FASB 123R Share-Based Payments Mar2009 GT

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

• 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 F.

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.


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


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


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.


− 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


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


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


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.


“[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.


• 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


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.


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


− 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.


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.


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.


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.


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


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


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.


• 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


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.


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.


Instrument classified in equity

Amount required to be classified outside of permanent equity

Fully vested award Partially vested award

Share with redemption features (that apply only after share has been fully vested for six months)

Redemption amount at balance sheet date

Redemption amount at balance sheet date multiplied by the vested percentage of the award

Option on a share redeemable at fair value (redemption feature applies only after option has been exercised and share held six months)

Intrinsic value of the option at the balance sheet date

Intrinsic value of the option at the balance sheet date multiplied by the vested percentage of the award

Contingently redeemable share if contingent event is outside the employee’s control and if it is not probable at the balance sheet date that the event will occur

Redemption amount at grant date

Redemption amount at grant date multiplied by the vested percentage of the award

Option redeemable at intrinsic value on occurrence of contingent event not within the employee’s control, provided it is not probable at the balance sheet date that the event will occur

Grant date intrinsic value (which would be $0 if the award was at-the-money when granted)

Grant date intrinsic value multiplied by the vested percentage of the award

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.


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


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.


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.


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


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.


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.


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.


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.


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


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:


• 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.


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.


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


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.


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


• 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


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


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


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.


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;


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.


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


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.


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.


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.


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.


• 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.


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,


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.


• 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.


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


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.


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


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


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.


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.


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.


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.


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.)


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.


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


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


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:


• 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:


• 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:


• 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


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.


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.


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


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


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 15 percent a year, each employee receives 400


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


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


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.

Tran

che

2007 $250,000

2008 $250,000

2009 $250,000

2010 $250,000

2007 2008 2009 2010



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


• 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.

Tran

che

2007 $250,000

2008 $300,000

2009 $320,000

2010 $270,000

2007 2008 2009 2010



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


• 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.


• 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.

Tran

che

2007 $250,000

2008 $250,000

2009 $250,000

2010

2007 2008 2009 2010



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


• 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.


• 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.

Tran

che

2007 $250,000

2008 $250,000

2009 $250,000

2010 $250,000

2007 2008 2009 2010



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.


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.


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.


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 be recognized as of the modification date 0

400,000

Total cost if service and performance conditions are met $400,000


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.


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:


• 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


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.


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


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).


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.


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


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


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.


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.


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 award

Repurchase Cancellation

Fair value of new award

$2,200,000 $1,800,000 $ 0

Fair value of original award on modification date

$2,000,000 $2,000,000 $2,000,000

Incremental cost $ 200,000 $ 0 $ 0

Unrecognized grant-date fair value of original award on modification date

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

Cost to be recognized after modification

$1,400,000 $1,200,000 $1,200,000

Recognition period 3-year vesting period

Immediately Immediately

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.


• 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.


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.”


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).


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


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.


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 price

Fair value Exercised Stock 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.


• 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


− 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 from stock-based

employee compensation plans financial statements)

Statement 123 fair value

(from pro forma)

APB Opinion 25 expense

(per 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


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:


• 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


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


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.


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.


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

Tax benefit

$1,200

700

2nd Quarter Deferred tax asset

Tax benefit

2,000

2,600

3rd Quarter Deferred tax asset

Tax benefit

2,500

3,200

4th Quarter Deferred tax asset

Tax benefit

5,000

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.


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 + $0)/2) 1,250


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


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 stock

Unvested 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 + 1,000))

11,000

$13,200 X (1,000 / (5,000 + 1,000))

2,200

Allocated net income $21,000 $ 4,000

Earnings per share

$21,000 / 5,000 $ 4.20


$ 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


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.


