noted), compensation cost is recognized for employee share
purchase plans unless they meet all of the following criteria, which are more stringent than the
requirements of section 423:

• The plan satisfies at least one of the following conditions:

− Its terms are no more favorable than those available to all holders of the same class of shares.
(However, if the class is exclusively for employees, the transaction may be compensatory,
depending on its terms. For example, if a class of shares is issued only to employees (Class E)
and is the same as a class of shares sold to nonemployees except the employees can buy Class
E shares at a discount, it would appear Class E shares are compensatory unless the discount
does not exceed the per-share cost to raise significant capital.) This provision differs from the
Statement 123 provision it replaces.

− Any discount from the market price does not exceed the per-share cost to raise a significant
amount of capital in a public offering. A discount of five percent or less satisfies this condition. A
New Developments Summary 29

discount of more than five percent may satisfy the per-share cost condition based on objective
evidence, for example, if the discount does not exceed the entity’s own offering costs in a recent
offering or the offering costs incurred by similar entities. Such an entity, however, is required to
reassess the justifiable discount amount at least annually and no later than the first share
purchase offer during each fiscal year.

• Substantially all employees meeting limited employment requirements may participate.

• The plan has no option features other than the following:

− Employees are required to enroll in the plan within 31 days after the purchase price has been
fixed.

− The purchase price is the market price of the shares at the date of purchase and employees may
cancel their participation before the purchase date and receive a refund.

If the purchase price specified under a plan offering is the lesser of the share’s market price at the
grant date or at the purchase date, the plan would be compensatory because of that option
feature (which is known as a look-back option). If the purchase price is the share’s market price at
the grant date and participants can cancel their participation at any time before the purchase
date, the option to cancel would cause the plan to be compensatory.

Because the above criteria for employee share purchase plans to be noncompensatory are considerably
more stringent than the requirements of section 423 for tax-favored plans, plans structured to meet the
provisions of section 423 will be compensatory under Statement 123R unless the plans are modified—for
example, to reduce the discount given to employees and eliminate certain option features, such as look-
back options.

Entities with compensatory employee share purchase plans are required to determine the fair value of the
awards and recognize it over the requisite service period, which would be the period during which the
employee participates in the plan and pays for the shares. If the awards have look-back options, guidance
on determining the fair value of the award is provided in illustration 19 of Statement 123R. For more
complex options, valuation guidance is provided in FASB Technical Bulletin 97-1, Accounting under
Statement 123 for Certain Employee Stock Purchase Plans with a Look-Back Option, as amended by
Statement 123R. That Technical Bulletin provides that if the fair value of the award cannot be reasonably
estimated, it should be accounted for using variable intrinsic value, which is discussed above under the
heading “Exceptions from the requirement to use the fair-value-based measurement method.”

If an award provides for purchase of shares at a fixed discount from the purchase date stock price, the
discount and any withholdings to date are classified as liabilities, because the award requires settlement
of a fixed monetary amount known at inception with a variable number of the employer’s equity shares.
Under the classification provisions of paragraph 12 of Statement 150, the award requires liability
classification.

An employee has agreed to have $1,000 withheld from the employee’s salary over a six-
month period. At the end of the six-month period the $1,000 will be used to buy the
employer’s shares at a 10 percent discount from the purchase date share price.
Regardless of the share price of the employer’s stock on the purchase date, the
employee will receive shares with a value of $1,111. The award requires settlement of a
fixed monetary amount known at inception, $1,111, with a variable number of shares. It
therefore requires liability classification under Statement 150. The compensation cost of
$111 would be recognized ratably over the six-month purchase period.
New Developments Summary 30

If an employee forfeits an award in a compensatory plan, compensation previously recognized should be


reversed. However, if an employee completes the requisite service period for an award but elects not to
purchase some or all of the awards, compensation is not reversed. In effect, the employee has elected
not to exercise a fully vested option.
New Developments Summary 31

E. When is fair value measured?


The cost to be recognized for an employee share-based payment award is its fair value on Statement
123R’s specified measurement date. The measurement date for an award depends on whether the award
is classified in equity or as a liability.

Equity awards
The cost for a share-based payment award classified in equity is measured on the award’s grant date
(except, as discussed in section D, in rare circumstances in which the award is accounted for at variable
intrinsic value because its fair value cannot be reasonably determined on the grant date). Consequently,
determining the grant date is an important aspect of determining the cost of a share-based equity award.

When does the grant date occur?


A grant date does not occur until five conditions have been met. In accounting for share-based payment
awards, an entity needs to be familiar with those conditions and how they are interpreted in the
Statement’s implementation guidance. Entities will have to ascertain for each employee grant the date on
which all conditions have been met. The following five conditions, which are described in more detail
below, are required to be met in order to have a grant date for an employee award:

• Mutual understanding exists between the employer and the employee.

• All approvals have been obtained.

• The grantee is an employee under common law.

• The entity is obligated to issue the awards.

• The employee is affected by subsequent changes in the share price.

Mutual understanding between employer and employee


The employer and the employee must have reached a mutual understanding sufficient for both to
understand the compensatory and the equity relationship established by the award. In other words, the
employer and employee need to have agreed on the key terms of the share-based payment award and
the conditions the employee has to satisfy to earn the award. Key terms for an option would include the
option’s exercise price and contractual term, the vesting provisions, and the number of options the
employee will receive. Those terms may be established through a written or oral agreement. Some
aspects may be communicated based on the company’s past practice.

If a look-back share option provides that the exercise price of the option will be the lower of the share
price on the date of grant or on the one-year anniversary date, the employee knows the exercise price
cannot exceed the share price on the date of grant and that it may be lower. That information about the
exercise price and the current share price is sufficient to understand the compensatory and equity
relationship established by the award.

Assume an option award permits only physical settlement; that is, to exercise the option,
the employee pays the exercise price and the employer issues the share. If the employer
has a past practice of settling such option awards in cash equal to the option’s intrinsic
value (net-cash settlement of the award) when requested to do so by employees, the
net-cash settlement feature would be understood by the employer and the employee
based on that past practice. In that situation, the option would be classified as a liability.
New Developments Summary 32

FSP on timing of communication of key terms and conditions of award

The FASB staff has issued FSP FAS 123R-2, “Practical Accommodation to the Application of Grant Date
as Defined in FASB Statement No. 123(R).” That FSP provides that, assuming all other conditions
required to achieve a grant date have been met, a mutual understanding of key terms and conditions is
presumed to exist at the date final approval of the award occurs, provided both of the following conditions
are satisfied:

• The award is a unilateral grant and the recipient is therefore unable to negotiate the key terms and
conditions of the award with the employer.

• The key terms are expected to be communicated to the employee within a relatively short time period
after the approval date. A relatively short time period is defined as “that period an entity could
reasonably complete all actions necessary to communicate the awards to the recipients in
accordance with the entity’s customary human resource practice.”

Subjective performance conditions

Under Statement 123R, a performance condition may pertain to an assessment of an individual’s


performance as an employee. Whether the employer and employee have a mutual understanding of the
key terms and conditions of an award that includes a performance condition based on the employee’s
performance evaluation depends on the objectivity of the evaluation. All facts and circumstances
pertaining to the performance evaluation process should be considered. If the evaluation is solely for the
purpose of determining whether the employee’s share-based awards vest, it is unlikely the evaluation
process would be sufficiently objective to establish a mutual understanding of the award. In contrast, if the
employer has an established evaluation system used as the basis for all compensation decisions, if the
system includes specific criteria on which the employee will be evaluated, and if the results of the overall
evaluation process are required to result in a specified distribution pattern, then the performance
condition may be sufficiently objective that the conditions of the award are mutually understood by the
employer and the employee.

All approvals have been obtained


If the award is subject to approval(s), such as the approval of shareholders, the board of directors, the
compensation committee, and/or management, all approvals must have been obtained in order to have a
grant date. Requirements to obtain approval are generally specified in the entity’s share-based awards
plan, but may also be required by, among other things, a board resolution or regulatory requirements.

Actual shareholder approval is not required in order to have a grant date if obtaining shareholder approval
is essentially a formality (or perfunctory). Statement 123R does not provide guidance on what is meant by
“approval is essentially a formality.” The FASB, however, provided an illustration of when that condition
exists in Interpretation44: “[I]f management and the members of the board of directors control sufficient
votes to approve the plan, a grant date … may be deemed to occur prior to shareholder approval
because such approval is essentially a formality.” That illustration has been applied in practice to mean
management and board members currently hold a majority of the voting shares and are expected to
continue doing so through the shareholder meeting date. Also, control is determined based on
outstanding voting shares, not shares expected to be voted at the shareholders’ meeting. The probability
of shareholders approving the award, even if based on past experience, would not make shareholder
approval a formality or perfunctory.
New Developments Summary 33

Grantee is an employee
The grant date cannot occur until the recipient meets the Statement 123R definition of an employee, that
is, until the individual is providing services and an employer-employee relationship based on common law
exists.

On February 1, 20X1, an individual is hired to be Company A’s new controller and is


awarded 5,000 options that will vest on February 1, 20X2. The new controller will begin
the new position on May 1, 20X1. The grant date of the award is May 1, 20X1, the day
the new controller begins to provide employee services and meets the definition of an
employee, provided all other grant date conditions are met on that date. Compensation
cost for the options would be recognized on a straight-line basis over the nine-month
period from May 1, 20X1 through February 1, 20X2. (For an illustration of how cost is
recognized if the award has graded vesting, see “Awards with graded vesting” in
section G.)

Entity is obligated to issue awards


The employer has to be obligated to issue the equity instrument or transfer assets to the employee
contingent on the employee rendering the service required during the requisite service period. This would
usually occur by the time the preceding conditions required to establish a grant date have been met.

Employee is affected by changes in share price


A grant date does not occur until the employee begins to benefit from, or be adversely affected by,
subsequent changes in the price of the employer’s shares. Therefore, if an employee is granted options in
which the exercise price will be based on the entity’s share price at a future date, the grant date cannot
occur before that future date.

If the exercise price of the controller’s award described in the preceding example is the
share price on the first anniversary of the controller’s hire date, the grant date would be
February 1, 20X2, because the controller will not be affected by subsequent changes in
the price of the employer’s shares until then. In addition, the award would not provide a
sufficient basis to understand the nature of its compensatory and equity relationships until
then.
In contrast, if an employee received a share option with the look-back feature described
in the first example in this section, the employee would not be adversely affected by
decreases in the share price during the first year, but the employee would benefit from
increases in the share price during that period. Statement 123R provides that such an
exposure to changes in the share price would meet this condition for establishing a grant
date.

Effect of a deferred grant date on recognition of compensation cost


Compensation cost is not recognized until all the above conditions for establishing a grant date have
been met, except in the unusual circumstances discussed in section G when the service inception date
precedes the grant date. There is no “catch up” of compensation cost on the grant date for the period
New Developments Summary 34

from the approval date to the grant date. Instead, for equity awards with only a service condition,
compensation cost is generally recognized on a straight-line basis over the remaining service period.

Assume an award subject to shareholder approval was communicated to employees and


approved by the board on January 1, had a one-year vesting period ending
December 31, and received required shareholder approval on July 1. Compensation cost
would be recognized on a straight-line basis over the six-month period from July 1
through December 31. There would be no catch up of compensation cost on July 1 for
the period from January 1 through June 30.

Procedures to determine when grant date occurs


Knowledge of the accounting rules for when grant date occurs is essential, as grant date is the date on
which fair value is estimated for purposes of cost recognition in the financial statements. However,
familiarity with the rules for when grant date occurs is also important for designing employee share-based
payment awards that do not expose the entity to unexpected accounting consequences.

Employment contracts for new managerial employees are often entered into several
weeks, and sometimes several months, before the individuals can begin providing
services for the new employer. If a contract will include option grants, the entity may want
to provide that the exercise price of the options will be the share price on the date the
individual begins to provide services as an employee. The grant date, and therefore the
measurement date, for an equity award cannot occur before the individual is an
employee. By deferring the determination of the exercise price, the entity avoids
accounting for awards that perhaps unintentionally include intrinsic value.

Internal controls and procedures for granting options


Statement 123R is explicit on the importance of completing certain corporate governance procedures
when determining whether a grant date has occurred. The SEC staff has observed that certain granting
practices that did not delay the measurement date under APB Opinion 25 may in fact delay the grant date
under Statement 123R. Entities that intentionally or inadvertently use the wrong grant date in accounting
for their option awards encounter accounting, tax, regulatory compliance, and possibly executive turnover
dilemmas. How do entities avoid grant date problems? The Director of the SEC Division of Enforcement
and others have addressed this topic, and a common recommendation is for all entities to improve their
process and internal controls for granting and administering share-based payment awards. The SEC staff
noted that accounting issues rarely arise if a company has a well controlled process for granting options.

The recommended objective is for an entity to establish a well defined process, and related internal
controls, that (1) result in the issuance of share-based awards that comply with requirements of the
entity’s stock plan, bylaws and/or other corporate operating procedures, stock exchange requirements,
accounting requirements, tax laws, SEC disclosure rules, and other regulatory requirements and (2)
provide for fair and transparent disclosures for investors. The following are some suggestions for entities
to consider to strengthen their existing process, procedures, and internal controls:
New Developments Summary 35

• Establish procedures that result in grants that comply with all legal requirements for stock or option
issuance, as the SEC and/or the Internal Revenue Service may, in the future, require legal issuance
to establish a grant date for accounting and/or tax purposes.

• If exceptional situations are contemplated that could affect when the grant date occurs, establish
appropriate procedures. For example:

− If delegation of authority to approve grants is contemplated, such as approval of grants to new


employees by management

 Determine whether delegation is permitted under the stock plan and not prohibited by other
corporate governance policies or state law

 Establish procedures to delegate award issuance authority and provide for oversight of the
delegated authority by the compensation committee or board of directors

− If authorization of grants by unanimous written consent is contemplated

 Determine when approval legally occurs under state law

 Develop procedures to track receipt of the consents and determine the final authorization
date

• Require that a grant-date compliance document be completed for each grant. The grant-date
compliance document should list the accounting requirements for achieving a grant date, specify
required documentation, and provide for sign-off of each step.

• Require a written list as of the approval date that identifies the individuals receiving grants and the
number of shares or options they will receive

• Establish a standard procedure for notifying each employee of the terms of his or her share-based
awards on a timely basis following final approval in a manner that complies with FSP FAS 123(R)-2,
which is discussed above under the subheading “FSP on timing of communication of key terms and
conditions of award.”

• Consider establishing a fixed schedule for awarding share-based compensation, such as prescribed
dates for quarterly or annual grants. It could include guidelines both for grants to new employees and
on employees’ promotions. The schedule would eliminate problems surrounding random grants, such
as the possibility of backdating, by imposing discipline on the timing of granting awards and
eliminating the ability to game share price lows or the timing of disclosures of information expected to
affect the share price.

• Develop internal controls over the share-based payment process

• Establish a tone at the top that supports the process and prohibits deviations, exceptions, and
management overrides

Liability awards
The measurement date for share-based payment awards classified as liabilities is the settlement date.
Liabilities are therefore remeasured at the end of each reporting period through settlement. The final
measurement of the award is the amount of cash or other assets paid to settle the liability (paragraph 50).
Therefore, in the period settlement occurs, cumulative compensation cost recognized is adjusted to the
settlement amount.
New Developments Summary 36

Public entities

Public entities account for share-based payment liabilities at fair value, with the liability’s fair value
remeasured as of the end of each reporting period until settlement (or when the award no longer requires
classification as a liability). Prior to settlement, the cost is recognized proportionately over the employees’
requisite service period, and once that period is over and the awards are fully vested, changes in fair
value are recognized in the period in which they occur.

Nonpublic entities

As noted in section D, a nonpublic entity is required to make a policy decision about whether it will
account for its employee share-based payment liabilities at fair value (calculated value if they are unable
to reasonably estimate the expected volatility of their share price) or intrinsic value. Regardless of the
valuation method selected, the amount is remeasured each period until settlement (or when the award no
longer requires classification as a liability). It is adjusted at settlement to the amount paid to settle the
liability. The fair value method is considered preferable to the intrinsic value method in justifying a change
in accounting method. The FASB noted that some nonpublic entities may be planning an initial public
offering and therefore may choose to record share-based payment liabilities at fair value.
New Developments Summary 37

F. How is fair value determined?


Fair value hierarchy for share-based payment awards
As noted in section D, the measurement objective for share-based payment equity awards granted to
employees is the grant-date fair value of the awards the employer will be obligated to issue when the
employee has rendered the service required during the requisite service period. The fair value is
determined based on the share price and other factors pertinent to the award at the grant date and is not
subsequently remeasured.

For liability awards, fair value is determined in the same manner, except the final measurement date is
not the grant date; it is the date the award is settled. Therefore, fair value for liability awards is determined
as of the end of each reporting period until settlement, based on the share price and other factors
pertinent to the award on the measurement date.

As noted in section D, the fair value of share-based payment awards is not determined under the
provisions of FASB Statement 157, Fair Value Measurements, because Statement 123R and related
interpretive pronouncements are excluded from the scope of Statement 157. Their fair value is
determined under the measurement guidance in Statement 123R and related pronouncements, which is
discussed in this section, section D, and section E.

Conceptually, fair value is the value of the share-based instrument in a current exchange. Because there
are not always observable exchange values for share-based instruments, Statement 123R requires that
the fair value of instruments should be determined according to the following hierarchy:

• If observable market prices (exchange values) in active markets are available for identical or similar
equity or liability instruments, they should be used to value the equity or liability instrument. The
following are examples of awards whose fair value should be based on observable market prices:

− An observable market price of an identical equity instrument is available for a grant of a fully
vested, unrestricted share of a public company.

− An observable market price of a similar equity instrument is available for a grant of an unvested,
nontransferable share of a public company that will be transferable (unrestricted) when fully
vested.

• If observable market prices for identical or similar equity or liability instruments are not available, fair
value should be estimated by applying a valuation technique that would be used to determine the
amount at which instruments would be exchanged. The valuation technique should

− Be applied in a manner consistent with the fair-value-based measurement objective

− Be based on generally applied principles of financial economic theory

− Reflect all substantive characteristics of the instrument not explicitly excluded under the fair-
value-based method

Market quotes are not available for long-term, nontransferable share options because such
instruments are not traded. Valuation techniques are generally required to estimate the fair value
of long-term employee options.

As discussed in section D, although the measurement objective in Statement 123R is fair value, the
Statement specifies a fair-value-based measurement method that entities are required to follow to
estimate the value of employee awards. Under the fair-value-based measurement method, the fair value
New Developments Summary 38

of an award should reflect all substantive characteristics of the instrument, except those explicitly
excluded by Statement 123R. Explicitly excluded features include

• Service conditions

• Performance conditions

• Restrictions that apply during the vesting period

• Reload features

• Certain contingent features, such as clawbacks related to noncompete agreements

Share-based payment awards typically specify a service or performance condition, or both, that must be
met for an employee to earn the right to an award. Under Statement 123R, no compensation cost is
recognized for instruments that are forfeited because a service or performance condition is not met.
Therefore, to avoid duplicating the impact of service and performance conditions on compensation cost,
those conditions are excluded from the estimation of an instrument’s fair value. In contrast, instruments
with market conditions are included in compensation cost if the employee renders the requisite service,
regardless of whether the market condition is achieved and the employee is able to exercise the award.
Market conditions are therefore included in the estimation of an award’s fair value.

Restrictions on share-based instruments during the vesting period, such as the inability to transfer
unvested awards, are not taken into account in estimating the fair value of the award. However,
restrictions that remain in effect after an award is vested, such as the inability to transfer or hedge vested
options or a prohibition on the sale of outstanding vested shares for a period of time, affect the estimate
of an award’s fair value.

The effect on fair value of the inability to transfer or hedge vested options is taken into account by a
requirement to use the expected life in the valuation of the option rather than the option’s contractual
term. The SEC staff confirmed in SAB Topic 14.D.2 that no additional reduction in the option term or other
discount to the estimated fair value is appropriate for those particular factors.

A vested share that the employee is prohibited from selling due to a contractual or governmental
restriction is measured at the same amount as similarly restricted shares issued to third parties.

Note that the use of a value other than the fair value of an unrestricted share is limited to
shares that the employee is prohibited from selling. If sales of vested shares are not
prohibited but are subject to certain limitations, such as sales of securities subject to SEC
Rule 144A that are limited to qualified institutional buyers, the shares are valued at the
fair value of an unrestricted share. Most restrictions seen in practice are limitations on
sale, not prohibitions, and therefore would not be considered for a discount from the
value of an unrestricted share.

At the 2007 AICPA National Conference on Current SEC and PCAOB Developments, the SEC staff
reminded registrants that any discount on a restricted vested award should be specific to the security and
not derived from a general rule of thumb. Footnote 42 of Statement 123R provides that “if shares are
traded in an active market, post-vesting restrictions may have little, if any, effect on the amount at which
the shares being valued would be exchanged.” Further, the SEC staff believes that, absent objective
evidence of the fair value of similarly restricted shares, the quoted market price of unrestricted shares is
the best evidence of the fair value of restricted shares.
New Developments Summary 39

The SEC staff also clarified at the 2007 Conference that management should consider only the attributes
of a share-based payment award itself—that is, attributes a market participant would consider as opposed
to attributes a specific employee might consider—in valuing a security issued in a share-based payment
arrangement. Some registrants have argued in favor of taking a significant discount on certain share-
based payment awards, because the securities were issued to executives who were subject to higher
taxes than other employees. The staff believes it would be difficult to substantiate that assumptions
reflecting an attribute of a specific holder, as opposed to an attribute of the award itself, would be
appropriate. The staff, therefore, does not believe that such a discount is consistent with the fair value
measurement objective included in Statement 123R.

In SAB Topic 14.C, the SEC staff clarified that public entities are not required to use external valuation
professionals to determine the fair value of their share-based payment awards if employees have the
requisite expertise to perform the valuation. The Statement 123R Resource Group reached a consensus
at its July 21, 2005 meeting that, for nonpublic entities, either the requisite expertise to determine the fair
value of share-based payment awards should exist internally or entities should use the services of
valuation professionals. The assessment of whether an employee has the requisite expertise will depend
on an entity’s specific situation.

Option valuation
The guidance in Statement 123R on option valuation applies to call options granted to employees, as well
as to similar instruments. Similar instruments refer to other employee share-based payment awards that
have time value, which is the possibility that the instrument may increase in value over its remaining term
because of the volatility of the underlying asset—the entity’s shares. The most commonly seen similar
instrument is a share appreciation right (SAR). SARs have a time value component and are required to
be accounted for at fair value, not intrinsic value, under Statement 123R. (As described in section D,
there is an elective exception to fair value accounting available to nonpublic entities for their awards
classified as liabilities.) The guidance in this section on option valuation would therefore also apply to the
valuation of SARs accounted for at fair value. The use of the term option in the remainder of this section
refers to options and similar instruments.

Observable market price


The best evidence of the fair value of employee share options is observable market prices of identical or
similar instruments in an active market. However, market prices for employee share options or similar
instruments are generally not available because most options are not traded, although Statement 123R
notes that observable prices may become available in the future (paragraph 22 and related footnote).
However, see the description below of market-traded instruments used to estimate the fair value of
employee options.

Market-based instrument to measure grant-date fair value


The SEC staff has encouraged the private sector to design market-traded instruments that would provide
a market-based measurement of the grant-date fair value of employee stock option grants. The staff
believes a market-based instrument that incorporates the following three elements could provide a
reasonable estimate of the grant-date fair value of an employee option:

• Appropriate instrument design that results in a market instrument that provides holders with net
payments equal in value to the fair value of all or a portion of the employee option grant

• A credible information plan that provides market participants with entity-specific information needed to
price the instruments
New Developments Summary 40

• A market-pricing mechanism for trading the instrument that encourages sufficient market participation
to allow competition among willing buyers and sellers

According to the staff, either of the following instrument designs may meet the measurement objectives of
Statement 123R:

• Layoff instruments: instruments that transfer an employers’ obligation under a share-based payment
arrangement to a third party

• Tracking instruments: instruments sold in an open market that track the payout employees receive
under a share-based payment arrangement

In 2007 Zions Bancorporation held two auctions of instruments intended to measure employee share-
based payments, correcting flaws in the instrument’s design and market-pricing mechanism between the
first and second auction. For the second auction, which took place in May 2007, the company analyzed
the instrument’s design, the auction process, and bidder participation. It compared the auction price to the
value of the company’s options using a widely applied modeling technique. The company concluded that
its instrument was appropriately designed, bidders were provided adequate information about employees’
option exercise behavior, the auction process functioned appropriately, and the model-based
assumptions implicit in the auction price were reasonable.

The SEC’s Office of the Chief Accountant issued a letter in October 2007 expressing the staff’s
conclusion that Zions Bancorporation’s second auction of a tracking instrument meets the measurement
objective of Statement 123R. The auction price therefore provided a reasonable estimate of the grant-
date fair value of the employee options that the issuer granted concurrently with the sale of the market
instruments.

Because market-based approaches are currently in the development stage and no secondary market
exists for these instruments to support the assumption that the clearing price is within a reasonable
spread, the staff believes registrants should benchmark the market-clearing price for these instruments. A
substantial difference between the market price and the value derived from an option-pricing model may
indicate deficiencies in the auction process that should be analyzed.

In its October 2007 letter, the SEC staff stated that it would expect issuers contemplating future auctions
to conduct a review similar to that undertaken by Zions Bancorporation that would address whether

• There are sufficient sophisticated bidders to constitute an active market.

• The bidders have sufficient information to value the investment and make an investment decision.

• The pattern of bidding consists of a reasonably low disparity between the lowest and highest bids
among the winning bidders.

• Bidders’ perceptions of material costs of holding, hedging, or trading the instrument substantially
affect their valuation of the instrument.

The SEC staff also indicated that a registrant and its external auditor should evaluate the results of each
auction based on the entity’s relevant facts and circumstances to ensure that the resulting price
represents a reasonable estimate of fair value in accordance with Statement 123R.

The accounting for the market-based instruments discussed in this section is affected by EITF Issue 07-5,
which is effective for fiscal years, including interim periods within those fiscal years, beginning after
December 15, 2008. The guidance provides a two-step method for determining whether an equity-linked
financial instrument is considered to be indexed to the entity’s own stock. This guidance is significant in
New Developments Summary 41

determining whether an equity-linked financial instrument is subject to the accounting guidance in either
Statement 133 or EITF Issue 00-19.

Although the guidance in EITF Issue 07-5 does not apply to share-based payment awards subject to
Statement 123R for purposes of determining whether the awards should be classified as liabilities or in
equity, market-based instruments are not within the scope of Statement 123R and are subject to the
guidance in EITF Issue 07-5. In fact, example 20 of EITF Issue 07-5 specifically addresses whether a
market-based instrument in the form of a tracking instrument is considered indexed to an entity’s own
stock and concludes that it is not. As a result, an entity that issues a tracking instrument to estimate the
fair value of a pool of its employee stock options would not meet the scope exception in paragraph 11(a)
of Statement 133 for instruments indexed to an entity’s own stock. Therefore, if the tracking instrument
meets the definition of a derivative in paragraphs 6 through 12 of Statement 133, it would be accounted
for as a liability at fair value, with changes in fair value recognized in earnings each reporting period.
Some tracking instruments may not meet the definition of a derivative. If they are not considered indexed
to the entity’s own stock, they would not be eligible for equity classification under EITF Issue 00-19. Such
market-based instruments should be accounted for as liabilities under appropriate GAAP. For instruments
in the form of options, the SEC staff has a long-standing position that written options should be accounted
for as liabilities at fair value, with changes in fair value recognized in earnings each reporting period.

Requirements for a valuation technique for options


Because market prices are generally not available for long-term, nontransferable employee share options,
entities generally use a valuation technique. It should be one that they would use to determine the
amount at which an option with the same substantive characteristics (except those explicitly excluded
from the fair value calculation by Statement 123R) would be exchanged with a third party (paragraph A8
of Statement 123R). Thus, the valuation model used should be consistent with a model marketplace
participants would likely use to value the option. Judgment is required to identify an award’s substantive
characteristics and to select a valuation technique that incorporates those characteristics. For example, if
an option contains a market condition (for instance, the award becomes exercisable when and if the
share price reaches $20), the valuation technique has to incorporate the market condition in the
determination of fair value.

Required assumptions
Statement 123R requires a valuation technique used to estimate the fair value of an option to take into
account the following characteristics, at a minimum:

• The exercise price

• The current share price

• The expected term of the option, taking into account both the contractual term of the option and the
effects of employees’ expected exercise and post-vesting employment termination behavior

• The expected volatility of the underlying share price:

− For the expected term of the option if the valuation technique used is a closed-form model such
as the Black-Scholes-Merton model

− For the contractual term of the option if a lattice or other model is used that derives the expected
option term based on employees’ expected exercise and post-vesting termination behavior

• The expected dividends on the underlying share over the expected (or contractual) term of the option

• The expected risk-free interest rate(s) for the expected (or contractual) term of the option
New Developments Summary 42

Those and any other characteristics, such as a market condition, that should be included in a fair value
estimate should be based on available information at the time of measurement.

The method of determining appropriate assumptions should be consistent from period to period.

Consistent use of a valuation technique


The valuation technique for a particular share-based payment instrument should be applied consistently
and should not be changed unless a different valuation technique is expected to produce a better
estimate of fair value. However, an entity that issues different types of instruments, each having a unique
set of substantive characteristics, may use a different valuation technique for each type of instrument. A
change in either the valuation method used, or the method of determining assumptions used in the
valuation technique, is a change in accounting estimate that will apply prospectively to new awards under
FASB Statement 154, Accounting Changes and Error Corrections.

The SEC staff indicated in SAB Topic 14.C that it will not object if a registrant changes its valuation
technique or model, provided the new technique or model meets the fair value measurement objective in
Statement 123R. The reason for the change affects whether the new technique meets the fair value
measurement objective. Changes in the model used from period to period for the sole purpose of
lowering the fair value estimate of the options would not meet that objective. A change in the valuation
technique or model would not be considered a change in accounting principle and therefore would not
require a preferability letter from the registrant’s independent accountants. The staff would, however, not
expect frequent changes in the valuation technique or model for a particular type of award, especially if
the form of the share-based payment had not changed significantly. In the PCAOB Staff Questions and
Answers: Auditing the Fair Value of Share Options Granted to Employees, the staff indicated that
frequent changes in the valuation technique or model might indicate the possibility of fraud.

Comparison of a lattice model and a closed-form model


Valuation techniques for share options include option-pricing lattice models and closed-form models, such
as the Black-Scholes-Merton model. A lattice option-pricing model, such as a binomial model, produces
an estimated fair value of the option based on the assumed changes in the price of the underlying share
over successive periods of time. To visualize how a binomial (or other lattice) model develops, imagine a
decision tree on its side, that is, developing from left to right, instead of from top to bottom. At each new
time period, each path of the decision tree (or lattice) branches into two new paths—one representing an
upward movement in the share price and the other representing a downward movement in the share
price. The point at which the tree (that is, the lattice) branches is referred to as a node. The branches of
the lattice are referred to as paths or, more precisely, share price paths. The lattice represents the
evolution of the value of the share and is used to calculate the value of the option.

The amount of the upward and downward price movements in an option-pricing lattice model is
determined based on the expected volatility of the underlying share. Because the lattice is the
development of the value of the option over discrete time periods during the option’s term (say, monthly
over a five-year term), it can accommodate changes in the characteristics of the option that are expected
to occur over time—such as changes in share price volatility, expected dividends, and the risk-free
interest rate. A lattice structure can also accommodate assumptions about employees’ expected exercise
and post-vesting termination behavior over the option’s life. This is in contrast to the Black-Scholes-
Merton option-pricing model, which uses only one weighted-average amount for each option
characteristic.

Both the Black-Scholes-Merton model and the lattice model have been extensively validated in financial
markets. They are used by valuation professionals, dealers of derivative instruments, and others to value
options and similar instruments. Both models can be modified to account for the substantive
New Developments Summary 43

characteristics of employee options and similar instruments, such as share appreciation rights. Monte
Carlo simulation, a valuation technique that uses randomly generated values, can also be used to satisfy
the measurement objective for instruments accounted for under Statement 123R.

In working with its Option Valuation Group (option valuation experts who advised the FASB on option
valuation methodologies), the FASB considered whether a closed-form or a lattice model would result in
the best estimate of fair value for long-term employee options. A lattice model can be adapted to produce
an estimated fair value based on assumed changes in the option’s characteristics over successive
periods of time. For example, instead of estimating fair value based on one input for the risk-free rate, the
calculation could be performed using the term structure of the risk-free rate over the option’s term.

Volatility and the option’s term are the inputs in an option-pricing model that generally have the most
significant impact on the resulting estimate of fair value. A lattice model can be developed that takes into
account the historical exercise behavior of an entity’s employees to derive the expected term of a new
option grant. Based on historical experience (or academic studies or industry data if an entity does not
have sufficient experience with past employee option-exercise behavior), an entity may determine that the
likelihood of employees exercising options early may increase as the intrinsic value of the options
increases. The timing of employee exercise will also be influenced by the length of the options’ vesting
period. In addition, most employee options expire within a short period after an employee terminates;
therefore, an employer’s turnover experience can affect the expected option term. Analysis of the entity’s
data (or academic research or industry data) on employees’ exercise behavior can be used to develop
rules about employees’ expected exercise behavior for a new option grant. A lattice model can be
designed to use those rules to derive the options’ expected term. A closed-form model cannot use such a
dynamic process to determine the expected term. A single weighted-average expected life of the option
has to be determined and used. To the extent information is available, lattice models can be modified to
accommodate assumptions about how certain characteristics—the share price volatility, the risk-free
interest rate, and expected changes in dividends—are expected to change over time.

The FASB did not identify a preferable option pricing model in Statement 123R, although in the
Statement’s “Basis for Conclusions” (paragraph B64), it noted that, compared to a closed-form model, a
lattice model can more fully reflect the effect of the term structure of interest rates and volatility, expected
changes in dividends over the option’s term, and employees’ option exercise and post-vesting
employment termination patterns. The Statement requires entities to select a valuation technique that
best fits their circumstances and estimate the fair value of the option that would be determined for an
instrument with the same characteristics (other than characteristics that Statement 123R explicitly
excludes from the estimation of fair value) for purposes of an exchange transaction. The FASB believes,
however, that both lattice models and the Black-Scholes-Merton formula, as well as other valuation
techniques, can provide a fair value estimate that meets the measurement objective of Statement 123R
(paragraph A15).

The SEC staff stated in SAB Topic 14.C that it will not object to the valuation technique or model used by
a registrant, provided it meets the requirements of Statement 123R that the technique be applied in a
manner consistent with the fair value measurement objective, be based on principles of financial
economic theory, and reflect the substantive characteristics of the award. For example, the staff does not
expect a registrant to use the lattice model simply because it is the most complex model considered by
the registrant. However, it observed that the Black-Scholes-Merton model would generally not be
appropriate for valuing a share option that is exercisable only if a specified increase in the price of the
underlying share occurs because the model is not designed to take into account that type of market
condition, which is one of the award’s substantive characteristics. The PCAOB staff also expresses that
view in its response to question 5 of its Q&A on auditing the fair value of employee options.
New Developments Summary 44

Although registrants are not required to hire an outside third party to assist in determining the fair value of
share options, the SEC staff noted that valuations should be performed by an individual with the
appropriate expertise. At its July 21, 2005 meeting, the FASB’s Statement 123R Resource Group
reached a consensus that nonpublic entities should use individuals with the appropriate expertise to
estimate the fair value of their share-based payment awards. Those individuals may be employees or
external valuation professionals. The requisite expertise required depends on the facts and
circumstances specific to the entity and its awards.

For some entities, compensation cost under Statement 123R for employee options will be a significant
expense. Those entities may want to evaluate the costs and benefits of using the more complex lattice
models if sufficient, reliable information about employee exercise and post-vesting termination behavior is
available.

Selecting assumptions for use in option-pricing models


Because the valuation process should be one that would be used to determine the option value in an
exchange (paragraph A8 of Statement 123R), the method of selecting each assumption should be
consistent with the method marketplace participants would likely use. Regardless of the valuation
technique used, an entity is required to develop reasonable and supportable estimates for each
assumption used in an option-pricing model. Supportable means the assumption is based on reasonable
arguments that consider the instrument’s substantive characteristics and other relevant facts and
circumstances, such as historical experience (paragraph A16). In addition, an entity is required to
determine the amount for each assumption in a consistent manner from period to period (paragraph A23).
This means an entity needs to establish a process for determining each input into a valuation model and
apply those processes consistently each period. For example, the entity needs to determine if share price
will be based on the opening, average, or closing share price on the measurement date and then use the
appropriate price whenever it values awards. The processes for determining how to estimate the option’s
expected term and expected volatility will be much more involved. A change in the method of determining
appropriate assumptions used in a valuation technique is a change in accounting estimate that should be
applied prospectively.

Statement 123R states that historical experience is generally the starting point for developing
expectations about the future. However, information based on historical experience should be modified if
available information indicates the future is reasonably expected to differ from past experience. The
following example illustrating when historical experience would need modification is provided in
paragraph A21.

[A]n entity with two distinctly different lines of business of approximately equal size may
dispose of the one that was significantly less volatile and generated more cash than the
other. In that situation, the entity might place relatively little weight on volatility, dividends,
and perhaps employees’ exercise and post-vesting employment termination behavior
from the predisposition (or disposition) period in developing reasonable expectations
about the future.

Therefore, when developing assumptions for a valuation model, an entity should consider to what extent
future results may differ from historical data. Other circumstances in which an entity’s future results would
be expected to be different from historical results might include the addition of a new product line or
development of a new product key to the entity’s business; significant changes in the entity’s industry;
New Developments Summary 45

changes in the life cycle of the entity; increased or decreased competition; or expected changes in
demographics that will affect the entity.

There is likely to be a range of reasonable estimates for expected volatility, dividends, and/or the option’s
expected term. If no amount within the range is more or less likely than the other amounts, the
assumption used should be an average of the amounts in the range (the expected value).

In a lattice model, assumptions are to be determined for a particular node or multiple nodes during a
particular time period, but assumptions should not cover multiple periods, unless that application is
supportable.

Current share price


For many public entities, the current share price used in an option pricing model is the closing share price
on the award’s measurement date. It could, however, be the opening or average share price on that date.
An entity needs to decide if it will use the measurement date opening, average, or closing share price to
value share-based awards and then use the appropriate price whenever it values awards. The use of the
prior day’s closing share price may be an acceptable method of determining the grant date share price if
that method is used consistently, that is, if the prior day’s closing share price is always used as the grant
date share price.

Estimating the fair value of nonpublic entities’ shares

Nonpublic entities face unique valuation issues in applying Statement 123R because, in most cases,
observable market prices for their equity securities do not exist. As a result, when awarding an equity-
classified share or option to an employee, nonpublic entities typically need to calculate the fair value of
their stock as of the award’s grant date (see section D above). The requisite expertise to determine the
fair value of share-based payment awards should either exist internally or entities should use the services
of valuation professionals. The assessment of whether an employee has the requisite expertise depends
on an entity’s specific situation.

In many cases, a nonpublic entity has its stock appraised before granting a stock option (or other share-
based award). The fair value of the award, however, is not determined until the grant date requirements
of Statement 123R are met. The gap between the appraisal date and the accounting grant date may have
unintended accounting consequences. For instance, a nonpublic entity may decide to grant at-the-money
options and, as a result, obtains a valuation of its stock as of January 1. Due to the time required to
complete the appraisal and the various approval and other grant date requirements of Statement 123R,
the accounting grant date does not occur until mid-February. Because the appraisal date differs from the
grant date, the company cannot assume that the appraisal price is the grant date fair value without
assessing whether events occurred (such as significant contracts, litigation, stock transactions, or a buy-
out offer) or other circumstances changed after the appraisal date that impacted the share price.
Companies should consider consulting with valuation experts in these situations.

Some entities issue share-based awards several times throughout the year and must therefore determine
the fair value of their share-based awards on each grant date. Some entities that have frequent grants
may either use a valuation model obtained from a valuation specialist for their particular situation or
internally estimate the fair value of their stock in some other manner, such as using a well established
industry formula. For example, a company may be aware that a multiple of five times net income before
interest, income taxes, depreciation, and amortization is widely used to establish sales prices in its
industry and would be appropriate to use in estimating the fair value of its shares.
New Developments Summary 46

We believe an entity should reestablish the validity of a model or formula used for an
internal valuation of the fair value of its shares on each grant date to determine whether it
still results in an appropriate estimate of fair value. That requires an entity to evaluate
company milestones, industry developments, the competitive environment, the business
environment, and other relevant factors. If something in the entity’s environment has
changed, the entity should consider whether to consult with a valuation specialist. If an
entity does not have an employee with the requisite valuation expertise, a valuation
expert should generally be consulted periodically to redetermine the appropriate model or
formula, even if the entity believes that its operations and business environment have
remained relatively stable.

Risk-free interest rate


The risk-free interest rate assumption a U.S. entity is required to use to value an option on its own shares
depends in part on the type of valuation model the entity is using. If it is using a lattice model that
incorporates the option’s contractual term, it is required to use the implied yields from the U.S. Treasury
zero-coupon yield curve over the contractual term of the option. If using a closed-form model, a U.S.
entity is required to use the implied yield on a U.S. Treasury zero-coupon security with a remaining term
equal to the expected term of the option used in the valuation model. A rate quoted in the financial press,
such as The Wall Street Journal, is often an annual effective yield, while the rate used in the Black-
Scholes-Merton formula is a continuously compounded rate. If the valuation model being used requires
the continuously compounded rate as an input, an entity can convert the annual effective yield to the
continuously compounded rate using an electronic spreadsheet to find the lognormal of 1 plus the annual
effective yield or ln(1 + annual effective yield).

Entities based outside the United States should use the implied yield on zero-coupon government issues
denominated in the currency of the market in which the underlying share primarily trades. An appropriate
substitute should be used if there is no zero-coupon government security or if its implied yield does not
represent a risk-free interest rate.

Expected term
Although the fair value of traded options is based on the instrument’s contractual term, entities are
required to use the instrument’s expected term to estimate the fair value of an employee share option
because, unlike a traded instrument, an employee option is usually not transferable and is therefore often
exercised before the end of its contractual term. The expected term is the length of time employee
options are expected to be outstanding before being exercised. Paragraph A27 defines expected term as
the period from the service inception date (the first day of the award’s requisite service period, a term that
is defined in section G) to the date of expected exercise or settlement.

Because the expected term will generally be shorter than the contractual life of the option, use of the
expected term to value the option will result in a lower fair value. That reduction in value compensates for
the fact that generally employees can neither transfer nor hedge their options. Therefore, a separate
discount to the resulting fair value for the inability to transfer and/or hedge an employee option is not
permitted, as the SEC staff explicitly states in SAB Topic 14.D.2.

If an employee option is freely transferable, the contractual term, rather than the expected term, should
be used in the valuation model.

In a Black-Scholes-Merton model, expected term is a single estimated input. In contrast, in a lattice model
designed to take into account employees’ expected exercise and post-vesting termination behavior, the
New Developments Summary 47

expected term is derived from the output of the lattice. Regardless of the type of valuation technique used
to estimate fair value, the following requirements apply:

• An option or similar instrument’s expected term should be determined based on, among other factors,
the instrument’s contractual term and the effects of employees’ expected exercise behavior and their
expected post-vesting employment termination behavior. The terms of employee options usually
provide that if the employee terminates his or her employment, the remaining term of any unexercised
vested options is shortened to a specified period, which is usually between 30 and 180 days. For that
reason, employees’ post-vesting terminations accelerate the exercise of the employees’ vested
options. Data about post-vesting turnover is, therefore, a significant factor in estimating an option’s
expected term. In contrast, prevesting employee terminations result in forfeiture of the awards and
are therefore not a factor in estimating the expected term.

• An entity is required to aggregate individual awards into relatively homogeneous groups based on
exercise and post-vesting termination behavior and determine the expected term and fair value of
each group based on expectations about employee exercise behavior in that group.

Identification of homogeneous groups

Option value is not directly proportional to an option’s expected term because the option value increases
at a decreasing rate as the option term is extended. Using a weighted-average expected term for
employees with different expected option exercise and termination behavior will therefore misstate (that
is, overstate) the value of the entire award. For that reason, Statement 123R requires entities to
aggregate individual option awards into relatively homogeneous employee groups based on the expected
option term for the group, which will be a function of the employee groups’ expected exercise patterns,
including employee post-vesting termination behavior.

Entities can identify employee groups expected to have different exercise patterns and therefore different
expected terms for their option grants, using

• Historical data about exercise behavior for previous awards, if sufficient information is available

• Academic research about the exercise patterns of different categories of employees

• Industry data, as it becomes available

An entity has analyzed historical exercise behavior of its employees for similar awards
and determined that hourly employees tend to exercise options shortly after vesting if the
options are in the money and salaried employees exercise, on average, when the share
price is 180 percent of the exercise price. However, senior management tends to hold its
options until close to the termination date before exercise. If that behavior is (a) expected
to continue in the future for similar awards and (b) results in significantly different
expected terms for options held by each of the three groups of employees, the entity has
identified three homogeneous groups. It would estimate the expected term separately for
each group, determining a weighted-average expected term for each group if using a
Black-Scholes-Merton model or modeling the expected behavior for each group if using a
lattice model. The fair value for each group would be determined separately, utilizing the
appropriate expected term assumption for the group if using the Black-Scholes-Merton
model, or expected exercise behavior rules if using a lattice model.
New Developments Summary 48

In SAB Topic 14.D.2, the SEC staff expressed its view that an entity may generally make a reasonable
fair value estimate with as few as one or two groupings. Academic research suggests two groups might
be executives and nonexecutives.

Implementation guidance for expected term

The process an entity uses to estimate the expected term of employee options should be consistent with
a method that would be used in an exchange transaction, that is, a method marketplace participants
would likely use. The estimate is required to be reasonable and supportable and determined in a
consistent manner from period to period. The entity’s process should therefore be documented and
controls established to ensure the process for determining the expected option term is followed
consistently in the future.

Statement 123R indicates that historical experience is generally the starting point for developing
expectations about the future. The information derived from an analysis of historical experience should,
however, be modified to reflect how currently available information indicates future results may differ from
past results. There is therefore an expectation in Statement 123R that entities would consider whether
data gathered about employees’ historical exercise and post-vesting termination behavior for similar
grants would provide reasonable and supportable data for an estimate of the options’ expected term.
Similar grants are grants to employees of the same homogeneous employee group, having similar
vesting provisions and contractual terms of similar length, as well as other similar features, such as the
relationship of the exercise price to the share price on the grant date.

An entity may calculate the period during which similar options have historically been outstanding by
determining the historical weighted-average period of time previous grants of share options were
outstanding, including both exercised options and options that expired unexercised. In analyzing
employees’ past exercise behavior, however, historical experience is relevant for grants whose
contractual term has lapsed or for which all of the options have been exercised. Those would be the only
grants for which there is complete data available to determine the average period the awards were
outstanding before being exercised. An entity has to take into consideration the unexercised awards
when compiling data about exercise behavior if the grants being analyzed have outstanding unexercised
awards.

An entity may not have sufficient relevant historical experience if

• The entity has been a public company for only a few years and does not have significant data on
employee exercise behavior

• The entity’s stage of development has evolved

• The nature of the entity’s business has changed—for example, due to acquisitions or dispositions

• A significant feature of the current options differs from that of previous grants, such as the contractual
term has changed from 10 years to 5 years

• Historical exercise behavior is limited to a period when the pattern of movement in the share price
was atypical compared to long-term historical norms. For example, an entity may have experience
when option grants were exercisable only during a period of consistently rising share prices or only
during a long period in which the exercise price was above the share price so that it was not
advantageous for employees to exercise their options.
New Developments Summary 49

If sufficient relevant historical experience on employee exercise behavior is available,


organizing the data, extracting the pertinent information, and analyzing the results may
be a time-consuming effort for many entities. However, once systems are developed for
capturing the pertinent information, the task of updating the data on an ongoing basis is
more routine.

In analyzing their employees’ historical exercise behavior, entities should isolate option exercises that
occur around the time an employee terminates or shortly thereafter if termination results in shortening the
remaining option term. Termination experience should be evaluated separately, as it has a distinct impact
on when exercise occurs. It should be considered in estimating the expected option term if a closed-form
model is used. It should be modeled separately if a lattice model is used.

Once an entity has developed historical information about employee exercise and post-vesting
termination behavior, it needs to consider the extent to which the historical information requires
modification due to currently available information about how future behavior is expected to differ from
historical behavior. For example, expected changes in the entity’s stage of development, planned
structural changes in the business, or changes in employee demographics may indicate that historical
exercise behavior may understate or overstate expectations about options’ expected terms in the future.
Paragraph A21 provides that the weight to place on historical experience is a matter of judgment based
on relevant facts and circumstances.

Other factors that may affect expectations about employees’ expected exercise behavior include

• The length of the vesting period: A longer vesting period will usually result in a longer expected term.
The expected term can never be less than the vesting period, or the average expected term for
options with graded vesting if options vesting in different periods (for example, one-third vesting at the
end of year 1, one-third vesting at the end of year 2, and one-third vesting at the end of year 3) are
valued using the same average expected term. If an entity’s historical experience is based on grants
with one-year vesting, an adjustment would generally be necessary if current grants have four-year
vesting.

• The expected volatility of the underlying share: Options on shares with high volatility may have
shorter expected terms than options on shares with low volatility for a number of reasons. Employees
may tend to exercise their options when the intrinsic value reaches a certain percentage over the
exercise price (say, 200 percent of the exercise price), and the intrinsic value is likely to increase
faster if the underlying shares are highly volatile. In addition, if shares are highly volatile, employees
may exercise sooner to capture the option’s intrinsic value before the share price begins to decline.

• Applicable blackout periods and any arrangements employees have made related to blackout
periods: Blackout periods are periods of time during which exercise of options is prohibited. If
material, they can affect the expected term because either the awards cannot be exercised during
those periods (therefore suboptimal exercise behavior is affected) or because employees have
programs in place for automatic exercise during blackout periods.

• Employees’ ages, length of service, and domicile: These factors may affect expected exercise
behavior. Domicile refers to whether employees’ residences are domestic or foreign.

In its Q&A on auditing the fair value of employee options, the PCAOB staff indicates that an entity’s
adjustment or lack of adjustment to historical exercise behavior should be reasonable and supportable.
Entities are therefore advised to document their support for such adjustments.
New Developments Summary 50

If there is a range of possible expected terms, none of which is more or less likely than other amounts, an
entity should use the average of the amounts in the range (that is, the expected value).

Forfeitures or terms stemming from forfeitability should not be factored into the determination of expected
term. Under Statement 123R, prevesting restrictions or similar terms are accounted for by recognizing
compensation cost only for awards for which employees render the requisite service.

If sufficient information is available about employees’ expected exercise and post-vesting termination
behavior, a lattice model could be designed to use the information to determine when exercise occurs on
each share price path.

If the entity’s experience indicates options are exercised when the share price is 200
percent of the exercise price, the lattice model could be modified to include a rule that
assumes exercise at the node on each share price path at which the early exercise
expectation is first met, provided the option is vested at that point. The model would
assume exercise at the contractual term for price paths on which the early exercise
expectation is not met, provided the options are in the money on that date. The model
would also be modified to include a rule that assumes early exercise based on
assumptions about employees’ post-vesting termination behavior. The effect of the
modeled rules on individual share paths will ultimately affect the option value determined
by the lattice model.

When using a lattice model, the expected term, which is a required disclosure, may be determined by
using a Black-Scholes-Merton model, using the option value determined with the lattice model as an input
to the Black-Scholes-Merton model.

If an entity plans to use a closed-form model to estimate option value and will use historical exercise
experience to estimate the expected term assumption, it should consider whether the historical periods
included a variety of upward and downward share price movements. If they did not, the entity may be
able to use suboptimal exercise behavior based on the historical data to simulate the expected term using
a lattice model with multiple share price paths. The resulting expected term could be used as an input in
the closed-form model.

If an entity determines its historical employee exercise behavior experience does not provide a
reasonable basis on which to estimate expected term, the entity should estimate an instrument’s
expected term in another manner, using available relevant and supportable data, such as expected terms
of similar options granted by similar entities, industry averages, and other pertinent evidence, including
published academic research. Although currently there is little information about employee exercise
behavior by industry, such data is expected to become available.

SEC’s simplified method for determining expected term

The SEC staff acknowledges in SAB Topic 14.D.2 that an entity that concludes its historical experience
does not provide a sufficient basis to estimate expected term has limited alternative sources for making
the estimate. The staff therefore introduced a simplified method for computing the expected term. The
method can be used, however, only for plain vanilla options. In addition, only certain entities can use the
simplified method after December 31, 2007, as discussed below.

Plain vanilla options are equity share options that have the following basic characteristics:

• They are granted at-the-money.


New Developments Summary 51

• Exercisability is conditional only on performing service through the vesting date.

• Employees terminating service prior to vesting would forfeit their options.

• Employees terminating service after vesting would have a limited time to exercise their options.

• The options are not transferable and cannot be hedged.

Under the simplified method, the expected option term is the average of the vesting period and the
original contractual term, as illustrated in the following example.

An option with a 10-year original contractual term and graded vesting over 4 years would
have an expected term of 6.25 years. This is calculated as a 1-year vesting term for the
first 25 percent vested, plus a 2-year vesting term for the second 25 percent vested, plus
a 3-year vesting term for the third 25 percent vested, plus a 4-year vesting term for the
last 25 percent vested, divided by 4 total years of vesting plus a 10-year contractual life,
divided by 2; that is, (((1+2+3+4)/4) + 10) /2 = 6.25 years.

The simplified method is not a benchmark to evaluate the appropriateness of more refined estimates of
expected term.

Under SAB 107, which was issued in March 2005 and introduced SAB Topic 14.D, the simplified method
was available to all public companies, including those with sufficient entity-specific data about employee
exercise behavior. The SAB provided that, if a company elects to use the simplified method, it must apply
the method to all plain vanilla employee share options. At the time the staff issued SAB 107, it believed
that external information about exercise behavior, including actuarial studies on expected terms for
various categories of similar entities, would become available in the near future. As a result, SAB 107
precluded the use of the simplified method for share option grants after December 31, 2007, regardless of
a registrant’s fiscal year-end.

Subsequently, on December 21, 2007, the SEC staff issued SAB 110, which amends SAB 107 to permit
public companies, under certain circumstances, to use the simplified method in SAB 107 for share option
grants made after December 31, 2007. Use of the simplified method after December 2007 is permitted
only for companies whose historical data about their employees’ exercise behavior does not provide a
reasonable basis for estimating the expected term of the options. Registrants with sufficient historical
exercise data may therefore not use the simplified method for share option grants made after December
2007.

SAB 110 provides the following examples of when a company may not have sufficient relevant historical
option exercise data to provide a reasonable basis to estimate an option’s expected term:

• A company’s shares have been publicly traded for only a limited time.

• A company significantly changes the terms of its options or grants options to a different type of
employee.

• A company has or expects to have significant structural changes in its business.

A company may have sufficient historical exercise data for some of its share option grants but not for
others. In such cases, SAB 110 states that the SEC staff will accept the use of the simplified method for
only some, but not all, of the company’s share option grants. The staff also observes that a company
need not consider the use of a lattice model before concluding it is eligible to use the simplified method.
New Developments Summary 52

In addition, the staff does not object if a company applies the simplified method in periods before its
shares are traded in a public market.

Companies using the simplified method should disclose the following information in their financial
statements:

• Their use of the method

• The reasons why they used the method

• The types of options for which the method was used, if not for all option grants

• The periods the method was used, if not in all periods

The staff believes that, in the future, companies will have access to useful external information about
employee exercise behavior. When such information becomes widely available, the staff believes that
companies should no longer use the simplified method.

At its meeting on September 13, 2005, the FASB’s Statement 123R Resource Group reached a
consensus that nonpublic entities could also use the simplified method for estimating the expected term
of plain vanilla options. Use of that method is available for grants of plain vanilla options over the same
periods that are permissible for public entities, as discussed above. Options of nonpublic entities may
have repurchase features, which need to be evaluated in the determination of whether the options meet
the definition of plain vanilla options. The Resource Group discussed this issue and concluded that a fair
value repurchase feature would likely meet the definition of plain vanilla, but others, such as certain book
value repurchase features, would not.

Expected volatility
Share price volatility is a statistical measure of the amount an entity’s share price has fluctuated (upward
and downward price movements) annually (historical volatility) or is expected to fluctuate annually
(expected volatility). Expected volatility provides an estimate of the potential for the share price to
increase over the life of the option. The expectation of an increasing share price is what gives value to an
option. Therefore, an option on a share with a high volatility is worth more than an option on a share with
lower volatility, other things being equal.

Under Statement 123R, a valuation technique used to estimate the fair value of an option must take into
account the expected volatility of the price of the underlying share for the expected term of the option. If
the valuation technique being used is a lattice model that has been adapted to include employees’
expected exercise and post-vesting termination behavior, the valuation technique would take into account
the expected volatility for the contractual term of the option.

Developing a process to estimate expected volatility

Entities are required to establish a process for estimating expected volatility that a market participant
would likely use in determining the option’s exchange price. Historical volatility is generally the starting
point for developing expectations about future volatility. The volatility estimate is required to be
reasonable and supportable. Evidence that the estimate is reasonable includes that the entity considered
how factors other than historical volatility could affect the volatility estimate. An entity’s process for making
the estimate should therefore include identification of available relevant information pertaining to the
entity’s share price volatility, including the factors listed below under the headings “Historical volatility”
and “Other factors to consider.” That process should include a procedure to review the period over which
historical volatility data was gathered and evaluate the extent to which current information indicates future
volatility will differ from historical volatility, considering, for example, public announcements, future plans,
New Developments Summary 53

and industry trends. It should also specify how such information will be used in the estimate of expected
volatility, including a procedure for evaluating and weighting the information. If an entity determines it
would be inappropriate to rely exclusively on historical volatility, it has to consider all other available
information. The SEC staff has noted that there is no “magic formula” for assigning probabilities to
available information for an individual company or industry group. An entity’s approach should be guided
by the objective of determining the assumption marketplace participants would likely use.

The SEC staff is aware of two methods of computing historical volatility that it does not consider suitable
for an appropriate estimate of expected volatility:

• A method that weighs the most recent periods of historical volatility much more heavily than earlier
periods

• A method that uses the average of the daily high and low share prices to compute volatility

An entity should use the process it develops for estimating expected volatility consistently from period to
period. The process should, however, incorporate new or different information that would be useful in
developing the estimate when it becomes available. A change in the estimation process should be
accounted for as appropriate under Statement 154.

Factors to consider in estimating expected volatility are described below.

Historical volatility

For many entities, determining the historical volatility of their share price will be the starting point in their
process to estimate expected volatility. Over what period should historical volatility be calculated?
Statement 123R indicates the historical period should be the most recent historical period that is equal to
the contractual term of the option, if using a lattice model, or the expected term, if using a closed-form
model. The SEC staff observed, however, that a longer period may be used if a registrant reasonably
believes the additional historical information improves the estimate. An entity should have a reasonable
basis for using an extended period of volatility data and should use the extended period consistently to
the extent appropriate.

In their calculation of historical volatility, entities should use appropriate and regular intervals for price
observations:

• Publicly traded entities: Statement 123R indicates that publicly traded entities would likely use daily
price observations in calculating their historical share price volatility. The SEC staff observed in SAB
Topic 14:D.1 that, to determine the appropriate frequency of price observations, a registrant should
consider the frequency of the trading of its shares and the length of its trading history. The staff
considered daily, weekly, or monthly price observations a sufficient basis to estimate expected
volatility if a registrant’s trading history provides enough data points for estimation. The minimum
number of price observations (data points) needed to calculate historical volatility appropriately is not
specified, but the SEC staff observed that if the expected or contractual term, as appropriate, is less
than three years, monthly price observations would not provide a sufficient number of data points. It
also noted that, if the expected or contractual term, as appropriate, is less than two years, an entity
should use daily or weekly prices for at least the length of the applicable term.

• Thinly traded entities: The SEC staff believes that, for thinly traded shares, the use of weekly or
monthly price observations would generally be more appropriate than daily price observations
because the use of daily observations could cause volatility to be artificially inflated by large spreads
between bid and ask prices and the lack of consistent trading.
New Developments Summary 54

• Nonpublic entities: Entities whose shares are not publicly traded but are exchanged occasionally at
negotiated prices might use monthly price observations if there is sufficient history to provide enough
data points for a reasonable and supportable volatility calculation. See below under the heading
“Other factors to consider” for entities lacking sufficient trading history for their own shares.

If an entity changes the frequency of the price observations it uses to calculate its volatility assumption,
for example, from daily observations to weekly or monthly observations, it should have a reasonable
basis for the change.

In determining historical volatility, consideration should be given to the following:

• Changes in volatility over the relevant period: Changes in historical volatility may be identified by
dividing the contractual or expected term into several segments of equal length and calculating the
historical volatility for each segment. However, methods that weight more recent periods more heavily
than earlier periods may not be appropriate for longer-term options. SAB Topic 14.D.1 includes the
following example: “[A] method that applies a factor to certain historical price intervals to reflect a
decay or loss of relevance of that historical information emphasizes the most recent historical periods
and thus would likely bias the estimate to this recent history.”

• A possible mean reversion tendency of the volatility: This refers to a tendency for the volatility, after a
period of unusually high volatility, to return over time to a long-run average level. A mean reversion
tendency may be evidenced in the segment volatility calculation described in the preceding bullet.

Other factors to consider

In modifying historical volatility for currently available information that indicates future volatility may differ
from historical volatility, an entity should

• Consider future events that marketplace participants would consider in estimating future volatility. For
example, a registrant that has announced a merger that will change its future business risks should
consider the impact of the merger in estimating expected volatility if it reasonably believes a
marketplace participant would consider the merger.

• Give little weight to historical information if the entity’s operations have changed significantly in ways
that are expected to impact the volatility of the share price. An example would be if riskier business
segments have been added or disposed of.

• Disregard an identifiable period of time during which the share price was unusually volatile due to a
situation that is not expected to recur during the option’s expected or contractual term. For example, a
period of extraordinary volatility in connection with a failed takeover bid that is not expected to recur
should be disregarded.

The staff noted in SAB Topic 14.D.1 that a registrant should be able to support its conclusion that a
previous period is irrelevant with one or more discrete and specific historical events that are not
expected to recur during the option’s expected term. The staff expects that such situations will be
rare.

• Consider implied volatility if available. Implied volatility is the volatility assumption inherent in the
market prices of a company’s traded options or other financial instruments that have features like
options, such as the conversion option in publicly traded convertible debt. It is particularly useful in
estimating expected volatility because it generally reflects both historical volatility and market
participants’ expectations of how future volatility will differ from historical volatility.

The effect of an entity’s corporate and capital structure on its expected volatility should be considered.
Highly leveraged companies, for example, tend to have higher volatilities, other things being equal.
New Developments Summary 55

The following factors should be considered by entities whose shares have not been publicly trading for a
period at least as long as the expected term (or contractual term if a lattice model is used) of the options
being valued:

• Public entities whose shares have been trading for a period that is less than the expected or
contractual term of the option should use share prices for the longest period for which their shares
have been publicly traded. The SEC staff, however, noted in SAB Topic 14.D.1 that a minimum of two
years of daily or weekly historical data may provide a reasonable basis on which to base an estimate
of expected volatility if a company has no reason to believe that its future volatility will differ materially
during the expected or contractual term, as applicable, from the volatility calculated from this past
information.

• A newly public entity that does not have entity-specific historical or implied volatility information
available should base its estimate of expected volatility on the historical, expected, or implied volatility
of similar entities whose share or exercise prices are publicly available. To identify similar entities, the
entity should consider the industry, stage of life cycle, size, and financial leverage of such other
entities. Also, if an entity operates in multiple industries, it could identify a few similar companies in
each industry, determine the weighted-average volatility of the group of companies from each
industry, and then weight the volatilities of the various industry groups as appropriate based on its
own operations.

The SEC staff would not object to a registrant looking to an industry sector index, such as NASDAQ
Computer Index, that is representative of the registrant’s industry, and possibly its size, to identify one
or more similar entities. However, because the volatility of an industry sector index is affected by the
inherent diversification in the index, registrants should never substitute the volatility of an index for the
expected volatility of its share price as an assumption in their valuation model.

After identifying similar entities, a registrant should continue to consider the volatilities of those
entities, unless circumstances change and the identified entities are no longer similar to the
registrant. Until the registrant has sufficient entity-specific information available, the SEC staff would
not object to the registrant basing its estimate of expected volatility on the volatility of similar entities.
As noted above, the staff believes at least two years of daily or weekly historical data would be
needed to provide a reasonable basis for estimating expected volatility, and then only if the entity has
no reason to believe that future volatility will differ materially from its historical volatility to date.

• Nonpublic entities might estimate their expected volatility based on an average of the volatilities of
similar public entities for an appropriate period after they went public, as discussed in the preceding
bullet.

As discussed above, an entity may use peer group volatility data in estimating its volatility assumption, for
example, because the entity does not have sufficient historical data or because its historical data needs
adjustment, such as when its operations have changed or diversified. Depending on the situation, the
volatility of peer companies may be used exclusively or blended with the entity’s historical volatility
estimation. An entity should use an appropriate peer group that is reasonably comparable to its own
operations and have a reasonable basis for the extent to which it adjusts its historical data using the peer
group volatility.

If there is a range of reasonable estimates for expected volatility and the entity uses a closed-form
valuation model, it should choose the most likely estimate. However, if no estimate within the range is
more or less likely than the other estimates, the assumption of expected volatility should be an average of
the amounts in the range (the expected value). Lattice models can incorporate a term structure of
expected volatility rather than a single average volatility. A term structure is a range of expected
volatilities. Incorporating a term structure of volatility requires judgment, including consideration of factors
New Developments Summary 56

such as those discussed above and other relevant factors. If an entity is not able to develop a reasonable
and supportable term structure of expected volatility, it would use a single volatility input in the lattice
model.

Implied volatility

Entities should consider the implied volatility determined from their traded options or traded convertible
debt, if any, in estimating the expected volatility of their share price. The SEC staff suggests that
registrants with actively traded options assessing the extent of their reliance on implied volatility in their
estimate of expected volatility should

• Consider the volume of trading in its underlying shares and traded options. Prices from active
markets are more likely to reflect a marketplace participant’s expectations about share price volatility.

• To the extent possible, synchronize variables. For example, when computing implied volatility,
measure the market price of the traded options and the market price of the underlying shares on the
same date. That measurement should also be synchronized with the grant date of the employee
options, or, if not reasonably practicable, a registrant should derive implied volatility at a point in time
as close to the grant of the options as is reasonably practicable.

• Use implied volatility derived from traded options that are at- or near-the-money in valuing an
employee share option that is at-the-money. If it is not possible for the registrant to find a traded
option with the same or similar exercise prices, it should use multiple traded options with an average
exercise price similar to the exercise price of the employee share options.

• Use the implied volatility of a traded option with a term similar to that of the employee option. If there
are no traded options with terms similar to the option’s contractual or expected term, the staff believes
a registrant should consider traded options with a remaining maturity of six months or greater.
However, when using traded options with a term of less than one year, the staff expects the registrant
to also consider other relevant information in estimating expected volatility. Generally, the staff
believes more reliance on the implied volatility derived from a traded option would be expected the
closer the remaining term of the traded option is to the expected or contractual term, as applicable, of
an employee share option. However, the staff believes the implied volatility derived from a traded
option with a term of one year or greater would not significantly differ from the implied volatility
derived from a traded option with a significantly longer term.

Exclusive reliance on historical or implied volatility in estimating expected volatility

In certain situations, the SEC staff believes that a registrant could reasonably conclude that exclusive
reliance on either historical or implied volatility would provide an estimate of expected volatility that meets
the stated objective of Statement 123R.

For instance, the staff would not object to a registrant placing exclusive reliance on historical volatility
when the following factors are present, provided the methodology is consistently applied:

• The registrant has no reason to believe that the future volatility of its shares over the expected or
contractual term, as applicable, is likely to differ from its past volatility.

• The computation of historical volatility is based on a simple average calculation.

• A sequential period of historical data at least equal to the expected or contractual term of the share
option, as applicable, is used.

• A reasonably sufficient number of price observations are used, and they are measured at consistent
points throughout the historical period.
New Developments Summary 57

Questions have arisen about how the unusually high share-price volatility experienced during the 2008-
2009 economic crisis should be considered in determining expected volatility. The SEC staff has
indicated that an entity relying exclusively on historical volatility in its estimate of expected volatility should
not exclude current market volatility in that estimate. This is consistent with SAB 107, Topic 14.D,
question 4, which lists a simple average calculation method as a factor required for the staff to not object
to a registrant relying exclusively on historical volatility in estimating its expected volatility.

The staff would not object to a registrant placing exclusive reliance on implied volatility when the following
factors are present, provided the methodology is consistently applied:

• The registrant uses a valuation model that is based on a constant volatility assumption.

• The implied volatility is derived from actively traded options.

• Market prices of both the traded options and underlying shares are measured at a similar point in time
and on a date reasonably close to the employee option grant date.

• Traded options have exercise prices that are both near-the-money and close to the exercise price of
the employee share options.

• The remaining maturities of the traded options that are the basis for the estimate are at least one
year.

The SEC staff indicated that a registrant estimating expected volatility based on the implied volatility in
other instruments should identify a reason other than that the current market is unusual (for example,
during the 2008-2009 economic crisis) to justify a change from the use of implied volatility in its volatility
estimate.

Disclosures of estimated volatility

Under the guidance in Statement 123R, a registrant is required to disclose its expected volatility and the
method used to estimate it. The SEC staff would expect a registrant, at a minimum, to disclose whether it
used only implied volatility, historical volatility, or a combination of both in estimating expected volatility.
Additionally, the staff expects disclosures in a registrant’s discussion of critical accounting policies and
estimates in Management’s Discussion and Analysis (MD&A) to include an explanation of the method
used to estimate the expected volatility of its share price. Generally, this explanation should have a
discussion of the reasons for the registrant’s conclusions regarding the extent to which it used historical
volatility, implied volatility, or a combination of both.

Guidance applicable to nonpublic entities

The above discussion of methodologies for estimation of expected volatility combines guidance from
Statement 123R and SEC staff guidance from SAB Topic 14.D. At its July 21, 2005 meeting, the
Statement 123R Resource Group reached a consensus that nonpublic entities should follow relevant
guidance in both the Statement and SAB Topic 14.D. The Resource Group noted that Statement 123R
does not specify which method of estimating expected volatility an entity should use. However, SAB Topic
14.D provides guidance on when it would be appropriate for an entity to rely exclusively on historical
volatility or implied volatility. That guidance would be applicable to nonpublic entities as well. The
Resource Group concluded that the method a nonpublic entity uses to estimate expected volatility will
depend on the entity’s specific facts and circumstances.

Expected dividends
Option valuation techniques require an assumption for dividends expected to be paid to holders of the
underlying shares (expected dividends) over the option’s term. Dividends are taken into account because
New Developments Summary 58

payment of dividends to shareholders reduces the fair value of the underlying shares, and option holders
generally do not receive dividends. Expected dividends used in the valuation model may be expressed as
a dividend yield (a percentage of the share price) or a dividend amount.

Entities need to determine a reasonable, supportable estimate of expected dividends, that is, an estimate
likely to be included in the valuation of an option used in an exchange transaction with a third party.
Entities should therefore develop and document a process for determining expected dividends and use
that process consistently, unless new information becomes available. Current dividends would usually be
the starting point, taking into consideration the entity’s historical pattern of increasing (or decreasing)
dividends, and any other currently available information likely to affect future dividends.

An entity that has a pattern of regular, periodic increases in its dividend would incorporate
that pattern into its expected dividend assumption. Use of an expected dividend of a fixed
amount equal to its current dividend would not be a reasonable, supportable estimate or
one likely to be used by market participants in an exchange transaction.

Valuation of options with dividend protection

If the options are structured to protect option holders from dividend payments by reducing the option
exercise price for dividend payments, the expected dividend assumption used in the estimation of option
fair value should be zero.

Entities sometimes pay employees dividends or dividend equivalents on the shares underlying their
outstanding options. The grant-date fair value of option awards that include dividend payments on the
underlying shares of the unexercised options should take into consideration both the fair value of options
on dividend-paying shares and the fair value of a stream of dividend payments on the options until
exercised. For example, the fair value of such an award on the grant date could consist of two
components: the estimated fair value of the options using a valuation technique that includes an
assumption for the expected dividend payments and the present value of the estimated cash dividend
payments over the options’ expected term.

Accounting implications of dividend protection

Dividends and dividend equivalents paid to employees on awards expected to vest should be charged to
retained earnings. Dividends and dividend equivalents paid on awards not expected to vest should be
recognized as compensation cost. To determine the amount of dividends not expected to vest, an entity
should use the forfeiture rate it uses in estimating awards not expected to vest. If the forfeiture rate is
subsequently adjusted, the entity should adjust the cumulative expense recognized for dividends paid to
date in the period the forfeiture rate is changed. On the vesting date, the entity should adjust the
cumulative cost of dividends charged to expense so that the amount equals the cumulative amount on
dividends paid on awards actually forfeited during the vesting period. Dividends paid on vested,
unexercised options should be charged to retained earnings. The accounting for the tax benefit of
dividends paid on employee share-based awards is addressed in EITF Issue 06-11, “Accounting for
Income Tax Benefits of Dividends on Share-Based Payment Awards,” which is discussed under the
subheading “Tax effects of dividends paid on equity awards,” in section J.

Nonrecourse loans
Employers sometimes finance their employees’ purchases of company stock or their exercise of options.
The structure of such loans, that is, whether they are recourse or nonrecourse, has accounting
New Developments Summary 59

consequences. If the employer has recourse only to the stock purchased, not to other assets of the
employee, the loan is nonrecourse. In contrast, a recourse loan gives the employer the legal right to
foreclose on other assets of the employee in the event of default.

The purchase of stock through a nonrecourse loan is effectively the same as being granted an option to
buy stock. If stock is purchased or an option is exercised using a nonrecourse note and the value of the
underlying shares subsequently decreases to less than the loan amount, an employee can return the
stock instead of repaying the loan. The employee is in the same position as if the stock purchase or
option exercise had never occurred. This is explicit in paragraph 6 of Statement 123R, which provides
that

the rights and obligations embodied in a transfer of equity shares to an employee for a note that
provides no recourse to other assets of the employee (that is, other than the shares) are
substantially the same as those embodied in a grant of equity share options. Thus that
transaction shall be accounted for as a substantive grant of equity share options.

The purchase of shares or exercise of an option with a recourse loan, however, is a substantive purchase
or exercise. Paragraph 6 does not explicitly address situations in which a recourse note could be
considered, in substance, a nonrecourse loan, nor does it address the accounting for a transaction
involving an in-substance nonrecourse loan. That paragraph does provide, however, that “[a]ssessment
of both the rights and obligations in a share-based payment award and any related arrangement and how
those rights and obligations affect the fair value of an award requires the exercise of judgment in
considering the relevant facts and circumstances.”

Relevant facts and circumstances to consider in assessing whether a recourse loan is, in substance,
nonrecourse, are addressed in Issue 34 of EITF Issue 00-23. Under Issue 34, a loan that legally provides
recourse should be considered a recourse loan, unless any of the following conditions applies:

• The employer has legal recourse to the employee’s other assets, but does not intend to seek
repayment beyond the shares issued.

• The employer has a history of not demanding repayment of loan amounts that exceed the fair value
of the shares.

• The employee does not have sufficient assets or other means (beyond the shares) to justify the
recourse nature of the loan.

• The employer has accepted a recourse note on exercise and subsequently has converted that note to
a nonrecourse note.

Although Statement 123R supersedes EITF Issue 00-23, we believe the facts and
circumstances listed above are appropriate considerations for an assessment of whether
a recourse note is a substantive nonrecourse loan under Statement 123R.

If a loan is determined to be nonrecourse, it is not recorded on the balance sheet. Interest on the note is
not recorded on the income statement unless the interest portion of the loan is considered recourse.
Instead, the exercise price of the option includes the nonrecourse principal and nonrecourse interest due
on the loan. The terms of the arrangements must be considered to determine the resulting fair value,
classification, and effects of earnings per share.
New Developments Summary 60

Before undertaking the financing of share-based payment awards, entities should consider the provisions
of the Sarbanes-Oxley Act of 2002 that prohibit issuers from providing personal loans to directors,
executive officers, or individuals in equivalent positions.

Other considerations
Dilution
Entities need to consider whether the potential dilutive effect of employee option grants should be
reflected in estimations of the fair value of their options.

For public entities, the FASB believes an adjustment for dilution would be rare. Assuming the market for
the entity’s shares is reasonably efficient, the potential dilutive effect of recurring awards of employee
options, or option grants otherwise expected by the market, should be reflected in the share price. The
exception might be a large, unexpected grant of options to employees for which the market does not
expect a commensurate benefit.

For nonpublic entities, if investors involved in negotiated exchanges of the entities’ shares do not have
sufficient information about the size and frequency of employee option grants, the dilutive effect of those
grants may not be reflected in share prices. Whether a nonpublic entity’s fair value estimate of its
employee options needs a separate adjustment may depend on how fair value was determined for the
entity’s shares included in the option valuation model. Statement 123R does not provide guidance on how
to calculate an adjustment for dilution.

Awards issued prior to an IPO


At the 2008 AICPA National Conference on Current SEC and PCAOB Developments, the SEC staff
discussed how the fair value of a share-based payment award classified as a liability should be estimated
if the company is in the process of going public. The awards are expected to increase in value when the
initial public offering (IPO) occurs.

The staff indicated that, under the fair value measurement objective of Statement 123R, the periodic
remeasurement of the fair value of liability-classified awards should include the effects of significant
contingencies that affect the value of the awards. The periodic remeasurements of the liability awards
should therefore include the effect of the contingency related to the IPO, although the uncertainty of the
IPO occurring would significantly reduce the value of that contingency in periods before the IPO takes
place.

Credit risk
An entity may need to consider a credit risk adjustment to an award with a cash settlement feature if the
instrument’s payoff amount increases with decreases in the price of the entity’s shares. The decrease in
share price would likely indicate a lessening of the entity’s ability to liquidate its liabilities.

Instruments whose payoff increases with decreases in an entity’s share price include a
put with a fixed exercise price and a share with an embedded put that has a fixed
exercise price.
New Developments Summary 61

Calculated value: nonpublic entities unable to estimate volatility


Nonpublic entities have to estimate the expected volatility of their share price in order to apply a valuation
technique to estimate the fair value of their employee share options. Because their shares are not actively
traded, determining share price volatility is particularly challenging. Statement 123R, paragraph A43,
provides, however, that they may be able to obtain sufficient historical information based on transactions
on an internal market for their shares, private transactions, or new issuances of shares or convertible debt
instruments. If sufficient share price information is not available from those sources to determine a
reasonable and supportable estimate of expected volatility, nonpublic entities should generally base their
estimate of expected volatility on available information about the historical, expected, or implied volatilities
of similar entities whose shares are publicly traded, using information from an appropriate period after
those similar entities went public. To evaluate similarity, entities should consider factors such as the other
entities’ industry, stage of life cycle, size, and financial leverage (paragraph A32, footnote 60).

Entities identify appropriate similar entities in a variety of ways. They may be the entity’s
competitors, companies the entity uses to benchmark aspects of its performance, or
companies included in an appropriate industry sector.

If it is not practicable for a nonpublic entity to estimate the expected volatility of its share price, Statement
123R requires the entity to estimate the value of its options and similar instruments using the calculated
value method. Note that use of the calculated value method is not optional. It is used only if it is not
practicable for an entity to estimate its share price volatility assumption. The Statement (paragraph A45)
specifically defines not practicable for purposes of the calculated value method as follows:

For purposes of this Statement, it is not practicable for a nonpublic entity to estimate the expected
volatility of its share price if it is unable to obtain sufficient historical information about past
volatility, or other information such as that noted in paragraph A43 [paragraph A43, which
discusses, among other things, the use of the share price volatility of similar entities, is
summarized in the first paragraph of this subsection], on which to base a reasonable and
supportable estimate of expected volatility at the grant date of the award without undue cost and
effort.

Therefore, before using the calculated value method, a nonpublic entity has to determine it is not
practicable to estimate the expected value of its share price volatility without undue cost and effort. To
determine that, the entity has to determine both of the following:

• It does not have sufficient historical information about its share price volatility to estimate expected
volatility.

• It is not able to identify one or more similar entities, even after considering the similarity of companies
that are components of appropriate industry sector indices.

As a result, use of the calculated value method to determine volatility is anticipated to be rare.

As noted under the subheading “Guidance applicable to awards to nonemployees” in section B, there is a
presumption that an entity that issues option awards to nonemployees should not use the calculated
value method for employee awards because the entity is required to determine expected volatility to
estimate the fair value of its nonemployee option grants under the provisions of EITF Issue 96-18.
New Developments Summary 62

The calculated value method consists of substituting the historical volatility of an appropriate industry
sector index for the entity’s own expected volatility in the valuation model used to value its options. All
other assumptions used in the option valuation model, such as the expected (or contractual) term, are the
same as discussed above in this section.

An appropriate industry sector index is one that is representative of the industry in which the nonpublic
entity operates. If possible, the index should also reflect the size of the entity. A nonpublic entity that
operates in multiple industry sectors could identify multiple appropriate industry sector indices and weight-
average the historical volatility of each industry index in a manner that reflects the entity’s operations.
Alternatively, it may select an industry sector that is most representative of its operations. If a nonpublic
entity operates in an industry in which no public companies operate, the entity should select an index for
the industry sector most closely related to the nature of its operations. A broad-based industry sector,
such as the S&P 500, may never be used. The diversification of a broad-based index would prevent the
index’s historical volatility from being representative of the volatility of the industry sector in which the
nonpublic entity operates.

Footnote 65 of Statement 123R indicates that Dow Jones Indexes maintain a global series of stock
market indices with industry sector splits available for many countries, including the United States. The
historical values of those indices are obtainable from its website. The indices can be found using the
website’s Industry Classification Benchmark. To select a subindex whose companies reflect a nonpublic
entity’s size, the Dow Jones industry indices can be subdivided based on market-capitalization
categories, such as small-cap. This process is described in paragraph A139 of Statement 123R.

Entity W operates exclusively in the medical equipment industry. It visits the Dow Jones
Indexes website and, using the Industry Classification Benchmark, reviews the various
industry sector components of the Dow Jones U.S. Total Market Index. It identifies the
medical equipment subsector, within the health care equipment and services sector, as
the most appropriate industry sector in relation to its operations. It reviews the current
components of the medical equipment index and notes that, based on the most recent
assessment of its share price and its issued share capital, in terms of size it would rank
among companies in the index with a small market capitalization (or small-cap
companies). Entity W selects the small-cap version of the medical equipment index as an
appropriate industry sector index because it considers that index to be representative of
its size and the industry sector in which it operates. Entity W obtains the historical daily
closing total return values of the selected index for the five years immediately prior to
January 1, 20X6 from the Dow Jones Indexes website. It calculates the annualized
historical volatility of those values to be 24 percent, based on 252 trading days per year.

If applying the calculated value method, a nonpublic entity should use the selected index consistently for
all its share options and similar instruments, unless the nature of the entity’s operations changes and
another industry sector would be more appropriate. Historical volatility of the selected industry sector,
which will be used in place of the volatility of the entity’s share price, is required to be calculated based on
daily closing values for the expected term of the entity’s options.

The calculated value method is not considered fair value. The method is available only to a nonpublic
entity if it is not practicable for the entity to estimate the expected volatility of its share price without undue
cost or effort.
New Developments Summary 63

An entity that is planning to go public should carefully evaluate whether determining the
volatility of its share price is impracticable. The SEC staff stated in SAB Topic 14.B that it
“would expect an entity that becomes a public entity and had previously measured its
share options under the calculated value method to be able to support its previous
decision to use calculated value” and to disclose the reasons why it was not practicable
for it to estimate the expected volatility of its share price, as required by Statement 123R,
paragraph A240 (e) (2) (b). Use of the calculated value method implies, among other
things, that the entity could not identify similar entities that had publicly traded shares,
even after using the method suggested by the SEC staff of evaluating the public
companies making up an industry sector index reflective of the nonpublic entity’s
operations to identify one or more similar entities.

Intrinsic value: entities unable to reasonably estimate fair value


The FASB believes it should be possible to estimate the fair value (or calculated value for a nonpublic
entity unable to estimate its volatility) of most employee share options, even those with complicated
features. However, Statement 123R provides that, in rare instances, it may not be possible to estimate
fair value because of the complexity of an option’s terms.

If an entity, public or nonpublic, is not able to reasonably estimate an instrument’s fair value (or calculated
value) on the grant date because of the complexity of the instrument’s terms, the instrument should
initially be accounted for based on its grant-date intrinsic value, and remeasured and reported at current
intrinsic value as of each reporting date until it is exercised or settled or expires unexercised. Even if the
entity is later able to reasonably estimate the fair value of the award, the award must continue to be
accounted for at intrinsic value and continue to be remeasured each reporting date until settlement. (This
accounting is similar to the variable accounting required for repriced options under APB Opinion 25.)
New Developments Summary 64

G. How is measured compensation cost recognized?


Recognition principle
In exchange for share-based payment awards, employers receive employee services. The measured
compensation cost for share-based awards is recognized as those employee services are received. The
corresponding credit is an increase in equity or a liability, depending on whether the share-based
payment award is classified in equity or as a liability (see section C for a description about when liability
classification is required).