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

Method used for computing beginning APIC pool

APIC balance sheet account

APIC pool addition

Cash flow statement

Treasury stock method and

earnings per share

Statement 123R, paragraph 81 method

No Yes Yes Either: accounting policy decision

Alternative method (FSP FAS 123R-3)

No No No Either: accounting policy decision

Partially vested award: adoption using modified prospective method

Method used for computing beginning APIC pool

APIC balance sheet account

APIC pool addition

Cash flow statement

Treasury stock method and

earnings per share

Statement 123R, paragraph 81 method


Alternative method (FSP FAS 123R-3)



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


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


− 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.


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.


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):


− 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:


− 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.


Number of company

outstanding options

Weighted-average exercise

price

Weighted- average

remaining contractual

life (months)

Aggregate intrinsic

value

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 June 30, 20X6

35,000 $19.99 83 $340,000

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 - -


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.


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-based payments were issued in exchange for goods or services, other than those related to employee share ownership plans (ESOPs), which are accounted for under SOP 93-6. Therefore, it applied to transactions with both employees and nonemployees.

An entity accounted for a share-based payment award granted to its employee by a principal shareholder (an owner of more 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.

The scope of Statement 123R is the same as that of Statement 123.

Statement 123R expands the principal shareholder rule of Statement 123. An entity accounts for a share-based payment award granted to its employee by a related party or other economic interest holder in the entity as compensation for services to the entity, unless the award is clearly for a purpose other than compensation for services to the entity.

Measurement of equity awards to employees

Entities had a choice of using the grant-date fair value method of Statement 123 or continuing to use the intrinsic-value method of APB Opinion 25.

Nonpublic entities were permitted to apply the Statement 123 fair-value method using either the grant-date fair value or grant-date minimum value (a valuation method that excludes the effect of stock price volatility).

If the award’s fair value could not be reasonably estimated on the grant date, the intrinsic-value method was used until the award’s fair value could be reasonably estimated.

Entities are required to use the fair-value-based measurement method, with the following exceptions:

If fair value cannot be reasonably determined on the grant date, the entity is required to measure the award based on its intrinsic value, remeasuring each period until the award is exercised, settled, or it expires. It is expected to be rare that the fair value of even a complex award cannot be reasonably determined.

If it is not practicable for a nonpublic 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.



Accounting for awards to nonemployees for goods and services

Entities were required to account for share-based payment awards to nonemployees using the applicable guidance in Statement 123 and EITF Issue 96-18.

Entities are required to account for share-based payment awards to nonemployees using the applicable guidance in Statement 123R, EITF Issue 96-18, and SAB 107.

Liability classification of awards

Share-based payment awards were classified as liabilities if the holder could compel the issuing entity to settle the award by transferring its cash or other assets.

Statement 123R provides more explicit criteria for liability classification. The following awards are classified as liabilities:

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



Awards that would be classified as liabilities under other applicable GAAP, with some exceptions

Liability awards: measurement

Liability awards were measured at intrinsic value and remeasured at each reporting date.

Public entities are required to measure liability awards at fair value and remeasure 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 valuation techniques

An option valuation model, such as the Black-Scholes-Merton or a binomial model (binomial is a type of lattice model), was required to be used.

The Statement 123 requirements for an option valuation technique continue to apply, but Statement 123R provides 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.



Option model inputs

The option valuation technique used had to take the following into account: the option exercise price, the current stock price and its expected volatility, expected dividends on the stock, the expected term of the option, and the risk-free interest rate.

The inputs required by Statement 123 are also required by Statement 123R. Statement 123R, however, provides considerably more guidance for the estimate of certain inputs. To determine the 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.



Option inputs determined within a range

If the value of an input was determined within a range (such as an estimate of volatility between 60 percent and 75 percent), and no amount within the range was a better estimate than other amounts, the end of the range that produced the lowest option value should be used.

If the value of an input is determined within a range, and no amount within the range is a better estimate than other amounts, the average of the range (the expected value) should be used.

Accounting for forfeited awards

No compensation cost was recognized for awards with service and/or performance conditions if the conditions were not met and the awards were forfeited.

Entities could choose to recognize forfeitures as they occurred or estimate expected forfeitures on the grant date and revise the estimate as necessary.