Classification of share-based compensation cost


The compensation cost recognized for share-based payment awards is generally expensed, but
Statement 123R does not specify how it should be classified in the income statement. In SAB Topic 14.F,
however, the SEC staff states that the expense should be reported in the same income statement line or
lines as cash compensation paid to the same employees, such as compensation expense or cost of
sales. Further, the staff believes the compensation cost related to share-based payment awards should
not be shown as a separate, noncash line item. The staff noted that a registrant could, however, disclose
the share-based payment amount included in an income statement line item parenthetically on the face of
the income statement or on the cash flow statement, in the financial statement footnotes, or in MD&A.

The recognition of share-based compensation cost will not always result in an immediate income
statement charge. If the employee’s services are part of the cost to construct, develop, or acquire another
asset (such as inventory; property, plant, or equipment; certain computer software development costs;
loan origination costs; capitalized exploration costs; contract accounting costs; or other assets that
include capitalized payroll costs), the recognized cost of the share-based payment award is initially
capitalized as part of that asset and recognized in the income statement as the asset is consumed or
disposed of.

Entities that accrue liabilities that include certain payroll costs, such as the accrual of a loss on a long-
term contract and warranty costs, should consider in the amount of the accrual share-based
compensation cost for the employees whose wages are included in the accrual.

Appropriate classification of share-based compensation cost is an area entities should focus on in


applying Statement 123R. Companies that capitalize some of their payroll costs should consider the need
for a process to identify and quantify share-based compensation costs that should be capitalized and to
track when those capitalized costs should be included in income. Regarding the accounting for
compensation costs that are inventoriable costs, the SEC staff noted in SAB Topic 14.I that registrants
may reflect the effect of share-based payment awards on inventory through a period-end adjustment to
inventory. The staff observed that using this methodology, in contrast to incorporating the cost in the
inventory costing system, would not be considered a deficiency in internal controls.

Requisite service period


Compensation cost for a share-based payment award is recognized over the award’s requisite service
period — the period over which an employee is required to provide service in exchange for the share-
based payment award. For an award classified as a liability, changes in the award’s fair value (or intrinsic
value or calculated value for certain nonpublic entities) subsequent to the end of the requisite service
period are recognized in the period of the change. The service required to be provided during the
requisite service period is referred to as the requisite service.

The requisite service period will usually be the vesting period for an award that has only a service
condition, unless there is clear evidence to the contrary.
New Developments Summary 65

Twenty employees are each awarded 1,000 shares of the employer’s stock that will vest
in three years. The related compensation cost, the grant-date fair value of the shares, will
be recognized over the three-year requisite service period.

The requisite service period, which is estimated based on an analysis of all the terms and conditions of an
award, may be explicit, implicit, or derived.

Explicit service period


A service period is explicit when it is stated in the terms of the award. Explicit service periods usually exist
in awards that have a service condition requiring the grantee to continue to provide service to the
employer for a specified period to earn the award.

An award provides that the options vest on the third anniversary of the grant date. The
award has an explicit service period of three years.

Implicit service period


The service period is implicit when it is not explicitly stated in the award, but can be inferred from an
analysis of the terms of the award. Awards that have performance conditions sometimes have implicit
service periods. A performance condition relates to achievement of a specified target defined by
reference to the employer’s own operations or activities, such as an option that vests if the employer’s
growth rate increases a certain amount or regulatory approval is obtained for a product. A performance
condition may also be in reference to the same performance measure of another entity or group of
entities, such as a vesting requirement that the company attain an increase in earnings per share that
exceeds the average growth rate in earnings per share of other entities in the same industry.

An award provides that the options vest on completion of the new product prototype. If it
is probable that the prototype will be completed in two years, the implied requisite service
period is two years.

Derived service period


A derived service period is a service period for an award with a market condition. The service period is
inferred from the application of a valuation technique that takes into consideration the market condition. A
market condition relates to the achievement of a specified price of the issuer’s shares, a specified amount
of intrinsic value indexed solely to the issuer’s shares, or a specified price of the issuer’s share in terms of
a similar equity security or index of similar securities.

An award provides that the options are exercisable only if the employer’s share price
increases 25 percent or more above the grant-date share price. The derived service
period would be inferred from a valuation technique that takes the share-price vesting
New Developments Summary 66

provision into consideration. Statement 123R provides that, in a lattice model, the derived
service period would be the duration of the median share path of the share paths on
which the market condition is satisfied. The duration is the period from the first day of the
service period until the expected date of satisfaction as inferred from the valuation
technique. In a lattice model, the duration is the period from the first day of service until
the date the market condition is satisfied on the median share path.

Service inception date


The service inception date, the date the requisite service period begins, is usually the grant date. This is
also the point at which cost begins to be recognized, except in some cases when there is a performance
condition. The service inception date cannot precede the grant date unless all of the following conditions
apply:

• The award is authorized.

• Service begins before a mutual understanding of the key terms and conditions of the award is
reached (for example, because one of the terms, such as the exercise price, is not yet known).

• Either of the following applies:

− The award does not include a substantive future service period as of the grant date.

− The award has a performance or market condition that has to be satisfied during a service period
preceding the grant date and following the inception of the arrangement; if the performance or
market condition is not met during that period, the award will be forfeited.

On January 1, 20X2, an employee is granted options that vest in two years. The exercise
price will be the share price on January 1, 20X3. However, if the employee does not
satisfy a sales target (a performance condition) in 20X2, the award is forfeited. The grant
date is January 1, 20X3, which is the date the employee will begin to benefit from future
movements in the share price. The service inception date, January 1, 20X2, precedes the
grant date because the performance condition has to be satisfied during a service period
preceding the grant date. The service period ends on December 31, 20X3. Cost is
recognized over a two-year period beginning on January 1, 20X2.

When the service inception date precedes the grant date, recognition of compensation cost for periods
before the grant date is based on the fair value of the award at the reporting dates that occur before the
grant date. In the period the grant date occurs, cumulative compensation cost is adjusted to reflect the fair
value at the grant date and the pro rata portion of the vesting period that has elapsed as of that date.

The service inception date may be later than the grant date in certain awards that have performance
conditions. This occurs when an award consists of several separately vesting tranches (portions), each of
which has a separate performance condition, and all of the terms of the awards, including the
performance target for each tranche, are established at inception. Because a mutual understanding of the
key terms and conditions is known at inception, if all other conditions required to have a grant date are
met, the grant date and the measurement date occur at inception. However, if each tranche has its own
independent performance condition for a stated period of service, each tranche will have its own service
New Developments Summary 67

inception date and requisite service period. Such awards are illustrated below in Situations A, B, and C
under the subheading “Awards with performance conditions and multiple tranches.”

Initial estimate of requisite service period


Entities are required to make their best estimate of the requisite service period on the grant date (or
service inception date, if it precedes the grant date) and begin recognizing compensation cost based on
that period.

The initial estimate of an award’s requisite service period requires an analysis of

• All vesting and exercisability conditions

• All explicit, implicit, and derived service periods, including any provisions that make explicit or implicit
service periods nonsubstantive

• The nature of service, performance, and/or market conditions and how they are combined (for
example, whether both the service and performance conditions have to be satisfied for vesting to
occur or whether only one is required for vesting). See the subsection headed “Multiple explicit,
implicit, and/or derived service periods” below.

• The probability that performance or service conditions will be satisfied

In-substance service conditions: certain noncompete provisions

Employee awards may contain provisions (clawbacks) that require employees to return vested awards if
specified contingent events occur. For example, a noncompete provision in an award may require the
grantee to return vested shares if the employee terminates employment to work for a competitor within
three years after the vesting date. As noted in section D, such contingent features are not included in the
grant-date fair value of the award. Instead, the clawback is accounted for if and when the contingent
event occurs. Such a situation is described in illustration 15 of appendix A of Statement 123R.

However, illustration 16 of appendix A indicates that, in limited circumstances, a noncompete provision


may function as an in-substance service period even though the award has no explicit requisite service
period. The FASB reached this conclusion based on the particular facts and circumstances described in
illustration 16. Those facts include the legal enforceability of the agreement and the entity’s intent to
enforce it, the magnitude of the value of the award relative to the employee’s other compensation, and
the severe impact the noncompete provision would have on the employee’s ability to obtain employment
elsewhere. The FASB staff indicated that most noncompete provisions are expected to be accounted for
as contingent clawback provisions as described in illustration 15. The SEC staff noted at the 2005 AICPA
National Conference on Current SEC and PCAOB Developments that the FASB reached its conclusion in
illustration 16 because, based on the facts pertaining to the employee, the entity, and the noncompete
provision, the employee was in essentially the same position as if the award contained a substantive
stated vesting period—in effect, in most cases the employee would receive the shares at the end of the
noncompete period only if still employed by the entity at that time.

In the SEC staff’s view, the fact that a noncompete provision is substantive would not, in and of itself, lead
to a conclusion that an in-substance requisite service period exists. The SEC staff also believes that a
conclusion that a noncompete agreement creates a substantive service period would not be a common
occurrence. To assess whether a noncompete provision results in an in-substance requisite service
period, an entity should evaluate the facts and circumstances considering the FASB’s intended
application of illustration 16. In particular, the following circumstances should be considered:
New Developments Summary 68

• The specific terms of the share-based payment award

• The terms of the related noncompete arrangements

• The entity’s past practice regarding the enforcement of noncompete provisions

• Past employees’ actions regarding the terms of noncompete provisions, if relevant to the current
assessment

• The circumstances of the employees receiving the awards

If an SEC registrant believes it has a fact pattern that results in a noncompete provision creating an in-
substance requisite service period in an award, the SEC staff encourages the registrant to discuss the
facts with its staff before reaching a final determination.

At its meeting on September 13, 2005, the FASB Statement 123R Resource Group reached a consensus
on another issue that involved a noncompete provision. If an entity issues a new award with a
noncompete provision when an employee terminates service, the award should generally be accounted
for as compensation for prior service with a potential clawback feature. The fair value of the award would
be expensed immediately, and a contingent gain accounted for if the clawback occurs because of a
breach of the noncompete provision.

Nonsubstantive conditions: retirement eligible provisions

Awards with explicit service conditions may have other provisions that indicate that the explicit service
condition is nonsubstantive. Some entities, for example, have provisions in their awards that the awards
will continue to vest if the employee retires or that vesting accelerates when the employee becomes
retirement eligible. When such provisions exist and the employee reaches retirement age, he or she no
longer has to provide service to earn the award. Therefore, when awards have nonsubstantive service
conditions because of provisions for retirement eligible employees, the requisite service period excludes
any period for which the employee is retirement eligible. The period over which compensation cost is
recognized is therefore from the grant date (or service inception date, if it precedes the grant date, as
described in the subheading “Service inception date” above) until the employee reaches retirement age. If
the employee has reached retirement age at the grant date, the award does not contain a service
condition for vesting. The award is effectively vested on the grant date, and its entire fair value should be
recognized as compensation cost on the grant date (paragraphs A57 to A58). Because of the special
rules for determining the requisite service period for awards with retirement eligible provisions, entities
issuing such awards should establish procedures to ensure that individual awards affected by the
retirement eligible provisions are identified and accounted for using the appropriate requisite service
periods.

Change in initial estimate of requisite service period


An entity should revise its initial estimate of requisite service period as necessary based on changes in
facts and circumstances. If there is a change in the expected or actual outcomes of service or
performance conditions, the initial estimate of the requisite service period may need to be adjusted based
on the new information. Guidance on accounting for such changes is provided in paragraphs A65 to A66
of Statement 123R.

If an award requires satisfaction of either a market condition or a service or performance condition and
the initial estimate of the requisite service period is the market condition’s derived service period, the
requisite period should not change unless either of the following occurs:
New Developments Summary 69

• The market condition (for example, a market price trigger that affects exercisability) is satisfied before
the end of the derived service period. (This will shorten the requisite service period, and any
unrecognized compensation cost should be recognized immediately.)

• Satisfying the market condition is no longer the basis for determining the requisite service period (for
example, because a performance condition that satisfies the award’s vesting requirement becomes
probable of achievement and the implicit service period is shorter than the derived service period).

When a change to the initial estimate of the requisite service period occurs, there are two possible
accounting results: accounting for the change is prospective, or the cumulative effect of the change must
be recognized as an adjustment to compensation expense in the period the estimate changes. As
discussed below, which of those accounting methods applies depends on whether the change in the
initial estimate of the requisite service period caused by a change in actual or estimated outcomes affects
the grant-date fair value of the award or the quantity of instruments expected to vest.

If the change affects the grant-date fair value or the quantity of instruments expected to vest, the
cumulative effect of the change on current and prior periods is recognized in the period of change.

If the quantity of instruments expected to vest changes because a performance condition


affecting vesting becomes probable of achievement, or if the grant-date fair value
changes because a performance condition that affects exercise price becomes probable
of achievement, the cumulative effect of the change is recognized in the period of
change.

If compensation cost is already being attributed over the requisite service period and the estimated
requisite service period (over which cost is being recognized) changes solely because another market,
performance, or service condition becomes the basis for the revised requisite service period,
unrecognized compensation cost on the date of change, if any, is recognized prospectively over the
revised requisite service period, and a cumulative effect adjustment is not recognized.

Multiple explicit, implicit, and/or derived service periods


An award may have multiple explicit, implicit, and/or derived service periods, but it can have only one
requisite service period unless the award has in-substance multiple awards. An example of an award that
is accounted for as in-substance multiple awards is an award with graded vesting when each separately
vesting portion has its own requisite service period (see the description of such awards under the
subheading “Awards with performance conditions and multiple tranches” below).

Awards have multiple service periods when they have more than one condition requiring service. An
award, for example, may have multiple performance conditions, a service condition and one or more
performance conditions, or a market condition and a service and/or performance condition(s). For such
an award, the initial estimate of the requisite service period requires an analysis of the award’s vesting
and exercisability conditions; all explicit, implicit, and derived service periods; and the probability that
performance and/or service conditions will be satisfied. Paragraphs A63 to A74 of Statement 123R
provide guidelines for determining the requisite service period in those situations, once the relevant terms
of the award have been identified. Although the guidelines are complex, they will promote consistency in
practice as entities begin to issue employee awards with multiple conditions. The following is a summary
of those guidelines:
New Developments Summary 70

• For awards with a service condition and one or more performance conditions:

− If both a service condition and one or more performance conditions have to be satisfied to vest in
an award, the entity should first determine if satisfaction of the service condition and the required
performance condition(s) are probable:

 If both the service condition and the performance condition(s) are probable of achievement,
the initial estimate of the requisite service period is the longer of the explicit (service
condition) service period or the implicit (performance condition) service period(s).

 If satisfaction of the service condition or the required performance condition(s) is not


probable, no compensation should be recognized unless all condition(s) required for vesting
become probable of achievement.

− If either a service condition or one or more performance conditions has to be satisfied to vest in
an award and if

 Both the service condition and the performance condition(s) are probable of achievement, the
requisite service period is the shorter of the explicit or implicit service period

 The achievement of the performance condition(s) is not probable, the explicit service period
is the requisite service period

• For awards with a market condition and a performance or service condition:

− If both a market condition and a performance or service condition have to be satisfied to vest in
an award and if

 It is probable the performance or service condition will be satisfied, the initial estimate of the
requisite service period is generally the longest of the implicit, explicit, or derived (market
condition) service period

 Satisfaction of the performance or service condition is not probable, no compensation should


be recognized unless the performance or service condition becomes probable of
achievement

− If either a market condition or a performance or service condition has to be satisfied to vest in an


award and if

 The performance or service condition is probable of achievement, the initial estimate of the
requisite service period is generally the shortest of the implicit, explicit, or derived service
periods

 The achievement of the performance or service condition is not probable, the derived service
period is the requisite service period

At its May 26, 2005 meeting, the Statement 123R Resource Group addressed the accounting for an
award that had a market condition and a service condition. The award would vest, for example, in five
years or when the market price doubled. Assume the fair value of the award with only a service condition
was $8 and the fair value of the award with the service condition and the market condition was $6. In this
situation, the award would vest in any event at the end of five years, but it could vest earlier if the market
condition was satisfied earlier. Assume the market condition had a derived service period of three years.
The Resource Group concluded that the accounting should follow the above rule for situations in which
either a market condition or a performance or service condition has to be satisfied to vest in the award,
although it initially seemed counterintuitive to some members. The fair value of the award should take into
New Developments Summary 71

consideration all the award’s features, including the market condition that may serve to shorten the
expected term of the award. Therefore, the fair value of the award is $6. The requisite service period is
the shorter of the explicit or derived service period, which in this example would be three years.

Amount of cost to recognize


Awards expected to vest
Grant-date fair value of employee equity awards is recognized over the requisite service period, but only
for awards expected to vest (that is, for which the employees are expected to provide the requisite
service). Therefore, after determining the grant-date fair value for a new award and the requisite service
period, an entity has to estimate the number of awards that are expected to vest.

The initial estimate needs to be revised if subsequently available information indicates the actual number
expected to vest differs from the previous estimate. If an entity determines a change is required, the
cumulative effect on current and prior periods is recognized in the period of change. If the affected
awards were issued before adoption of Statement 123R and previously accounted for under APB Opinion
25, the adjustment should take into account

• For periods prior to adoption: cost recognized under APB Opinion 25, if any (not Statement 123 pro
forma cost)

• For periods subsequent to adoption: cost recognized under Statement 123R

By the time the award (or each separately vesting portion of an award with graded vesting) is fully vested,
the cumulative compensation cost recognized for the award (or portion of the award) is required to be
adjusted to the number of awards that are actually vested.

An entity needs to develop a method for estimating expected forfeitures at the date it
grants share-based payment awards. Available information may include forfeiture
experience with similar awards, the turnover rate for the group of employees receiving
the awards, and expectations about future turnover. Because the number of awards
expected to vest has to be adjusted as expectations about actual forfeitures change, and
adjusted to actual experience as of the final vesting date, the entity’s process for
estimating expected forfeitures should include a procedure for monitoring actual
experience and adjusting estimates periodically based on actual forfeitures within the
grantee group and current expectations about future turnover.

Awards with cliff vesting


Cliff vesting refers to a method of vesting in which the instruments in an award all vest on the last day of
the vesting period.

If an employee is awarded 1,000 options on the employer’s stock that will vest in four
years and all 1,000 shares vest on the last day of the four-year period, the award cliff
vests in four years.
New Developments Summary 72

For awards with only a service condition that cliff vest, compensation cost is recognized on a straight-line
basis over the awards’ requisite service period.

Awards with graded vesting


Graded vesting is a method of vesting in which portions of an award vest in different periods.

The following award has graded vesting: an award of 1,000 options granted to an
employee on January 1, 20X1 that vests 25 percent a year over a four-year period.

An entity has to make an accounting policy decision about how to recognize compensation cost for
awards with only service conditions that have a graded vesting schedule. The election is available
regardless of the valuation technique used for the award (that is, regardless of whether a separate fair
value is estimated for the options in each separately vesting portion or a single fair value is estimated that
applies to all options in the award). Entities issuing awards with graded vesting that have only service
conditions (no performance or market condition) have to select one of the following two methods for
recognizing compensation cost and apply the method consistently for all awards with graded vesting that
have only service conditions:

• Straight-line attribution method: Compensation cost is recognized on a straight-line basis over the
requisite service period for the entire award. However, the percentage of grant-date fair value
recognized at any date must at least equal the portion of the award that is vested at that date.
Therefore, entities that grant awards with graded vesting and use the straight-line attribution method
should have a control in place to ascertain at each reporting date that the cumulative cost recognized
for the grant is at least equal to the grant date fair value of the awards vested at that date.

If an award vests 50 percent at the end of the first year and 25 percent at the end of the
second and third years, compensation cost for the 50 percent of the options that vest at
the end of year one is recognized in the first year, and compensation cost for the options
that vest at the end of the second and third years is recognized over the remaining two-
year requisite service period.
That accounting is clarified in illustration 4(b), paragraphs A97 to A104, as amended by
FSP FAS 123R-6. If each separately vesting portion of an option award has been valued
separately, the compensation cost recognized for awards vested as of the end of a
reporting period should be determined based on the fair value estimated for the portion of
the awards that have vested. For example, assume the entity valued each separately
vested portion of the award, and the options that vest in year 1 have a grant-date fair
value of $15, those vesting at the end of year 2 have a grant-date fair value of $16, and
those vesting in year 3 have a grant-date fair value of $17. Compensation cost for 50
percent of the awards vesting at the end of year 1 would be equal to the number of
options that actually vested times $15.
If awards vest over a seven-year period, with 50 percent vesting at the end of the fifth
year, 10 percent vesting at the end of the sixth year, and 40 percent vesting at the end of
the seventh year, the entity would recognize compensation cost on a straight-line basis
over seven years.
New Developments Summary 73

If the grant date is delayed, the attribution period is from the grant date to the end of the vesting
period.

On February 1, 20X1, an individual is hired to be Company A’s new controller and is


awarded 5,000 options. Fifty percent will vest on February 1, 20X2, and the remaining
fifty percent on February 1, 20X3. The new controller will begin his new position on
May 1, 20X1. The grant date of the award is May 1, 20X1. Company A has elected the
straight-line attribution method for graded vesting awards. The options will vest over the
21-month period from May 1, 20X1 through February 1, 20X3. However, fifty percent of
the awards will vest in 9 months. Company A will recognize cost for those awards vesting
on February 1, 20X2, based on their grant-date fair value, over the 9 months from May 1,
20X1 to February 1, 20X2.

• Graded-vesting attribution method: Compensation cost is recognized on a straight-line basis over the
requisite service period for each separately vesting portion as if the grant consisted of multiple
awards, each with the same service inception date but different requisite service periods. This
method accelerates the recognition of compensation cost. In computing compensation cost, the entity
has to determine the number of awards expected to vest separately for each vesting period. In
addition, in the period a portion of the award becomes 100 percent vested, cumulative recognized
compensation cost for that portion has to be adjusted to the number of awards that vested, taking into
account actual forfeitures.

An award of 1,000 options granted to an employee on January 1, 20X1 vests 25 percent


a year over a four-year period. The following vesting would be attributed to 20X1:

Tranche vesting in 20X1 100% of 25% of the award 25.0%

Tranche vesting in 20X2 50% of 25% of the award 12.5%

Tranche vesting in 20X3 33-1/3% of 25% of the award 8.3%

Tranche vesting in 20X4 25% of 25% of the award 6.3%

Total compensation cost to be recognized in 20X1 52.1%

When a portion of equity-classified, graded-vesting options vests, an entity should ensure that

• The number of awards expected to vest has been adjusted to the actual number of options vested

• Compensation cost recognized at least equals the grant-date fair value of the vested awards

Awards with a performance condition


For awards with a performance condition that affects vesting or the exercisability of options, cost is
recognized only if the performance condition is probable of being satisfied. Probable for this purpose is
New Developments Summary 74

the meaning of probable in paragraph 3 of FASB Statement 5, Accounting for Contingencies: “the future
event or events are likely to occur.” If satisfaction of the performance condition does not meet that
threshold of probability of being satisfied, compensation for the award is not recognized.

In practice, performance conditions affecting vesting or exercisability associated with certain liquidity
events, such as the occurrence of an initial public offering or a change of control, have not been
considered probable until the liquidity event occurs. If the performance condition is based on satisfaction
of a liquidity event having a specified return to investors, achievement of the return is excluded from the
probability assessment as it is a market condition. Such a vesting requirement would therefore consist of
a performance condition (the occurrence of the liquidity event) and a market condition (achieving a
specified return).

An entity is required to reassess at each reporting date whether satisfaction of the performance condition
is probable, and begin recognizing compensation cost if and when achievement of the performance
condition becomes probable. As noted above under the subheading “Change in initial estimate of
requisite service period,” if the change in the estimated outcome of a performance condition affects the
quantity of awards expected to vest, the cumulative effect of the change should be recognized in the
period of the change.

The vice president of marketing is awarded 10,000 shares that vest if annual sales
revenue increases, on average, 3 percent a year over the next four years. The requisite
service period for the award is four years, based on the explicit four-year service period.
At the end of year 1, management has not determined that achievement of the revenue
target is probable. No cost is recognized for the shares in year 1. Management
determines at the end of year 2 that achievement of the performance condition for the
four-year period is probable. The entity recognizes 50 percent of the grant-date fair value
of the award at the end of year 2. If achievement of the revenue target remains probable
for years 3 and 4, and is ultimately achieved, 25 percent of the grant-date fair value will
be recognized in each year.

Performance conditions often affect vesting or exercisability, but they may affect the number of awards
each employee will receive or the exercise price or other factors that impact the fair value of the award.
The compensation cost ultimately recognized is equal to the grant-date fair value of the award that
coincides with the actual outcome of the performance condition.

An entity grants options to 3,000 employees. The number each will receive varies
depending on the average annual increase in EBITDA over four years:

• If EBITDA increases an average of 5 percent a year, each employee receives 100


options.

• If EBITDA increases an average of 8 percent a year, each employee receives 200


options.

• If EBITDA increases an average of 10 percent a year, each employee receives 300


options.

• If EBITDA increases an average of 15 percent a year, each employee receives 400


New Developments Summary 75

options.

The award’s requisite service period is the four-year explicit service period. At the grant
date, management determines it is probable that EBITDA will increase, on average, 5
percent a year, and it accrues 25 percent of the grant-date fair value of 300,000 options.
At the end of year 2, it determines that it is probable that EBITDA will increase, on
average, 8 percent a year. At the end of that year, the entity recognizes the cumulative
effect on the current and prior periods of the change in the probable outcome of the
award. The entity recognizes 50 percent of the grant-date fair value of 600,000 options,
less the cumulative cost previously recognized. The cumulative effect of the change in
the estimate of the expected outcome of the performance condition is recognized in year
2 because the change in estimate affects the quantity of awards expected to vest.

If a performance condition affects the exercise price or contractual term of an award, there is more than
one award to value at the grant date because there is more than one possible award that employees may
receive. In that situation, the grant-date fair value is estimated for each potential outcome of the award
based on the performance condition. The following is based on illustration 5(b) in appendix A of
Statement 123R.

A CEO is granted 10,000 options that have an exercise price of $30. The options vest
immediately. However, if EBITDA increases, on average, 10 percent a year over a two-
year period, the exercise price of the options decreases to $15 on options not previously
exercised, provided the CEO is still an employee. The requisite service period for the
options with a $30 exercise price is 0 years, because those options are vested on the
grant date. The requisite service period for options with a $15 exercise price is the two-
year explicit period, because the award provides that the CEO has to provide service for
two years to vest in that award. On the grant date, the entity determines the fair value of
the potential outcomes of the performance condition:

• The fair value of the option with a $30 exercise price and a requisite service period of
0 is $13.08.

• The fair value of the option with a $15 exercise price and a requisite service period of
2 years is $19.99.

Because the options with the $30 exercise price are fully vested on the grant date, the
entity recognizes their grant-date fair value of $130,800 on that date. The entity also
estimates at the grant date that it is probable the 10 percent growth in EBITDA will be
achieved. It therefore recognizes the remaining compensation cost of $69,100 (($19.99 -
$13.08) x 10,000) over the two-year requisite service period for the performance
condition. If it subsequently estimates the EBITDA target will not be achieved, it would
adjust compensation cost in the period of the change, so that by the end of the two-year
period, cumulative compensation cost reflects the outcome of the performance condition.

Awards with performance conditions and multiple tranches

Determining the grant date, the service inception date, and the requisite service period (RSP) for awards
with multiple separately vesting tranches requires careful evaluation if there is a separate performance
New Developments Summary 76

condition for each tranche. Slight differences in how performance conditions are structured can affect how
cost is recognized for the award. The grant date depends on when the performance targets are
determined. The RSP depends on whether the performance targets of different tranches are independent,
dependent on each other, or can be substituted for each other. This is illustrated in the four situations
below, all of which relate to the same awards, but in each situation, the performance condition is
structured a little differently.

On January 1, 2007, Tech Company granted its CEO 40,000 options that will vest over
four years. Ten thousand of those options will vest based on an EBITDA target specified
for each year.
Apply the following questions to the four situations below:

• What is the grant date for each separately vesting tranche?

• What is the service inception date for each tranche?

• What is the RSP for each tranche?

The answers for each situation depend on both

• When performance conditions are established

• Whether conditions for different tranches are interdependent


New Developments Summary 77

Situation A
Facts

• EBITDA targets for all years are set on January 1, 2007.

• Each tranche vests only if the EBITDA target for that year is achieved.

• Failure to satisfy a target in one year has no impact on outcome of any other year.

The accounting under situation A

• Grant date for all options: January 1, 2007

− Mutual understanding of key terms and conditions on that date

• Service inception date: Each tranche has its own service inception date (beginning of
year over which performance condition must be satisfied).

• Cost recognition period for each tranche: one year RSP beginning January 1 of the
tranche year

− Because each tranche has an independent performance condition (not


dependent on satisfying a target for any other tranche) for a stated period of
service (one year), service inception date is delayed until January 1 of tranche
year.

How cost would be recognized under the following assumptions:

• Options have a grant date fair value of $25.

• Each tranche consists of 10,000 options.

• Management determines that the achievement of all performance conditions is


probable at inception. They remain probable throughout the term of the award and
are achieved.

2007 $250,000
Tranche

2008 $250,000

2009 $250,000

2010 $250,000

2007 2008 2009 2010

Requisite service period


New Developments Summary 78

Situation B
Facts
The facts are the same as in situation A except the EBITDA target for each tranche is set
in January of the tranche year.
The accounting under situation B

• Grant date changes: Grant date for measuring fair value of each tranche is January
of the tranche year when the EBITDA target is set

− Because a mutual understanding of key terms and conditions is not reached until
then

• Service inception date is unchanged: Each tranche has its own service inception
date (the beginning of year over which performance condition must be satisfied).

• Cost recognition period unchanged: Grant-date fair value of each tranche is


recognized over the tranche’s one year RSP if satisfaction of the target is probable

− Because there is no requirement to satisfy the condition of another tranche to


vest in current tranche

How cost would be recognized under the following assumptions:

• The grant-date fair value of options for the 2007 tranche is $25, for the 2008 tranche
is $30, for the 2009 tranche is $32, and for the 2010 tranche is $27.

• Management determines that the achievement of all performance conditions is


probable at inception. This remains probable throughout the term of the award and is
achieved.

2007 $250,000

2008 $300,000
Tranche

2009 $320,000

2010 $270,000

2007 2008 2009 2010

Requisite service period


New Developments Summary 79

Situation C
Facts
The facts are the same as in situation A except that a failure to satisfy a current year
target is overcome if a subsequent year target is satisfied.
For example, if the EBITDA targets for 2007 and 2008 are not satisfied, but the 2009
target is satisfied, the 2007, 2008, and 2009 tranches vest at the end of 2009.
The accounting under situation C

• Grant date unchanged from situation A: January 1, 2007

− Mutual understanding of key terms and conditions on that date

• Service inception date unchanged: Each tranche has its own service inception date
(beginning of year over which performance condition must be satisfied).

• Cost recognition period changed: RSP extends to the end of the first period a target
is achieved:

− RSP for each tranche begins on January 1 of tranche year and ends at end of
the first year thereafter for which the target is achieved.

 Begin recognizing cost when satisfaction of some future target is probable.

How cost would be recognized under the following assumptions:

• Grant date fair value of options is $25 for all tranches, because all targets are
established on January 1, 2007.

• Management determines on January 1, 2007 that 2009 is the first target probable of
achievement. This remains probable and the 2009 target is achieved.

• Management determines on January 1, 2010 that the 2010 EBITDA target is not
probable of achievement, and it ultimately is not achieved.

2007 $250,000

2008 $250,000
Tranche

2009 $250,000

2010

2007 2008 2009 2010

Requisite service period


New Developments Summary 80

Situation D
Facts
Situation D is the same as situation A except satisfaction of the performance target for
each tranche is dependent on satisfaction of the performance targets for all preceding
awards as well as the satisfaction of the current year’s EBITDA target.
The accounting under situation D

• Grant date unchanged from situation A: January 1, 2007

− Mutual understanding of key terms and conditions on that date

• Service inception date changed: January 1, 2007 for all tranches

− Achievement of target for each award is dependent on achievement of target for


each previous award.

• Cost recognition period for each tranche changed: RSP for each tranche includes
RSP of each previous award.

How cost would be recognized under the following assumptions:

• Grant date fair value of options is $25 for all tranches, because all targets are
established on January 1, 2007.

• Management determines in January 2007 that achievement of all targets is probable.


This remains probable throughout the term of the award and is achieved.

2007 $250,000

2008 $250,000
Tranche

2009 $250,000

2010 $250,000

2007 2008 2009 2010

Requisite service period


New Developments Summary 81

Awards with a market condition


Compensation cost is recognized for an award with a market condition, provided the requisite service
period is satisfied, regardless of when, if ever, the market condition is satisfied.

An employee is awarded 10,000 nonvested shares that vest in four years if the share
price increases 25 percent over the grant-date share price during that four-year period.
The explicit service period is four years. The derived service period for the market
condition, determined using a lattice model, is three years. The requisite service period is
the longer of the explicit or the derived service period, which is four years. If the
employee provides service over the four-year period, the requisite service period is met,
and compensation cost equal to the grant-date fair value of the award is recognized,
even if the share price does not increase 25 percent and the shares are never issued to
the employee.

Awards classified as liabilities


Because the measurement date for share-based payment awards classified as liabilities is the settlement
date, compensation cost is remeasured at the end of each reporting period through settlement. When
settlement occurs, cumulative compensation cost recognized is adjusted to the settlement amount.

Public entities

Public entities account for share-based payment liabilities at fair value, with the liability’s fair value
remeasured as of the end of each reporting period until settlement. Prior to settlement, the cost is
recognized proportionately over the employees’ requisite service period based on the fair value of the
award at the end of each reporting period. When the awards are fully vested, changes in fair value are
recognized in the period in which they occur.

Nonpublic entities

A nonpublic entity makes a policy decision to account for share-based payment liabilities incurred at fair
value (calculated value if they are unable to reasonably estimate the volatility of their share price) or
intrinsic value. Regardless of the valuation method selected, the amount is remeasured each period until
settlement. Prior to settlement, the cost is recognized proportionately over the employees’ requisite
service period based on the fair value of the award at the end of each reporting period. When the awards
are fully vested, changes in fair value are recognized in the period in which they occur.
New Developments Summary 82

H. How are modifications accounted for?


Events sometimes occur within an entity or its economic or regulatory environment that cause the entity to
consider modifying outstanding share-based payment awards. Such events include, for example, a
termination of an employee, a significant drop in the entity’s share price, a change of control event, a
stock split, a change in the tax law, and changes in the entity’s regulatory requirements.

Equity awards
If the terms or conditions of an equity award are modified, the modification is accounted for as the
exchange of the original award for a new award.

The entity determines the fair value of the modified award on the modification date and compares that to
the fair value of the original award determined immediately before the modification occurs. If the fair value
of the modified award exceeds the fair value of the original award immediately before its terms are
modified, the excess is additional compensation cost. Total compensation cost is generally the sum of the
grant-date fair value of the award plus the additional compensation cost resulting from the modification.
The cost is recognized prospectively over the remaining requisite service period or, if the modified award
is fully vested, the incremental compensation cost is recognized on the modification date.

Statement 123R addresses accounting for modifications in paragraphs 51 through 57 and additional
guidance is provided in illustrations 12 to 14 (paragraphs A149 to A189). The guidance applies to
modifications, repurchases, and cancellations of awards, as well as to equity restructurings and
exchanges of employee share-based payment awards in business combinations.

The following illustrates the accounting for modifications.

On January 1, 2004, a company issued 10,000 employee options, each having an


exercise price of $30 and a grant-date fair value of $8. All options were expected to vest.
Total compensation cost to be recognized over the four-year vesting period was $80,000.
On January 1, 2006, the share price had fallen to $20 and the company lowered the
exercise price of the 2004 options to $20.
Fair value of repriced option on 1/1/06 $5
Fair value of original option on 1/1/06 $2
Additional cost to be recognized per option $3
Total compensation cost after the modification was $80,000 + $30,000, or $110,000. The
entity had recognized $40,000 as of December 31, 2007. It will recognize the remaining
compensation cost of $70,000 ($40,000 + $30,000) over the remaining two years of the
requisite service period.

All facts and circumstances need to be considered in determining the fair value of the modified and
original awards at the time of the modification.

In the preceding example of the repricing of out-of-the-money options, the expected term of the original
options would likely be longer than that of the repriced options because only in-the-money options are
exercised. The entity has to separately estimate those expected terms in order to determine the fair value
of both the original and modified options. The estimate of expected term will affect other inputs in the
option-pricing model, such as the estimate of the risk-free rate and the estimated volatility.
New Developments Summary 83

If the event triggering the modification is the pending severance of an employee and the entity agrees to
extend the remaining exercise period of the employee’s vested options from 90 days (the original
provision for the term of the options on the employee’s termination) to 180 days, the entity needs to
determine the expected term of both the modified options with a remaining term of 180 days and the
original options with a remaining term of 90 days. Using those expected terms, the entity will then
determine the fair value of both the modified options and the original options on the modification date.
The entity would recognize the excess fair value of the modified options on the modification date because
the options were fully vested on that date. Similar accounting would apply whenever an entity decides to
modify vested employee options by extending the remaining term of the options.

In contrast, if a terminated employee held unvested options and the entity agrees to accelerate the
vesting of those options, the fair value of the unvested options on termination, prior to modification, would
be zero. The entity would recognize the entire fair value of the modified options on the modification date.

In determining the additional compensation cost, the effect of the modification on the number of
instruments expected to vest should be taken into consideration. Paragraph A160 provides guidance on
the cost to recognize if modified awards were expected to vest under the original vesting conditions. In
that situation, the entity should recognize compensation cost if the awards ultimately vest under either the
original or modified vesting conditions. At its May 26, 2005 meeting, the Statement 123R Resource Group
addressed a commonly encountered modification that results in fewer awards expected to vest under the
modified vesting conditions than under the original vesting conditions.

Entities sometimes reprice option awards that are significantly out-of-the-money and, at
the same time, extend the vesting period. For example, option awards originally had a fair
value of $8 and a four-year vesting period. At the end of two years, the options are out-of-
the-money and the entity decides to lower the exercise price of the options and extend
the vesting period to five years. On the modification date, the fair value of the modified
award is $5 and the fair value of the original award immediately before the modification is
$3. Compensation cost for the modified award consists of $4 remaining from the original
award and an incremental $2 resulting from the modification, for a total remaining cost to
recognize over the remaining three-year vesting period of $6.

The issue the Resource Group addressed is how the cost should be recognized after the modification
date, as some employees will satisfy the original four-year vesting period, but not the new five-year
vesting period. The Resource Group concluded that either of the following methods is acceptable, but the
method chosen should be applied consistently and disclosed in the financial statements:

• Method 1: The $4 remaining of the original fair value is amortized over the two years remaining in the
original vesting period and the incremental $2 is amortized over the modified remaining vesting period
of three years. Employees who terminate after the end of the original vesting period but before the
end of the modified vesting period do not vest in the award. However, the entity would reverse only
the amortized amount of the incremental $2 on termination.

• Method 2: The total $6 of remaining compensation cost is amortized over the remaining three-year
vesting period. For employees who terminate after the end of the original vesting period and before
the end of the modified vesting period, compensation cost related to their forfeited awards is adjusted
in the period of the termination so that cumulative recognized compensation cost is equal to the
grant-date fair value of the awards.
New Developments Summary 84

In accounting for a modification, total compensation cost for the award should generally not be less than
the award’s original fair value. Therefore, if the fair value of the modified award is less than the fair value
of the original award on the modification date, the grant date fair value is not reduced. Total
compensation cost is the award’s grant date fair value.

There is one exception to the general rule that total compensation cost cannot be less than the grant-date
fair value of the award: if the performance or service conditions of the original award are not expected to
be satisfied as of the modification date. In that situation, total compensation expense at the modification
date consists of the sum of the following:

• The portion of the grant-date fair value of the original award for which requisite service is expected to
be rendered (or has been rendered) as of the modification date. (This amount would be zero if it was
probable at the modification date that the performance condition in the original award would not be
achieved. This situation is illustrated in the example below.)

• The incremental cost resulting from the modification

Assume the following conditions exist:

• An employee has to sell 100,000 units in three years to vest in an award.

• The grant-date fair value is $600,000, and at the grant date the company determines
the sales target is probable of achievement.

• At the end of year 1, the sales target is not expected to be achieved because of
unanticipated competition, and the cumulative cost recognized to date is reduced to
$0 (see FSP FAS 123R-6, paragraphs 8 to 10).

• At the end of year 2, the sales target required for vesting is reduced to 80,000 units.
The company determines the modified sales target is probable of achievement.

• The fair value of the modified award is $400,000.

Total cost after modification:

• Fair value of the original award expected to be


recognized as of the modification date $ 0

Additional cost resulting from modification:

• Fair value of the modified award $400,000

• Less fair value of the original award expected to


0
be recognized as of the modification date

400,000

Total cost if service and performance conditions are


met $400,000
New Developments Summary 85

An entity should subsequently adjust compensation cost for changes in estimates about satisfaction of
any modified service and performance conditions.

If the service condition and modified sales target are met, the company would recognize
cumulative compensation cost of $400,000.
If the service condition and the original sales target are met (sale of 100,000 units), the
company would recognize cumulative compensation cost of $400,000. The original sales
target is no longer relevant.
If neither sales target is met, cumulative compensation cost would be $0.

To account for modifications of share-based payment awards appropriately, entities should consider the
following procedures, among others:

• Identify all changes to share-based payment awards by examining available information, such as
compensation committee minutes and share-based payment agreements

• Carefully evaluate the probability of performance conditions in the original award being met
immediately before the modification date, as well as the probability of performance conditions in the
modified award being met on the modification date

• Consider whether the modification of the award changes its balance sheet classification to a liability

• Include the remaining unrecognized compensation cost of the original award in the total
compensation cost to be recognized for the modified award

Acceleration of vesting of deep-out-of-the-money options


Some entities have considered accelerating the vesting of options that no longer effectively promote
employee motivation and retention because the options are deep-out-of-the-money. Normally, if awards
are modified to accelerate vesting, the unrecognized compensation cost is recognized immediately on the
modification date. However, if the options being modified are deep-out-of-the-money, they are still not
exercisable. The modified options have an in-substance market condition: the entity’s share price must
increase to the options’ exercise price before the employee can benefit from exercising the options. If the
employee has only a limited period of time to exercise vested options after terminating service, the entity
in effect has exchanged options with an explicit service period for options with a derived service period
(meaning derived using an option valuation model) that is based on the market condition inherent in
deep-out-of-the-money options. A question therefore arises about whether the unrecognized
compensation cost of the modified options should be recognized on the modification date if the options
continue to have a service period requirement that exists because they are deep-out-of-the-money.

Footnote 69 in FASB Statement 123R, Share-Based Payment, provides the following guidance on this
specific situation:

[I]f an award with an explicit service condition that was at-the-money when granted is
subsequently modified to accelerate vesting at a time when the award is deep-out-of-the-money,
that modification is not substantive because the explicit service condition is replaced by a derived
service condition.

In informal discussion, the SEC staff indicated that it concurs with that guidance. Although it did not define
deep-out-of-the-money, the staff noted that not all out-of-the-money options are deep-out-of-the-money.
New Developments Summary 86

As seen in footnote 69, however, the reason why accelerating the vesting of a deep-out-of-the-money
option is not substantive is because the modification replaces one service period with another. The staff
indicated that if, on the modification date, the derived service period for an out-of-the-money option is
significant, that would be an indicator that the option is deep-out-of-the-money.

If the vesting of a deep-out-of-the-money option is accelerated and the employee has a limited period of
time to exercise vested options after terminating service, the modification is not considered substantive,
and the entity should continue recognizing the option’s unrecognized compensation cost over the
remaining service period of the original award. However, the SEC staff observed that, in the unusual
circumstance in which the remaining explicit service period is longer than the derived service period on
the modification date, the entity should consider whether the unrecognized compensation should be
recognized over the shorter derived service period.

The issue of a derived service period does not arise if an entity accelerates the vesting of unvested
shares or restricted stock units. Therefore, the unrecognized compensation cost in these situations is
recognized immediately on the modification date.

Change in status from an employee to a nonemployee


Recipients of employee share-based awards sometimes experience a change in employment status, but
continue to provide services to an employer as consultants or in other nonemployee capacities. For
example, a retired employee may continue to provide substantive services to the employer as a
consultant. If an employee holds unvested share-based awards when a change in status occurs and will
continue to hold and vest in the awards while performing services in a nonemployee capacity, the former
employer’s accounting for the awards will likely change, as discussed below. The nature of the change in
accounting and whether the change in status results in a modification depends on whether the share-
based payment awards include a provision that permits the former employee to retain and continue to
vest in the awards in the event of a change in employment status.

The accounting for unvested awards generally changes on a change in employment status because the
accounting guidance for determining the measurement date for the awards differs depending on whether
the award is held by an employee or a nonemployee. Although Statement 123R applies to share-based
payment awards granted to individuals who are not employees, it does not specify the measurement date
if a transaction with a nonemployee is accounted for based on the fair value of the equity instruments
issued. Guidance on that measurement date is provided in EITF Issue 96-18. Under EITF Issue 96-18,
the measurement date for awards to nonemployees is generally the vesting date, unless the award is fully
vested and nonforfeitable on the grant date or if it includes a performance commitment, that is,
performance by the holder is probable due to a sufficiently large disincentive for nonperformance (such as
a sufficiently large economic penalty). This differs from the accounting for equity-based employee awards,
which are measured on the award’s grant date.

Terms permit retention of award on change in status

If the original award allows the holder to retain the award if the individual ceases to be an employee but
will continue to provide services to the former employer, the change in status does not result in a
modification. The change in status does result in a change in the method of determining the
measurement date for the awards, however, because the measurement date is determined under EITF
Issue 96-18 following the change in status. If, under the terms of the award, the final measurement date
under EITF Issue 96-18 is the vesting date, practice generally applies the following guidance in
Interpretation 44, paragraphs 15 to 17, to account for the award:
New Developments Summary 87

• No adjustment is made to compensation cost recognized by the grantor up to the time of the change
in status (unless the award is subsequently forfeited because the service requirements are not
satisfied).

• Prospectively, the award is accounted for under EITF Issue 96-18 as if it were newly issued, but only
the portion of the newly measured cost attributable to the remaining vesting period is recognized.
Under EITF Issue 96-18, the fair value of the award is remeasured each reporting period until the
earlier of the performance commitment date or the vesting date.

The following illustrates this accounting.

An employee was granted 100 options on January 1, 20X4 that cliff vest in five years if
the individual provides services as an employee or consultant until December 31, 20X8.
The arrangement does not include a performance commitment.
On January 1, 20X8 the employee terminates employment but continues to provide
services as a consultant.
The fair value of the award was $5 on January 1, 20X4 and $10 on December 31, 20X8.
Under those facts:

• Cumulative compensation cost recognized as of December 31, 2007 was $400 ($5 X
80% X 100) and would not be adjusted.

• Cumulative compensation cost recognized for 20X8 would be $200 ($10 X 20% X
100).

Terms do not provide for retention of award on change in status

If, under its original terms, an unvested award is forfeited if the holder ceases to be an employee, a
modification occurs if an individual is allowed to continue vesting in the award following a change in
employment status. Because the service condition of the original award will not be satisfied due to the
change in status, the fair value of that award immediately prior to the modification is $0. The award is
considered forfeited, and all previously recognized compensation cost is reversed. The incremental value
on modification is the entire fair value of the new award. Because the holder is a nonemployee, the award
is accounted for under EITF Issue 96-18. Absent a performance commitment in the modified award, the
fair value would be remeasured each reporting period until the earlier of the performance commitment
date or the vesting date. Compensation cost is recognized over the award’s remaining vesting period
based on the remeasured fair value of the award each reporting period.

The following illustrates this accounting.

An employee was granted 100 options on January 1, 20X4 that cliff vest in 5 years if the
individual provides services as an employee until December 31, 20X8.
The arrangement does not include a performance commitment.
On January 1, 20X8 the employee terminates his employment but continues to provide
services as a consultant.
The fair value of the award was $5 on January 1, 20X4; $9 on January 1, 20X8; and $10
New Developments Summary 88

on December 31, 20X8.


Under those facts:

• A modification of the award has occurred because the terms of the original award did
not permit the employee to retain the award on a change in employee status.

• The fair value of the modified award is $900 on the modification date ($9 X 100).

• The fair value of the original award is $0 immediately before the modification because
the employee failed to provide the employee service (five years) to vest in the award.
The cumulative compensation cost recognized as of December 31, 2007 of $400 ($5
X 80% X 100) would be reversed on January 1, 20X8.

• The incremental cost resulting from the modification is the entire fair value of the
modified award, or $900 ($900 - $0).

• The fair value of the award will be remeasured every reporting period under EITF
Issue 96-18 and recognized over the remaining one-year vesting period. Cumulative
compensation recognized will be $1,000 ($10 X 100).

Modifications of minimum value awards


The Statement 123R Resource Group addressed the accounting for the modification of an award issued
before a nonpublic entity adopted Statement 123R that was being accounted for under APB Opinion 25 if
minimum value had been used for the pro forma disclosures under Statement 123. The Resource Group
reached a consensus that if such an award is modified, any remaining unrecognized intrinsic value on the
modification date should be added to the incremental value resulting from the modification (the excess of
the fair value of the modified award over the fair value of the original award determined immediately
before the modification) and recognized over the remaining requisite service period.

Liability awards
A modification of a liability award is also accounted for as an exchange of the original award for a new
award. However, because the fair value (or intrinsic value for electing nonpublic entities) of the award is
remeasured each period, no special accounting is required for modification of a liability award.

Inducements
A short-term inducement is accounted for as a modification of the award only for awards of employees
who accept the inducement.

To raise capital, a company offers employees an inducement in the form of a 25 percent


reduction of the exercise price of their vested options, but only for options exercised
during the subsequent 30 days. The excess of the fair value of the options with the
reduced exercise price over the fair value of the original options on the modification date
is recognized as additional compensation cost for the number of options exercised during
the 30-day period.
New Developments Summary 89

Inducements that are not short-term in nature are accounted for as modifications for all awards subject to
the inducements. FSP FAS 123R-6 amends Statement 123R to clarify that short-term inducements are
limited to a modification of an award. The accounting for short-term inducements does not apply to short-
term offers to settle the option for cash. Cash settlements are discussed below under the heading
“Repurchases and cancellations.”

Business combinations
The information below applies to business combinations having an acquisition date before the beginning
of the acquirer’s first annual reporting period beginning on or after December 15, 2008. For acquisitions
after that date, see “Business combinations accounted for under Statement 141R” below.

Statement 123R does not include guidance on accounting for employee share-based awards exchanged
in a business combination, other than to provide that the exchange is considered a modification
(paragraph 53). Therefore, incremental value, if any, transferred to employees of the acquiree will
ultimately be recognized as compensation cost, as described below.

Because Statement 123R provides no further guidance, entities generally analogize to other literature for
guidance on (1) when the fair value of the awards exchanged is measured and (2) the amount of the total
fair value of the share-based awards issued to acquiree employees that is allocated to the transaction
purchase price and the amount allocated to compensation expense. That guidance is found primarily in
Interpretation 44, EITF Issue 00-23, and EITF Issue 99-12, “Determination of the Measurement Date for
the Market Price of Acquirer Securities Issued in a Purchase Business Combination.”

Interpretation 44, Issue 13, provides that entities should apply the guidance in EITF Issue 99-12 to
determine the date on which the fair value of awards exchanged should be measured. Issue 13 also
provides that the amount of intrinsic value of unvested awards allocated to unearned compensation cost
is determined at the date the transaction is consummated. Paragraphs 83 through 85 of Interpretation 44
describe the allocation of fair value of vested and unvested awards to the purchase price of an acquired
business and to compensation cost. That guidance is analogized to in the following description:

1. Preliminary determination of addition to the purchase price: The fair value of the acquirer’s share-
based awards issued in exchange for outstanding awards held by the acquiree’s employees is
estimated based on the acquirer’s share price and other valuation factors over a period extending a
few days before and after the acquisition is agreed to and announced (see EITF Issue 99-12). The
purchase price is computed for the number of awards expected to vest. To determine the number
expected to vest, the acquiring entity needs to estimate a forfeiture rate as of the transaction
consummation date for the unvested awards issued to acquiree employees and exclude the awards
not expected to vest from the purchase price calculation.

2. Adjustment to step 1 for incremental value, if any, allocated to compensation cost: If the
consummation-date fair value of acquirer awards issued in the combination that are vested or
expected to vest exceeds the fair value of acquiree awards exchanged that are vested or expected to
vest immediately before the consummation date, the excess value is deducted from the purchase
price. It is recognized as compensation cost by the acquirer as follows:

− For vested awards: at the consummation date

− For unvested awards: over their remaining service period

3. Amount of purchase price allocated to compensation cost for unvested awards: A portion of the fair
value of unvested awards issued to the acquiree’s employees represents compensation cost for
future services. The amount to be allocated to compensation cost for future services is the portion of
the consummation-date fair value of unvested awards expected to vest that relates to the future
New Developments Summary 90

vesting period for those awards. The amount of the purchase price allocable to compensation cost for
unvested awards is computed as follows: The estimated fair value at the consummation date of the
unvested awards that are expected to vest, excluding the incremental value for unvested awards
determined in step 2, is multiplied by the ratio of the remaining future service period to the total
service period. The total service period is the service period before the consummation date plus the
remaining future period required to vest in the acquirer’s award. The amount computed as
compensation cost related to unvested awards will be recognized over the remaining vesting period
of the awards. That amount is deducted from the amount allocated to purchase price in step 1 for
purposes of allocating the total transaction purchase price to assets acquired and liabilities assumed.
Changes to the estimated forfeiture rate after the consummation date require adjustment of the
cumulative compensation cost to be recognized after the consummation date, but do not affect the
purchase price (see Issue 11 of EITF Issue 00-23).

As a result, the portion of the fair value of the acquirer’s unvested share-based payment awards
exchanged for acquiree awards that will be recognized in compensation cost is the incremental value
allocable to unvested awards determined in step 2, if any, and the amount allocable to the unvested
portion of the awards determined in step 3. The sum of those amounts is recognized as compensation
cost over the remaining service period of the awards.

The accounting for the tax effects of awards issued in business combinations is described in section J.

The following example illustrates the accounting for share-based awards exchanged for acquiree awards
in a business combination.

Company B issued 10,000 options on January 1, 20X7, which cliff vest in two years.
Company A purchases Company B in a transaction that closes on June 30, 20X7 and
exchanges one share of its stock for each share of Company B stock.
Company A exchanges 10,000 of its options for Company B’s 10,000 outstanding
employee options. All option terms remain the same, and the option exchange results in
no incremental value.
There is no incremental compensation cost resulting from the comparison of the fair
value of acquirer and acquiree awards at the closing date.
The addition to the purchase price resulting from the exchange of the acquirer’s share-
based awards for acquiree awards is calculated based on the following assumptions:

• Fair value is $15 per option based on market price of stock a few days before and
after the announcement date

• Forfeiture rate is estimated to be 5 percent of the unvested options

Purchase price $142,500


APIC $142,500
10,000 x 95 = 9,500 options expected to vest
9,500 x $15 = $142,500
(Note: No deferred tax asset is recorded)
Fair value allocated to future services based on fair value at closing date of $17 per
option (question 17 of Interpretation 44, Issue 13 of EITF Issue 00-23).
New Developments Summary 91

9,500 x $17 x 75% (remaining vesting period) = $121,125


The fair value allocable to future services, $121,125, should be deducted from the
purchase price allocable to assets acquired and liabilities assumed ($142,500). It should
be recognized as compensation cost over the remaining vesting period of the options and
adjusted as necessary for forfeitures.

Business combinations accounted for under Statement 141R


The information below applies to business combinations having an acquisition date on or after the
beginning of the acquirer’s first annual reporting period beginning on or after December 15, 2008. For
acquisitions before that date, see “Business combinations,” above.

FASB Statement 141 (revised 2007), Business Combinations (Statement 141R), provides guidance on
the accounting for share-based payment awards issued by acquirers to replace share-based payment
awards of the acquired (target) company.

The primary accounting issue for replacement awards in business combinations is the allocation of the
acquisition-date fair value of the replacement awards between (1) consideration transferred for the
acquired business (consideration transferred) and (2) compensation cost to be recognized in the
acquirer’s postcombination financial statements as the services are performed, or immediately if the
replacement awards are fully vested on issuance (postcombination compensation cost).

Exchanges of the acquirer’s replacement awards for the target company’s share-based payment awards
are accounted for as modifications using the fair-value-based measurement method of Statement 123R. If
the acquirer is obligated to replace the target company’s awards, either all or a portion of the fair value of
the replacement awards is consideration transferred. The acquirer is obligated to replace the target
company awards if the target company or its employees can enforce replacement, for example, because
replacement is required under the terms of either the acquisition agreement or the awards or under
applicable laws or regulations. In contrast, the acquirer is not obligated to replace the awards if, for
example, the terms of the target company’s awards provide that the awards expire on the occurrence of a
business combination. If the acquirer either replaces awards that it is not obligated to replace or otherwise
grants share-based awards to employees of the target that are not replacement awards, the entire fair
value of the awards is accounted for as share-based compensation in the postcombination financial
statements, and no amount is allocated to consideration transferred.

To allocate between consideration transferred and postcombination compensation cost the fair value of
both equity- and liability-classified replacement awards that the acquirer is obligated to issue, the acquirer
must

1. Measure both the replacement awards and the target company awards as of the acquisition date
using the fair-value-based measurement method of Statement 123R (or, for nonpublic entities, the
calculated value method or, for awards classified as liabilities, the intrinsic value method, as
applicable to either the replacement awards or the target company awards).

The fair value of replacement awards that require postcombination service (unvested replacement
awards) should reflect only the number of replacement awards expected to vest.

Measuring the fair value of the replacement awards on the acquisition date differs from the
accounting under FASB Statement 141, Business Combinations, (before the December 2007
revisions), which requires measurement of fair value using a date determined under EITF Issue
99-12.
New Developments Summary 92

2. Allocate to consideration transferred the portion of the replacement award attributable to


precombination service, which is determined as follows:

− The fair value of the target company awards expected to vest is multiplied by the ratio of (a) the
requisite service completed before the acquisition date to (b) the greater of (i) the total service
period or (ii) the original requisite service period of the target company award. The total service
period is the sum of (a) the requisite service completed before the acquisition date and (b) the
postcombination requisite service period, if any, for the replacement awards. The requisite
service period consists of applicable explicit, implicit, and derived service periods as provided
under Statement 123R.

3. Allocate to postcombination compensation cost any excess of the total fair value of the
replacement awards expected to vest over the amount attributable to precombination service
computed in step 2.

Because the exchange of acquirer share-based payment awards for target company awards is accounted
for as a modification under Statement 123R, any excess of the fair value of the replacement awards over
the fair value of the target company awards must be recognized as postcombination compensation cost.
The calculation in step 3 automatically includes the excess fair value of replacement awards in
postcombination compensation cost because the amount attributable to precombination service in step 2,
and then subtracted from the fair value of replacement awards in step 3 (to determine postcombination
compensation cost), is based on the fair value of the target company award at the acquisition date.

The following example illustrates the allocation of the fair value of replacement awards between
consideration transferred and postcombination compensation cost.

An acquiring company issued 100 replacement awards having an acquisition-date fair


value of $1,200 and a two-year vesting period to replace 100 awards held by the target
company’s employees. The target company’s awards had a four-year requisite service
period and an acquisition-date fair value of $1,000. The employees had rendered one
year of service as of the acquisition date.
The fair value of the replacement awards attributable to precombination service and
accounted for as consideration transferred was $250, computed as follows:

$1,000 X (1 year of preacquisition service / 4-year original requisite service


period)

The four-year original requisite service period is used in the calculation because it is
greater than the total service period of one year of preacquisition requisite service plus
two years of postcombination requisite service.
The postcombination compensation cost would be $950 computed as follows:

$1,200 - $250

The $200 excess compensation included in the replacement awards ($1,200 - $1,000) is
included in postcombination compensation cost because (1) the calculation of fair value
attributable to precombination service is based on the fair value of the target company’s
award and (2) postcombination compensation cost is the fair value of the replacement
awards minus the fair value allocated to precombination service.
The allocation of the $1,200 between consideration transferred and postcombination
New Developments Summary 93

compensation cost would be the same if the replacement awards required no


postcombination service. However, in that situation, the acquirer would recognize the
$950 postcombination compensation cost immediately following the acquisition.

Postcombination compensation cost is recognized in the acquirer’s financial statements as required under
Statement 123R. Changes and events affecting the fair value of replacement awards after the acquisition
date do not affect the consideration transferred for the acquired business. Such changes and events,
including those listed below, are accounted for in the acquirer’s postcombination financial statements:

• A change in the number of replacement awards expected to vest

• Changes in the fair value of liability-classified replacement awards

• Modifications of the replacement awards

• Changes in the expected or ultimate outcome of performance conditions in replacement awards

The accounting for the tax effects of replacement awards is described in section J.

Equity restructurings
Statement 123R defines an equity restructuring as “a nonreciprocal transaction between an entity and its
shareholders that causes the per-share fair value of the shares underlying an option or similar award to
change.” Examples of an equity restructuring include a stock split, a spinoff, a stock dividend, and a large
nonrecurring cash dividend. If an entity has a 2-for-1 stock split or a spinoff and the exercise price and/or
number of shares underlying its options are not adjusted, the options’ value would be significantly diluted.
For that reason, awards of options or similar instruments (such as stock appreciation rights) frequently
include antidilution provisions designed to equalize the value of those instruments before and after an
equity restructuring.

Statement 123R requires an adjustment to a share-based payment award in conjunction with an equity
restructuring to be accounted for as a modification, with one exception. Modification accounting is not
required if an award is modified to add an antidilution provision and that modification is not made in
contemplation of an equity restructuring.

Accounting for a modification that occurs as a result of an equity restructuring requires a comparison of
the fair value of the modified award to the fair value of the original award immediately before the
modification. The entity is required to recognize any incremental fair value resulting from the modification
over the award’s remaining vesting period or immediately if the award is fully vested.

If the modified award contained a properly structured antidilution provision to equalize the award’s fair
value before and after the equity restructuring, there would be no incremental fair value resulting from the
modification. Market participants would anticipate the adjustment to the options’ exercise price and/or
number of options so that the fair value of the award immediately before the modification would
approximate the fair value of the modified award.

If an award does not contain an antidilution provision that requires the entity to adjust the award in the
event of an equity restructuring, the entity cannot assume the award will be modified in estimating its fair
value immediately before the modification date. The fair value of the unadjusted award before
modification may therefore be significantly less than the fair value of the modified award, and the entity
would be required to recognize as compensation cost that incremental fair value. If the entity modifies its
awards to add an antidilution provision after it has announced an equity restructuring, it would account for
New Developments Summary 94

that modification, as well as the modification to the exercise price and/or number of option awards, as
discussed in Statement 123R, paragraphs A158 to A159.

If an award has a provision that gives the entity, for example, the board of directors or the compensation
committee, discretion to adjust the award, marketplace participants would not know whether the award
would be adjusted for the equity restructuring. As a result, a discretionary antidilution provision would
result in the entity recognizing incremental fair value if the terms of the awards are modified. If they are
not adjusted, employees would lose significant value. In some situations, the wording of a particular
discretionary antidilution provision may be determined to require that the terms of the awards be equitably
adjusted. Interpretation of such a provision in a specific situation would be a legal determination, which
may require a legal opinion.

Repurchases and cancellations


Repurchases
Settlement accounting applies when an entity repurchases a share-based award. A settlement is an
action or event that irrevocably extinguishes the issuing entity’s obligation under a share-based payment
award. If an entity settles an award by repurchasing it for cash or other consideration or by incurring a
liability, the following apply:

• The amount paid, up to the fair value of the repurchased instrument, should be charged to equity.

• Any excess of the repurchase price over the fair value of the repurchased instrument should be
recognized as additional compensation cost, even if the award is no longer accounted for under
Statement 123R.

This accounting applies to repurchases of both vested awards and unvested awards that are expected to
vest. However, if the award is not fully vested (requisite service has not been rendered) on the
repurchase date, the repurchase has, in effect, curtailed the vesting period, and compensation cost
measured at the grant date and not yet recognized should be recognized on the repurchase date.

Distinguishing between a settlement and a modification

If an entity repurchases an equity-classified restricted share that does not have a repurchase feature, an
equity-classified option that does not have a cash settlement feature, or the option share immediately
after an option is exercised, a question may arise about whether to account for the transaction as a cash
settlement (repurchase) of the award or as a modification of the award to a liability, followed by a
repurchase.

There are two determining factors that distinguish a settlement from a modification:

• Whether the settlement amount continues to be indexed to the entity’s shares

• Whether future service is required

If either of those factors applies, modification accounting is required. If neither applies, settlement
accounting is required.

Therefore, if an equity-classified award is immediately purchased for cash and no future service is
required to retain the repurchase price, the transaction is a settlement and repurchase accounting applies
as described above. If the equity-classified award is exchanged for a promise to pay cash in the future,
the above factors should be applied to determine whether the transaction is a settlement or a modification
that would change the award’s classification to a liability.
New Developments Summary 95

However, if an entity has a pattern of settling awards in cash, that past practice may indicate that the
entity’s awards are, in substance, liabilities. Paragraph 34 of Statement 123R requires entities to account
for the substantive terms of their awards if past practice differs from the written terms of the awards.

Cancellations
If an award is cancelled for no consideration and it is not accompanied by a concurrent grant of (or offer
to grant) a replacement award, it is accounted for as a repurchase for no consideration. Any
unrecognized compensation cost is recognized on the cancellation date.

Cancellation of an award, accompanied by a concurrent grant of (or offer to grant) a replacement award,
is accounted for as a modification of the cancelled award. Total compensation cost for the cancellation
and replacement is the sum of

• The excess, if any, of the fair value of the replacement award over the fair value of the cancelled
award at the cancellation date

• The portion of the grant-date fair value of the cancelled award for which the requisite service is
expected to be rendered (or has been rendered) at the cancellation date

Entities sometimes modify options with only service conditions by increasing the exercise
price of the options. This might occur, for example, in connection with a change in tax law
or regulatory requirements. The fair value of the modified options would likely be less
than the fair value of the original options before the modification. The entity would not
reduce the grant-date compensation cost in this situation. Alternatively, an entity may
decide to cancel the original options and not provide replacement options. Such a
cancellation is accounted for as a repurchase for no consideration. The originally
measured compensation would not be reversed; any unrecognized compensation cost
would be recognized on the cancellation date. However, it is usually not possible for an
employer to take valuable consideration away from an employee without some type of
additional consideration. As a result, in situations such as cancellations or upward
repricings, an entity needs to consider all the terms of the arrangement in performing the
modification accounting. If, for example, the employees receive additional options in an
upward repricing or if a cancellation is accompanied by cash consideration or issuance of
other instruments, the fair value of all consideration received by the employee in the
modification is used to determine the excess consideration to be recognized.

The following examples illustrate various modification situations and a forfeiture.

An entity granted its CEO 200,000 options in 20X1 that had a grant-date fair value of
$1,600,000 and a four-year cliff vesting period. The following assumptions apply to the
three following scenarios:

• The options have been outstanding one year.

• The entity has recognized compensation cost of $400,000.

• The options’ unrecognized grant-date fair value on the modification date was
$1,200,000.
New Developments Summary 96

Scenario 1
In connection with obtaining new financing, an entity will have to cancel the 200,000
options held by its CEO. The current fair value of the options is $2,000,000. The entity is
evaluating three possible actions in connection with the cancellation of the options:

• Replace the cancelled options with 110,000 shares that have a fair value of $20 each
and would have a three-year vesting period

• Repurchase the options for $1,800,000

• Cancel the options with no replacement award

The following table summarizes the accounting effects of the three possible actions.

Replacement Repurchase Cancellation


award

Fair value of new $2,200,000 $1,800,000 $ 0


award

Fair value of $2,000,000 $2,000,000 $2,000,000


original award on
modification date

Incremental cost $ 200,000 $ 0 $ 0

Unrecognized $1,200,000 $1,200,000 $1,200,000


grant-date fair
value of original
award on
modification date

Cost to be $1,400,000 $1,200,000 $1,200,000


recognized after
modification

Recognition period 3-year vesting Immediately Immediately


period

Scenario 2
Assume the company asked the CEO to resign after the options had been outstanding
one year. As part of the CEO’s severance package, the entity accelerates the vesting of
the options. In effect, the CEO is exchanging the unvested original options that he will
forfeit on resignation for modified options that are fully vested and have a remaining life
of, say, 90 days.
New Developments Summary 97

• The fair value of the original options is reduced to $0 because the CEO will not
provide the requisite service. The $400,000 previously recognized compensation cost
would be reversed.

• The fair value of the modified options with a term of 90 days is $1,000,000.

• The incremental fair value is $1,000,000 ($1,000,000 - $0). It would be recognized on


the modification date.

Scenario 3
If the 200,000 options were instead being forfeited because the CEO terminated before
they were fully vested and there is no acceleration of vesting, the accounting would differ.
Because the requisite service was not provided, cumulative compensation cost should be
reduced to $0. The $400,000 cost previously recognized for the unvested awards would
be reversed in the period the CEO is terminated. This situation describes a forfeiture of
the original awards, not a modification.
New Developments Summary 98

I. How are instruments issued in exchange for employee service


accounted for after vesting?
A freestanding share-based instrument issued to an employee in exchange for past or future employee
services continues to be subject to the recognition and measurement provisions of Statement 123R as
long as the award is outstanding, unless its terms are modified when the holder is no longer an employee.
Similarly, share-based payment awards issued in a business combination in exchange for share-based
payment awards originally granted to employees of the acquired business that were outstanding on the
date of the business combination are accounted for under Statement 123R, unless their terms are
subsequently modified when the holder is no longer an employee.

Only for purposes of determining if an employee award should continue to be accounted for under
Statement 123R, a modification does not include changes to the terms of an award solely because of an
equity restructuring if conditions (1) and (2) below are satisfied:

1. One of the following applies:

a. There is no increase in the fair value of the award.

b. The holder is made whole because the ratio of the intrinsic value to the exercise price of the
award is retained.

c. An antidilution provision is added to the award, but not in contemplation of an equity restructuring.

2. All holders of the same class of equity instrument (for example, stock options) are treated in the same
manner.

This guidance reflects an amendment of paragraphs A230 to A232 in Statement 123R by FSP FAS
123R-1, “Classification and Measurement of Freestanding Financial Instruments Originally Issued in
Exchange for Employee Services under FASB Statement No. 123(R),” and FSP FAS 123R-5,
“Amendment of FASB Staff Position FAS 123(R)-1.” The guidance applies to employee share-based
payment awards that are freestanding financial instruments, regardless of whether they were initially
accounted for under Statement 123R, Statement 123, or APB Opinion 25.

If an employee share-based payment award is modified (including a cancellation and replacement) or


settled after the holder is no longer an employee, the modification or settlement should be accounted for
under Statement 123R, unless the modification or settlement applies to all holders of the same class of
instrument.

Following a modification that occurs when the holder is no longer an employee, the modified instrument is
accounted for under other GAAP applicable to such instrument, such as Statement 150, Statement 133,
or EITF Issue 00-19.

The guidance in FSP FAS 123R-1 and FSP FAS 123R-5 applies only to financial instruments issued to
employees. The accounting for awards issued as consideration for goods or services other than
employee services is described in section B under the heading “Guidance applicable to awards to
nonemployees.”
New Developments Summary 99

J. How are income taxes affected?


Recording deferred tax assets
An entity may receive a tax deduction for a share-based payment award in a later period than the period
in which compensation cost for financial reporting purposes was recognized. In that situation, when
compensation cost is recognized, the entity also recognizes a deferred tax asset for the deductible
temporary difference based on the amount of compensation cost recognized.

An entity is not permitted to adjust the amount of its deferred tax asset or establish a valuation allowance
as a result of changes in the entity’s share price in periods before the deduction is reported on the entity’s
tax return or, in the case of a vested option, it expires unexercised. For instance, an entity could have a
deferred tax asset related to significantly underwater options that are to expire on January 1, 2007.
Although the options would expire unexercised, no adjustment to the deferred tax asset would be made in
the December 31, 2006 financial statements—the write-off would not occur until the 2007 expiration date.

Differences between financial reporting costs and income tax deductions


If the deduction ultimately reported on the entity’s tax return exceeds compensation cost recognized for
financial reporting, the resulting tax benefit that exceeds the deferred tax asset for the award (the excess
tax benefit) is recognized

• In additional paid-in capital (APIC), but not before the tax benefit can actually be realized by the
entity. Realization may not occur, for example, if the entity cannot benefit from the deduction currently
because it has a net operating loss carryforward that is increased by the excess tax benefit. The
entity would not record the credit to APIC until the tax deduction reduces taxes payable. In fact, there
is no accounting entry made for the excess benefit until it is realized, even though it increases the
entity’s net operating loss. However, the amount of the excess benefit should be included in the
tabular reconciliation of the beginning and ending balances of unrecognized tax benefits required by
FASB Interpretation 48, Accounting for Uncertainty in Income Taxes. The cumulative amount of
excess tax benefits from previous awards accounted for under Statement 123R and Statement 123 is
known as the APIC pool (see further discussion below under “APIC pool”).

• In the income statement (but not before it is realizable), if the excess tax benefit results from
something other than an increase in the value of the entity’s shares between the date fair value is
measured for financial reporting purposes and a later measurement date for tax purposes

Enterprise A issues 1,000 nonqualified stock options with an exercise price of $21 per
share on December 31, 2006. The grant-date fair value of the options is $9 per share.
The options have a three-year cliff vesting period. The employee exercises the shares on
December 31, 2011, when the market price of an underlying share of stock is $33. The
tax rate is 40 percent for all periods. No awards are expected to be forfeited.
Enterprise A would recognize a tax benefit of $1,200 each year as it recognizes the
$3,000 annual compensation cost of the awards. When the options are fully vested,
Enterprise A would have a deferred tax asset of $3,600. It would be able to take a
$12,000 (the $33 market price at exercise less the $21 exercise price, times the 1,000
shares) tax deduction on its 2011 tax return. In the December 31, 2011 financial
statements, Enterprise A would reflect a credit in APIC for the $1,200 difference between
the $3,600 deferred tax asset and the tax benefit of the deduction ($12,000 times the 40
percent tax rate).
New Developments Summary 100

If the deduction for tax purposes is less than compensation cost recognized for financial reporting
purposes, the write-off of the deferred tax asset, net of any related valuation allowance, is

• Charged to APIC to the extent of the APIC pool

• Recognized in the income statement to the extent the write-off exceeds the amount available in the
APIC pool

Assume the same facts as above for Enterprise A, except the market price of the stock at
the exercise date is $27. Enterprise A had an APIC pool of $150 at January 1, 2011 and
had no 2011 option activity affecting that balance prior to the December 31, 2011
exercise.
As discussed above, Enterprise A would have a deferred tax asset of $3,600 when the
options are fully vested. Enterprise A would be able to take a $6,000 tax deduction (the
$27 market price at exercise less the $21 exercise price, times the 1,000 shares) on its
2011 tax return and receive a tax benefit of $2,400. In the December 31, 2011 financial
statements, Enterprise A would reduce APIC by $150 (the amount of the APIC pool) and
debit income tax expense for $1,050 (the difference between the $3,600 deferred tax
asset less the $2,400 tax benefit and the amount of the APIC pool).

Effects of net operating loss carryforward


As noted above, a company in a net operating loss carryforward (NOL) situation does not recognize an
increase in APIC for an excess deduction until that deduction reduces taxes payable. Even though no
valuation allowance may be considered necessary for the NOL, the APIC credit would still be delayed
until it reduces taxes payable. This will cause a difference between the company’s tax NOL and the
amount of NOL for which a deferred tax benefit is recognized. The amount of the NOL related to the
excess benefit of the tax deduction that will be recorded in APIC should be disclosed, as required by
FASB Statement 109, Accounting for Income Taxes. The NOL related to the excess tax benefit should be
considered the last portion of the NOL used.

At its July 23, 2005 meeting, the Statement 123R Resource Group addressed the following fact pattern in
which a company with an existing NOL has a deduction for excess tax benefits in the current period that
equals or exceeds taxable income for the period exclusive of the excess tax benefit.

Assume the following facts:

• The company has an NOL carryforward (assume that the entire NOL relates to
operating losses and none from excess tax benefits) of $1,000. The applicable tax
rate is 40 percent.

• Based on the existence of objective positive evidence (reversals of offsetting taxable


temporary differences), there is no valuation allowance recorded against the deferred
tax asset of $400.

• In the current period, the company generates book income of $1,000 that is offset by
New Developments Summary 101

excess tax deductions of $1,000 for net current taxable income of $0.

• There are no temporary differences either reversing or originating in the year.

View A
Although the actual NOL carryforwards remain unchanged under the tax law from the
beginning of the year, based on a "with and without" approach, the following entry is
appropriate:
Tax expense $400
Deferred tax asset $400
In this case, there would be no credit recorded to APIC in the current period, and the
company would reduce the previously recognized deferred tax asset related to the NOL
carryforward. This method diverges from how the NOLs are tracked under tax law.
View B
The tax ordering in the return would be followed, with the $1,000 carryforward remaining
as a deferred tax asset of $400. The resulting entry would be
Tax expense $400
APIC $400

The Resource Group decided either method described in the above views is acceptable. The accounting
method chosen should be disclosed, and should be consistently applied.

APIC pool
Computation of the APIC pool
The APIC pool is the cumulative amount of excess tax benefits from previous awards accounted for under
Statement 123R and Statement 123. For awards that were accounted for under the intrinsic value method
after the effective date of Statement 123, the amount to be included in the APIC pool is the net amount of
excess tax benefits that would have resulted if the entity had adopted Statement 123 for recognition
purposes on that Statement’s original effective date (employee awards granted, modified, or settled in
cash in fiscal years beginning after December 15, 1994).

The pool excludes excess tax benefits that

• Have not yet reduced taxes payable and are therefore not yet realizable

• Result from share-based payment arrangements outside the scope of Statement 123R, such as
employee stock ownership plans

At the July 21, 2005, Statement 123R Resource Group Meeting, the Group discussed whether separate
APIC pools should be maintained for employee and nonemployee awards, or whether there should be a
single pool grouping employee and nonemployee awards together. The Group concluded that either
method was permissible. A company should disclose the method it chooses as an accounting policy and
apply that method consistently.
New Developments Summary 102

Enterprise B has accounted for its options using APB Opinion 25. It has made the
following grants and the following option exercises have occurred since its inception in
1993:

Grant year Options Exercise Fair value Exercised Stock price


price at exercise

1993 2,000 $15 N/A 1998 $22

1996 1,000 20 6 2000 29

1999 1,000 25 8 2001 29

2002 5,000 32 11 2004 44

2005 10,000 27 10 N/A N/A

The tax rate is 40 percent. Each option is an individual grant.


The APIC pool would be computed as follows when Enterprise B adopts Statement 123R
at January 1, 2006:

• 1998 exercise — no pool effect since the options were granted before Statement
123’s effective date

• 2000 exercise — ($9 tax deduction less $6 pro forma fair value) X 1,000 X 40% =
$1,200 pool addition

• 2001 exercise — ($4 tax deduction less $8 pro forma fair value) X 1,000 X 40% =
$1,600 pool deduction (since the pool cannot go below 0, pool would be 0 at end of
2001)

• 2004 exercise — ($12 tax deduction less $11 pro forma fair value) X 5,000 X 40% =
$2,000 pool addition — cumulative pool at adoption would be $2,000

• 2005 grants would not have any effect since they have not been exercised.

The computation of the APIC pool for most companies will be much more complex than in the above
simplified example. Some special items that need to be considered include the following:

• Nonpublic companies that used the minimum value method for recognition or pro forma purposes
under Statement 123 (and are therefore using the prospective method of adoption) will not have a
beginning APIC pool balance. However, a company that is a public company on the required adoption
date of Statement 123R, but became public after the effective date of Statement 123, would be
permitted (but not required) to compute its beginning APIC pool using minimum value for those
awards that were valued using that method for recognition or pro forma purposes.
New Developments Summary 103

• Companies that have had business combinations accounted for as poolings should include all pooled
companies in computing the APIC pool.

• Companies that have had business combinations accounted for as purchases should include all
acquired companies in the APIC pool computation from the later of the date of acquisition or the
Statement 123 effective date. For awards issued in an acquisition, the fair value in purchase
accounting should be used and not the acquired company’s original fair value.

• In the sale of a subsidiary, the APIC pool stays with the parent if the excess tax benefit was from an
award of the parent’s equity; it follows the subsidiary if it was related to an award related to the
subsidiary’s equity.

• There are currently conflicting views with regard to spin-offs. We believe that either following the
subsidiary sale view above or having the APIC pool follow the employee are acceptable alternatives.

In SAB 107, the SEC staff indicated that it believes the timing of when a registrant needs to have
completed its calculation of its APIC pool will depend on a registrant’s particular facts and circumstances.
Further, the staff believes the APIC pool would not have to be calculated at the date of adoption of
Statement 123R and would need to be calculated only when the registrant has a situation in which its tax
return deduction is less than the related deferred tax asset. Consequently, a registrant needs to calculate
the APIC pool only when required to conclude that the APIC pool is sufficient to offset a tax deduction
shortfall. However, companies may be well advised to determine their APIC pool as soon as is
practicable. At a later date, required information for compiling the pool may be more difficult to retrieve.
Entities will need a separate APIC memo account or other method to track the amount of their Statement
123/123R APIC pool.

Alternative method of computing the APIC pool


Computing beginning balance

In November 2005, the FASB issued FSP FAS 123R-3, “Transition Election Related to Accounting for the
Tax Effects of Share-Based Payment Awards.” The FSP provides companies a practical transition
election in determining the initial balance of the APIC pool by allowing companies to compute the amount
using a simplified calculation.

Under the FSP, companies can choose to calculate the beginning balance of the APIC pool related to
employee compensation as follows:

• The sum of all net increases in additional paid-in capital recognized for tax benefits related to stock-
based employee compensation during fiscal periods after the adoption of Statement 123, but before
the adoption of Statement 123R, less

• The cumulative incremental pretax compensation costs that would have been recognized in the
entity’s financial statements had it used Statement 123 to account for stock-based compensation
costs (incremental cost) times the entity’s blended statutory tax rate. Cumulative incremental pretax
compensation costs are the difference between compensation cost computed under the Statement
123 fair value approach for pro forma disclosures and the APB Opinion 25 intrinsic value method
used for financial statement purposes. However, cumulative incremental pretax compensation costs
should exclude

− Awards that do not ordinarily result in a tax deduction (such as incentive stock options), unless
the award has resulted in a tax deduction prior to the adoption of Statement 123R, or the entity
cannot determine the amount of the incremental pretax compensation cost
New Developments Summary 104

− Compensation costs for awards that are partially vested upon the adoption of Statement 123R

Alpha Inc., a calendar-year company, adopted Statement 123 for disclosure purposes on
January 1, 1996, and elected to continue using APB Opinion 25 to account for its share-
based payment awards. The transition provisions of Statement 123 required pro forma
disclosures of the effects of awards granted since January 1, 1995. From January 1,
1995 through December 31, 2005, Alpha Inc. recognized the following increases in
additional paid-in capital in connection with its stock-based employee compensation
plans.

Total

Stock-based compensation expenses

Year Net increases in APIC Statement 123 APB Opinion 25


from stock-based fair value expense
employee (from pro forma) (per financial
compensation plans statements)
financial statements)

1995 $ 180 $ 320 $ -

1996 220 480 -

1997 310 500 -

1998 340 600 -

1999 360 500 160

2000 280 400 150

2001 100 200 90

2002 90 - -

2003 - - -

2004 - 200 40

2005 120 200 40

$2,000 $3,400 $ 480


New Developments Summary 105

Alpha’s share-based compensation grants include incentive stock options (ISOs). Fair
value expense included in Alpha’s pro forma expenses for ISOs that did not have
disqualifying dispositions is $500. Accordingly, no tax benefit has been recognized for
these awards. Alpha’s financial statements did not reflect any expense for these awards
as they were all granted at Alpha’s stock price at date of grant.
At the adoption date of Statement 123R, Alpha had unvested options for which it had
recognized $200 of pro forma fair value expenses and $80 of financial statement
expense.
Alpha’s blended statutory tax rate, inclusive of federal, state, local, and foreign taxes, is
40 percent.
Alpha would compute its beginning APIC pool under the alternative method in the FSP as
follows:
$2,000 – [(($3,400 – 480) – (500 – 0) – (200 – 80)) x 40%] = $1,080

Subsequent accounting

For awards fully vested prior to the adoption of Statement 123R but not exercised until after the adoption,
the entire tax benefit realized and recognized in equity increases the APIC pool. No reduction of that
amount for the tax effects of the cumulative incremental compensation cost is required because that
amount is already reflected in the computation of the beginning APIC pool.

Assuming the same facts as above, Alpha had 250 fully vested employee options at the
adoption date of Statement 123R with the following characteristics:

• Exercise price of $3 (Alpha’s share price at date of grant)

• Grant date fair value of $1

• Contractual term of 10 years and a vesting period of 3 years

The options are exercised in 2006 when the share price is $5. Alpha would get a tax
deduction of $500 (($5 - $3) x 250). Since Alpha had no financial statement expense
under APB Opinion 25 associated with these awards because they had no intrinsic
value at their grant date, the entire tax benefit of $200 ($500 x 40%) would be credited
to APIC. Under the alternative transition method, the entire increase in APIC of $200
would also increase the APIC pool.

For awards partially vested at the adoption of Statement 123R, the deduction for tax purposes should be
compared with the sum of the compensation cost recognized or disclosed under Statement 123 and
Statement 123R. The tax effect of an excess tax deduction increases the APIC pool; the tax effect of a
deficient tax deduction reduces the APIC pool.