No compensation cost is recognized for awards with service and/or performance conditions if the conditions are not met and the awards are forfeited.

Entities are required to estimate on the grant date the number of awards expected to vest and recognize cost only for awards expected to vest. The estimate should be revised as better information about awards expected to vest becomes available.

Cost recognition period

Compensation cost was recognized over the period the employee was required to provide service.

Compensation cost is recognized over the requisite service period. New guidance is 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 the accelerated method in Interpretation28 if the fair value of an award with graded vesting was determined by treating each separately vesting tranche as a separate award. If the award was valued as a single award, the straight-line method was used to recognize cost.

Entities make an accounting policy election for their awards with graded vesting that have only a service condition. They can elect to use the straight-line attribution method or the graded-vesting attribution method. The method selected is used for all awards with graded vesting that have only a service condition.

Employee share purchase plans

A broad-based share purchase plan, such as an Internal Revenue Code section 423 plan, was compensatory unless

The purchase price discount was 5 percent or less or no more than (a) a discount that would be reasonable in a

Similarly under Statement 123R, a broad-based share purchase plan, such as an Internal Revenue Code section 423 plan, is compensatory unless

The (a) purchase price discount is 5 percent or less, (b) terms are no more



recurring offer to existing shareholders or (b) the per-share cost avoided by not having to raise significant capital in a public offering

The terms included no option other than (a) a period of 31 days or less to decide to enroll in the plan after the purchase price is fixed or (b) the right to withdraw from the plan if the purchase price was the market price on the date of purchase

Virtually all section 423 plans were compensatory under those provisions.

favorable than those available to existing shareholders of the same class of shares, or (c) discount does not exceed the per-share cost that would have been incurred to raise significant capital in a public offering

The terms include no option other than (a) a period of 31 days or less to decide to enroll in the plan after the purchase price is fixed or (b) the right to withdraw from the plan if the purchase price is the market price on the date of purchase

Virtually all section 423 plans are compensatory under those provisions.

Modifications of awards

A modification was accounted for as an exchange of the original award for a new award. Additional compensation cost was recognized to the extent that the value of the new award exceeded the value of the original award on the modification date. The value of the original option award on the modification date was determined using the shorter of the remainder of the originally estimated expected term or the expected term of the new award.

A modification under Statement 123R is accounted for similarly to a modification under Statement 123, except the value of an original option award is determined using its estimated expected term immediately before the modification. The compensation cost recognized for the award cannot be less than the grant-date fair value of the award unless the original award was not expected to vest on the 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 effects of share-based payment awards

If the tax deduction for an award exceeded the compensation cost recognized for the award, the resulting excess tax benefit was credited to APIC. If the tax deduction was less than the compensation cost recognized, the resulting shortfall in the tax benefit (a tax benefit less than the deferred tax asset previously recognized) was recognized in APIC to the extent of previously recognized excess tax benefits

On adoption of Statement 123R, available Statement 123 excess tax benefits (the available APIC pool) include the net excess tax benefits computed under Statement 123, regardless of whether Statement 123 was used for recognition purposes or only for pro forma disclosure purposes. Alternatively, an entity may elect to determine the available APIC pool on adoption of Statement 123R under the



accumulated for awards accounted for under Statement 123. If the shortfall exceeds available Statement 123 excess tax benefits, that excess was recognized in the income statement.

method provided in FSP FAS 123R-3.

The accounting for an excess or shortfall of tax benefits under Statement 123R is 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.


Income tax effects of share-based payment awards were recognized in operating cash flows.

The gross amount of realized excess tax benefits is classified in the statement of cash flows as a cash inflow from financing activities and a cash outflow from operating activities.


Appendix C Summary of conditions requiring liability classification

Condition requiring liability classification Illustrations of condition Exceptions to liability

classification

Shares with repurchase provisions

Mandatorily redeemable shares within the scope of Statement 150, paragraphs 9 and 10, are classified as liabilities if both the issuer and the holder are unconditionally required to redeem the shares either

On a specified or determinable date

On the occurrence of an event certain to occur

For all entities, shares are classified as liabilities if they are required to be redeemed on a fixed date for a fixed amount or an amount determined by reference to an external index. This would include

A share redeemable in five years for $50

For SEC filers, all mandatorily redeemable shares within the scope of Statement 150 are classified as liabilities. This would include

A share required to be redeemed on an employee’s termination or death

A share subject to a shareholders’ rights agreement requiring share redemption on the employee’s death

The following shares are not considered mandatorily redeemable under Statement 150 (see special rule for these shares in next section):

Puttable or callable shares

Shares redeemable on termination at the option of employee

Shares redeemable on an event not certain to occur, such as a share redeemable on a change of control

Liability classification is not required for mandatorily redeemable shares subject to the deferral of the effective date of Statement 150 in FSP FAS 150-3. As a result, for non-SEC filers liability classification is not required for the following:

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



classification

that are not classified as liabilities.

Shares with an embedded put or call require liability classification if any of the following apply:

Employee can exercise put before shares have been vested at least six months.

It is probable the employer would call the shares or permit the employee to exercise the put before the shares have been vested for at least six months.

Repurchase price of shares is fixed.

Shares with the following characteristics would be classified as liabilities:

Shares that can be sold back (put) to the employer for fair value before they have been vested for at least six months

Employer generally exercises its right to repurchase (call) shares before the shares have been vested for at least six months.

Employer allows employees to redeem shares (exercise their put right) immediately after the shares are vested.

Employee can redeem (put) shares for a fixed price, say for $50.

It is probable the employer will call the shares for a fixed price, say for $50.

Liability classification of puttable or callable shares is not required if the employee is required to hold the vested shares at least six months before exercise of the put or call and the repurchase price is not fixed. The following would not require liability classification:

Shares with an embedded put exercisable at fair value anytime after shares have been vested for six months.

Shares that the employer will repurchase (call) at fair value after they have been vested at least six months.

Shares with an embedded put exercisable before the shares have been vested for six months are reclassified to equity after the shares have been vested for six months.

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



classification

Options and similar instruments

If either of the following applies, the option would be classified as a liability:

The share underlying the option (that is, the share that would be issued on exercise of the option), if outstanding, would be classified as a liability.

The entity can be required under any circumstances to settle the option (or similar instrument) by transferring cash or other assets, except as provided by FSP FAS 123R-4 for options with contingent cash-settlement provisions (see third column).

An option is a liability if its underlying share would be a liability under the mandatorily redeemable share provision of Statement 150 (discussed above). The following would therefore be liabilities:

For all entities: an option on a share redeemable in five years for $50

For SEC filers: an option on a share redeemable on the employee’s termination or death

An option on a share with an embedded put or call is a liability if, following exercise of the option,

The employee can put the share back to the entity before the share has been outstanding for at least six months

It is probable the employer would call the share or permit the employee to exercise the put before the share has been outstanding for at least six months

The employee can redeem the share for a fixed price (say, $50)

Options (or similar instruments, such as stock appreciation rights (SARs)) that can be net-cash settled under any circumstances (except as provided by FSP FAS 123R-4, which is described in the third column) are liabilities. This

An option on a share redeemable on an event that is not certain to occur is not classified as a liability until the contingent event is probable of occurring within six months. This includes, for example,

An option on a share mandatorily redeemable on a change of control

An option that otherwise qualifies for equity classification is not subject to liability classification if the share underlying the option is not subject to liability classification because of the deferral in FSP FAS 150-3. As a result, for a non-SEC filer the following are not subject to liability classification:

An option on a share redeemable at fair value (amount not fixed)

An option on a share mandatorily redeemable on the employee’s termination or death (not redeemable on a fixed date)

Options on puttable or callable shares are not classified as liabilities if the employee is required to hold the option shares at least six months before exercise of the embedded put or call and the repurchase price is not fixed. This includes, for example

An option on a share that the



classification

includes

Options that have cash-settlement provisions

SARs that can be net-cash settled

Options that have contingent cash-settlement provisions if the contingency is probable of occurring

employee can redeem at fair value after the option share has been outstanding for at least six months

Net-share settlement does not cause options or SARs to be classified as liabilities.