Assuming the same facts as in the previous examples, Alpha has partially vested options
for 100 shares at the adoption date of Statement 123R that have the following terms:
New Developments Summary 106

• The options were granted January 1, 2004 and have three-year cliff vesting.

• The options have an exercise price of $4.80 and were granted when the underlying
stock had a $6 market value. The intrinsic value of $1.20 was expensed prior to the
adoption of Statement 123R for the first two years of the three-year vesting period,
resulting in a cumulative expense of $80 ($1.20 x 100 x 2/3) prior to the adoption of
Statement 123R.

• The option had a fair value of $3 on the grant date. Subsequent to the adoption of
Statement 123R, Alpha recorded compensation expense of $100 ($3 x 100 x 1/3).
No awards were forfeited.

The options are exercised in 2007 when the share price is $12. Alpha would receive a tax
deduction of $720 (($12 - $4.80) x 100). This would be compared with the $300 ($3 x
100) fair value compensation cost related to the award that had been recognized for pro
forma purposes under Statement 123 and financial statement purposes under Statement
123R. As a result, the APIC pool would be increased by $168, the tax effect of the excess
tax deduction (($720 - $300) x 40%). However, the APIC equity account in the financial
statements would increase by $216, the tax effect of the excess tax deduction over the
financial statement recognized expense (($720 - $180) x 40%).

For awards granted after the adoption of Statement 123R, the deduction for tax purposes should be
compared with compensation cost recognized for financial statement purposes. The tax effect of an
excess tax deduction increases the APIC pool; the tax effect of a deficient tax deduction reduces the
APIC pool.

Statement 123R requires the excess tax benefit of a share-based payment award to be shown as a
financing cash flow. For awards that are fully vested or partially vested on the adoption date of Statement
123R, a company using the modified prospective transition method and applying the FSP’s alternative
APIC pool computation should include as a financing cash flow the same amount that it reflects as an
increase in the APIC pool.

Comparison with the paragraph 81 method

Companies can choose between computing the beginning APIC pool as described in the FSP and using
the method described in paragraph 81 of Statement 123R.

Whether a company will have a larger APIC pool under the FSP alternative method will depend on its
individual facts and circumstances. The alternative method will be favorable to some companies because
of the following:

• Excess tax benefits of pre-Statement 123 grants that resulted in an excess tax deduction recordable
in APIC after the adoption of Statement 123 are included in the alternative method. The paragraph 81
method does not allow recognition of tax benefits related to awards granted before the effective date
of Statement 123.

• Amounts related to excess tax benefits recognized in APIC that have not reduced taxes payable are
not excluded in the alternative method as they are in the paragraph 81 computation.

However, the alternative method unfavorably impacts companies with significant vested options on the
adoption date for Statement 123R. The company would not have reflected any addition to APIC since
New Developments Summary 107

there was no excess tax benefit, but the entire incremental compensation cost, multiplied by the
company’s statutory tax rate, reduces the beginning APIC pool.

Tax effects of awards that are vested or partially vested on adoption


In accordance with the consensus reached at the July 21, 2005 Statement 123R Resource Group
Meeting, the tax deduction realized (that is, it has reduced taxes payable) for awards that are vested or
partially vested on the required effective date of Statement 123R (assuming modified retrospective
transition is not used) should be compared to the amount of compensation cost recognized in the
financial statements, with the tax benefit of any excess recorded in APIC. However, the amount included
as an addition or reduction to the APIC pool would be determined based on comparing the tax deduction
to the compensation cost measured for the award under Statement 123 (regardless of whether that
compensation cost was recognized in the financial statements or disclosed as pro forma amounts in the
notes).

Clemens Company has 1,000 options that were partially vested on the adoption of
Statement 123R on January 1, 2006. These awards were granted on January 1, 2005
and have an exercise price at date of grant of $25 per share, which was the stock price at
date of grant. Vesting is three-year cliff vesting. Fair value at grant date was $9 per
share. Assume a tax rate of 40 percent.
In 2010, the awards were exercised when the stock price was $35. At that time, the credit
to APIC would be computed as follows:
$10 (tax deduction) – $6 (book compensation expense, limited to amount
recorded in financial statements, 2 years using $9 fair value) X 1,000 shares X
40% = $1,600
The APIC pool addition would be computed as follows:
$10 (tax deduction) – $9 (compensation cost measured for the award under
Statement 123) X 1,000 shares X 40% = $400

Tax effects of incentive stock options


If an award, such as an incentive stock option (ISO), does not result in a tax deduction, a deductible
temporary difference is not recognized. However, if a future event, such as an employee’s disqualifying
disposition of an ISO, results in a tax deduction, the tax effect is recognized when the future event occurs.

For a disqualifying disposition, the Statement 123R Resource Group reached a consensus at its July 21,
2005 meeting that a tax benefit for the deduction up to the financial statement compensation cost is
reflected as a reduction of income tax expense. If the tax deduction exceeds the cumulative financial
statement compensation cost, the tax benefit of any excess deduction should be credited to APIC. If the
tax deduction is less than the cumulative financial statement compensation cost, a deficiency will not
occur, as a deferred tax asset was not previously recognized.

An ISO granted after the adoption of Statement 123R resulted in financial statement
compensation of $500 and a tax deduction of $600 when a disqualifying disposition
occurred. Assuming a 40 percent tax rate, the company should record a $200 benefit to
income tax expense and a $40 (the tax benefit associated with the $100 excess
New Developments Summary 108

deduction) credit to APIC.


Assume the same facts as above, except the disqualifying disposition results in a tax
deduction of $400. In this instance, the entire tax benefit of $160 would be recorded as
an income tax benefit.

These guidelines should also be applied to an ISO that is vested or partially vested on the adoption of
Statement 123R, except the tax deduction related to a subsequent disqualifying disposition should be
split between pre-Statement 123R adoption and post-Statement 123R adoption periods. For instance, if
an ISO was 25 percent vested on the adoption of Statement 123R and, after vesting, the underlying stock
is transferred in a disqualifying disposition, the above guidelines would be applied by comparing the pre-
adoption book expense to 25 percent of the tax deduction and the post-adoption book expense to 75
percent of the deduction. If an ISO was vested at the date of adoption and a disqualifying disposition
occurs post adoption, the entire tax benefit (assuming that the company had used APB Opinion 25 and
had not recorded any financial statement compensation cost) would be recorded in APIC.

Tax effects of dividends paid on equity awards


Dividends and dividend equivalents paid to employees on awards expected to vest are charged to
retained earnings. If paid on awards not expected to vest, they are recognized as compensation cost. To
determine the amount of dividends not expected to vest, an entity should use the forfeiture rate it uses in
estimating awards not expected to vest.

EITF Issue 06-11, “Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards,”
addresses the accounting for the income tax benefits related to dividend or dividend-equivalent payments
made to employees holding equity-classified nonvested shares, equity-classified nonvested share units,
and equity-classified outstanding share options if both of the following conditions apply to those
payments:

• They are charged to retained earnings under Statement 123R because the related awards are
expected to vest.

• They result in an income tax deduction for the employer.

If the tax benefits from dividends or dividend equivalents within the scope of EITF Issue 06-11 have been
realized, they are accounted for as an increase to additional paid-in capital and are included in the entity’s
APIC pool. If not yet realized, for example, because an employer has a net operating loss carryforward,
the unrealized income tax benefits should not be recognized in APIC or included in the entity’s APIC pool.

Dividends and dividend equivalents are reclassified between retained earnings and compensation cost in
a subsequent period if the entity changes its forfeiture estimates or if actual forfeitures differ from previous
estimates. Adjustments to additional paid-in capital for reclassifications of the tax benefits from dividends
on those awards in subsequent periods will increase or decrease the entity’s APIC pool. However, the
reduction of the APIC pool when an entity’s estimate of forfeitures increases (or actual forfeitures exceed
the entity’s estimates) cannot exceed the balance of the entity’s APIC pool on the reclassification date
(that is, the balance in the APIC pool cannot be a negative amount).

The consensus on EITF Issue 06-11 is effective prospectively for fiscal years beginning after
December 15, 2007.
New Developments Summary 109

Tax effects of nonqualified employee options issued in business combinations


Business combinations with acquisition date before effective date of Statement 141R
The accounting for the tax benefits of nonqualified options issued to acquiree employees in a business
combination in exchange for their acquiree options are addressed in Issue 29 of EITF Issue 00-23.
Although that guidance applies to options accounted for under APB Opinion 25, it is analogized to for
options issued under Statement 123R.

The issuance of nonqualified employee options in a business combination does not result in the
recognition of a deferred tax asset when the business combination is consummated.

A future tax benefit realized on exercise of nonqualified options issued to acquiree employees that were
fully vested on issuance is recognized as a reduction of the purchase price of the acquired business to
the extent the tax deduction does not exceed the fair value of the options included in the purchase price.
If the tax deduction exceeds the fair value of the award included in the purchase price, the tax benefit for
the excess deduction is recognized in additional paid-in capital.

That accounting also applies to the tax benefit for the vested portion of nonqualified employee stock
option awards issued in a business combination that were not fully vested on issuance. However, the
unvested (compensatory) portion of those awards is accounted for as if the awards were granted to the
employees absent a business combination. As compensation cost is recognized over the remaining
service period of the awards, a deferred tax asset is recognized.

Business combinations with acquisition date after effective date of Statement 141R
Statement 141R addresses the accounting for the tax effects of equity-classified share-based payment
awards issued as replacement awards in exchange for outstanding awards of the target company in a
nontaxable business combination. If the replacement awards are nonqualified―that is, they will result in
postcombination tax deductions under current tax law―the acquirer would recognize a deferred tax asset
for the deductible temporary difference of the portion of the replacement awards’ fair value that relates to
precombination service. (Replacement awards and precombination service are discussed in section H,
under the heading “Business combinations accounted for under Statement 141R.”)

After the acquisition, the tax effects of nonqualified replacement awards are accounted for as required
under Statement 123R and do not affect the consideration transferred for the acquired business.
Similarly, the postacquisition tax effects of qualified replacement awards, such as disqualifying
dispositions of shares, are accounted for as provided by Statement 123R.

Interim period effects


The Statement 123R Resource Group reached a consensus at its July 21, 2005 meeting that any excess
tax benefits and deficiency in tax benefits should be recorded in the interim period that they occur. For
example, if a company did not have a beginning of the year APIC pool large enough to offset a deficiency
in tax benefits incurred in the first quarter, any shortfall would be recorded as a charge to income tax
expense. In a later quarter, if an APIC pool addition occurs, the first quarter shortfall should be reversed
in the subsequent quarter to the extent that it can be offset against the APIC pool. The Group agreed that
it is not appropriate for a company to anticipate future APIC pool additions or reductions before they
occur. Once amounts have been allocated as of a year-end, recapture of previously recognized income
tax credits should not be permitted.
New Developments Summary 110

Assume that Berkman Company has the option exercise history shown in the table below in
2009. The amounts shown are the deferred tax asset related to the options exercised and
the tax benefit (the tax deduction times the statutory rate) of the deduction. All options
were granted after the effective date of Statement 123R. The tax rate is 40 percent. The
Company’s APIC pool at January 1, 2009 is $100.

1st Quarter Deferred tax asset $1,200

Tax benefit 700

2nd Quarter Deferred tax asset 2,000

Tax benefit 2,600

3rd Quarter Deferred tax asset 2,500

Tax benefit 3,200

4th Quarter Deferred tax asset 5,000

Tax benefit 4,000

• 1st Quarter — The Company would record an additional $400 of income tax expense
for the quarter, and reduce APIC by $100. The APIC pool would now be $0.

• 2nd Quarter — The Company would record a tax benefit of $400 (recouping the deficit
reflected in the first quarter). APIC would be increased by $200. The APIC pool would
now be $200.

• 3rd Quarter — The Company would record $700 in APIC. The APIC pool would now
be $900.

• 4th Quarter — The Company would record a tax expense of $100 and a reduction of
APIC of $900. The APIC pool for the period would be $0 at the end of the period.

ISOs are permanent differences that should increase the estimated annual effective rate. A subsequent
disqualifying disposition would be reflected in the interim period of the disposition, provided that the
disqualifying disposition reduces taxes payable. Disqualifying dispositions should not be anticipated when
an entity computes its annual effective rate for interim reporting.
New Developments Summary 111

K. How are EPS, unvested shares in equity, and the cash flow statement
affected?
Earnings per share
Statement 123R provides only limited amendments to FASB Statement 128, Earnings per Share.
However, some aspects of Statement 123R require consideration in the computation of earnings per
share.

Forfeitures
As previously discussed, Statement 123R requires compensation cost to be recognized only for awards
expected to vest. For awards with only a service condition, companies will compute an estimated
prevesting forfeiture rate that will be applied to the outstanding awards to determine compensation cost
recognized. However, for purposes of computing the denominator for diluted earnings per share, all
awards that have not actually been forfeited should be included in the calculation.

Treasury stock method


Under Statement 128, the dilutive effect of employee options should be reflected in diluted earnings per
share (EPS) by application of the treasury stock method. Under the treasury stock method, the proceeds
from the options’ assumed exercise (assumed proceeds) are considered to be used to purchase common
stock at the average share price during the period. The assumed proceeds are the sum of

• The amount the employee must pay upon exercise

• The amount of compensation cost attributed to future services and not yet recognized (the average
amount of unearned compensation cost for the period, as illustrated below)

• The amount of tax benefits that would be credited to additional paid-in capital, assuming exercise of
the options. Tax deficiencies that would be charged to APIC on assumed exercise would reduce
assumed proceeds. Excess tax benefits or tax deficiencies should not be included for estimated
disqualifying dispositions of ISOs.

As discussed at the September 13, 2005 Statement 123R Resource Group meeting, a company should
not include in its treasury stock computation share-based payment awards that are currently “out-of-the
money,” even though the tax deficiency that would be debited to paid-in capital (and reduce assumed
proceeds) is large enough that it would make the award dilutive.

On January 1, 2006, a company grants 1,000 awards with an exercise price of $21 and a
grant-date fair value of $10 and a four-year vesting period. The average market price of
the stock for the reporting period is $20 and the company’s combined statutory tax rate is
40 percent. The assumed proceeds for the year ended December 31, 2009 are listed
below.

Exercise price $21,000

Unrecognized compensation cost (($2,500 +


1,250
$0)/2)
New Developments Summary 112

Excess tax benefit (4,000)

$18,250

Number of shares reacquired 912.50

Number of assumed shares 87.50

Even though this grant would be mathematically dilutive, it should not be considered in
dilutive EPS—the intent of Statement 128 is to include awards that a holder might
actually convert into a common share. Since this award is out of the money, a reasonable
person would not exercise the award.

Two-class method used for participating awards


The two-class method is used in the computation of EPS for restricted shares, stock options, and other
share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents. Such
share-based payment awards are considered participating securities.

The two-class method is an earnings allocation formula used to compute EPS when an entity has issued
more than one type of security entitled to distributions of earnings. Under the two-class method, an entity
generally allocates dividends or dividend equivalents and undistributed earnings to each class of common
stock and participating security to determine basic and diluted earnings per share. This process reduces
earnings available to a class of common shareholders, and therefore basic and diluted EPS of that class
of common, by the amount of earnings allocable to holders of other classes of common and/or to holders
of participating securities.

In EITF Issue 03-6, “Participating Securities and the Two-Class Method under FASB Statement No. 128,”
the EITF concluded that vested share-based awards with nonforfeitable rights to dividends or dividend
equivalents are participating securities subject to the two-class method. The FASB reached a similar
conclusion for unvested share-based payment awards with dividend participation rights in FASB Staff
Position (FSP) EITF 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment
Transactions Are Participating Securities.” FSP EITF 03-6-1 includes the following clarifications:

• Because nonforfeitable dividends or dividend equivalents on unvested participating awards that are
not expected to vest are recognized as compensation cost rather than being charged to retained
earnings, distributed dividends or dividend equivalents on awards not expected to vest are not
included in the two-class method.

• Undistributed earnings allocable to unvested participating awards, including awards not expected to
vest, are included in the two-class method.

The following two types of awards are not considered participating securities and would therefore be
included in an entity’s EPS calculation using the treasury stock method, not the two-class method:

• Awards with dividend rights that are forfeited if the award does not vest

• Awards with dividend rights that reduce the exercise price or purchase price of the award
New Developments Summary 113

FSP EITF 03-6-1 is effective for fiscal years beginning after December 15, 2008, and interim periods
within those years. Prior period EPS data must be adjusted retrospectively, and early application is not
permitted. EITF Issue 03-6 initially became effective in fiscal periods beginning after March 31, 2004.

The following example illustrates the application of the two-class method to an entity that has unvested
share-based payment awards with nonforfeitable dividend participation rights.

During 20X8, Company ABC has 5,000 shares of common stock outstanding and 1,000
unvested share-based payment awards with nonforfeitable rights to dividends. Initially 90
awards were not expected to vest, but the Company adjusted its estimate in the current
period and 100 awards are not expected to vest. Reported net income was $25,000, and
the company paid dividends of $2 per share. The following illustrates how Company ABC
would calculate the EPS of its common stock using the two-class method.

Allocation of earnings to

Common Unvested
stock share-based
payment
awards

Net income $25,000

Dividends paid

5,000 X $2 $10,000 (10,000)

(1,000 - 100) X $2 $ 1,800 (1,800)

Undistributed earnings $ 13,200

Allocation of undistributed earnings

$13,200 X (5,000 / (5,000 + 11,000


1,000))

$13,200 X (1,000 / (5,000 + 2,200


1,000))

Allocated net income $21,000 $ 4,000

Earnings per share

$21,000 / 5,000 $ 4.20


New Developments Summary 114

$ 4,000 / 1,000 $ 4.00

Transition for awards vested or partially vested


For companies using modified prospective transition, neither Statement 123R nor FSP FAS 123R-3
provides guidance for calculating the amount of tax benefits that would be credited or debited to APIC in
the assumed proceeds calculation for earnings per share if the related share-based payment awards
were fully or partially vested on the adoption date of Statement 123R. The FASB staff has informally
indicated that entities have an accounting policy choice as to whether they consider pro forma deferred
tax assets in the calculation. That is, an entity can choose to compute the amount of excess (deficient)
tax benefit that would increase (decrease) APIC by (1) considering only the deferred tax asset balance
recorded in the financial statements, or (2) considering the deferred tax asset that would have been
recorded had the entity always followed the fair value method of accounting in Statement 123 (the sum of
the recorded deferred tax asset balance and the pro forma deferred tax asset balance at the effective
date of Statement 123R).

Presentation of unvested shares in equity


Companies sometimes issue unvested shares to employees. If these unvested shares, often referred to
as restricted shares, have been legally issued, they are included as legally issued and outstanding in the
equity section of the balance sheet.

Because unvested shares are not included in basic EPS, the notes to the financial statements should
include a reconciliation between the number of issued shares shown on the balance sheet and the
number of shares used to determine basic EPS by identifying the number of shares that are not
considered issued for accounting purposes.

Unlike APB Opinion 25, Statement 123R does not permit presentation of a contra-equity account for
unearned compensation. Additional paid-in capital is increased as compensation is recorded.

Statement of cash flows


Cash retained as a result of realized excess tax benefits from employee and nonemployee share-based
payment awards that are not included in the cost of goods or services sold should be classified as a
financing cash inflow, with a corresponding amount shown as an operating cash outflow. An excess tax
benefit occurs if the deduction ultimately reported on the entity’s tax return exceeds compensation cost
recognized for financial reporting. As discussed in section J, the excess tax benefit is measured as the
excess of the tax benefit of the deduction over the deferred tax asset recorded. An excess tax benefit
resulting from an increase in the value of the entity’s shares is recognized in additional paid-in capital, but
not before the tax benefit is actually realizable by the entity (that is, not before the tax benefit of the
deduction reduces taxes payable).

Under the direct method of reporting cash flows, an entity should report excess tax benefits as separate
line items within the statement of cash flows. An entity using the indirect method usually includes the
change in income taxes payable for the period in the reconciliation of net income to operating cash flows.
Since that change includes the effect of excess tax benefits, the excess tax benefits would be presented
as a separate operating cash outflow to properly exclude the effects from total operating cash flows.

If the deduction for tax purposes is less than compensation cost recognized for financial reporting
purposes (deficient tax deduction), the write-off of the excess deferred tax asset, net of any related
valuation allowance, is charged to APIC to the extent of the available APIC pool. If a portion of the
New Developments Summary 115

deferred tax asset to be written off exceeds the amount available in the APIC pool, that excess is
recognized in the income statement.

The write-off of a deferred tax asset resulting from a deficient tax deduction is added back to net income
in the reconciliation of net income to operating cash flows. The computation of the amount of realized
excess tax benefits to be classified as a financing cash inflow should be performed at the individual award
level. Financing cash inflows resulting from excess tax benefits should not be reduced by the effect of
deficient tax deductions.

For an option that is vested on the adoption of Statement 123R, the computation of the amount of the
financing cash inflow on exercise of the option depends on the method the entity used to compute its
beginning APIC pool. If the entity used the method described in paragraph 81 of Statement 123R, the
financing cash inflow on exercise of the option would be the tax benefit related to the excess of the tax
deduction (if realized) over the compensation cost measured for the award under Statement 123
(regardless of whether that compensation cost was recognized in the financial statements or disclosed as
pro forma amounts in the notes).

However, the computation of the amount of the financing cash inflow on exercise of an option fully vested
on adoption of Statement 123R differs if an entity used the alternative method of FSP FAS 123R-3 to
compute its beginning APIC pool and adopted Statement 123R using the modified prospective transition
method. The excess tax benefit classified as a financing cash inflow would be the excess of the tax effect
of the tax deduction (if realized) over the deferred tax asset, if any, actually recognized in the entity’s
financial statements. If, before adoption of Statement 123R, the award was accounted for under APB
Opinion 25 and no compensation cost was recognized, the amount recognized as a financing cash inflow
would be the tax benefit of the tax deduction, as illustrated below.

Beta Corporation used the intrinsic value method of APB Opinion 25 to record share-
based payment arrangements before adopting Statement 123R. The Company adopts
Statement 123R using modified prospective transition. The Company had a single grant
of 250 fully vested employee options at the adoption date of Statement 123R with the
following characteristics:

• Exercise price of $6 (Beta’s share price at date of grant)

• Grant date fair value of $2

• Contractual term of 10 years and a vesting period of 3 years

The options are exercised in 2006 when the share price is $10. Beta would get a tax
deduction of $1,000 (($10 - $6) x 250). Beta’s statutory tax rate is 40 percent.
If Beta used the paragraph 81 of Statement 123R method to calculate its beginning APIC
pool, it would reflect an operating cash outflow and financing cash inflow of $200,
calculated as the difference between the tax benefit of the deduction ($1,000 x 40% =
$400) and the pro forma deferred tax asset (($2 x 250) x 40% = $200).
If Beta used the alternative method of FSP FASB 123R-3 to compute its beginning APIC
pool, it would reflect an operating cash outflow and financing cash inflow of $400,
calculated as the difference between the tax benefit of the deduction ($1,000 x 40% =
$400) and the financial statement deferred tax asset, which is $0 since the Company did
not recognize any expense for the award under APB Opinion 25.
New Developments Summary 116

The cash flow effects of an employee award that is partially vested on the adoption of Statement 123R, or
granted after the adoption, is not affected by the method used to compute the beginning APIC pool. The
financing cash inflow associated with the excess tax benefit should be determined as if the entity had
always followed a fair-value-based method of recognizing compensation cost in its financial statements
(the same method described above for a fully vested award when an entity used the paragraph 81 of
Statement 123R method of computing its beginning APIC pool).

The following tables summarize when the pro forma deferred tax asset should be considered in
computing an excess tax benefit or tax deficiency.

Fully vested award: adoption using modified prospective method

Treasury stock
Method used for computing APIC balance APIC pool Cash flow
method and
beginning APIC pool sheet account addition statement
earnings per share

Statement 123R, paragraph No Yes Yes Either: accounting


81 method policy decision

Alternative method (FSP FAS No No No Either: accounting


123R-3) policy decision

Partially vested award: adoption using modified prospective method

Treasury stock
Method used for computing APIC balance APIC pool Cash flow
method and
beginning APIC pool sheet account addition statement
earnings per share

Statement 123R, paragraph No Yes Yes Either: accounting


81 method policy decision

Alternative method (FSP FAS No Yes Yes Either: accounting


123R-3) policy decision
New Developments Summary 117

L. What are the required disclosures?


Financial statement disclosures
Statement 123R requires that an entity’s disclosures regarding its share-based payment arrangements
should allow financial statement users to understand the following:

• Nature and terms of its arrangements and the potential effects of the arrangements on shareholders

• Impact of compensation cost from share-based payment arrangements on the income statement

• Method the entity used to estimate the fair value of the goods or services received, or of the equity
instruments granted

• Cash flow effects of share-based payment arrangements

These disclosure objectives also apply to share-based payment transactions for goods or services other
than employee services if the disclosures are important to understanding the financial statement effects of
the transactions.

Although detailed disclosure requirements are not included in the standards section of the Statement,
paragraphs A240 and A241 of appendix A include minimum information that an enterprise should provide
in order to satisfy the disclosure objectives. However, an enterprise’s specific circumstances could cause
it to disclose more than these minimum disclosure items. A summary of the minimum detailed disclosures
are included in appendix A of this document.

Statement 123R and a subsequent FSP provide exceptions to nonpublic entities for certain minimum
disclosure requirements pertaining to intrinsic value:

• Paragraph A240(d)(2) of Statement 123R states that nonpublic entities are not required to disclose
the aggregate intrinsic value of options (or share units) currently exercisable (or convertible).

• FSP FAS 123R-6, “Technical Corrections of FASB Statement No. 123(R),” amends paragraph
A240(d)(1) to exempt nonpublic entities from the requirement to disclose the aggregate intrinsic value
of outstanding fully vested share options (or share units) and share options expected to vest.

Entities that have multiple share-based arrangements with employees should disclose information
separately for different award types to the extent that separate disclosure is important to an
understanding of an entity's use of share-based compensation. For example, it may be important to
provide separate disclosures of arrangements with

• Fixed exercise prices and those with an indexed exercise price

• Service conditions only and those with performance and service conditions

• Awards classified in equity and those with awards classified as liabilities

Disclosures in interim statements


Statement 123R does not require any disclosures of share-based payment information on a quarterly
basis. However, entities should consider the general requirements in paragraph 30 of AICPA Accounting
Principles Board (APB) Opinion 28, Interim Financial Reporting, when assessing whether to provide
disclosures in quarterly financial reports. APB Opinion 28 requires disclosures about changes in
accounting principles or estimates and significant changes in financial position. In addition, as discussed
in paragraph B239 of Statement 123R, entities with significant share-based compensation costs may
New Developments Summary 118

consider providing additional quarterly information, such as the total amount of that cost, to help users
better understand their quarterly financial reports.

Management’s Discussion and Analysis


The SEC staff believes that registrants should address in MD&A the significant trends and variability of
their earnings. It also believes that changes in the components of certain income statement line items are
important in assisting an investor in understanding the registrant’s performance. Particularly, the staff
believes that investors would benefit from disclosures in MD&A that explain the components of the
registrant’s expenses, including, if significant, the expense associated with share-based payment
transactions and a discussion of the reasons for any fluctuations between periods.

SEC executive compensation disclosure rules


In 2006 the SEC issued expanded disclosure requirements for executive compensation in revised Item
402. The requirements of revised Item 402 are summarized in appendix E of this document. The following
describes significant disclosure provisions applicable to public companies other than smaller reporting
companies. Modifications applicable to smaller reporting companies are described in section I of
appendix E.

Item 402 provides for enhanced disclosures of executive option awards, with particular emphasis on
plans, programs, or practices involving option timing in coordination with release of material nonpublic
information and option backdating or other practices affecting selection of an exercise price lower than
the company’s stock price on the grant date. Disclosures about such practices are required in
Compensation Discussion and Analysis (CD&A) and in the Grants of Plan-Based Awards Table, which
requires extra columns to disclose the award approval date if earlier than the award’s grant date and the
grant date closing market price of the company’s stock if higher than the award’s exercise price.

The Summary Compensation Table requires disclosure of stock and option awards within the scope of
Statement 123R. The amounts reported are the dollar amounts of Statement 123R compensation cost
recognized in the company’s financial statements during the subject fiscal year. Entities are required to
provide additional information about awards granted under incentive plans in the last fiscal year by
providing a supplementary Grants of Plan-Based Awards Table. Incentive plans are those requiring
satisfaction of performance and/or market condition(s) to earn the award. The condition(s) may relate to
the company’s stock price (a market condition), a financial or performance measure of the company, or
any other performance measure.

Item 402 requires a company to provide a narrative disclosure after the plan-based awards table that
describes material factors necessary to understand the information in that table and the Summary
Compensation Table. Factors requiring disclosure will vary depending on the details of a company’s
compensation arrangements. The Item provides a few examples of information that, among other things
and depending on the company’s compensation policies and components, may clarify the tabular
information. These include

• A description of any material modification of options or other equity-based awards, including each
repricing, modification, or elimination of a performance condition; term extension; or change in vesting
period. Changes resulting from provisions in the plan or award on the grant date, such as a change
resulting from an antidilution provision, or that affect all equity holders are not considered
modifications.

• Material terms of awards reported in the plan-based awards table, including


New Developments Summary 119

− A performance condition and/or market condition applicable to an award, except for factors or
criteria involving confidential trade secrets or commercial or financial information if disclosure
would result in competitive harm to the company

− The formula or criteria used to determine the payout amount

− The vesting schedule

− Dividends, if any, paid on the stock, including the dividend rate and whether it is preferential

Companies are required to provide two additional tables about outstanding options and shares awarded
under stock option or stock appreciation rights plans, restricted stock plans, and incentive plans. One
table presents all outstanding unexercised options and unvested shares of each named executive. The
other provides information on the amounts realized by each named executive during the fiscal year on the
exercise of options and the vesting of stock.

Non-GAAP financial measures


The SEC staff believes that a non-GAAP financial measure used by management that excludes share-
based payments, such as “Net income before share-based payment charge,” could be, after full
consideration of the existing SEC regulations on non-GAAP financial measures, a relevant disclosure for
investors in a registrant’s MD&A. Management should evaluate whether the measure violates any of the
prohibitions from inclusion in filings included in Item 10(e) of Regulation S-K. A registrant including such a
non-GAAP measure should consider the disclosure requirements of Item 10(e)(1) of Regulation S-K and
the response to question 8 included in “Frequently Asked Questions Regarding the Use of Non-GAAP
Measures,” issued in June 2003. Non-GAAP measures should not be presented on the face of the
registrant’s financial statements or in the accompanying notes.

The staff will object to registrants including a pro-forma income statement that removes the effects of
share-based payment arrangements from net income in a filing. Additionally, removal of the effects of
share-based payment arrangements should not be included as a pro forma adjustment for pro forma
information required for transactions such as recent or probable business combinations. Non-GAAP
financial measures are also prohibited from being presented on the face of any required pro forma
financial information.
New Developments Summary 120

M. What are the transition provisions?


Effective dates
In April 2005, the Securities and Exchange Commission adopted a rule amending the effective date for
Statement 123R for public companies, which allowed registrants to implement Statement 123R at the
beginning of their next fiscal year, instead of the next interim period, that begins after June 15, 2005, or
December 15, 2005 for small business issuers. Nonpublic entities must apply the Statement at the
beginning of their first annual period beginning after December 15, 2005. Early adoption is encouraged
for interim or annual periods for which financial statements have not been issued.

In applying the Statement, the term required effective date refers to the first date in the period of initial
adoption. For a public calendar-year company that is not a small business issuer and did not early adopt,
the required effective date would be January 1, 2006. The required effective date remains the same even
if an entity chooses the modified retrospective transition method discussed below.

Transition
All public entities and those nonpublic entities that used the fair-value-based method (not the minimum
value method) for either measurement or the pro forma disclosures under Statement 123 are required to
adopt the Statement using modified prospective application as of the required effective date. These
entities also have the choice of applying modified retrospective application to periods before the required
effective date.

Nonpublic entities that used the minimum value method for recognition or disclosure purposes under
Statement 123 must apply prospective application of the Statement as of the required effective date.

© 2009 Grant Thornton LLP, U.S. Member of Grant Thornton International. All rights reserved.

This Grant Thornton LLP document provides information and comments on current accounting and tax
issues and developments pertaining to FASB Statement 123R as of February 28, 2009. It provides a
summary of Item 402 of Regulation S-K, including the SEC staff’s interpretive guidance through
February 28, 2009. This document is not a comprehensive analysis of the subject matter covered and is
not intended to provide accounting, tax, or other advice or guidance with respect to the matters
addressed. All relevant facts and circumstances, including the pertinent authoritative literature, need to be
considered to arrive at conclusions that comply with matters addressed in this document.

Moreover, nothing in this document shall be construed as imposing a limitation on any person from
disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this document
may be considered to contain written tax advice, any written advice contained in, forwarded with, or
attached to this document is not intended by Grant Thornton to be used, and cannot be used, by any
person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

For additional information on topics covered in this document, contact your Grant Thornton LLP adviser.
New Developments Summary 121

Appendix A
Disclosure requirements
For share-based payment arrangements, the disclosures should include

• A description of the share-based payment arrangements, including

− The general terms of awards under the arrangements, such as the requisite service periods and
any other substantive conditions (including those related to vesting)

− The maximum contractual term of equity (or liability) share options or similar instruments

− The number of shares authorized for awards of equity share options or other equity instruments

• The method used for measuring compensation cost

• For the most recent year for which an income statement is provided:

− The number and weighted-average exercise prices (or conversion ratios) for each of the following
groups of share options (or share units): (a) those outstanding at the beginning of the year, (b)
those outstanding at the end of the year, (c) those exercisable or convertible at the end of the
year, and (d) those granted, (e) those exercised or converted, (f) those forfeited, or (g) those
expired during the year

− The number and weighted-average grant-date fair value (or calculated value for a nonpublic entity
that uses that method or intrinsic value as permitted for certain awards) of equity instruments not
specified in the previous disclosure (for example, shares of nonvested stock), for each of the
following groups of equity instruments: (a) those nonvested at the beginning of the year, (b) those
nonvested at the end of the year, and (c) those granted, (d) those vested, or (e) those forfeited
during the year

• For each year for which an income statement is provided:

− The weighted-average grant-date fair value (or calculated value for a nonpublic entity that uses
that method or intrinsic value as permitted for certain awards) of equity options or other equity
instruments granted during the year

− The total intrinsic value of options exercised (or share units converted), share-based liabilities
paid, and the total fair value of shares vested during the year

• For fully vested share options (or share units) and share options expected to vest at the date of the
latest statement of financial position:

− The number, weighted-average exercise price (or conversion ratio), aggregate intrinsic value
(except for nonpublic entities), and weighted-average remaining contractual term of options (or
share units) outstanding

− The number, weighted-average exercise price (or conversion ratio), aggregate intrinsic value
(except for nonpublic entities), and weighted-average remaining contractual term of options (or
share units) currently exercisable (or convertible)

• For each year for which an income statement is presented (except for awards accounted for under
the intrinsic value method under Statement 123R):
New Developments Summary 122

− A description of the method used during the year to estimate the fair value (or calculated value) of
awards under share-based payment arrangements

− A description of the significant assumptions used during the year to estimate the fair value (or
calculated value) of share-based compensation awards, including (if applicable)

 Expected term of share options and similar instruments, including a discussion of the method
used to incorporate the contractual term of the instruments and employees’ expected
exercise and post-vesting employment termination behavior into the fair value (or calculated
value) of the instrument. Companies using the simplified method of determining the expected
term permitted by SAB 107 and SAB 110 should disclose that fact, as well as the reasons
why they used the method; the types of options for which the method was used, if not used
for all option grants; and the periods the method was used, if not used in all periods.

 Expected volatility of the entity’s shares and the method used to estimate it or, if applicable,
the range of expected volatilities and the weighted-average expected volatility. A nonpublic
entity that uses the calculated value method should disclose the reasons why it is not
practicable for it to estimate the expected volatility of its share price, the appropriate industry
sector index that it has selected, the reasons for selecting that particular index, and how it
has calculated historical volatility using that index. In SAB 107, the SEC staff commented that
they would expect a registrant, at a minimum, to disclose whether it used only implied
volatility, historical volatility, or a combination of both in estimating expected volatility.

 Expected dividends or, if applicable, the range of expected dividends and the weighted-
average expected dividends when different dividend rates are used during the contractual
term

 Risk-free rate(s) or, if applicable, the range of risk-free rates used

 Discount for post-vesting restrictions and the method for estimating it

• For multiple share-based payment arrangements, the information specified in the disclosures above
should be presented separately for different types of awards if the characteristics of the awards differ
sufficiently so that separate disclosure is important to understanding the company’s use of share-
based compensation

• For acquired goods or services other than employee services in share-based payment transactions,
the information specified in the disclosures above to the extent that those disclosures are important to
an understanding of the effects of those transactions on the financial statements

• For each year for which an income statement is presented:

− Total compensation cost for share-based payment arrangements (a) recognized in income as
well as the total related recognized tax benefit and (b) the total compensation cost capitalized as
part of the cost of an asset

− A description of significant modifications, including the terms of the modifications, the number of
employees affected, and the total incremental compensation cost resulting from the modifications

• As of the latest balance sheet date presented, the total compensation cost related to nonvested
awards not yet recognized and the weighted-average period over which it is expected to be
recognized

• If not separately disclosed elsewhere:


New Developments Summary 123

− The amount of cash received from exercise of share options and similar instruments granted
under share-based payment arrangements and the tax benefit realized from stock options
exercised during the annual period

− The amount of cash used to settle equity instruments granted under share-based payment
arrangements

• A description of the policy, if any, for issuing shares upon share option exercise (or share unit
conversion), including the source of those shares (that is, new shares or treasury shares). If, as a
result of the policy, shares are expected to be repurchased in the following annual period, provide an
estimate of the amount (or a range, if more appropriate) of shares to be repurchased during that
period.

• The accounting policy for the method used to recognize compensation cost for awards with graded
vesting

• Other information deemed necessary to ensure the disclosures adequately disclose the

− Nature and terms of the arrangements and the potential effects of the arrangements on
shareholders

− Impact of compensation cost from share-based payment arrangements on the income statement

− Method the entity used to estimate the fair value of the goods or services received, or of the
equity instruments granted

− Cash flow effects of share-based payment arrangements

Illustrative disclosures
Share-based compensation
The Company accounts for the cost of employee services received in exchange for an
award of equity instruments based on the grant-date fair value of the award as required by
FASB Statement 123 (revised 2004), Share-Based Payment, and related interpretations.

The Company maintains several share-based compensation plans, which are more fully
described below. During the years ended June 30, 20X6 and June 30, 20X5, total
compensation cost charged against income for these plans was $13,000 and $12,000,
respectively, and the total income tax benefit recognized in the income statement from
these plans was $5,000 and $4,000, respectively.

Company share-based plans


The Company maintains several share-based compensation plans to award stock options
to certain members of Company management and the outside members of its Board of
Directors. The exercise price of each stock option equals 100 percent of the market price of
the Company's stock on the date of grant and generally has a maximum term of 10 years.
Options generally vest ratably over three years. The total number of shares reserved for
issuance under the Company’s four share-based compensation plans cannot exceed
500,000 shares.
The table below summarizes the options held by Company employees under the
Company’s option plans.
New Developments Summary 124

Number of Weighted- Weighted- Aggregate


company average average intrinsic
outstanding exercise remaining value
options price contractual
life
(months)

Outstanding at June 30, 20X5 32,000 $16.17 70

Granted 8,000 33.88 118

Exercised (2,000) 13.57 37

Forfeited (900) 17.51 60

Expired (100) 36.00 -

Outstanding at June 30, 20X6 37,000 $20.23 86 $370,000

Vested or expected to vest at 35,000 $19.99 83 $340,000


June 30, 20X6

Exercisable at June 30, 20X6 16,000 $15.22 44 $220,000

The fair value of each Company option grant is estimated on the date of grant using the
Black-Scholes-Merton option pricing model and the following weighted-average
assumptions.

Year ended

June 30, 20X6 June 30, 20X5

Expected term (years) 3.75% 1.92%

Risk-free interest rate 4.11% 2.45%

Expected volatility 37.43% 29.35%

Dividend yield - -
New Developments Summary 125

Expected term: The expected term represents the period during which the Company’s
stock-based awards are expected to be outstanding. The Company estimated this amount
based on historical experience of similar awards, giving consideration to the contractual
terms of the awards, vesting requirements, and expectations of future employee behavior,
including post-vesting terminations.

Risk-free interest rate: The Company bases the risk-free interest rate on the grant-date
implied yield on U.S. Treasury zero-coupon issues with an equivalent remaining term.

Expected volatility: The fair value of stock-based payments made during the year ended
June 30, 20X6 was valued using a volatility factor based on the Company’s historical stock
prices.

Dividend yield: The Company has not historically issued any dividends and does not expect
to in the future.

Estimated prevesting forfeitures: When estimating forfeitures, the Company considers


voluntary termination behavior as well as future workforce reduction programs.

During the years ended June 30, 20X6 and June 30, 20X5, the weighted-average grant-
date fair value of individual options granted was $11.06 and $3.38, respectively. At
June 30, 20X6, total unrecognized compensation cost of $98,000 is related to nonvested
awards. The unrecognized compensation cost will be recognized over a weighted-average
period of 2.0 years.
During the years ended June 30, 20X6 and June 30, 20X5, the total intrinsic value of
options exercised was $52,000 and $43,000, respectively. The total cash received from
these option exercises was $19,000 and $17,000, respectively, and the actual tax benefit
realized from the tax deductions from these option exercises was $21,000 and $16,000,
respectively.
New Developments Summary 126

Appendix B
Comparison of key provisions of Statement 123 and Statement 123R

Issue Statement 123 Statement 123R

Scope Applied to all transactions in which share- The scope of Statement 123R is the same
based payments were issued in exchange as that of Statement 123.
for goods or services, other than those
Statement 123R expands the principal
related to employee share ownership plans
shareholder rule of Statement 123. An
(ESOPs), which are accounted for under
SOP 93-6. Therefore, it applied to entity accounts for a share-based payment
award granted to its employee by a related
transactions with both employees and
party or other economic interest holder in
nonemployees.
the entity as compensation for services to
An entity accounted for a share-based the entity, unless the award is clearly for a
payment award granted to its employee by purpose other than compensation for
a principal shareholder (an owner of more services to the entity.
than 10 percent of the entity’s shares) as
compensation for services to the entity,
unless the award was clearly for a purpose
other than compensation for services.