The FASB issued 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,” 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.



classification

All types of share-based payment awards

Share-based payment awards are classified as liabilities if the awards would be classified as liabilities under Statement 150, paragraph 11 (as modified by the option provisions above) or paragraph 12.

An instrument settleable in a variable number of shares for a fixed amount known at inception is classified as a liability. An example is

A bonus of $500,000 that vests in three years that the entity must or may settle by issuing a variable number of shares

A freestanding put option granted to an employee is classified as a 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

Options on shares with embedded puts are not classified as liabilities if the put

Cannot be exercised until the option share has been outstanding for at least six months

Is contingent on an event outside the control of the employee, and the contingent event is not probable of occurring within six months

Substantive terms of awards may cause liability classification.

Awards are generally classified 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



classification

when requested to do so by an employee.

A share-based payment award indexed to a factor that is not a market, performance, or service condition is classified as a liability.

Awards indexed to prices or external indices, including commodity prices, the CPI, or foreign exchange rates, are classified as liabilities. The following would be classified as liabilities:

An award that becomes exercisable if the price of gold exceeds $450

An award with an exercise price that is indexed to variations in the prime interest rate

An option with an exercise price denominated in euros if the underlying share is traded only in dollars (see the third column for a limited exception)

An award indexed to a market or performance condition is not classified as a liability if it otherwise qualifies for equity classification. The following would therefore not require liability classification:

An option that is exercisable only if the entity’s share price is above $30 for 20 consecutive trading days (a market condition)

A restricted share that vests only if the entity obtains FDA approval for Product A (a performance condition)

An option with a fixed exercise price denominated in a foreign currency is not classified as a 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.



classification

Share-based payment awards are classified as liabilities if they would be classified as liabilities under other GAAP.

If an award is not classified as a liability under any explicit provisions in Statement 123R, it would be classified as a liability under Statement 123R if it would be classified as such under other accounting principles for financial instruments.

A requirement to issue registered shares would not, of itself, cause liability classification or require temporary equity classification.

Statement 133 and EITF Issue 00-19 do not apply to awards accounted for under Statement 123R.


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 in equity or liabilities

Statement 123R has specific criteria for determining when a share-based payment should be classified as a liability (see appendix C).

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-based measurement method

Statement 123R specifies a fair-value-based measurement method that entities are required to follow to estimate the fair value of employee awards. That method 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.

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.


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 valuation techniques

The valuation technique for a particular share-based payment instrument should be applied consistently. However, if an entity issues different types of instruments, each having a unique set of substantive characteristics, it may use a different valuation


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 expected option term

In estimating the period of time the option is expected to be outstanding, entities are required to take into account the effects of employees’ expected exercise and post-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 expected volatility

In determining the historical volatility of its share price, an entity should use a historical period equal to the contractual term of the option if using a lattice model, or a period 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


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 determined within a

There may 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


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 recognition period

Cost is recognized over the requisite service period, which is generally the service period unless the award has a performance or market condition.

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 recognition: retirement-eligible awards

Awards with an explicit service condition may have other provisions that indicate that the explicit service condition is nonsubstantive. Some entities, for example, have provisions in their awards that they will continue to vest if the employee retires or that vesting accelerates when the employee becomes retirement eligible. For such awards, the 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 recognition: capitalization

The recognition of 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, 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 recognition: 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. An entity therefore has to estimate on the grant date the number of awards that are expected to vest and begin recognizing cost for only those awards. The initial estimate needs to be revised if subsequently available information indicates the actual number expected to vest differs from the previous estimate.


Cost recognition: graded vesting

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. Entities issuing such awards have to select one of the following two methods 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 recognition: 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. If satisfaction of the performance condition is not probable, compensation for the award is not recognized unless the performance condition subsequently becomes probable of occurrence. Performance awards can therefore cause volatility in earnings.