Measurement Entities had a choice of using the grant- Entities are required to use the fair-value-
of equity date fair value method of Statement 123 or based measurement method, with the
awards to continuing to use the intrinsic-value method following exceptions:
employees of APB Opinion 25.
 If fair value cannot be reasonably
Nonpublic entities were permitted to apply determined on the grant date, the entity
the Statement 123 fair-value method using is required to measure the award based
either the grant-date fair value or grant-date on its intrinsic value, remeasuring each
minimum value (a valuation method that period until the award is exercised,
excludes the effect of stock price volatility). settled, or it expires. It is expected to be
rare that the fair value of even a
If the award’s fair value could not be
complex award cannot be reasonably
reasonably estimated on the grant date, the determined.
intrinsic-value method was used until the
award’s fair value could be reasonably  If it is not practicable for a nonpublic
estimated. entity to estimate the expected volatility
of its stock price without undue cost
and effort, it is required to use the
calculated value method to measure its
options and similar instruments.
New Developments Summary 127

Issue Statement 123 Statement 123R

Accounting for Entities were required to account for share- Entities are required to account for share-
awards to based payment awards to nonemployees based payment awards to nonemployees
nonemployees using the applicable guidance in Statement using the applicable guidance in Statement
for goods and 123 and EITF Issue 96-18. 123R, EITF Issue 96-18, and SAB 107.
services

Liability Share-based payment awards were Statement 123R provides more explicit
classification of classified as liabilities if the holder could criteria for liability classification. The
awards compel the issuing entity to settle the award following awards are classified as liabilities:
by transferring its cash or other assets.
 Awards that would be within the scope
of Statement 150, with certain
modifications. The deferrals provided in
FSP FAS 150-3 should be applied as
long as that FSP is in effect.

 Shares that are puttable, if the


repurchase feature can be exercised
within 6 months of share vesting or
option exercise, unless the put feature
is contingent and the contingency is not
expected to be met within 6 months

 Shares that are callable, if it is probable


the employer would call the shares
within 6 months of share vesting or
option exercise

 Options if the underlying shares would


be classified as liabilities

 Options if the entity, under any


circumstances, can be required to
settle the option by transferring cash or
other assets. However, under FSP FAS
123R-4, a cash-settlement feature that
can be exercised only on the
occurrence of a contingent event that is
outside the employee’s control would
not cause an option to be classified as
a liability until the contingency is
probable of occurring.

 Awards indexed to a factor that is not a


service, performance, or market
condition
New Developments Summary 128

Issue Statement 123 Statement 123R

 Awards that would be classified as


liabilities under other applicable GAAP,
with some exceptions

Liability awards: Liability awards were measured at intrinsic Public entities are required to measure
measurement value and remeasured at each reporting liability awards at fair value and remeasure
date. them at fair value each reporting period
until settlement.

Nonpublic entities are required to elect to


measure liability awards at either fair value
(calculated value if they cannot reasonably
estimate their stock price volatility) or
intrinsic value. The method elected must be
applied to all liability awards. Liability
awards have to be remeasured at each
reporting period until settlement.

Option An option valuation model, such as the The Statement 123 requirements for an
valuation Black-Scholes-Merton or a binomial model option valuation technique continue to
techniques (binomial is a type of lattice model), was apply, but Statement 123R provides
required to be used. significant additional guidance concerning
models appropriate for valuation of
employee awards. Entities are required to
use a model that a market participant would
use to measure the option in an exchange
transaction. The model has to be based on
generally applied principles of financial
economic theory and reflect all substantive
characteristics of the instrument not
excluded under the fair-value-based
measurement method. Characteristics
excluded from the determination of fair
value include service and performance
conditions, restrictions (such as
nontransferability) in effect during the
vesting period, reload features, and certain
contingent features (such as clawbacks).
Entities are required to use a model
consistently for similar types of awards, but
may use different models for different types
of awards.
New Developments Summary 129

Issue Statement 123 Statement 123R

Option model The option valuation technique used had to The inputs required by Statement 123 are
inputs take the following into account: the option also required by Statement 123R.
exercise price, the current stock price and Statement 123R, however, provides
its expected volatility, expected dividends considerably more guidance for the
on the stock, the expected term of the estimate of certain inputs. To determine the
option, and the risk-free interest rate. three estimated inputs (term, volatility, and
dividends), entities have to develop a
process that will result in a reasonable and
supportable estimation and use that
process consistently.

The estimate of the expected term has to


take into consideration the effects of
employees’ expected exercise and post-
vesting employment termination behaviors.
(SAB 107 provides a simplified method of
determining the expected term for options
that meet specified conditions. The method
may be used only for “plain vanilla” options.
SAB 110 provides that the simplified
method may be used for option grants on or
after December 31, 2007 only by an entity
whose historical data about employees’
exercise behavior does not provide a
reasonable basis for estimating the
expected term of the options.)

Entities are required to aggregate individual


option awards into homogeneous groups
based on expectations about the
employees’ exercise and post-vesting
termination behaviors. The fair value of the
options are then determined separately for
each homogeneous group.

The estimate of stock price volatility should


consider specified factors, including the
entity’s historical volatility, the length of time
the shares have been publicly traded,
appropriate intervals for price observations,
currently available information indicating
that future volatility will differ from historical
volatility, implied volatility if available, and
corporate and capital structure.
New Developments Summary 130

Issue Statement 123 Statement 123R

Option inputs If the value of an input was determined If the value of an input is determined within
determined within a range (such as an estimate of a range, and no amount within the range is
within a range volatility between 60 percent and 75 a better estimate than other amounts, the
percent), and no amount within the range average of the range (the expected value)
was a better estimate than other amounts, should be used.
the end of the range that produced the
lowest option value should be used.

Accounting for No compensation cost was recognized for No compensation cost is recognized for
forfeited awards awards with service and/or performance awards with service and/or performance
conditions if the conditions were not met conditions if the conditions are not met and
and the awards were forfeited. the awards are forfeited.

Entities could choose to recognize Entities are required to estimate on the


forfeitures as they occurred or estimate grant date the number of awards expected
expected forfeitures on the grant date and to vest and recognize cost only for awards
revise the estimate as necessary. expected to vest. The estimate should be
revised as better information about awards
expected to vest becomes available.

Cost Compensation cost was recognized over Compensation cost is recognized over the
recognition the period the employee was required to requisite service period. New guidance is
period provide service. provided on determining the requisite
service period, particularly for awards that
have performance or market conditions or
multiple conditions required for vesting.

Graded vesting Compensation cost was recognized using Entities make an accounting policy election
the accelerated method in Interpretation28 for their awards with graded vesting that
if the fair value of an award with graded have only a service condition. They can
vesting was determined by treating each elect to use the straight-line attribution
separately vesting tranche as a separate method or the graded-vesting attribution
award. If the award was valued as a single method. The method selected is used for all
award, the straight-line method was used to awards with graded vesting that have only
recognize cost. a service condition.

Employee A broad-based share purchase plan, such Similarly under Statement 123R, a broad-
share purchase as an Internal Revenue Code section 423 based share purchase plan, such as an
plans plan, was compensatory unless Internal Revenue Code section 423 plan, is
compensatory unless
 The purchase price discount was 5
percent or less or no more than (a) a  The (a) purchase price discount is 5
discount that would be reasonable in a percent or less, (b) terms are no more
New Developments Summary 131

Issue Statement 123 Statement 123R

recurring offer to existing shareholders favorable than those available to


or (b) the per-share cost avoided by not existing shareholders of the same class
having to raise significant capital in a of shares, or (c) discount does not
public offering exceed the per-share cost that would
have been incurred to raise significant
 The terms included no option other
capital in a public offering
than (a) a period of 31 days or less to
decide to enroll in the plan after the  The terms include no option other than
purchase price is fixed or (b) the right to (a) a period of 31 days or less to decide
withdraw from the plan if the purchase to enroll in the plan after the purchase
price was the market price on the date price is fixed or (b) the right to withdraw
of purchase from the plan if the purchase price is
the market price on the date of
Virtually all section 423 plans were
purchase
compensatory under those provisions.
Virtually all section 423 plans are
compensatory under those provisions.

Modifications of A modification was accounted for as an A modification under Statement 123R is


awards exchange of the original award for a new accounted for similarly to a modification
award. Additional compensation cost was under Statement 123, except the value of
recognized to the extent that the value of an original option award is determined
the new award exceeded the value of the using its estimated expected term
original award on the modification date. The immediately before the modification. The
value of the original option award on the compensation cost recognized for the
modification date was determined using the award cannot be less than the grant-date
shorter of the remainder of the originally fair value of the award unless the original
estimated expected term or the expected award was not expected to vest on the
term of the new award. modification date. The accounting for a
modification can be complex, especially if
the modification affects the probability of
the award vesting. Appendix A of
Statement 123R provides extensive
guidance on accounting for modified
awards.

Income tax If the tax deduction for an award exceeded On adoption of Statement 123R, available
effects of share- the compensation cost recognized for the Statement 123 excess tax benefits (the
based payment award, the resulting excess tax benefit was available APIC pool) include the net excess
awards credited to APIC. If the tax deduction was tax benefits computed under Statement
less than the compensation cost 123, regardless of whether Statement 123
recognized, the resulting shortfall in the tax was used for recognition purposes or only
benefit (a tax benefit less than the deferred for pro forma disclosure purposes.
tax asset previously recognized) was Alternatively, an entity may elect to
recognized in APIC to the extent of determine the available APIC pool on
previously recognized excess tax benefits adoption of Statement 123R under the
New Developments Summary 132

Issue Statement 123 Statement 123R

accumulated for awards accounted for method provided in FSP FAS 123R-3.
under Statement 123. If the shortfall
The accounting for an excess or shortfall of
exceeds available Statement 123 excess
tax benefits under Statement 123R is
tax benefits, that excess was recognized in
the income statement. similar to that of Statement 123, with one
exception. An entity may not immediately
realize the tax benefit of a tax deduction
related to a share-based payment award—
for example, because the entity has a net
operating loss carryforward. Unlike
Statement 123, Statement 123R explicitly
states that a tax benefit and a credit to
APIC for the excess tax benefit should not
be recognized until the tax deduction
reduces taxes payable.

Statement of Income tax effects of share-based payment The gross amount of realized excess tax
cash flows awards were recognized in operating cash benefits is classified in the statement of
flows. cash flows as a cash inflow from financing
activities and a cash outflow from operating
activities.
New Developments Summary 133

Appendix C
Summary of conditions requiring liability classification

Condition requiring liability Exceptions to liability


Illustrations of condition
classification classification

Shares with repurchase provisions

Mandatorily redeemable shares For all entities, shares are The following shares are not
within the scope of Statement classified as liabilities if they are considered mandatorily
150, paragraphs 9 and 10, are required to be redeemed on a redeemable under Statement 150
classified as liabilities if both the fixed date for a fixed amount or (see special rule for these shares
issuer and the holder are an amount determined by in next section):
unconditionally required to reference to an external index.
 Puttable or callable shares
redeem the shares either This would include
 Shares redeemable on
 On a specified or  A share redeemable in five
years for $50 termination at the option of
determinable date
employee
 On the occurrence of an For SEC filers, all mandatorily
 Shares redeemable on an
event certain to occur redeemable shares within the
event not certain to occur,
scope of Statement 150 are
classified as liabilities. This would such as a share redeemable
on a change of control
include
Liability classification is not
 A share required to be
required for mandatorily
redeemed on an employee’s
termination or death redeemable shares subject to the
deferral of the effective date of
 A share subject to a Statement 150 in FSP FAS 150-3.
shareholders’ rights As a result, for non-SEC filers
agreement requiring share liability classification is not
redemption on the required for the following:
employee’s death
 A share redeemable at fair
value (amount not fixed)

 A share redeemable on the


employee’s termination or
death (not redeemable on a
fixed date)

Note: Public entities are subject to


the temporary equity classification
requirements in ASR 268, EITF
Topic D-98, and SAB 107 for
shares with repurchase features
New Developments Summary 134

Condition requiring liability Exceptions to liability


Illustrations of condition
classification classification

that are not classified as liabilities.

Shares with an embedded put or Shares with the following Liability classification of puttable
call require liability classification if characteristics would be classified or callable shares is not required
any of the following apply: as liabilities: if the employee is required to hold
the vested shares at least six
 Employee can exercise put  Shares that can be sold back
months before exercise of the put
before shares have been (put) to the employer for fair or call and the repurchase price is
vested at least six months. value before they have been not fixed. The following would not
vested for at least six months require liability classification:
 It is probable the employer
would call the shares or  Employer generally exercises  Shares with an embedded put
permit the employee to its right to repurchase (call)
exercisable at fair value
exercise the put before the shares before the shares anytime after shares have
shares have been vested for have been vested for at least been vested for six months.
at least six months. six months.
 Shares that the employer will
 Repurchase price of shares is  Employer allows employees repurchase (call) at fair value
fixed. to redeem shares (exercise after they have been vested
their put right) immediately at least six months.
after the shares are vested.
Shares with an embedded put
 Employee can redeem (put) exercisable before the shares
shares for a fixed price, say have been vested for six months
for $50. are reclassified to equity after the
 It is probable the employer shares have been vested for six
will call the shares for a fixed months.
price, say for $50. If the put or call right embedded
in the share is contingent on an
event outside the employee’s
control, the share is not classified
as a liability until it is probable
that the contingent event will
occur within six months. The
following are examples of shares
with such contingent puts:

 Shares puttable on a change


of control

 Shares puttable on an IPO


New Developments Summary 135

Condition requiring liability Exceptions to liability


Illustrations of condition
classification classification

Options and similar instruments

If either of the following applies, An option is a liability if its An option on a share redeemable
the option would be classified as underlying share would be a on an event that is not certain to
a liability: liability under the mandatorily occur is not classified as a liability
redeemable share provision of until the contingent event is
 The share underlying the Statement 150 (discussed probable of occurring within six
option (that is, the share that months. This includes, for
above). The following would
would be issued on exercise example,
therefore be liabilities:
of the option), if outstanding,
would be classified as a  For all entities: an option on a  An option on a share
liability. share redeemable in five mandatorily redeemable on a
years for $50 change of control
 The entity can be required
under any circumstances to  For SEC filers: an option on a An option that otherwise qualifies
settle the option (or similar share redeemable on the for equity classification is not
instrument) by transferring employee’s termination or subject to liability classification if
cash or other assets, except death the share underlying the option is
as provided by FSP FAS not subject to liability
123R-4 for options with An option on a share with an classification because of the
embedded put or call is a liability deferral in FSP FAS 150-3. As a
contingent cash-settlement
if, following exercise of the option, result, for a non-SEC filer the
provisions (see third column).
 The employee can put the following are not subject to liability
share back to the entity classification:
before the share has been  An option on a share
outstanding for at least six redeemable at fair value
months (amount not fixed)
 It is probable the employer  An option on a share
would call the share or permit mandatorily redeemable on
the employee to exercise the the employee’s termination or
put before the share has death (not redeemable on a
been outstanding for at least fixed date)
six months
Options on puttable or callable
 The employee can redeem shares are not classified as
the share for a fixed price liabilities if the employee is
(say, $50) required to hold the option shares
Options (or similar instruments, at least six months before
such as stock appreciation rights exercise of the embedded put or
(SARs)) that can be net-cash call and the repurchase price is
settled under any circumstances not fixed. This includes, for
(except as provided by FSP FAS example
123R-4, which is described in the  An option on a share that the
third column) are liabilities. This
New Developments Summary 136

Condition requiring liability Exceptions to liability


Illustrations of condition
classification classification

includes employee can redeem at fair


value after the option share
 Options that have cash-
has been outstanding for at
settlement provisions least six months
 SARs that can be net-cash Net-share settlement does not
settled
cause options or SARs to be
 Options that have contingent classified as liabilities.
cash-settlement provisions if
The FASB issued FSP FAS
the contingency is probable of 123R-4, “Classification of Options
occurring
and Similar Instruments Issued as
Employee Compensation That
Allow for Cash Settlement upon
the Occurrence of a Contingent
Event,” which amends Statement
123R. It provides that a cash
settlement feature that can be
exercised only on the occurrence
of a contingent event outside the
employee’s control would not
cause an option to be classified
as a liability until it is probable the
contingent event will occur.
Consequently, an option
otherwise qualifying for equity
classification that can be cash
settled on a change of control
would not require liability
classification until the change of
control was probable of occurring.

Public entities are subject to the


temporary equity classification
requirements in ASR 268, EITF
Topic D-98, and SAB 107 for
options and similar awards with
repurchase features if the
instruments are not classified as
liabilities.
New Developments Summary 137

Condition requiring liability Exceptions to liability


Illustrations of condition
classification classification

All types of share-based payment awards

Share-based payment awards are An instrument settleable in a Options on shares with


classified as liabilities if the variable number of shares for a embedded puts are not classified
awards would be classified as fixed amount known at inception as liabilities if the put
liabilities under Statement 150, is classified as a liability. An
 Cannot be exercised until the
paragraph 11 (as modified by the example is
option share has been
option provisions above) or
 A bonus of $500,000 that outstanding for at least six
paragraph 12.
vests in three years that the months
entity must or may settle by
 Is contingent on an event
issuing a variable number of
outside the control of the
shares
employee, and the contingent
A freestanding put option granted event is not probable of
to an employee is classified as a occurring within six months
liability, regardless of the method
of settlement. It is a liability
regardless of whether it can be

 Physically settled by the


employee tendering shares to
the entity and receiving the
put exercise price

 Net-cash settled for the


intrinsic value of the put

 Net-share settled for the


intrinsic value of the put

Substantive terms of awards may Awards are generally classified


cause liability classification. based on their written terms,
however, if the entity’s past
practice indicates the substantive
terms of the award differ from the
written terms, such as in the
following example:

 An award is a substantive
liability if the entity has a
choice of settling awards in
shares or cash, but
predominately settles them in
cash or settles them in cash
New Developments Summary 138

Condition requiring liability Exceptions to liability


Illustrations of condition
classification classification

when requested to do so by
an employee.

A share-based payment award Awards indexed to prices or An award indexed to a market or


indexed to a factor that is not a external indices, including performance condition is not
market, performance, or service commodity prices, the CPI, or classified as a liability if it
condition is classified as a liability. foreign exchange rates, are otherwise qualifies for equity
classified as liabilities. The classification. The following would
following would be classified as therefore not require liability
liabilities: classification:

 An award that becomes  An option that is exercisable


exercisable if the price of gold only if the entity’s share price
exceeds $450 is above $30 for 20
consecutive trading days (a
 An award with an exercise
market condition)
price that is indexed to
variations in the prime  A restricted share that vests
interest rate only if the entity obtains FDA
approval for Product A (a
 An option with an exercise
performance condition)
price denominated in euros if
the underlying share is traded An option with a fixed exercise
only in dollars (see the third price denominated in a foreign
column for a limited currency is not classified as a
exception) liability if the award otherwise
qualifies for equity classification
and the foreign currency is either
the functional currency of the
foreign operation or the currency
in which the employee is paid.
The following illustrates this
exception:

 Options with an exercise


price denominated in euros
issued to employees of a
foreign subsidiary who are
paid in euros would not
require liability classification if
the options otherwise
qualified for equity
classification.
New Developments Summary 139

Condition requiring liability Exceptions to liability


Illustrations of condition
classification classification

Share-based payment awards are If an award is not classified as a A requirement to issue registered
classified as liabilities if they liability under any explicit shares would not, of itself, cause
would be classified as liabilities provisions in Statement 123R, it liability classification or require
under other GAAP. would be classified as a liability temporary equity classification.
under Statement 123R if it would
Statement 133 and EITF Issue
be classified as such under other
00-19 do not apply to awards
accounting principles for financial
instruments. accounted for under Statement
123R.
New Developments Summary 140

Appendix D
Statement 123R provisions to keep in mind

Statement 123R contains numerous provisions that, if not properly considered and applied, could cause
a preparer to account for share-based awards incorrectly. The list provided below includes some of the
more significant requirements that a preparer should keep in mind when evaluating and accounting for
share-based transactions. However, it is not a substitute for reading and applying the specific guidance
referred to in Statement 123R and other applicable accounting literature.

Scope Statement 123R applies to the issuance of equity instruments in exchange for goods or
services. However,

 Equity instruments held by employee stock ownership plans (ESOPs) are outside the
scope of Statement 123R. They are accounted for under SOP 93-6.

 The measurement date for instruments issued to nonemployees is determined under


EITF Issue 96-18.

 Equity instruments issued in connection with financings are outside the scope of
Statement 123R.

Classification Statement 123R has specific criteria for determining when a share-based payment should
in equity or be classified as a liability (see appendix C).
liabilities
The classification of an award as a liability has a significant accounting impact. Equity
awards are measured on their grant date. Liability awards are subject to variable
accounting (remeasurement each reporting period) until they are settled or expire:

 Public entities remeasure liability awards to fair value each reporting period.

 Nonpublic entities make an accounting policy decision to account for liability awards
using either fair value or intrinsic value. The valuation method chosen is required to
be used consistently to remeasure each reporting period all share-based payment
awards accounted for under Statement 123R that are classified as liabilities.

Fair-value- Statement 123R specifies a fair-value-based measurement method that entities are
based required to follow to estimate the fair value of employee awards. That method specifies
measurement the following requirements, some of which differ from a pure fair value approach:
method
 Fair value is determined based on the substance of an award, regardless of how it is
structured.

 Restrictions on share-based instruments issued to employees affect the estimate of


fair value only if the restrictions remain in effect after the requisite service period.

 Service conditions and performance conditions affecting vesting or exercisability are


ignored in determining the fair value of the awards.
New Developments Summary 141

 A market condition is included in the estimation of an award’s fair value.

 The fair value of employee share-based payment awards excludes reload features
and certain contingent features of awards, such as clawbacks.

Statement 123R makes an exception to the requirement to value options at fair value in
the following two limited circumstances, neither of which is optional:

 Use of calculated value—applicable only to certain nonpublic entities: If it is not


practicable for a nonpublic entity to reasonably estimate the expected volatility of its
share price, the entity is required to use the calculated value method to estimate the
value of its options and similar instruments. A determination that it is not practicable
to reasonably estimate its expected share price volatility implies that the nonpublic
company could not identify one or more similar public entities whose average
volatilities the entity could use as a surrogate for its own share price volatility.

 Use of variable intrinsic value—applicable to all entities, but only in rare


circumstances: If an entity is not able to reasonably estimate an option’s fair value (or
calculated value) on the grant date because of the complexity of the option’s
provisions, the option should initially be accounted for based on its grant-date intrinsic
value, and then be remeasured and reported at current intrinsic value as of each
reporting date until the award is settled or expires. This situation is expected to be
rare.

Statement 123R makes an exception to the requirement to recognize compensation cost


for share-based payment awards if the awards are issued under employee share
purchase plans that meet specified criteria. However, those criteria are considerably
more stringent than the requirements of Internal Revenue Code section 423 for tax-
favored plans. As a result, plans structured to meet the provisions of section 423 will be
compensatory under Statement 123R unless the plans are modified.

Grant date The following five conditions are required to be met to have a grant date for an employee
award:

 Mutual understanding between the employer and the employee. This requires
notifying employees about the terms of their share-based payment awards within the
timeframe described in FSP FAS 123R-2.

 All approvals have been obtained.

 The grantee is an employee under common law.

 The entity is obligated to issue the awards.

 The employee is affected by subsequent changes in the share price. This condition
would not be met, for example, if the exercise price of an option is determined based
on the entity’s stock price at a future date.

Option The valuation technique for a particular share-based payment instrument should be
valuation applied consistently. However, if an entity issues different types of instruments, each
techniques having a unique set of substantive characteristics, it may use a different valuation
New Developments Summary 142

technique for each different type of instrument.

Entities need to establish a process for determining reasonable and supportable


estimates for each assumption used in an option valuation technique and apply those
processes consistently each period. Supportable means the assumption is based on
reasonable arguments that consider the instrument’s substantive characteristics and
other relevant facts and circumstances, such as historical experience. A change in the
method of determining appropriate assumptions used in a valuation technique is a
change in accounting estimate that should be applied prospectively.

Estimating In estimating the period of time the option is expected to be outstanding, entities are
expected required to take into account the effects of employees’ expected exercise and post-
option term vesting termination behavior.

Entities are required to aggregate individual awards into relatively homogeneous groups
in terms of the employees’ expected exercise and post-vesting termination behavior and
determine the expected term and fair value of each group based on expectations about
employee behavior in that group.

If an entity determines its historical employee exercise behavior experience does not
provide a reasonable basis on which to estimate the expected term, the entity should
estimate an instrument’s expected term in another manner, using available relevant and
supportable data, such as expected terms of similar options granted by similar entities,
industry averages, and other pertinent evidence, including published academic research.

The SEC staff has provided a simplified method for computing the expected option term
in SAB 107 that can be used only for options that qualify as plain vanilla options. Both
public and nonpublic entities may use the simplified method, but for options granted on or
after December 31, 2007, the simplified method may be used only by an entity whose
historical data about employees’ exercise behavior does not provide a reasonable basis
for estimating the expected term of new option grants.

Estimating In determining the historical volatility of its share price, an entity should use a historical
expected period equal to the contractual term of the option if using a lattice model, or a period
volatility equal to the expected term if using a closed-form model. The SEC staff observed,
however, that a longer period may be used if a registrant reasonably believes the
additional historical information improves the estimate.

In their calculation of historical volatility, entities should use appropriate and regular
intervals for price observations:

 Publicly traded entities: Daily, weekly, or monthly price observations provide a


sufficient basis to estimate expected volatility if a registrant’s trading history provides
enough data points for estimation. If the expected or contractual term, as appropriate,
is less than three years, daily or weekly price observations should be used. If the
expected or contractual term, as appropriate, is less than two years, an entity should
use daily or weekly prices for at least the length of the applicable term.

 Thinly traded entities: The use of weekly or monthly price observations would
generally be more appropriate than daily price observations because the use of daily
New Developments Summary 143

observations could cause volatility to be artificially inflated.

The following guidance should be considered by entities whose shares have not been
publicly trading for a period at least as long as the expected term (or contractual term if a
lattice model is used) of the options being valued:

 Public entities should use share prices for the longest period for which their shares
have been publicly traded. A minimum of two years of daily or weekly historical data
may provide a reasonable basis on which to base an estimate of expected volatility if
a company has no reason to believe that its future volatility will differ materially during
the expected or contractual term, as applicable, from the volatility calculated from this
past information.

 A newly public entity that does not have entity-specific historical or implied volatility
information available should base its estimate of expected volatility on the historical,
expected, or implied volatility of similar entities whose share or option prices are
publicly available. Until the registrant has sufficient entity-specific information
available, the SEC staff would not object to the registrant continuing to base its
estimate on the volatility of similar entities.

 Nonpublic entities might estimate their expected volatility based on an average of the
volatilities of similar public entities for an appropriate period after they went public, as
discussed in the preceding bullet.

An entity may use an industry sector index that is representative of its industry to identify
one or more similar entities. However, because the volatility of an industry sector index is
affected by the inherent diversification in the index, an entity (other than a nonpublic
entity required to use the calculated value method) should never substitute the volatility of
an index for the expected volatility of its share price as an assumption in its valuation
model.

In modifying historical volatility based on currently available information that indicates


future volatility may differ from historical volatility, an entity should

 Consider future events that marketplace participants would consider in estimating


future volatility, such as a recently announced merger

 Give little weight to historical information if the entity’s operations have changed
significantly in ways that are expected to impact the volatility of the share price—for
example, in a situation where riskier business segments have been added or
disposed of

 Disregard an identifiable period of time during which the share price was unusually
volatile due to a situation that is not expected to recur during the option’s expected or
contractual term. The SEC staff stated in SAB 107 that a registrant should be able to
support its conclusion that a previous period is irrelevant with one or more discrete
historical events that are not expected to recur during the option’s expected term. The
staff expects that such situations will be rare.

Option inputs There may be a range of reasonable estimates for expected volatility, dividends, and/or
determined the option’s expected term. If no amount within the range is more or less likely than the
within a other amounts, the assumption used should be an average of the amounts in the range
New Developments Summary 144

range (the expected value). This is a significant change from the requirement in Statement 123
and, to the extent it affects the assumption of volatility or expected term, it could have a
significant effect on the value of an entity’s options.

Cost Cost is recognized over the requisite service period, which is generally the service period
recognition unless the award has a performance or market condition.
period
The service inception date, which is the date the requisite service period begins (and cost
begins to be recognized, except in some cases when there is a performance condition), is
usually the grant date. The service inception date cannot precede the grant date unless
all of the following are applicable:

 The award is authorized.

 Service begins before a mutual understanding of the key terms and conditions of the
award is reached.

 Either the award does not include a substantive future service period as of the grant
date or the award has a performance or market condition that has to be satisfied
during a service period preceding the grant date and following the inception of the
arrangement. If the performance or market condition is not met during that period, the
award will be forfeited.

Cost Awards with an explicit service condition may have other provisions that indicate that the
recognition: explicit service condition is nonsubstantive. Some entities, for example, have provisions
retirement- in their awards that they will continue to vest if the employee retires or that vesting
eligible accelerates when the employee becomes retirement eligible. For such awards, the
awards requisite service period excludes any period for which the employee is retirement eligible.
The period over which compensation cost is recognized is from the grant date until the
employee reaches retirement age. If the employee has reached retirement age at the
grant date, the entire fair value of the award should be recognized as compensation cost
on the grant date.

Cost The recognition of compensation cost will not always result in an immediate income
recognition: statement charge. If the employee’s services are part of the cost to construct, develop, or
capitalization acquire another asset, the recognized cost of the share-based payment award is initially
capitalized as part of that asset and recognized in the income statement as the asset is
consumed or disposed of.

Cost Grant-date fair value of employee equity awards is recognized over the requisite service
recognition: period, but only for awards expected to vest. An entity therefore has to estimate on the
awards grant date the number of awards that are expected to vest and begin recognizing cost for
expected to only those awards. The initial estimate needs to be revised if subsequently available
vest information indicates the actual number expected to vest differs from the previous
estimate.
New Developments Summary 145

Cost An entity has to make an accounting policy decision about how to recognize
recognition: compensation cost for awards with only service conditions that have a graded vesting
graded schedule. Entities issuing such awards have to select one of the following two methods
vesting for recognizing compensation cost and apply the method consistently to all such awards:

 Straight-line attribution method: Total compensation cost for the award is recognized
on a straight-line basis over the requisite service period for the entire award.

 Graded-vesting attribution method: Compensation cost is recognized on a straight-


line basis over the requisite service period for each separately vesting portion as if
the grant consisted of multiple awards, each with the same service inception date but
different requisite service periods.

Cost For awards with a performance condition that affects vesting or the exercisability of
recognition: options, cost is recognized only if the performance condition is probable of being
performance satisfied. If satisfaction of the performance condition is not probable, compensation for
condition the award is not recognized unless the performance condition subsequently becomes
probable of occurrence. Performance awards can therefore cause volatility in earnings.

Cost Compensation cost is recognized for an award with a market condition, provided the
recognition: requisite service period is satisfied, regardless of when, if ever, the market condition is
market satisfied.
condition

Income tax If the deduction ultimately reported on the entity’s tax return exceeds compensation cost
effects of recognized for financial reporting, the resulting tax benefit that exceeds the deferred tax
share-based asset for the award (the excess tax benefit) is recognized
payment
 In additional paid-in capital (APIC), but not before the tax benefit can actually be
awards
realized by the entity

 In the income statement (but not before the tax benefit is realizable) if the excess tax
benefit results from something other than an increase in the value of the entity’s
shares

If the deduction for tax purposes is less than compensation cost recognized for financial
reporting purposes, the write-off of the deferred tax asset, net of any related valuation
allowance, is

 Charged to APIC to the extent of the APIC pool

 Recognized in the income statement to the extent the write-off exceeds the amount
available in the APIC pool

The APIC pool is the cumulative amount of excess tax benefits from previous awards
accounted for under Statement 123R and Statement 123 (regardless of whether
Statement 123 was used for recognition or only for disclosure purposes). FSP FAS 123R-
3 provides an alternative elective method for determining the APIC pool on adoption of
Statement 123R.
New Developments Summary 146

The pool excludes excess tax benefits

 That have not yet reduced taxes payable and are therefore not yet realizable

 That result from share-based payment arrangements outside the scope of Statement
123R, such as employee stock ownership plans

Statement of Cash retained as a result of excess tax benefits resulting from employee and
cash flows nonemployee share-based payment awards should be classified as financing cash
inflows, with a corresponding reduction of operating cash flows.

In contrast, if the deduction for tax purposes is less than compensation cost recognized
for financial reporting purposes, the write-off of the deferred tax asset is classified in
operating cash flows.

Disclosures Statement 123R expands disclosure requirements for share-based payment awards.
Appendix E
SEC executive compensation disclosure rules

Contents
A. Overview of Item 402 .......................................................................................................................... 148
Disclosures ......................................................................................................................................... 148
Enhanced option disclosures ....................................................................................................... 149
Applicability of Item 402 in spin-offs, mergers, and IPOs ................................................................... 149
Spin-offs ....................................................................................................................................... 149
Mergers ........................................................................................................................................ 149
Initial public offering ..................................................................................................................... 150
Named executive officers ................................................................................................................... 150
Presentation guidance from SEC staff ............................................................................................... 151
Compliance ......................................................................................................................................... 152
B. Compensation Discussion and Analysis ............................................................................................ 152
Disclosures about options and other forms of equity compensation .................................................. 153
Timing of equity compensation awards ........................................................................................ 154
Exercise prices ............................................................................................................................. 154
Compensation restrictions on entities receiving government financial assistance ............................ 154
Compliance guidelines ....................................................................................................................... 155
How and why compensation decisions are made ........................................................................ 155
Performance targets ..................................................................................................................... 156
Benchmarking .............................................................................................................................. 157
Other SEC staff comments on reviews of companies’ CD&A disclosures .................................. 157
Filed status of CD&A .......................................................................................................................... 158
C. Summary Compensation Table and related disclosure...................................................................... 158
Summary Compensation Table .......................................................................................................... 158
Guidelines for specific situations .................................................................................................. 158
Salary and bonus columns ........................................................................................................... 160
Plan-based awards ...................................................................................................................... 161
Change in pension value and nonqualified deferred compensation earnings ............................. 164
All other compensation................................................................................................................. 165
Supplemental Grants of Plan-Based Awards Table ........................................................................... 167
Narrative disclosure of Summary Compensation Table and Grants of Plan-Based Awards Table ... 170
D. Tables on previously awarded equity instruments ............................................................................. 170
E. Post-employment compensation ........................................................................................................ 174
Potential payments on termination or change in control .................................................................... 177
F. Compensation of directors .................................................................................................................. 179
Narrative disclosure ............................................................................................................................ 182
G. Compensation Committee Report ...................................................................................................... 182
H. Form 8-K disclosure requirements ..................................................................................................... 182
I. Modifications for smaller reporting companies ................................................................................... 183
Summary Compensation Table .......................................................................................................... 183
Narrative disclosure of the Summary Compensation Table ........................................................ 183
Outstanding Equity Awards at Fiscal Year-End Table ....................................................................... 184
Director Compensation Table ............................................................................................................. 184
J. Effective date and transition ............................................................................................................... 185
K. Compensation restrictions on recipients of government financial assistance under TARP ............... 185
Restrictions on executive compensation ............................................................................................ 185
New Developments Summary 148

Other executive compensation provisions of EESA and ARRA ......................................................... 187


Chief executive officer certification .............................................................................................. 187
Compensation Committee certification ........................................................................................ 187
Nonbinding shareholder vote on executive compensation (say on pay) ..................................... 187
Limitation on luxury expenditures ................................................................................................ 188

A. Overview of Item 402


This summary details the executive and director compensation disclosure requirements contained in
Regulation S-K Items 402 and 407(e)(5), as revised in August and December 2006. The August 2006
final rule and the December 2006 interim final rules are available on the SEC website.

In 2007 and again in July 2008, the SEC staff issued Compliance and Disclosure Interpretations in
question and answer format on the executive compensation disclosure rules (sections 117 through 128
under the heading “Regulation S-K,”). The SEC staff has also provided Interpretive Responses to specific
circumstances. The provisions of Item 402 include requirements about the type of compensation to
include in each column of each required tabular disclosure. The staff interpretations clarify those
requirements and provide guidance for situations not specifically addressed in Item 402. In October 2007
the SEC staff issued its observations on its review of a cross section of registrants’ executive
compensation disclosures under the revised rules. In an October 2008 speech, the then-Director of the
Division of Corporation Finance, John White, provided a summary of the staff’s findings on review of
companies’ 2008 executive compensation disclosures. The staff’s interpretive guidance and observations
on companies’ disclosures are summarized in this document.

Sections A through H of this summary apply to public companies other than smaller reporting companies.
Section I describes modifications to the information in sections A through H that pertain to smaller
reporting companies.

Disclosures
The executive compensation disclosures consist of

• Compensation Discussion and Analysis (CD&A), which is a required comprehensive overview of a


company’s executive compensation policies and related components. It addresses such issues as the
objectives of the company’s executive compensation programs, what performance-based
compensation is designed to reward, the elements of compensation and why the company chooses
to pay each element, and how the company determines the amount for each element. Companies
must file CD&A with the SEC, making it part of the disclosure subject to certification by a company’s
principal executive officer and principal financial officer.

• Executive compensation tables and related narrative covering three broad categories:

− A Summary Compensation Table, which is the principal disclosure vehicle, showing


compensation for each of the named executive officers in the last three complete fiscal years.
The Summary Compensation Table is supplemented by a Grants of Plan-Based Awards Table
and narrative disclosure.

− Equity-based interests

− Retirement and other post-employment compensation, including amounts payable on termination


or a change in control

• Director Compensation Table


New Developments Summary 149

• Compensation Committee Report, which states whether the compensation committee has discussed
CD&A with management and recommended to the board of directors that it include CD&A in the
annual report on Form 10-K

Companies are required to present the required disclosures using the SEC’s plain English style, which
requires disclosures to be written in a clear, concise, and understandable manner. The SEC’s A Plain
English Handbook is available on the SEC website.

All tables should include in their title the fiscal year to which they relate.

A table or a column may be omitted if no such compensation has been earned, awarded, or paid to a
named executive officer or director in any fiscal year covered by the table.

Enhanced option disclosures


Item 402 requires disclosures of equity awards, with particular emphasis on plans, programs, or practices
involving

• Timing equity award grants to coordinate with the release of material nonpublic information

• Option backdating or other practices affecting selection of an exercise price lower than the company’s
stock price on the grant date

Disclosures about such practices are required in CD&A and in the Grants of Plan-Based Awards Table,
which requires additional columns to disclose (1) the award approval date if earlier than the award’s grant
date and (2) the grant-date closing market price of the company’s stock if higher than the award’s
exercise price.

Applicability of Item 402 in spin-offs, mergers, and IPOs


The SEC staff has addressed the applicability of Item 402 disclosures for historical compensation on the
occurrence of certain equity restructurings and business combinations (Staff Interpretive Responses 1.01,
1.02, and 1.03).

Spin-offs
Whether a newly spun-off registrant should provide Item 402 disclosures for compensation paid before
the spin-off requires evaluating the continuity of management and determining if, before the spin-off, the
spun-off entity was a reporting entity or a separate division. Item 402 disclosures for historical
compensation would likely

• Be required if both of the following apply:

− A parent company spins off a subsidiary that made up one line of the parent’s operations

− The spinee’s executive officers before and after the spin-off remain the same, provide the same
services to the spinee, and provide no services to the parent

• Not be required if the spinee has new management and is a subsidiary newly formed from portions of
several parts of the parent’s operations

Mergers
The fact that there is not a concept of successor compensation in a merger has the following implications
for application of Item 402:
New Developments Summary 150

• The surviving company is not required to include in its Item 402 disclosures compensation paid by
predecessor corporations that disappeared in the merger. Similarly, a parent company would not
include compensation paid to an employee of a subsidiary before the acquired entity became a
subsidiary.

• Income paid by predecessor companies is not considered in determining whether an individual is a


named executive officer.

The staff observed that those conclusions may differ if the business combination involves an
amalgamation or combination of companies.

In a combination of an operating company and a shell company, as defined in Securities Act Rule 405,
the disclosure document soliciting shell company shareholder approval of the combination should include
the following information (Staff Interpretive Response 1.12):

• Item 402 disclosure for the shell company before the combination

• The Item 402 disclosure regarding the operating company that would be required if it were filing a
registration statement, including CD&A disclosure

• Item 402 disclosure regarding each person who will serve as a director or an executive officer of the
surviving company, as required by Item 18(a)(7)(ii) or 19(a)(7)(ii) of Form S-4, including CD&A
disclosure that may emphasize new plans or policies

Initial public offering


In contrast to the spin-off situation, when a subsidiary of a public company goes public, the subsidiary’s
registration statement would not include Item 402 disclosures for historical compensation cost paid by the
parent company if the officers of the subsidiary were officers of the parent and, in some cases, had
worked exclusively for the subsidiary. Reporting for the subsidiary would begin as of the initial public
offering (IPO) date.

Named executive officers


The required executive compensation disclosures apply only to the named executive officers, who are the
principal executive officer (PEO), the principal financial officer (PFO), and the three most highly
compensated executive officers other than the PEO and PFO:

• The PEO and the PFO are named executive officers regardless of compensation level. If more than
one individual served in the capacity of PEO or of PFO during the last completed fiscal year, each
individual serving in either of those capacities is a named executive officer whose compensation
information for the full fiscal year must be provided.

• The three most highly compensated executive officers are determined based on their total
compensation (the amount reportable in column (j) of the Summary Compensation Table, which is
discussed below in section C) reduced by the sum of the increase in pension values and nonqualified
deferred compensation above-market or preferential earnings (the amount reportable in column (h) of
the Summary Compensation Table). However, disclosure is not required if that amount is not greater
than $100,000. If compensation previously expensed under FASB Statement 123 (revised 2004)
(123R), Share-Based Payment, is reversed in the last completed fiscal year, the negative amounts
should be included in determining which executives are among the company’s named executive
officers for that year, but only if the previously expensed amount would have been included in the
Summary Compensation Table after the 2006 executive compensation disclosures became effective
if the executive had been a named executive officer for the earlier year (regardless of whether the
New Developments Summary 151

executive officer was a named executive officer in the year the award was expensed) (Staff Q&A
119.12, July 3, 2008).

If an executive officer ceases to be an executive officer before the end of the fiscal year but continues to
provide services as an employee, the individual’s compensation for the entire fiscal year should be
considered in determining whether the individual is a named executive officer for that fiscal year (Staff
Interpretive Response 1.09). Up to two additional individuals must be included in the disclosures if they
would have been among the named executive officers except they were no longer executive officers at
the end of the last fiscal year. Their compensation for the entire fiscal year is required to be disclosed.

The disclosure provisions apply to all plan and nonplan compensation awarded to, earned by, or paid to
the named executive officers by any person for services the named executive provided to the company
and its subsidiaries in any capacity, unless such compensation is specifically excluded under Item 402.
Thus, reportable compensation includes transactions between the company and a third party if a purpose
of the transaction is to provide compensation to a named executive officer.

If a company changes its year-end, say from December 31 to June 30, the SEC staff has provided
guidance on how the $100,000 threshold for qualifying as one of the three most highly compensated
executive officers should be evaluated for the short period—for example, from January 1 to June 30—in
the year of the change (Staff Interpretive Response 1.04):

• No disclosure is required for an executive officer whose employment began during the short period if
the individual’s total compensation during that period did not exceed $100,000.

• The earnings taken into consideration for an executive officer who was employed before and during
the short period are the executive officer’s earnings for the one-year period ending on the last day of
the short period. For a company changing its year-end from December 31 to June 30, the one-year
period would be from July 1 of the preceding fiscal year to June 30 of the year of change.

Presentation guidance from SEC staff


In October 2007 the SEC staff released a summary of observations from its initial review of the executive
compensation disclosures under the new rules. A primary theme of the staff’s observations is that
companies should prepare their compensation disclosure and analysis so that investors receive clear
explanations of “how and why” the boards and management made certain compensation decisions. They
should present their disclosures in a direct, specific, clear, and understandable manner. The SEC staff
emphasized that companies should use plain English in their disclosures and a short, crisp writing style.
They should improve the organization of tabular and graphic information to assist readers in
comprehending the volume of required disclosures. The staff required a significant percentage of the
companies reviewed to present some items more prominently and to de-emphasize less important
information in their disclosures. The following are examples of changes the staff asked companies to
make to improve disclosures:

• Place required compensation tables after the Compensation Discussion and Analysis (CD&A)

• If a company includes alternative summary compensation tables, it should also

− De-emphasize the alternative table to ensure that it is not presented more prominently than the
required table

− Change the title of the alternative table if the title could cause a reader to assume that table was
part of the required compensation tables

− Explain the differences between compensation amounts presented in alternative tables and in the
required tables
New Developments Summary 152

• Replace boilerplate discussions of individual performance with more specific analysis

• Replace disclosures that repeat information in the required compensation table with clear and concise
analysis of that information

• Replace language that appears identical to language in a compensation plan or employment


agreement with clear, understandable information

The staff noted that the inclusion of charts, tables, and graphs not specifically required was almost always
helpful to understanding the disclosures. About two-thirds of the companies reviewed in 2007 included
such exhibits.

Compliance
Application of the required disclosures is a legal matter that companies should discuss with their legal
counsel.

Companies need to define and analyze the principles underpinning their executive and director
compensation programs. They then need to consider how each compensation component relates to their
overarching compensation principles, how the elements are decided on, and the corporate objectives
they serve.

This process will require companies to identify all their compensation components, where they belong in
the tabular disclosure structure, and how the numeric information will be obtained. For some elements,
such as perquisites and other personal benefits, calculating the amount to be disclosed may require
compiling information specifically to satisfy disclosure obligations.

B. Compensation Discussion and Analysis


The compensation disclosures require companies to provide a narrative overview to give investors
material information needed to understand the company’s compensation policies and decisions for its
named executive officers. This section, Compensation Discussion and Analysis (CD&A), is similar in
concept to the overview that companies are required to provide in their Management’s Discussion and
Analysis (MD&A).

CD&A should focus on principles underlying the company’s compensation policies for its named
executive officers, including both the separate elements of executive compensation and executive
compensation as a whole. It should provide context for the tabular information and disclosures that follow.
The content is required to be principles-based, reflect the company’s specific situation, and avoid
boilerplate.

A company’s CD&A should answer the following questions:

• What are the objectives of the company’s compensation programs?

• What is the compensation program designed to reward?

• What is each element of compensation?

• Why does the company choose to pay each element?

• How does the company determine the amount (and, if applicable, the formula) for each element?

• How does each element, including ongoing decisions pertaining to that element, relate to the
company’s overall compensation objectives and affect decisions regarding other elements?
New Developments Summary 153

Examples are provided of information that, if applicable, is appropriate to address in CD&A. Because
disclosure is required only if an issue is material, a company must assess the materiality of an issue to
investors based on its particular situation. The scope of CD&A is intended to be comprehensive, requiring
a company to address compensation policies it applies regardless of whether they are included in the
following illustrative examples contained in Item 402:

• Policies for allocating between long-term and currently paid compensation

• The basis for allocating among different forms of long-term compensation, for example, based on
consideration of long-term company goals, exposure to downside equity risk, or the cost/benefit
relationship

• Policies for allocating between cash and noncash compensation and among different forms of
noncash compensation

• How the company determines when awards, including options, are granted

• What specific items of corporate performance the entity considers in establishing compensation
policies and making compensation decisions

• How specific elements of compensation are structured and implemented to reflect the items of
corporate performance discussed under the preceding bullet and the executive’s individual
performance. CD&A should state whether there is discretion to waive or modify performance goals, if
that discretion is exercised, and instances of discretion being exercised and whether those situations
applied to one or more named executives or to all compensation subject to the performance goal.

• Policies and decisions about the adjustment or recovery of awards or payments if the related
performance measures are restated or otherwise adjusted in a way that would reduce the award or
payment

• Factors considered in decisions to increase or decrease compensation materially

• How the company considers compensation or amounts realizable from prior compensation in setting
other elements of compensation (for example, how are gains from prior option awards considered in
setting retirement benefits)

• The basis for selecting particular events to trigger payment of post-termination agreements, such as a
single trigger on a change in control

• The effect of any accounting and tax treatments of a particular form of compensation as it relates to
the company or to the named executive officers that is material to the company’s compensation policy
or decisions. This includes but is not limited to the company’s Internal Revenue Code Section 162(m)
policy.

• The company’s equity or other security ownership requirements or guidelines and any policies on
hedging the related risk

• Whether the company benchmarked total compensation or any material element of compensation,
identifying the benchmark and, if applicable, its components, including component companies

• The role of executive officers in the compensation process

Disclosures about options and other forms of equity compensation


The SEC states in its explanation of CD&A included in the Final Rule Release that companies are
required to address information about executives’ equity compensation, including existing or planned
New Developments Summary 154

practices of timing or backdating awards. In the SEC’s view, the selection of a grant date timed to
coordinate with the release of material nonpublic company information and the use of an option exercise
price lower than the grant date stock price are material compensation practices requiring full disclosure in
CD&A, as well as specific line item disclosure in the Grants of Plan-Based Awards Table (Staff Q&A
118.01).

Timing of equity compensation awards


How a company determines grant dates of equity awards, such as options and restricted stock, and the
reasons the company selects particular dates may be material market information requiring disclosure. If
a company has a program, plan, or practice of granting executives equity awards in coordination with
announcements of material nonpublic information, that information is material to investors and should be
fully disclosed. Disclosure is also required if the company has adopted such a program or has made any
decisions since the beginning of the past fiscal year to time grants of equity awards, including options.
The company might also need to disclose how such information is used when deciding whether and in
what amounts to make grants. A company should consider the following questions, among others, when
drafting its disclosure on the timing of awards:

• Does the company have any program, plan, or practice to time executive equity compensation
awards in coordination with announcements of material nonpublic information?

• How does such a practice relate to the company’s general practice of granting employee equity
compensation awards?

• What was the role of the board or compensation committee in a timing program and how did they use
the information to make decisions about whether to make grants and the size of the grants?

• Did the compensation committee delegate any part of the administration of the program or practice to
others?

• What role did the executive officers have in the practice of timing equity awards?

• Is the timing of grants to new executives coordinated with the release of material nonpublic
information?

• Does the company plan to time or has it timed its release of material nonpublic information to affect
the value of executive compensation?

Exercise prices
An option exercise price is a material term of a stock option grant, and practices related to its selection
may require disclosure in CD&A.

A practice of setting exercise prices based on the company’s stock price on a date other than the option’s
actual grant date requires disclosure in CD&A. The disclosure should include all relevant material
information based on the company’s facts and circumstances.

A company should also disclose a plan provision or practice of determining exercise prices based on a
formula that uses, for example, average prices or the lowest price in a period before, after, or surrounding
the award’s grant date.

Compensation restrictions on entities receiving government financial assistance


Entities receiving government financial assistance under the Troubled Asset Relief Program are subject
to the executive compensation provisions of the Emergency Economic Stabilization Act of 2008 and the
subsequent amendments to those provisions included in the American Recovery and Reinvestment Act of
New Developments Summary 155

2009 (see section K). The provisions impose restrictions on the executive compensation of named
executive officers. Participating entities should evaluate the impact the restrictions have on their CD&A,
narrative disclosures, tables, and footnotes to tables.

Compliance guidelines
CD&A applies to the last fiscal year, but may also require discussion of post-termination compensation
arrangements, ongoing compensation arrangements, policies that apply prospectively, and actions taken
after that fiscal year-end, such as the adoption or implementation of new or modified programs and
policies or decisions that could affect the understanding of the compensation for the last fiscal year. The
company may need to disclose information about option grant programs, plans, or practices of prior years
to provide context to the disclosure (Staff Q&A 118.02).

The company should make its disclosures sufficiently precise to enable investors to identify material
differences in compensation among named executive officers, if any. For example, if the policies or
decisions for the principal executive officer (PEO) are materially different from other named officers, the
PEO’s compensation should be discussed separately.

New public companies are not permitted to present a prospective CD&A, but they may emphasize new
plans or policies.

How and why compensation decisions are made


After completing its 2007 initial review of the executive compensation disclosures of a cross section of
issuers, the staff published its observations, many of which focused on the content of companies’ CD&A
disclosures. In general, the staff expects a company’s CD&A to focus on how and why its board and
management made certain executive compensation decisions. The staff found that, although companies
often discussed compensation philosophies and decision mechanics in great detail, many omitted a
substantive discussion of their compensation decisions by failing to disclose how they analyzed certain
information or why their analyses resulted in the compensation paid. In an October 2008 speech, John
White noted that in 2008 the staff continued to observe that the disclosure of many companies lacked “the
how and the why” when explaining the connection between their compensation philosophy and the
amounts included in the tables. He indicated that the staff commented repeatedly that CD&A disclosure
should be an analytic discussion of the following information:

• The material elements of compensation

• How the company decided on the levels of compensation

• Why a company believes its compensation practices and decisions represent its compensation
philosophy and objectives

Mr. White explained that the CD&A should inform investors about the material factors underlying the
compensation decisions that resulted in the amounts in the compensation tables. To emphasize that goal,
the staff encourages companies to explain the following in their CD&A:

• Each factor considered when deciding on each element of an executive officer’s compensation
package

• Why the company believes the amounts paid are appropriate based on the factors it considered in
making specific compensation decisions

• Why or how determinations about one element affected other compensation decisions
New Developments Summary 156

Mr. White provided the following examples to illustrate application of these steps. If company
performance affected compensation decisions, the company should describe the extent to which
minimum, target, or maximum levels of performance goals were achieved and how achievement of
various objectives resulted in specific compensation amounts. If discretion affected the amounts actually
paid, a company should provide qualitative disclosure of the reasons discretion was used and how it
affected amounts paid.

Performance targets
In its reviews of 2007 filings, the staff requested many companies to explain in their CD&A how qualitative
inputs translate to objective pay determinations. Such inputs include performance targets, which
generated more staff comments than any other disclosure topic. If performance targets are material to the
decision-making processes, the SEC staff asked companies to either disclose them or demonstrate that
such disclosure could cause competitive harm. In addition, the staff asked companies to disclose

• How non-GAAP financial measures are calculated from audited financial statement amounts if non-
GAAP measures are identified as performance targets

• Both prior-year and current-year targets if these targets are material to understanding compensation

The staff provided further guidance on disclosure of performance targets in staff Q&A 118.04 (July 3,
2008), observing that a company is not required to disclose performance targets unless they are material
to its executive compensation policies or decisions. A company should determine the materiality of its
performance targets based on a good faith analysis of the facts and circumstances of the company and
its compensation policies. The staff also clarified that companies are not required to provide quantitative
performance targets for performance targets that are inherently qualitative (subjective), such as targets
related to effective leadership. However, in his speech in October 2008, John White indicated that when
disclosures of quantitative performance targets are not required for material qualitative performance
targets, the disclosure should explain how qualitative inputs are translated into objective pay
determinations.

If performance targets are material, a company is required to disclose targets of specific quantitative or
qualitative performance-related factors (or other factors or criteria) unless they involve confidential trade
secrets or commercial or financial information and disclosure would result in competitive harm. The
standard to apply to determine whether disclosure is not required is the same standard the company
would use for confidential treatment requests for trade secrets or commercial or financial information in
SEC filings under Securities Act Rule 406 or Exchange Act Rule 24b-2. However, under Item 402, a
company is not required to submit a confidential treatment request.

The staff indicated in Q&A 118.04 that, to conclude that disclosure would result in competitive harm, a
company must perform a competitive harm analysis to determine whether, in its industry and competitive
environment, a competitor or contractual counterparty could use the targets to obtain information about
the company’s business or strategy that could be used to the company’s detriment. Thus, a company
must have a reasoned basis for concluding, based on the specific facts and circumstances of the
company and its competitive environment, that the disclosure of the targets would cause it competitive
harm, using established standards for what constitutes confidential commercial or financial information
that would cause competitive harm on disclosure. These standards have been established largely through
case law. However, a company could not avoid disclosing a performance target if it had previously
disclosed it publicly.

At the 2007 AICPA National Conference on Current SEC and PCAOB Developments, the SEC staff
encouraged registrants, when responding to staff comments concerning omitted information, not to just
state that disclosing certain targets or data would cause competitive harm, but to clearly demonstrate to
New Developments Summary 157

the SEC staff why this is true. If the confidential treatment standard is not met, companies should be
prepared to disclose the information.

If performance targets or other factors are not disclosed, the company must describe how difficult their
achievement will be for the executive or the likelihood of achievement by the company. In his October
2008 speech, Mr. White stated that this disclosure should be as detailed as possible to clearly address
the criteria for determining the undisclosed target levels and it must establish the connection between
achievement of the performance objective and the characteristics of the incentive payment received if the
goal is satisfied. For example, if a company has a pay-for-performance philosophy, the disclosure should
describe why the performance goals or metrics were sufficiently challenging and how achievement of the
objectives rewarded performance. This might involve a description of how the company determined the
incentive amounts based on a historical review of the predictability of achievement of the performance
objectives. The disclosure should provide investors with an understanding of the difficulty or ease of
satisfying the undisclosed target levels.

Benchmarking
The SEC staff clarified In Q&A 118.05 (July 3, 2008) that benchmarking refers to the use of compensation
data about other companies as a basis, wholly or in part, to establish, justify, or provide a framework for a
compensation decision. Using a broad-based, third-party survey to obtain a general understanding of
current compensation practices would not be considered benchmarking for disclosure purposes.

If benchmarking to other companies is deemed material to compensation policies and decisions, the staff
indicated in its observations of 2007 Item 402 disclosures that companies should provide a detailed
explanation of how benchmarking information is used and how the comparison affects compensation
decisions. Also, the staff asked companies to

• Explain the nature and extent of any discretion used if benchmarking was used but the company
retained discretion to benchmark to a different point

• Identify comparable companies

• Specify where compensation falls within the range if a vague or broad range of data exists among
comparable companies

In his October 2008 speech, John White noted that benchmarking disclosure should include the basis for
selecting the peer group and the relationship between compensation paid and the data used in the
benchmarking study. For many companies, remaining competitive with a peer group of companies is an
essential element of their compensation policy, which makes a description of benchmarking an essential
aspect of their disclosure.

Other SEC staff comments on reviews of companies’ CD&A disclosures


In addition to its comments on performance targets, benchmarking, and the “how and why” of
compensation decisions, the SEC staff, in its reviews of 2007 executive compensation disclosures, asked
companies to disclose the following:

• The reasons for structuring certain material terms and payment provisions in change-in-control and
termination agreements

• How potential payments and benefits under change-in-control and termination agreements may have
influenced decisions regarding other compensation elements

• Who makes compensation decisions


New Developments Summary 158

• A material role that compensation consultants play in the company’s compensation decision-making
practices

Filed status of CD&A


CD&A is considered a part of the proxy statement and any other filing in which it is included and is
therefore “filed” with the Commission. In addition, to the extent CD&A is included or incorporated by
reference into a periodic report, it is covered by the certifications required of the principal executive officer
and principal financial officer under the Sarbanes-Oxley Act.

A company’s disclosure controls and procedures apply to CD&A.

C. Summary Compensation Table and related disclosure


The Summary Compensation Table requires tabular presentation of the components of compensation
separately for each of the named executives for each of the company’s last three fiscal years. It is
supplemented by a table disclosing additional information about grants of plan-based awards in the last
fiscal year. Those two tables are followed by narrative disclosure of material information needed to
understand the tabular information.

A company is not required to provide information for fiscal years preceding its most recently completed
fiscal year if it was not an SEC registrant during those preceding years, unless it was required to provide
that information previously by another SEC rule.

Summary Compensation Table


The Summary Compensation Table presents tabular information about all elements of each executive’s
compensation. The last column consists of total compensation, which is a total of all the preceding
elements of compensation.

Companies must report the compensation value specified for each tabular grid as a single rounded dollar
amount. If paid in another currency, a footnote to the table must indicate the currency and describe the
conversion rate and methodology used.

Guidelines for specific situations


Specific guidance is provided for the following situations:

• Named executive is also a director: If a named executive is also a director, compensation received for
services as a director, if any, should be included in the Summary Compensation Table (and other
tabular information), along with a footnote that itemizes the type of compensation and amounts using
categories in the Director Compensation Table (see section F). Director compensation for that named
executive is not included in the Director Compensation Table.

• Executive officer becomes or ceases to be a named executive officer: Compensation of incoming and
departing named executives should not be annualized (Staff Interpretive Response 1.06). If a named
executive officer ceases to be an executive officer before the end of the fiscal year but continues to
provide services as an employee, the Item 402 disclosures should include the individual’s
compensation for the entire fiscal year (Staff Interpretive Response 1.09). If an executive officer is a
named executive officer in only the most recently completed fiscal year, include that individual’s
compensation information in the Summary Compensation Table only for that year, not for the two
previous years (Staff Q&A 119.01).
New Developments Summary 159

• Deferred compensation: Any amount earned and currently payable that has been deferred for any
reason (including in a 401(k) plan) must be included in the salary, bonus, or other appropriate column
for the fiscal year in which it is earned. The amount deferred in the last fiscal year is also reported in
the Nonqualified Deferred Compensation Table (see section E).

• Allocations when both parent and a subsidiary are reporting companies:

− If the parent company compensates a named executive who provides services to the subsidiary,
the compensation is reported in the subsidiary’s Summary Compensation Table only if the
executive works exclusively or almost exclusively for the subsidiary. If the executive provides
services to both the parent and the subsidiary, all compensation should be reported in the
parent’s Summary Compensation Table, with no allocation reportable by the subsidiary.

− If the subsidiary pays a management fee to the parent for the services of the parent’s executives,
disclosure of the arrangement and the fee is required under Item 404, “Transactions with related
persons, promoters and certain control persons.”

− If the subsidiary directly compensates the parent’s named executive officer, the parent must
include the compensation in its Summary Compensation Table. If the payments are part of a
management arrangement, disclosure is required in Item 404 (Staff Interpretive Response 1.10).

• Disclosures in filings made shortly after year-end: If a filing is made shortly after year-end (say, on
January 2 for a company with a calendar year-end) when compensation information may not be
incorporated by reference in the filing, compensation for the year just ended must be included in the
disclosures. If applicable, the company may disclose that compensation amounts are based on
assumptions in financial statements that have not yet been audited. For compensation amounts not
yet determined, such as a bonus, pertinent information should be disclosed in a footnote, including
the date the bonus will be determined and the criteria or formula to be used. A Form 8-K filing is
required when the bonus is determined (Staff Interpretive Response 4.01).

• Disclosure periods when a company changes its fiscal year-end: Compensation reported in the short-
period following a change of year-end should not be annualized. The Summary Compensation Table
should also include compensation for the preceding three 12-month periods. For example, if a
company changes its year-end from June 30 to December 31 in 2012, its Summary Compensation
Table should include the following four periods:

− July 1, 2012 to December 31, 2012

− July 1, 2011 to June 30, 2012

− July 1, 2010 to June 30, 2011

− July 1, 2009 to June 30, 2010

The company would continue to include four periods in its Summary Compensation Table until there
are three full years after the stub period, for example, at December 31, 2015 (Staff Interpretive
Response 1.05).

• If footnote disclosure not specifically limited to last fiscal year: Footnote disclosure would be required
for other years reported in the Summary Compensation Table only if material to an understanding of
compensation for the last fiscal year (Staff Q&A 119.14, July 3, 2008).
New Developments Summary 160

Summary Compensation Table

Name Year Salary Bonus Stock Option Non-Equity Change in All Other Total
and ($) ($) Awards Awards Incentive Plan Pension Value Compensation ($)
Principal ($) ($) Compensation and Nonqualified ($)
Position ($) Deferred
Compensation
Earnings
($)

(a) (b) (c) (d) (e) (f) (g) (h) (i) (j)

PEO —

PFO —

A —

B —

C —

Salary and bonus columns


The dollar value of base salary and bonus (including both cash and noncash) is reported in columns (c)
and (d), respectively.

As noted above under the heading “Summary Compensation Table,” any amount earned that is deferred
for any reason must be included in the salary, bonus, or other appropriate column for the fiscal year in
which it is earned.
New Developments Summary 161

If a company enters into an agreement with its CEO in 2008 in which it agrees to pay a cash retention
bonus if the CEO remains employed through December 31, 2010, the company should report the
retention bonus in the Summary Compensation Table in 2010, the year in which the performance
condition is satisfied. Interest payable would also be included in the Summary Compensation Table in
2010 if it is not payable unless and until the performance condition is satisfied. The company is not
required to include the retention bonus in the Summary Compensation Table or in the Nonqualified
Deferred Compensation Table in fiscal years before the performance condition is satisfied, although it
should discuss the agreement in Compensation Discussion and Analysis in those earlier fiscal years
(Staff Q&A 119.17, July 3, 2008).

The amounts reported in columns (c) and (d) should include the amount of any salary or bonus the
named executive elected to forgo in exchange for stock, options, or other form of noncash compensation.
In addition, if noncash compensation was received for forgone salary or bonus, the salary and/or bonus
column should include a footnote disclosing the receipt of noncash compensation, as well as a reference
to the Grants of Plan-Based Awards Table if the noncash compensation was in the form of stock, options,
or a nonequity incentive plan award. The company should provide disclosure about equity compensation
received instead of salary or bonus in the Grants of Plan-Based Awards Table, the Outstanding Equity
Awards at Fiscal Year-End Table, and the Option Exercises and Stock Vested Table (Staff Q&A 119.03).

If salary or bonus cannot be calculated as of the latest practicable date, the company must provide an
explanatory footnote, including the expected date the amount will be determined. The company is
required to file a Form 8-K when some or all of the salary or bonus amount becomes known, disclosing
that amount and a new total compensation amount.

Plan-based awards
Plan-based awards are reported in columns (e), (f), and (g)—stock awards, option awards, and nonequity
incentive plan compensation.

The company should not include in those columns, however, stock, options, or nonequity incentive plan
compensation a named executive elects to receive in exchange for forgoing salary or bonus. Instead, the
company should report the forgone salary or bonus in the salary or bonus column, as discussed above
under the heading “Salary and bonus columns.” However, there are two situations in which an amount is
reported in the Stock Awards or Option Awards column:

• If the amount of forgone salary or bonus is less than the amount of equity compensation received, the
excess equity compensation should be reported in the Stock Awards or Option Awards column, as
appropriate.

• If the arrangement under which the named executive officer could elect settlement in equity-based
compensation instead of salary or bonus is within the scope of Statement 123R (because, for
example, the right to stock settlement is embedded in the terms of the award), the entire award would
be reported in the Stock Awards or Option Awards column.

In those two situations that result in an amount being reported in the Stock Awards or Option Awards
column, the amount reported is the dollar amount recognized for financial statement reporting purposes
for the applicable fiscal year. In addition, the company should explain the circumstances of the award in a
footnote (Staff Q&A 119.03).

Stock awards and option awards

Stock awards are awards within the scope of FASB Statement 123R that derive their value from the
company’s equity securities or permit settlement in those equity securities but do not have option-like
features. They include
New Developments Summary 162

• Restricted stock

• Restricted stock units

• Phantom stock

• Phantom stock units

• Common stock equivalent units

Option awards are instruments with option-like features that are within the scope of Statement 123R.
They include the following:

• Options

• Stock appreciation rights, regardless of whether settled in stock or cash

• Reload options

The amounts to be reported in the stock awards column and in the option awards column are the dollar
amounts of compensation cost determined under Statement 123R that are recognized in the company’s
financial statements during the subject fiscal year. The following clarifications apply:

• Include compensation cost recognized in the subject year financial statements for awards granted in
both previous fiscal years and the subject fiscal year. This applies to compensation cost related to
awards classified as equity and to those classified as liabilities. Compensation cost includes the
amount expensed in the income statement for the named executive, as well as the amount, if any,
capitalized on the balance sheet.

• Reload options are issued when an employee exercises options with reload features using previously
acquired employer shares to satisfy the options’ exercise price. The reload options issued usually
equal the number of shares the employee used to exercise the options. The amount reported in the
Summary Compensation Table for the granting of reload options is the amount of cost recognized in
the financial statements on issuance of those options. Reload options are also included in the Grants
of Plan-Based Awards Table in the year they are granted (Staff Interpretive Response 1.07).

• If an award granted after the end of the last completed fiscal year relates to service performed during
the last completed fiscal year, the amount recognized in the financial statements for that year is
reportable in the option awards or stock awards column of the Summary Compensation Table. The
award would not, however, be reported in the Grants of Plan-Based Awards Table until the fiscal year
in which the award is made. Such a situation should be considered for disclosure in CD&A (Staff Q&A
119.05).

• In determining the amount of compensation cost for purposes of these disclosures, do not include an
estimate for forfeitures of service-based awards. Assume the named executive will provide the
service required to vest in the award. The amount reported in the table may therefore not be the
same as the amount reported in the financial statements.

• When awards are forfeited, in the fiscal year the forfeiture occurs deduct compensation cost that was
reported for those awards in previous years, even if the deduction results in a negative amount in the
stock awards column and/or the option awards column for the year. The amount deducted is limited
to expensed amounts previously reported in the Summary Compensation Table. It should therefore
exclude expensed amounts pertaining to periods before the 2006 executive compensation disclosure
rules became effective and before the individual became a named executive officer (Staff Q&A
119.11).The resulting amount, whether positive or negative, is reported in the relevant column and
New Developments Summary 163

included in the calculation of total compensation in column (j). Companies are required to provide
footnote disclosure of all forfeitures occurring during the fiscal year.

• Include compensation cost for awards with a performance-based vesting condition only if
achievement of the performance condition is probable. Previously recognized compensation cost is
reversed if achievement of the performance condition is no longer considered probable in a
subsequent period.

• If under Statement 123R, recognition of compensation cost (a) begins before the award is granted or
(b) is delayed beyond the grant date, the disclosure of the compensation cost in the Summary
Compensation Table should follow that pattern of cost recognition.

• Disclose assumptions used in the valuation of each option and stock award for which compensation
cost is reported in the option awards column or in the stock awards column for the company’s most
recent fiscal year. The required information about assumptions will generally be in the financial
statements or footnotes for the year the award was granted. The disclosure should therefore consist
of references to the financial statements or footnotes for the years in which the awards were granted
(Staff Q&A 119.15, July 3, 2008).

If a named executive holds options or other rights to purchase the company’s securities that are not within
the scope of Statement 123R, they should be reported in the same manner as compensatory options
(Staff Interpretive Response 1.08).

Nonequity incentive plan compensation

How does an entity distinguish among stock and option awards, bonuses, and nonequity incentive plans?
Item 402 defines an incentive plan as “any plan providing compensation intended to serve as an incentive
for performance to occur over a specified period.” The length of the performance period does not affect
the analysis; therefore, an incentive plan may have a performance period of less than a year. Further
guidance provides that an award is an incentive plan if the outcome of the performance target is
substantially uncertain at the time the target is established and communicated to the executive. In
contrast, a cash bonus is reportable in column (d) as a bonus if it was not based on performance criteria,
had a performance target that was not preestablished, or did not have a substantially uncertain outcome.
An equity incentive plan is defined as “an incentive plan or portion of an incentive plan under which
awards are granted that fall within the scope of FAS 123R,” and are reported as stock or options in
columns (e) or (f). Consequently, awards not within the scope of Statement 123R that are granted under
an incentive plan are nonequity incentive plan awards. Nonequity incentive plan status is not impacted by
a provision that permits the company to exercise negative discretion in determining the amount of the
award. However, a company should consider whether its basis for the use of various performance
measures and/or negative discretion is material information that should be disclosed in CD&A. If an
award exceeds the amount earned by meeting the performance measure, the excess should be reported
in the bonus column, not in the nonequity incentive plan column (Staff Q&A 119.02).

Awards are reported in the nonequity incentive plan compensation column in the year the relevant
specified performance criteria under the plan are satisfied and the compensation is earned, regardless of
whether payment is made in that year. (Note that this differs from the timing of reporting stock and option
awards, which are included in the table over each award’s requisite service period as determined under
Statement 123R.) No further disclosure is required if payment of the award is made in a subsequent
period. However, if the award remains subject to forfeiture conditions, for example, based on the named
executive’s continued service, the staff encourages a company to disclose in the related narrative section
material features not reflected in the tables, such as forfeitures of awards reported as earned in previous
years.
New Developments Summary 164

Earnings on outstanding nonequity incentive plan awards are also reported in the nonequity incentive
plan awards column, even if payable at a later date or deferred at the election of the named executive.
The earnings must be identified and quantified in a footnote to the table.

Awards under nonequity incentive plans are disclosed in the supplemental Grants of Plan-Based Awards
Table in the year of grant, which may be in a year prior to when the award is included in the Summary
Compensation Table.

Change in pension value and nonqualified deferred compensation earnings


Although the change in pension value is reported in column (h) along with nonqualified deferred
compensation earnings, a company is required to disclose the total amount of each element in a footnote
to the Summary Compensation Table. In addition, if the aggregate change in value of all of a named
executive officer’s defined benefit plans is a negative amount, the company should disclose the net
negative amount in a footnote but not include the amount in the table (Staff Q&A 119.06).

Increase in pension value

The increase in pension value included in the Summary Compensation Table is the aggregate increase in
the actuarial present value of the executive officer’s accumulated benefit under all defined benefit and
actuarial pension plans, including supplemental plans. This applies to each plan that provides for
payment of retirement benefits, or benefits payable primarily after retirement, including but not limited to
tax-qualified defined benefit plans and supplemental executive retirement plans, but excluding defined
contribution plans. The change in actuarial present value is measured from the plan measurement date of
the prior year used for purposes of the company’s audited financial statements to the measurement date
of the covered fiscal year used for purposes of the audited financial statements. In computing the amount,
a company must use the assumptions used for financial reporting purposes, except the retirement age is
assumed to be the normal retirement age as defined in the plan or, if retirement age is undefined, the
earliest date the executive may retire without an age-related benefit reduction.

An in-service distribution should be considered in determining the reportable increase in pension value.
For example, if the actuarial present value of the accumulated pension benefit for a named executive is
$1,000,000 on the measurement date of the prior fiscal year and on the measurement date of the most
recently completed fiscal year, but the named executive earned and received an in-service distribution of
$200,000 during the intervening year, the reportable increase in pension value is $200,000 (Staff
Interpretive Response 9.01).

Under FASB Statement 158, Employers’ Accounting for Defined Benefit Pension and Other
Postretirement Plans, a company’s pension plan measurement date must be as of the date of its fiscal
year-end for fiscal years ending after December 15, 2008. For many companies with a calendar year-end,
that provision will require changing the pension plan measurement date from September 30 to
December 31. In determining the increase in pension value in the year the measurement date is changed,
companies may annualize the amount of the change. They must, however, disclose their method for
determining the amount of the change. A company with a calendar year-end, for example, could report
12/15ths of the amount of change in the actuarial present value of the executive’s accumulated benefit in
the 15 months from October 1, 2007 to December 31, 2008. Companies should report the actuarial
present value as of the new measurement date in the Pension Benefits Table (see section E) in the year
of the change (Staff Interpretive Response 4.02).

Earnings on deferred compensation

The earnings on nonqualified deferred compensation, including nonqualified defined contribution


retirement plans, that companies are required to include in the pension and deferred compensation
New Developments Summary 165

column are limited to the above-market or preferential portion. Above-market interest is the excess of the
rate under the company’s plan at the time the interest rate or formula is set over 120 percent of the
applicable federal long-term rate, with compounding, on that date. If the company has discretion to reset
the rate, the above-market portion is recalculated at the time of reset. The company may use either
footnote or narrative disclosure to explain the criteria for calculating the above-market portion. If the rate
varies on a condition such as the length of continued service, the calculation assumes all conditions are
satisfied to earn the highest rate. Above-market or preferential dividends are determined by reference to
the dividend rate on the company’s common stock.

Above-market or preferential earnings are reportable regardless of whether the deferred compensation is
unfunded and therefore subject to risk of loss (Staff Interpretive Response 4.03).

If earnings on nonqualified deferred compensation are determined in the same manner and at the same
rate as earnings on externally managed investments of employees participating in a qualified plan with
broad-based employee participation, the earnings are not reportable as above-market or preferential. This
position applies to excess benefit plans but not to “top hat” or Supplemental Employee Retirement Plans
that are unrelated to a tax-qualified plan (Staff Interpretive Response 4.03).

Although only the above-market or preferential portion of earnings on deferred compensation is included
in the Summary Compensation Table, all earnings on nonqualified deferred compensation are disclosed
in the required Nonqualified Deferred Compensation Table (see section E).

All other compensation


All other compensation (column (i)) includes all compensation items not included in any of the preceding
columns of the table. Companies must separately identify and quantify in a footnote each item of
compensation for the last fiscal year that exceeds $10,000, unless it is a perquisite or other personal
benefit (disclosures pertaining to perquisites and other personal benefits are discussed below). Items
below that amount are included in the column total (except perquisites and other personal benefits if less
than $10,000 in the aggregate, as discussed below) but are not required to be separately identified in the
footnote.

Perquisites and other personal benefits

The aggregate incremental cost to the company of perquisites and other personal benefits is included in
all other compensation unless their aggregate incremental cost for a named executive officer is less than
$10,000.

If the aggregate value of perquisites and other personal benefits is $10,000 or more, the company must
provide footnote disclosure of the nature of each perquisite and other personal benefit received by the
named executive officer. Disclosure of the nature of a perquisite or other personal benefit is required even
if the company incurred no aggregate incremental cost for the particular perquisite or personal benefit.
However, if the executive officer fully reimbursed the company for the total cost of an item, the item is not
considered a perquisite or other personal benefit and need not be separately identified. In the staff’s view,
if a company pays for country club annual dues, and the executive fully reimburses the company for the
cost of meals and incidentals, the company would report the annual dues as a perquisite, but not the
meals and incidentals (Staff Q&A 119.07, July 3, 2008). For any perquisites or other personal benefits
with a value in excess of the greater of $25,000 or 10 percent of total perquisites and other personal
benefits, the company must provide the dollar value and describe the company’s method for computing
the benefit’s aggregate incremental cost. The identification and quantification requirements apply only to
compensation for the last fiscal year. In describing the particular nature of perquisites or other benefits, it
is not sufficient to characterize as “travel and entertainment” company-provided benefits that include, for
example, clothing, jewelry, artwork, theater tickets, and housekeeping services.
New Developments Summary 166

Item 402 does not provide a definition of perquisites or personal benefits, but it does provide two factors
to consider in making the determination of whether something is a perquisite or personal benefit:

• An item that is integrally and directly related to the performance of an executive’s duties is not a
perquisite or personal benefit. Further, there is no requirement to disclose the excess over a less
expensive alternative, such as the cost differential between renting a mid-sized car over a compact
car. Integrally and directly related is a narrow concept that applies only to items the executive needs
to do the job, such as a laptop or, if required to be accessible to colleagues and clients when out of
the office, a Blackberry.

• An item that is not integrally and directly related to job performance is a perquisite or personal benefit
if it directly or indirectly confers a benefit with a personal aspect, regardless of whether it is provided
for a business reason or for the convenience of the company, unless it is available to all employees.
The tax characterization of the expense does not affect the characterization for purposes of the
Summary Compensation Table. The provision of a personal benefit for corporate reasons does not
change its nature as an includible personal benefit. For example, if a company requires an executive
to use a company plane for personal travel for security purposes, personal use of the plane is
nonetheless reportable as a perquisite or personal benefit as it is not directly related to job
performance.

Using those factors, perquisites and personal benefits subject to the disclosure rules include, but are not
limited to, the following:

• Club memberships not used exclusively for business entertainment

• Personal financial or tax advice

• Personal travel using company owned or leased vehicles

• Personal travel financed by the company

• Personal use of other company-owned or leased property

• Housing and other living expenses, including relocation assistance

• Security provided at a personal residence or during personal travel

• Commuting expenses

• Discounts on the company’s products or services not available to employees generally

Additional all other compensation items

Items to be disclosed in all other compensation other than perquisites and personal benefits include, but
are not limited to, the following:

• Amount paid or accrued in connection with termination of employment or a change in control. An


amount is accruable if payment has become due. For example, if the named executive has completed
the required performance to earn an amount, but payment is subject to a six-month deferral to comply
with Internal Revenue Code Section 409A, the amount is accruable and should be disclosed. In
contrast, if an amount is payable two years after termination if the executive officer complies with a
covenant not to compete during that two-year period, the amount should not be disclosed because
payment is not due until after the executive officer’s post-termination performance has been
completed. Narrative disclosure of both amounts is required, however, as described in section E
under the subheading “Potential payments on termination or change in control” (Staff Q&A 119.13
July 3, 2008).
New Developments Summary 167

• The company’s contribution or other allocation to a defined contribution plan

• The dollar value of life insurance premiums

• Tax reimbursements and gross-ups, including those on perquisites and personal benefits eligible for
exclusion from all other compensation

• Compensation cost determined under Statement 123R for any security of the company or its
subsidiaries purchased at a discount from the market price on the purchase date, unless the discount
is available to all security holders or all salaried employees. Internal Revenue Code Section 423
plans are generally broad-based, nondiscriminatory stock purchase plans that would not require
disclosure (Staff Q&A 119.08).

• The dollar value of dividends or other earnings paid on stock or option awards if the company did not
include the dividends or earnings when estimating the grant-date fair value of the equity award, which
the company was required to report in column (l) of the Grants of Plan-Based Awards Table in the
fiscal year the award was granted. The value of the dividends, dividend equivalents, or other
distributed earnings is included in the other compensation column if the payments are structured in a
manner that excludes them from the grant-date fair value calculation under Statement 123R (Staff
Q&A 119.09). Dividends credited to restricted stock units that are not paid until the restricted stock
units vest should be reported in the year they are credited, not in the year the dividends vest and are
paid (Staff Interpretive Response 4.04).

The following items are not included in all other compensation to prevent double counting of
compensation:

• Payments of benefits from pension or actuarial plans, unless accelerated under a change-in-control
provision

• Distributions of nonqualified deferred compensation. The distributions are disclosed, however, in the
aggregate withdrawals/distributions column of the Nonqualified Deferred Compensation Table (see
section E).

• Distributions from 401(k) plans. Salary or bonus contributed to a 401(k) plan is reported in the salary
or bonus column of the Summary Compensation Table. Earnings on 401(k) plans are not disclosed.
Item 402 requires disclosure of only above-market or preferential earnings on nonqualified deferred
compensation arrangements (Staff Q&A 119.10).

A company is not required to disclose the reimbursement of a named executive’s legal expenses incurred
in a lawsuit in which the named executive is a defendant in his or her capacity as an officer (Staff
Interpretive Response 1.11).

Supplemental Grants of Plan-Based Awards Table


Companies are required to provide additional information about awards granted under incentive plans in
the last fiscal year by providing a supplementary table, Grants of Plan-Based Awards. Incentive plans
require satisfaction of performance and/or market condition(s) to earn the award. The condition(s) may
relate to the company’s stock price (a market condition), a financial or performance measure of the
company, or any other performance measure.
New Developments Summary 168

Grants of Plan-Based Awards

Name Grant Estimated Future Estimated Future Payouts All Other All Other Exercise Grant
Date Payouts under Non- under Equity Incentive Plan Stock Option or Base Date
Equity Incentive Plan Awards Awards: Awards: Price of Fair
Awards Number Number Option Value of
of of Awards Stock
Thresh- Target Maxi- Thresh- Target Maxi- Shares Securities ($/Sh) and
old ($) mum old (#) mum of Stock Under- Option
($) ($) (#) (#) or Units lying Awards
(#) Options ($)
(#)

(a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l)

PEO

PFO

Item 402 provides the following disclosure guidelines for this table:

• Disclosure is required for all grants made during the current year, including grants of reload options
(Staff Interpretive Response 1.07). Note that the information reported in this table is for awards
granted in the last fiscal year. This differs from the information reported about stock, option, and
nonequity incentive plan awards reported in the Summary Compensation Table.

• The company should report each grant to each named executive officer on a separate line. If a
named executive officer receives awards under more than one plan, the plan under which each grant
is made should be identified.

• Column (b): The company should provide the Statement 123R grant date for equity awards. If the
grant date differs from the date the compensation committee or board approved the award, the
approval date must be provided in a column inserted between columns (b) and (c).

• Columns (c) through (h): For estimated future payouts under incentive plan awards, the following
apply:

− The threshold is the minimum payout (cash, shares, or shares underlying options) under the plan
if the lowest performance level is achieved.

− The target is the payout if the specified performance target(s) is reached. If the target amount is
not determinable, the company must provide a payout based on the prior fiscal year’s
New Developments Summary 169

performance. If an incentive plan award consists of a single estimated payout, that amount is
reported as the target.

− The maximum is the maximum possible payout under the plan.

− If plans do not include threshold or maximum amounts, a company is not required to provide
arbitrary amounts. If an executive will receive $10,000 for each $0.01 increase in earnings per
share during the performance period, the company is not required to report the threshold as 0 or
the maximum as N/A. A footnote should state that the plan does not have thresholds or
maximums (Staff Interpretive Response 5.01).

− If nonequity incentive plan awards are denominated in units or other rights, the company should
insert an additional column between columns (b) and (c) that quantifies the units or other rights
awarded.

− If all nonequity incentive plan awards were made in the same year they were earned and the
earned amounts are therefore included in the Summary Compensation Table, the heading over
columns (c), (d), and (e) may be changed to “Estimated Possible Payouts under Non-equity
Incentive Plan Awards” (Staff Q&A 120.02).

− If an equity incentive plan award is denominated in dollars but payable in shares, its value is
reported in dollars. However, the company must provide a footnote explaining that the number of
shares paid out will be determined using the share price on the payout date. In the limited
situation in which all awards reportable in columns (f) through (h) are denominated in dollars and
payable in shares, the caption for those columns may be changed from “(#)” to “($)” (Staff Q&A
120.01).

• Columns (i) and (j): The company should provide the number of shares of stock and the number of
shares underlying option awards, respectively, granted during the fiscal year that are not required to
be disclosed in columns (f) through (h).