Cost recognition: 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.

Income tax effects of share-based payment awards

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

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.


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


Cash retained as a result of excess tax benefits resulting from employee and 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


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

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• 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:

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• 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


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


• 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?


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


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


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


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


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


• 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).


• 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).



Name and

Principal Position

(a)

Year

(b)

Salary ($)

(c)

Bonus ($)

(d)

Stock Awards

($)

(e)

Option Awards

($)

(f)

Non-Equity Incentive Plan Compensation

($)

(g)

Change in Pension Value

and Nonqualified Deferred

Compensation Earnings

($)

(h)

All Other Compensation

($)

(i)

Total ($)

(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.


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


• 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


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.


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


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.


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).


• 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.


Grants of Plan-Based Awards

Name

(a)

Grant Date

(b)

Estimated Future Payouts under Non-Equity Incentive Plan

Awards

Estimated Future Payouts under Equity Incentive Plan

Awards

All Other Stock

Awards: Number

of Shares of Stock or Units

(#)

(i)

All Other Option

Awards: Number

of Securities

Under-lying

Options (#)

(j)

Exercise or Base Price of Option Awards ($/Sh)

(k)

Grant Date Fair

Value of Stock and

Option Awards

($)

(l)

Thresh-old ($)

(c)

Target ($)

(d)

Maxi-mum ($)

(e)

Thresh-old (#)

(f)

Target (#)

(g)

Maxi-mum (#)

(h)

PEO

PFO

A

B

C

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


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


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.


Outstanding Equity Awards at Fiscal Year-End

Option Awards Stock Awards

Name

(a)

Number of Securities Underlying

Unexercised Options

(#) Exercisable

(b)


Unexercised Options

(#) Unexercisable

(c)

Equity Incentive

Plan Awards:


Unexercised Unearned Options

(#)

(d)

Option Exercise

Price ($)

(e)

Option Expiration

Date

(f)

Number of

Shares or Units

of Stock That Have Not

Vested (#)

(g)

Market Value

of Shares

or Units

of Stock That Have Not

Vested ($)

(h)

Equity Incentive

Plan Awards:

Number of Unearned Shares, Units, or

Other Rights

That Have Not

Vested (#)

(i)

Equity Incentive

Plan Awards:

Market or Payout

Value of Unearned Shares, Units, or

Other Rights

That Have Not

Vested ($)

(j)

PEO

PFO

A

B

C

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)


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.


Option Exercises and Stock Vested

Option Awards Stock Awards

Name

(a)

Number of Shares Acquired on Exercise

(#)

(b)

Value Realized on Exercise

($)

(c)

Number of Shares Acquired on Vesting

(#)

(d)

Value Realized on Vesting

($)

(e)

PEO

PFO

A

B

C


• 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.


• 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

(a)

Plan Name

(b)

Number of Years Credited Service

(#)

(c)

Present Value of Accumulated Benefit

($)

(d)

Payments During Last Fiscal Year

($)

(e)

PEO

PFO

A

B

C

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.


• 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.


• 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


• 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

(a)

Executive Contributions in

Last FY ($)

(b)

Registrant Contributions in

Last FY ($)

(c)

Aggregate Earnings in Last

FY ($)

(d)

Aggregate Withdrawals/ Distributions

($)

(e)

Aggregate Balance at Last

FYE ($)

(f)

PEO

PFO

A

B

C

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


• 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,


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


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

(a)

Fees Earned or Paid in

Cash ($)

(b)

Stock Awards

($)

(c)

Option Awards

($)

(d)

Non-Equity Incentive Plan Compensation

($)

(e)

Change in Pension Value and

Nonqualified Deferred Compensation

Earnings ($)

(f)

All Other Compensation

($)

(g)

Total ($)

(h)

A

B

C

D

E

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).


− 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.


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.


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.


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


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


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


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.

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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.


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.


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.

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