− In a tandem grant of two instruments (such as an option and a performance share), only one of
which (say, the performance share) is granted under an incentive plan, the one not granted under
an incentive plan (the option) should be reported in column (i) or (j), and the tandem feature (the
performance share) should only be described in a footnote or accompanying narrative. It should
not be included in the tabular information.

• In the unusual situation in which the executive paid consideration to receive a stock or option award,
the company should include a footnote to the appropriate column providing the amount paid.

• Column (k): The company should report the exercise (or base) price of each option grant. If the
exercise price is less than the closing market price of the underlying security on the grant date, the
company should add a column reporting the closing market price. (The closing market price is the last
sale price on the principal U.S. market for the security on the specified date.) If there is no market for
the stock, the entity should determine the price using a formula prescribed for the security and
provide either a footnote or include in the accompanying narrative a description of the methodology
for determining the exercise price.

• Column (l): On a grant-by-grant basis, the company should provide the full grant-date fair value
computed under Statement 123R for each equity award granted during the fiscal year. If a company
reprices (adjusts or amends the exercise or base price) options (including stock appreciation rights or
similar option-like instruments) previously awarded to the named executive officer, or if it otherwise
materially modifies such awards during the last fiscal year, it should report in column (l) on a grant-by-
grant basis the incremental fair value computed under Statement 123R for the modified awards. An
New Developments Summary 170

option is not considered repriced or modified and disclosure is not required if the modification occurs
as a result of a provision in the original award or plan. The following therefore do not result in
incremental fair value if they occur as a result of a formula or provision in the plan or award: (a) a
periodic adjustment of the exercise price, (b) an adjustment under an antidilution provision, or (c) an
adjustment resulting from a recapitalization that affects equally all holders of the class of securities
underlying the options.

Narrative disclosure of Summary Compensation Table and Grants of Plan-Based


Awards Table
Item 402 requires a company to provide a narrative disclosure after the Grants of Plan-Based Awards
Table that describes material factors necessary to understand the information in that table and the
Summary Compensation Table. Factors requiring disclosure will vary depending on the details of a
company’s compensation arrangements. Item 402 provides the following examples of information that,
among other things and depending on the company’s compensation policies and components, may clarify
the tabular information:

• Material terms of each named executive officer’s employment agreement, regardless of whether it is
in writing

• A description of any material modification of options or other equity-based awards, including each
repricing, modification, or elimination of a performance condition, term extension, or change in vesting
period. Changes resulting from provisions in the plan or award on the grant date, such as a change
resulting from an antidilution provision, are not considered modifications.

• Material terms of awards reported in the Grants of Plan-Based Awards Table, including

− A performance condition and/or market condition applicable to an award, except for factors or
criteria involving confidential trade secrets or commercial or financial information if disclosure
would result in competitive harm to the company (see discussion of such situations in section B)

− The formula or criteria used to determine the payout amount

− The vesting schedule

− Dividends, if any, paid on the stock, including the dividend rate and whether it is preferential

• An explanation of the amount of salary and bonus relative to total compensation

D. Tables on previously awarded equity instruments


Companies are required to provide two additional tables providing information about outstanding options
and shares previously awarded under stock option or stock appreciation rights plans, restricted stock
plans, and incentive plans. One table presents all outstanding unexercised options and unvested shares
of each named executive. The other provides information on the amounts realized by each named
executive during the fiscal year on the exercise of options and the vesting of stock.
New Developments Summary 171

Outstanding Equity Awards at Fiscal Year-End

Option Awards Stock Awards

Name Number of Number of Equity Option Option Number Market Equity Equity
Securities Securities Incentive Exercise Expiration of Value Incentive Incentive
Underlying Underlying Plan Price Date Shares of Plan Plan
Unexercised Unexercised Awards: ($) or Units Shares Awards: Awards:
Options Options Number of of or Number of Market or
(#) (#) Securities Stock Units Unearned Payout
Exercisable Unexercisable Underlying That of Shares, Value of
Unexercised Have Stock Units, or Unearned
Unearned Not That Other Shares,
Options Vested Have Rights Units, or
(#) (#) Not That Have Other
Vested Not Rights
($) Vested That Have
(#) Not
Vested
($)

(a) (b) (c) (d) (e) (f) (g) (h) (i) (j)

PEO

PFO

In completing the table, the company should enter separately each award for each named executive as of
the end of the last fiscal year, except that an executive’s awards with the same expiration date and
exercise or base price can be aggregated. In addition, awards consisting of a combination of options,
stock appreciation rights, and/or other option-like instruments must be treated as separate awards for
each portion having a different exercise price and/or expiration date.

Columns (b) and (c) should include the underlying securities of options that have been transferred other
than for value. Such transferred options should also be identified in a footnote that describes the nature of
the transfer.

Options and stock awards are part of an equity incentive plan if they are subject to a performance and/or
market condition(s). The company should report such awards in column (d) or columns (i) and (j), as
appropriate, until the performance or market condition(s) is satisfied. Once the required condition(s) is
met and regardless of whether the award remains subject to forfeiture conditions (for example, if the
executive resigns), the company should report the securities underlying the options in column (b) or (c)
New Developments Summary 172

until the options are exercised or expire, and report unvested restricted stock in columns (g) and (h) until
it vests.

The company is generally required to determine the number of shares or units in equity incentive plans
(for purposes of columns (d), (i), and (j)), assuming satisfaction of the threshold performance goals.
However, if

• The performance during the last completed fiscal year (or, if the payout is based on performance over
more than one year, the last completed fiscal years over which performance is measured) exceeded
the threshold, the disclosure should be based on the next higher performance measure (the target or
maximum) that exceeds the last completed fiscal year’s (or years’) performance (Staff Q&A 122.01)

• The award has only one payout amount, the company should use that amount in determining the
number of shares or units

• The target amount is not determinable, the company must provide a representative amount based on
the previous fiscal year’s performance

Some options may be exercisable on issuance, but, on exercise, the option shares are subject to
repurchase at the exercise price if the executive terminates employment before a specified date. If the
executive exercises such options before the repurchase provision lapses, the executive effectively
receives unvested restricted stock, which should be reported as unvested stock awards in columns (g)
and (h) until the repurchase restriction lapses (Staff Interpretive Response 8.01).

If restricted stock awards have earned dividends or dividend equivalents payable in shares, the
outstanding in-kind earnings at the end of the fiscal year should be included in

• The Outstanding Equity Awards at Fiscal Year-End Table if the earnings are unvested

• The Option Exercises and Stock Vested Table (see below) if the earnings are vested

The vesting dates of option, stock, and equity incentive plan awards must be disclosed in a footnote to
the column in which the awards are reported. A company can comply with the vesting date disclosure
requirement by adding a column to the table for the grant date of each reported award and a footnote
describing the standard vesting schedule that applies to the reported awards. If a different vesting
schedule applies to any of the awards, the footnote should disclose that vesting schedule as well (Staff
Q&A 122.02, July 3, 2008).

Exercise price information (column (e)) and the expiration date (column (f)) are required for each
instrument reported in columns (b), (c), and (d).

The market value in columns (h) and (j) is based on the closing market price of the company’s stock at
the end of the last fiscal year.
New Developments Summary 173

Option Exercises and Stock Vested

Option Awards Stock Awards

Name Number of Shares Value Realized on Number of Shares Value Realized on


Acquired on Exercise Exercise Acquired on Vesting Vesting
(#) ($) (#) ($)

(a) (b) (c) (d) (e)

PEO

PFO

Item 402 provides the following disclosure guidelines for this table:

• Column (b): A company must report each exercise of stock options, stock appreciation rights, and
similar instruments by each named officer during the last fiscal year, except as noted at the end of
this bulleted item. The number of shares reportable in column (b) is the total number of shares
underlying the option or share appreciation right. This is the case regardless of whether there was a
cashless exercise or exercise of a share appreciation right and the executive received only the net
number of shares representing the increase in the stock price since the grant date. The company
could provide a footnote or narrative to explain and quantify the net number of shares received (Staff
Q&A 123.01).

If an option is exercisable before it is fully vested, exercise of the unvested option should not be
reported in the Option Exercises and Stock Vested Table. However, the option shares should be
reported in columns (d) and (e) as they vest and are no longer subject to a repurchase provision
(Staff Interpretive Response 8.01).

• Column (c): The aggregate amount realized on exercise of options reportable in column (c) is the
difference between the market price of the securities received on the exercise date and the exercise
or base price. Value received on transfer of options and option-like instruments is also included in
column (c). Column (c) does not include any payment the company makes to the named executive
related to the exercise price or related taxes. Such amounts are reported in the all other
compensation column of the Summary Compensation Table.

• Column (d): A company must report all stock that became fully vested during the last fiscal year,
including restricted stock, restricted stock units, and similar instruments.
New Developments Summary 174

• Column (e): The company reports the amount realized by the named executive on the vesting of
stock based on the vesting date market value of the stock. The value received on the executive’s
transfer of stock is also reported in column (e).

• Columns (c) and (e): If receipt of all or part of the amount realized on exercise or vesting is deferred,
the company must disclose the amount and terms of the deferral in a footnote.

E. Post-employment compensation
Post-employment compensation is reported in three parts:

• A table for defined benefit pension plans, together with related narrative disclosure

• A table for nonqualified defined contribution plans and other deferred compensation, with related
narrative disclosure

• Disclosure of compensation arrangements triggered on termination and on changes in control

Pension Benefits

Name Plan Name Number of Years Present Value of Payments During


Credited Service Accumulated Benefit Last Fiscal Year
(#) ($) ($)

(a) (b) (c) (d) (e)

PEO

PFO

The company reports in this table a separate row for each defined benefit plan in which each named
executive participates that provides benefits primarily following retirement. This includes, but is not limited
to, both tax-qualified defined benefit plans and supplemental executive defined benefit plans. Defined
contribution plans are not included in this table.

Item 402 provides the following disclosure guidelines for this table:

• Column (c): The credited years of service under the plan are determined as of the plan measurement
date used for the audited financial statements for the last fiscal year. If the credited years differ from
the actual years of service, the company is required to disclose the difference in a footnote, as well as
any resulting increased benefit.
New Developments Summary 175

• Column (d): The amount reported is the actuarial present value of the named executive officer’s
accumulated benefit computed as of the plan measurement date for the audited financial statements
for the last fiscal year. In computing that amount, the company must use current compensation and
the same assumptions used for financial reporting purposes, except the retirement age is assumed to
be the normal retirement age defined in the plan. The assumptions used for financial reporting that
should be used are the discount rate, the lump sum interest rate (if applicable), postretirement
mortality, and payment distribution assumptions. The company should assume the named executive
will provide service until the plan’s normal retirement age. It should therefore not factor into the
calculation what actuaries refer to as preretirement decrements. However, any contingent benefits on
death, early retirement, or other termination events should be disclosed in the postemployment
narrative disclosure (Staff Q&A 124.04).

Companies are not permitted to use assumptions based on the circumstances of the named
executive officer rather than the assumptions used for financial reporting purposes (Staff Q&A
124.01). However, if participants may retire earlier than the normal retirement age without an age-
related benefit reduction, the company should use the younger age for determining the actuarial
present value. A company may, however, add an additional column to report the actuarial present
value using the normal retirement age (Staff Q&A 124.02). If a named executive officer will receive a
special benefit if she remains employed until a specified age that is younger than the normal
retirement age, the company should calculate the accumulated benefit as though the named
executive will continue to provide service until retirement at the specified age and will receive the
special benefit (Staff Q&A 124.03).

The amount disclosed for a cash balance plan is similar to the amount disclosed for other defined
benefit plans, that is, the actuarial present value of the executive officer’s accumulated benefit under
the plan determined as of the plan measurement date. It is not the amount credited to the executive
officer’s cash balance account on the measurement date (Staff Q&A 124.05).

If the plan does not define normal retirement age, the retirement age must be the earliest age the
executive may retire under the plan without an age-related benefit reduction.

If a company changes its pension measurement date, the actuarial present value reported is the
amount computed on the new measurement date (Staff Interpretive Response 4.02).

To allocate the present value amount between a tax-qualified plan and a related supplemental plan,
the company should use the Internal Revenue Code limitations on tax-qualified defined benefit plans
applicable on the plan measurement date.

• Column (e): The reportable amount is the dollar amount of any payments and benefits paid to the
named executive during the last fiscal year.

The company is also required to provide a concise accompanying narrative disclosure of any material
factors an investor needs in order to understand each plan reported in the table. The factors that are
material vary depending on the specific facts of the plans. Examples of material factors may include, but
are not limited to, the following:

• Material terms and conditions of benefits under the plan, including its normal retirement payment and
benefit formula, eligibility standards, and the effect of the elected form of benefit on the annual benefit
amount

• Identification of executives currently eligible for early retirement, the applicable plan, and the plan’s
early retirement payment and benefit formula and the eligibility standards
New Developments Summary 176

• The specific elements of compensation (for example, salary and certain specified types of bonus) to
which the payment and the benefit formula applies

• If named executives participate in multiple plans, the purpose for each plan

• Policies for matters such as granting extra years of credited service

The narrative disclosure must also describe the valuation method and all material assumptions applied in
determining the actuarial present value amount or a reference to disclosure of such information in the
notes to the company’s financial statements or MD&A.

Nonqualified Deferred Compensation

Name Executive Registrant Aggregate Aggregate Aggregate


Contributions in Contributions in Earnings in Last Withdrawals/ Balance at Last
Last FY Last FY FY Distributions FYE
($) ($) ($) ($) ($)

(a) (b) (c) (d) (e) (f)

PEO

PFO

The Summary Compensation Table requires disclosure only of any above-market or preferential portion
of earnings on nonqualified deferred compensation. The Nonqualified Deferred Compensation Table
requires a company to provide specified information on a plan-by-plan basis (Staff Q&A 125.03, July 3,
2008). A company must report the full amount of compensation deferred during the last fiscal year, as
well as earnings on each nonqualified defined contribution or other nonqualified deferred compensation
plan in which the named executive participates.

If the contributions earned in , say, 2008 for an excess (supplemental) plan related to a qualified plan are
not credited to the executive’s account until January 2009, the contributions are nonetheless considered
company contributions during 2008 and are reportable in the All Other Compensation column of the 2008
Summary Compensation Table (Staff Q&A 125.04, July 3, 2008).

Earnings include all changes to the account balance during the last completed fiscal year other than
contributions, withdrawals or distributions. They include, for example, interest, dividends, stock price
appreciation or depreciation, and similar items (Staff Q&A 125.02).

The company is required to provide a footnote indicating the amounts reported in


New Developments Summary 177

• Columns (c) and (d) that are also reported in the Summary Compensation Table for the last fiscal
year

• Column (f) that were reported as compensation to the named executive officer in the company’s
Summary Compensation Tables of previous years. Amounts need to be disclosed in the footnote only
if they were previously reported in Summary Compensation Tables. If amounts were not previously
reported in Summary Compensation Tables because, for example, the named executive officer is
included in the table for the first time in the current fiscal year, no amounts would be disclosed by
footnote for previous years (Staff Q&A 125.01).

The company is also required to provide a concise accompanying narrative disclosure of any material
factors an investor needs to understand each plan reported in the table. Whether factors are material
depends on the specific facts in each situation. Examples of material factors may include, but are not
limited to, the following:

• The types of compensation the named executive is permitted to defer and any limitations on the
deferred amount (for example, based on a percentage of compensation or some other means)

• How interest and other earnings are calculated, whether the executive or the company selects the
measure, the frequency and manner in which selected measures may be changed, and the interest
rates and other earnings measures applicable during the year

• Material terms governing payments, withdrawals, and other distributions

Potential payments on termination or change in control


Companies are required to provide narrative disclosure of potential payments or other benefits for each
named executive that would be triggered by termination, including resignation, severance, retirement, or
constructive termination; a change in control of the company; or a change in the named executive’s
responsibilities. The following disclosures are required regardless of whether the contracts, plans,
agreements, or arrangements are written or unwritten:

• A description of the specific circumstances that trigger payments or other benefits, including
perquisites, health care benefits, and tax gross-up payments (benefits)

• A description and the amount of the estimated benefits to be provided in each covered circumstance,
their duration, and whether they would or could be paid out in a lump sum or annually:

− Quantitative disclosures are required regardless of whether there are uncertainties regarding the
benefits or their amount. A company is required to disclose a reasonable estimate, or estimated
range, and the material assumptions underlying the estimate. Such disclosures are considered
forward-looking information, as appropriate, and covered by applicable safe harbors.

− Quantitative amounts are calculated assuming

 The triggering event occurred on the last business day of the last fiscal year

 The stock price is the closing market price on that date

− If unvested options would vest immediately on termination or change in control, the amount to
disclose is the spread between the closing market price per share on the last business day of the
issuer’s last completed fiscal year-end and the option exercise price (Staff Q&A 126.01).

− The date used to calculate the disclosure can affect the calculation of tax gross-ups on the excise
tax on excess parachute payments under Internal Revenue Code Section 280G. Therefore, if the
last business day of the last completed fiscal year of a calendar-year issuer is not December 31,
New Developments Summary 178

the issuer may calculate the excise tax and related gross-up as though the change in control
occurred on December 31, but using the issuer’s stock price as of the last business day of its last
completed fiscal year. The issuer may not substitute January 1 of the current year for the last
business day of its last completed fiscal year (Staff Interpretive Response 11.01).

− Health care benefits are quantified based on assumptions used for financial reporting purposes.

− The disclosure and itemization thresholds for perquisites and other personal benefits in the
Summary Compensation Table apply to this narrative disclosure of post-termination perquisites
and other personal benefits as well.

• A description of how benefit levels are determined under the various triggering events

• Who provides the benefits

• Any material conditions or obligations affecting the receipt of benefits, including but not limited to
confidentiality, noncompete, nonsolicitation, or nondisparagement agreements; the duration of such
agreements; and provisions regarding waiver of a breach of an agreement

• Other material factors pertaining to such contracts, agreements, plans, or arrangements

If a triggering event occurred for a named executive officer who was no longer a named executive officer
at the end of the year, the disclosure for that executive is limited to a triggering event that actually
occurred during the last fiscal year. If a named executive officer leaves the company (say, in early 20X8)
after the end of an issuer’s last completed fiscal year (say, 20X7) but before the proxy statement is filed,
the issuer may limit the disclosure on potential payments on termination and change in control for that
named executive to the triggering event that actually occurred if both of the following apply (Staff
Interpretive Response 11.02):

• The named executive is not the PEO or the PFO and is not a named executive officer for the current
fiscal year (20X8).

• The severance package was not renegotiated.

If an issuer’s proxy statement for its annual meeting also solicits shareholder approval of a pending
acquisition of the issuer, the disclosure of post-termination compensation arrangements should include
both the termination agreements specific to the pending acquisition, if any, and the issuer’s generally
applicable post-termination arrangements. The staff explains that disclosure of both arrangements would
be required for the following reasons (Staff Interpretive Response 11.03):

• A comparison of the acquisition-specific arrangements with the generally applicable arrangements


may be material information to shareholders.

• If the acquisition does not occur, the issuer’s generally applicable post-termination arrangements will
continue to apply.

If the form and amount of a benefit triggered under an event covered by this post-termination narrative
disclosure is fully disclosed in the Pension Benefits Table or the Nonqualified Deferred Compensation
Table and the related narrative disclosure, reference may be made to that disclosure. If the benefit would
increase or accelerate, however, the increase or acceleration must be specifically disclosed in this
narrative disclosure.

Disclosures are not required for benefits that are available to all salaried employees if they do not
discriminate in scope, terms, or operation in favor of a company’s executive officers. However, even if all
of an issuer’s employee stock option awards immediately vest on a change-in-control, disclosure of that
New Developments Summary 179

benefit is required for named executives if amounts of option awards to executives are greater than those
provided to other salaried employees. In that situation, the scope of the immediate vesting arrangement
discriminates in favor of the executives because of the greater number of options held (Staff Q&A
126.02).

F. Compensation of directors
The executive compensation disclosure requirements include a Director Compensation Table. It is similar
in content to the Summary Compensation Table except it requires information for only the last fiscal year.

Director Compensation

Name Fees Earned Stock Option Non-Equity Change in Pension All Other Total
or Paid in Awards Awards Incentive Plan Value and Compensation ($)
Cash ($) ($) Compensation Nonqualified Deferred ($)
($) ($) Compensation
Earnings
($)

(a) (b) (c) (d) (e) (f) (g) (h)

All directors are included in column (a) except those who are

• Also named executive officers if their director compensation is included in the Summary
Compensation Table, together with a footnote disclosing the table amounts that represent their
compensation for director services, and other tables and narrative disclosures required for
compensation of named executive officers

• Executive officers of the company who are not named executive officers, if the following apply (Staff
Interpretive Response 12.02):

− They do not receive additional compensation for services provided as a director.

− For purposes of Item 404, “Transactions with Related Persons, Promoters and Certain Control
Persons,” the executive officers and their compensation satisfy the conditions in Instruction 5.a.ii
to Item 404(a).
New Developments Summary 180

− A footnote or narrative disclosure explains that the directors are executive officers, other than
named executive officers, who receive no additional compensation for their director services.

If a director is an employee but not an executive officer, disclosure of the employee’s compensation for
services as an employee is required under Item 404(a) because the exemption provided in Instruction 5
of Item 404(a) would not apply. However, the staff believes that disclosure of the employee’s
compensation in the Director Compensation Table under Item 402, with a footnote or narrative disclosure
of the allocation of the compensation to services provided as an employee, would be clearer and more
concise than the Item 404(a) disclosure. The staff therefore indicated that, if disclosure is provided in the
Director Compensation Table, it would not need to be repeated in the Item 404(a) disclosure (Staff
Interpretive Response 12.03).

An individual, other than an executive officer described in the preceding paragraph, who served as a
director for any part of the last fiscal year must be included in the Director Compensation Table, even if
no longer serving as a director at year-end or if not standing for reelection for the coming year (Staff
Q&As 127.01 and 127.02).

Multiple directors may be included in a single row if all the elements and amounts of their compensation
are identical; the name of each director included in the group, however, should be clearly identified.

The instructions for the Summary Compensation Table columns (b) through (h) and related footnote
disclosures apply as well to comparable items, including disclosures, in the Director Compensation Table
columns (b) through (f), with the following clarifications and exceptions:

• All fees for services as a director, including annual retainer fees, committee and/or chairperson fees,
and meeting fees, are included in the table. Fees paid or payable in cash are reported separately
(column (b)) from such fees paid in stock or other securities (columns (c) or (d)).

• Column (c): For stock awards granted during the fiscal year, a footnote is required for each director
disclosing the grant-date fair value of each award (Staff Q&A 127.03). That fair value is the amount
computed under Statement 123R. Companies are also required to disclose the aggregate number of
unvested shares outstanding at the end of the fiscal year (Staff Q&A 127.04).

• Column (d): For stock options (or other option-like awards) granted during the fiscal year, with or
without tandem stock appreciation rights, the grant-date fair value of each award as computed under
Statement 123R must be disclosed in a footnote (Staff Q&A 127.03). Disclosure is also required of
the incremental fair value measured under Statement 123R for options repriced or otherwise
materially modified during the fiscal year. Disclosure is not required, however, if the option
modification was pursuant to terms included in the original award or the plan. The company should
include a footnote for each director disclosing the aggregate number of unexercised options
(regardless of whether they are exercisable) that remain outstanding at the end of the fiscal year
(Staff Q&A 127.04).

• Column (e): Nonequity incentive plan compensation includes the dollar value of plan earnings for
services performed during the fiscal year as well as earnings on any outstanding awards.

• Column (f): If a director was previously the issuer’s employee and receives pension benefits from the
issuer, the following applies to disclosures in column (f) (Staff Interpretive Response 12.04):

− If pension benefits are not conditioned on, or increased due to, services as a director, they do not
need to be disclosed, regardless of whether the former employee is compensated for services as
a director.

− If service as a director results in new accruals to the pension, disclosure in column (f) is required.
New Developments Summary 181

Column (g) should include all compensation for the fiscal year not reportable in other columns, regardless
of the amount (except for perquisites and other personal benefits, which are excluded if their aggregate
value is less than $10,000, as discussed in the first bullet below). All other compensation for directors
includes, but is not limited to, the following:

• Perquisites and other personal benefits if their total value for a director is $10,000 or more. Their
value is based on their aggregate incremental cost to the company. If perquisites and other personal
benefits must be reported, the company must identify each perquisite and other personal benefit by
type, regardless of the amount. In addition, it must disclose and quantify in a footnote any perquisite
or other personal benefit with a value exceeding the greater of $25,000 or 10 percent of total
perquisites and other personal benefits. The footnote must include a description of the company’s
method for determining aggregate incremental cost for each perquisite or other personal benefit
requiring footnote quantification.

• All tax gross-ups and other tax reimbursements. The company must include all reimbursements of
taxes owed on perquisites or other personal benefits (regardless of whether the perquisites and other
personal benefits themselves are eligible for exclusion from all other compensation because their
aggregate value for a director is less than $10,000). Tax reimbursements are subject to quantification
and identification separately from perquisites and other personal benefits.

• The compensation cost determined under Statement 123R for the purchase of securities from the
company or its subsidiaries at a discount from the market price on the purchase date, unless the
discount is available to all security holders or to all salaried employees

• Amounts paid or accrued in connection with the director’s termination or retirement or on a change in
control of the company

• Company contributions or other allocations to defined contribution plans

• Consulting fees paid or payable by the company, its subsidiaries, or its joint ventures. Consulting fees
are reportable even if paid for services unrelated to the individual’s services as a director, such as
services as an economist (Staff Interpretive Response 12.01).

• Annual cost of donations and promises to give to charitable institutions in a director’s name payable
currently or on a designated event, such as on retirement. Such programs are known as charitable
awards programs or director legacy programs. Charitable award programs include a charitable
matching program, regardless of whether the program is available to all employees (Staff Q&A
127.05). The company is required to provide footnote disclosure of the total amount payable and
other material terms of each program.

• Premiums paid by, or on behalf of, the company for life insurance for the director’s benefit

• The amount of dividends or other earnings paid on stock or option awards if the amounts were not
included in estimating the grant date fair value of those awards

The following items are not included in the all other compensation column to prevent double counting of
compensation:

• Payments of benefits from pension or actuarial plans, unless accelerated under a change-in-control
provision

• Distributions of nonqualified deferred compensation

A company is required to include a footnote to column (g) identifying and quantifying any item other than
a perquisite or other personal benefit whose value exceeds $10,000.
New Developments Summary 182

The amount reportable in column (h) is the sum of the amounts reported in columns (b) through (g) for the
fiscal year.

Narrative disclosure
A company is required to provide narrative disclosure following the table that describes material factors
necessary to understand director compensation, such as a description of a standard compensation
arrangement (for example, fees for retainer, committee service, chairing the board or a committee, and
meeting attendance). If any directors have a different arrangement, the narrative should identify the
individual directors and describe the terms of their compensation. If applicable, option timing or option
dating practices should be described.

G. Compensation Committee Report


The compensation committee is required under Regulation S-K, Item 407(e)(5), to issue a Compensation
Committee Report, similar to the Audit Committee Report. The Report must state whether

• The compensation committee has reviewed and discussed the CD&A with management

• Based on the review and discussions, the committee recommended to the board of directors that it
include the CD&A in the company’s annual report on Form 10-K and proxy statement

The company is required to include or incorporate by reference the Compensation Committee Report in
its annual report on Form 10-K along with the CD&A. The names of each member of the compensation
committee must appear below the disclosure. This report is “furnished” rather than “filed.” The principal
executive officer and principal financial officer can look to the Compensation Committee Report for their
required certifications.

The compensation committee of an entity that has received financial assistance under the Emergency
Economic Stabilization Act of 2008 has additional certification responsibilities during the period the
Treasury holds the entity’s debt or equity obligations acquired under the 2008 Act (see section K).

H. Form 8-K disclosure requirements


Under Item 5.02, a company is required to file Form 8-K to provide a brief description of the terms and
conditions of a plan, contract, or arrangement and the amounts payable to a named executive officer if
the company

• Enters into a material compensatory plan, contract, or arrangement, regardless of whether it is in


writing, to which a named executive officer participates or is a party

• Materially modifies such a plan, contract, or arrangement

• Makes or materially modifies a material grant or award under such a plan, contract, or arrangement

If the salary or bonus of a named executive officer is omitted from a company’s Summary Compensation
Table because it is not calculable, the company is required to file Form 8-K to disclose the information
when it becomes calculable and provide a new total compensation amount for the named executive
officer.
New Developments Summary 183

I. Modifications for smaller reporting companies


The disclosure requirements described in sections A through H apply to public companies other than
smaller reporting companies. Because their executive compensation arrangements are generally less
complex than those of larger public companies, complying with disclosures required of companies with
complicated arrangements would impose unwarranted burdens on smaller reporting companies. The
scaled disclosures required of smaller reporting companies are therefore limited to the following tables
and related narrative disclosures:

• Summary Compensation and narrative disclosure

• Outstanding Equity Awards at Fiscal Year-End and narrative disclosure

• Director Compensation and narrative disclosure

Smaller reporting companies are not required to provide

• Compensation Discussion and Analysis or the related Compensation Committee Report

• Tables on grants of plan-based awards, options exercised and stock vested, pension benefits, or
nonqualified deferred compensation

Summary Compensation Table


The disclosure requirements in the Summary Compensation Table for smaller reporting companies differ
from those of other public companies, as follows:

• Two years, rather than three years, of information are required to be provided for the Summary
Compensation Table.

• Named executives are generally limited to three individuals instead of five—the PEO and the two
most highly compensated officers other than the PEO. Provisions regarding identification of the
named executives of other public companies apply, for example, including all individuals who served
as PEO during the last fiscal year and including the most highly compensated individuals only if their
compensation exceeds $100,000, excluding compensation reported in column (h) of the Summary
Compensation Table (which is discussed in the next bullet). Up to two additional individuals must be
included if they would have been among the named executive officers except they were no longer
executive officers at the end of the last fiscal year.

• Smaller reporting companies are not required to disclose the change in actuarial value of defined
benefit pension plans in column (h) of the Summary Compensation Table. Therefore, the amount
reportable as nonqualified deferred compensation earnings in column (h) consists of only above-
market or preferential earnings on nonqualified deferred compensation and nonqualified defined
contribution retirement plans. In addition, benefits paid by defined benefit pension plans are not
reportable in column (i) as all other compensation, unless accelerated by a change in control.

Narrative disclosure of the Summary Compensation Table


Smaller reporting companies are required to provide in their narrative disclosure to the Summary
Compensation Table information about certain items that other public companies are required to disclose
in tables that are not required of smaller reporting companies. That additional information includes the
following:

• Material terms of each grant. For option awards, material terms to be disclosed include, but are not
limited to, the exercisability date and conditions; tandem, reload, or tax-reimbursement features; and
New Developments Summary 184

any provisions that could reduce the exercise price. Smaller reporting companies are not required to
disclose an equity award’s grant-date fair value or the incremental fair value if an equity award is
repriced or otherwise modified.

• Material terms of any nonequity incentive plan award made to a named executive officer during the
last fiscal year, including a description of the criteria used to determine amounts payable and the
vesting schedule

• Waiver or modifications of performance targets or conditions related to amounts reported under


nonequity incentive plan compensation (column (g)), including whether the waiver or modification
applied to specified named executives or to all recipients of the award subject to the target or
condition

• The method of determining earnings on nonqualified deferred compensation and nonqualified defined
contribution plans

• Identification of material items included in the all other compensation (column (i)). Amounts are
material if they exceed the greater of $25,000 or 10 percent of one of the following categories that are
specified for all other compensation: perquisites and other personal benefits, tax gross-ups and
reimbursements, the discount from market price on company securities purchased, payments for
retirement or other termination or on a change of control of the company, contributions and
allocations to defined contribution plans, life insurance premiums paid for the named executive’s
benefit, and dividends on stock or option awards not included in the grant date fair value estimate of
the award. This disclosure is in lieu of the requirement applicable to larger public companies to
identify and quantify in a footnote items in the all other compensation (column (i)) of the Summary
Compensation Table if their value exceeds certain amounts.

Outstanding Equity Awards at Fiscal Year-End Table


Smaller reporting companies must provide the same tabular and footnote information as larger public
entities for the Outstanding Equity Awards at Fiscal Year-End Table. In addition, smaller reporting
companies are required to provide the following narrative disclosure for the tabular information:

• Material terms of each plan that provides benefits primarily after retirement, including qualified
defined benefit plans; supplemental executive retirement plans; and defined contribution plans,
regardless of whether qualified

• Material terms of each written or unwritten arrangement that provides benefits for a named executive
that are triggered by resignation, retirement, or other termination; a change in control of the company;
or a change in the named executive’s responsibilities following a change in control

Director Compensation Table


The requirements for the Director Compensation Table are the same for smaller reporting companies as
for other public companies, with a few exceptions.

Smaller reporting companies are not required to

• Disclose stock or option awards’ grant-date fair values or the incremental fair value of an award that
is repriced or otherwise modified

• Include the change in actuarial value of defined benefit pension plans in column (h)

• Provide footnote disclosure for the types of all perquisites or other personal benefits included in all
other compensation
New Developments Summary 185

Other public companies are required to identify and quantify in a footnote items included in all other
compensation if their value exceeds specified amounts. In contrast, smaller reporting companies are
required only to identify material items included in all other compensation. Amounts are deemed to be
material if they exceed the greater of $25,000 or 10 percent of all items in a specified category required to
be included in all other compensation.

Smaller reporting companies should include a narrative disclosure following the Director Compensation
Table, similar to the narrative disclosure required for larger companies.

J. Effective date and transition


The interim final rules amending the Summary Compensation Table, the Grants of Plan-Based Awards
Table, and the Director Compensation Table were effective on December 29, 2006. Compliance with the
executive compensation disclosure rules, as amended by the interim final rules, is required for

• Forms 10-K and 10-KSB for fiscal years ending on or after December 15, 2006

• Proxy statements, information statements, and registration statements filed on or after December 15,
2006 if they are required to include Item 402 disclosures for fiscal years ending on or after
December 15, 2006 (Staff Q&A 1.01)

The disclosure requirements are phased in over two years for smaller reporting companies and three
years for all other public companies; companies are not required to restate executive compensation
disclosures for prior years. For example, in the first year the revised rules are applied, the Summary
Compensation Table will include only information required for the most recent fiscal year; no disclosures
will be made for prior years in the year of initial application. Public companies (other than smaller
reporting companies that are not required to provide CD&A) are required to include disclosure about
programs, plans, or practices relating to option grants in their CD&A for their first fiscal year ending on or
after December 15, 2006 (Staff Q&A 3.03).

K. Compensation restrictions on recipients of government financial


assistance under TARP
Entities participating in the Troubled Asset Relief Program (TARP) are subject to the executive
compensation provisions of Section 111 of the Emergency Economic Stabilization Act of 2008 (EESA), as
amended. To clarify the application of those provisions and related reporting requirements of Section 111,
the U.S. Department of the Treasury issued Interim Final Rules in October 2008 and in January 2009,
and Frequently Asked Questions in January 2009. In February 2009, Division B, Title VII of the American
Recovery and Reinvestment Act of 2009 (ARRA) amended Section 111 of EESA. In amending Section
111, Title VII adds a new term, TARP recipients, which are entities that receive, or will receive, financial
assistance under TARP. A TARP recipient is subject to the executive compensation provisions of Section
111 as long as the Treasury holds the entity’s debt or equity obligations acquired under TARP.

Restrictions on executive compensation


EESA Section 111 imposes certain restrictions on compensation paid to senior executive officers (SEOs),
who are the top five highly paid named executive officers identified under Item 402 of Regulation S-K or
comparable individuals if the TARP recipient is a nonpublic entity. Publicly held entities that are smaller
reporting companies must identify at least five SEOs even if there are only three named executive officers
for purposes of its disclosures under Regulation S-K, Item 402.
New Developments Summary 186

Because participation in TARP imposes restrictions on the TARP recipient’s compensation policies
related to its named executive officers, participating entities should evaluate the impact the following
Section 111 executive compensation rules and limitations have on their Compensation Discussion and
Analysis (CD&A), narrative disclosures, tables, and footnotes to the tables:

• No incentives to take excessive risk: Compensation of SEOs must exclude any incentives to take
unnecessary and excessive risks that threaten the value of the TARP recipient.

• Golden parachute payments: TARP recipients are prohibited from making a golden parachute
payment to an SEO. Under EESA, a prohibited golden parachute payment is compensation paid to,
or for the benefit of, an SEO made because of the SEO’s severance of employment to the extent the
aggregate present value of the payments equals or exceeds three times the SEO’s base amount.
ARRA amends Section 111 of EESA to define golden parachute payments as any payment for
departure from a company for any reason, except for payments for services performed or benefits
accrued. ARRA also amends the prohibition on golden parachute payments to apply not only to
SEOs, but also to the next five most highly compensated employees.

• Clawback of bonuses, retention awards, or incentive compensation: Bonus and incentive


compensation paid to an SEO must be subject to recovery (clawback) by the TARP recipient if the
payments were based on materially inaccurate financial statements or other materially inaccurate
performance criteria. The clawback applies to bonuses, retention awards, and incentive
compensation earned during the Treasury holding period if the SEO has a legally binding right to the
payment during the holding period, regardless of whether the compensation is paid during that period.
ARRA amended this provision to also apply to the next 20 most highly compensated employees.

• Prohibition on bonuses, retention awards, and incentive compensation: Under Section 111, as
amended by ARRA, the payment of bonuses, retention awards, and incentive compensation is
prohibited, except for restricted stock that meets the following conditions:

− It does not fully vest until obligations issued for TARP financial assistance are no longer
outstanding.

− The value of the restricted stock is not greater than one-third of the employee’s annual
compensation.

The number of employees affected by this prohibition increases as the amount of financial
assistance received by the TARP recipient increases. If TARP financial assistance is

− Less than $25 million, the prohibition applies to the most highly compensated employee

− More than $25 million and less than $250 million, it applies to at least the five most highly
compensated employees

− More than $250 million and less than $500 million, it applies to the SEOs and at least the 10 next
most highly compensated employees

− $500 million or more, it applies to the SEOs and at least the 20 next most highly compensated
employees

The prohibition does not apply to a bonus payable under a written employment contract executed
on or before February 11, 2009.

• The remuneration deduction on the entity’s federal tax return cannot exceed $500,000 for each SEO,
as if Internal Revenue Code Section 162(m)(5) applied to the entity.
New Developments Summary 187

Other executive compensation provisions of EESA and ARRA


Chief executive officer certification
Within 120 days of the closing date of the TARP securities purchase agreement, the entity’s chief
executive officer must provide a certification to the TARP Chief Compliance Officer that the compensation
committee has reviewed the SEO incentive compensation arrangements with the entity’s senior risk
officers to ensure that the compensation arrangements do not encourage the SEOs to take excessive
risks that could threaten the value of the entity. In addition, within 135 days of the completion of each
fiscal year that the entity is subject to the executive compensation provisions of EESA, the chief executive
officer must certify to the TARP Chief Compliance Officer that the entity and its compensation committee
have complied with the executive compensation standards. The Interim Final Rules issued in January
2009 contain illustrative certifications.

Compensation Committee certification


A TARP recipient’s compensation committee is required to identify features in its SEOs’ compensation
arrangements that could result in the SEOs taking unnecessary and excessive risks that could threaten
the value of the entity. Under the interim final rules, within 90 days after an entity’s sale of its securities
under TARP, its compensation committee is required to review the SEO incentive compensation
arrangements with the entity’s senior risk officers to ensure the SEOs are not encouraged to take such
risks. The compensation committee must also meet at least annually with the entity’s senior risk officers
to review the relationship between the entity’s risk management policies and the SEO incentive
compensation arrangements.

ARRA amended Section 111 of EESA to require that a TARP recipient must have a Board compensation
committee consisting entirely of independent directors. However, if the TARP recipient is a nonpublic
entity and received $25 million or less of TARP assistance, the board of directors should perform the
duties of the board compensation committee. ARRA also requires that the committee meet at least semi-
annually to assess whether the compensation plans pose any risk to the TARP recipient.

The compensation committee must certify that it has completed the required reviews of the SEOs’
incentive compensation arrangements and include the certification in the Compensation Committee
Report required under Item 407(e) of Regulation S-K. Entities that are smaller reporting public companies
and nonpublic entities are required to provide the certification to their primary regulatory agency. The
primary regulatory agency of a state-chartered bank is its primary federal banking regulator.

Nonbinding shareholder vote on executive compensation (say on pay)


ARRA amended EESA Section 111 to require TARP recipients to have an annual advisory shareholder
vote on executive compensation. While any obligations resulting from TARP financial assistance remain
outstanding, a TARP recipient’s proxy, consent, or authorization for an annual meeting, or a special
meeting held instead of an annual meeting, must permit a separate, nonbinding shareholder vote to
approve the compensation of executives, as disclosed pursuant to Regulation S-K, Item 402. The
disclosure must include CD&A, the compensation tables, and any related material. Smaller reporting
companies and nonpublic companies are not required to provide CD&A.

This provision is referred to as shareholder say on pay. It became effective on February 17, 2009, the
date ARRA was enacted, and applies to proxy statements filed with the SEC after February 17, 2009,
except for definitive proxy statements if the related preliminary proxy statement was filed on or before that
date.
New Developments Summary 188

A TARP recipient’s CEO and CFO or equivalents must provide written certification that the entity has
complied with the requirement regarding the annual shareholder vote on executive compensation as
follows:

• For a public company, with its annual SEC filing

• For a TARP recipient that is not a public company, annually with the Treasury

The effective date of this certification requirement is deferred until the Treasury issues implementing
regulations.

Limitation on luxury expenditures


ARRA amended EESA Section 111 to require the Board of a TARP recipient to adopt a policy on
excessive or luxury expenditures. Treasury regulations will stipulate the type of expenditures the policy
should address, which may include entertainment or events, office and facility renovations, airline or other
transportation services, or activities or events that are not reasonable expenses for staff development,
reasonable performance incentives, or other expenditures incurred in the normal course of business.

© 2009 Grant Thornton LLP, U.S. Member of Grant Thornton International. All rights reserved.

This Grant Thornton LLP document provides information and comments on current accounting and tax
issues and developments. It provides a summary of Item 402 and Item 407(e) of SEC RegulationS-K,
including SEC staff Q&As and Interpretive Responses through July 2008 and SEC staff observations
regarding registrant filings. It also summarizes Section 111 of the Emergency Economic Stabilization Act
of 2008, as amended through February 2009. This document is not a comprehensive analysis of the
subject matter covered and is not intended to provide accounting, tax, or other advice or guidance with
respect to the matters addressed. All relevant facts and circumstances, including the pertinent
authoritative literature, need to be considered to arrive at conclusions that comply with matters addressed
in this document.

Moreover, nothing in this document shall be construed as imposing a limitation on any person from
disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this document
may be considered to contain written tax advice, any written advice contained in, forwarded with, or
attached to this document is not intended by Grant Thornton to be used, and cannot be used, by any
person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

For additional information on topics covered in this document, contact your Grant Thornton LLP adviser.