This article is reprinted with permission from the
May 31, 2000
edition of
New York Law Journal.
© [Year] Incisive Media US Properties, LLC.


New Stock Option Accounting Interpretation

By Joseph E. Bachelder

On March 31, 2000 the Financial Accounting Standards Board (FASB) issued an Interpretation of Accounting Principles Board (APB) Opinion No. 25 (1972) entitled "Accounting for Certain Transactions involving Stock Compensation."1  The Interpretation was issued as FASB Interpretation No. 44 (March 2000). The introductory Summary to FASB Interpretation No. 44 explains the background to it:

APB Opinion No. 25, Accounting for Stock Issued to Employees, was issued in October 1972. Since its issuance, questions have been raised about its application and diversity in practice has developed. During its consideration of the accounting for stock-based compensation, which led to the issuance of FASB Statement No. 123, Accounting for Stock-Based Compensation, the Board decided not to address practice issues related to Opinion 25 because the Board had planned to supersede Opinion 25. However, Statement 123 permits entities to continue applying Opinion 25 to stock compensation involving employees. Consequently, questions remain about the application of Opinion 25 in a number of different circumstances.

For public corporations generally, the most important aspect of APB Opinion No. 25 is that a grant of a stock option to an employee does not result in a charge against earnings provided the requirements of that opinion are met. As indicated in the above-quoted excerpt from the Summary to FASB Interpretation No. 44, APB Opinion No. 25 was given close scrutiny by FASB several years ago in its review of accounting for stock compensation that resulted in FASB Statement 123.2  FASB, under considerable pressure from industry, decided to allow continued use of APB Opinion No. 25, but with a requirement for supplemental footnote disclosure. (As indicated in Footnote 2 to this column, FASB Statement 123 provides that employers may elect to treat stock option awards as a charge against earnings under Statement 123. Few corporations have made that election.)

The following discussion summarizes certain of the points covered by FASB Interpretation No. 44 and focuses on its impact on stock options. Accordingly, it is by no means a complete discussion of all the points covered by FASB Interpretation No. 44 and readers should consult with their auditors regarding application of the Interpretation to specific situations, whether involving stock options or some other form of stock award.

Effective Dates

The summary to FASB Interpretation No. 44 provides as follows:

This Interpretation is effective July 1, 2000, but certain conclusions in this Interpretation cover specific events that occur after either Dec. 15, 1998, or Jan. 12, 2000. To the extent that this Interpretation covers events occurring during the period after Dec. 15, 1998, or Jan. 12, 2000, but before the effective date of July 1, 2000, the effects of applying this Interpretation are recognized on a prospective basis from July 1, 2000.

The last section of this column discusses consequences of these effective dates for specific types of stock option modifications and the importance of these consequences to employers planning stock option modifications.

Application to 'Employee'

Under FASB Interpretation No. 44, with limited exception, APB Opinion No. 25 applies only to options granted to persons who come within the common law meaning of "employee." The Interpretation provides at Paragraph 5 as follows (parenthetical references throughout the column to "¶" followed by one or more numbers are to numbered paragraphs of FASB Interpretation No. 44):

A grantee is an employee if the grantor exercises or has the right to exercise sufficient control over that individual to establish an employer- employee relationship. That relationship shall be determined based on common law as illustrated in case law and currently under U.S. Internal Revenue Service Revenue Ruling 87-41. Accordingly, for purposes of applying Opinion 25, a grantee meets the definition of an employee if the grantor consistently represents that individual to be an employee under common law.

Generally speaking this means APB Opinion No. 25 applies to persons who are "employees" for federal payroll tax purposes provided they meet the common law definition of employee, which they usually do.

An outside (nonemployee) director does not meet the foregoing test for a common-law employee. However, FASB Interpretation No. 44 makes an exception (¶¶7- 8) as follows:

[A]n exception is made to require the application of Opinion 25 to stock compensation granted to a nonemployee member of the grantor's board of directors for services provided as a director if the nonemployee director (a) was elected by the grantor's shareholders or (b) was appointed to a board position that will be filled by shareholder election when the existing term expires. Opinion 25 does not apply to awards granted to individuals for advisory or consulting services in a nonelected capacity or to nonemployee directors for services outside their role as a director, such as legal advice, investment banking advice, or loan guarantees.

FASB Interpretation No. 44 contains a number of other definitions for including individuals as employees, including employees of subsidiaries and other consolidated affiliates (¶¶9-11) and leased employees (¶6). Excluded are employees of a parent or a "sister" company for separate company financial reporting purposes (¶14) and independent contractors (¶¶2-3).

If Grantee Is Not an 'Employee'

If the grantee of a stock option does not meet the definition of "employee," APB Opinion No. 25 does not apply and the grantor must recognize an expense for the award. The method for determining the charge is to be based on the "fair value" of the option, using an option pricing model such as Black-Scholes. On this basis, the option is to be "marked to market" over the period until it vests.3  (This method of charging earnings is to be distinguished from (i) the "intrinsic value" method and (ii) the "variable accounting" method applicable in the case of certain modifications to options as described in subsequent sections of the column.)

Award Modifications

Modifications are of two kinds in terms of their expense consequences. One set of changes - including accelerating the vesting of the option or extending the exercise period - results in a new "measurement date" at which point the "intrinsic value" of the option (commonly referred to as the "spread") establishes the basis for the charge against earnings as discussed in the next section. 4

The other set of changes results in "variable accounting" as discussed in a subsequent section. These include modifications that reduce the exercise price of an option (also referred to as a "repricing") and that add a "reload" feature to an option.

Award Modifications that Cause a New "Measurement Date." Under FASB Interpretation No. 44 there are four types of modifications to an outstanding stock option grant that result in a change in the "measurement date" of the award (¶¶32-37). These are as follows:

1. Accelerated vesting of an award that would, absent such acceleration, have expired without vesting (unless done pursuant to specific, pre- established criteria, such as a change in control or the achievement of specified performance objectives) (¶¶30-34,36).

2. Extension of the post-termination exercise period for an award (¶¶30-35).

3. Extension of the exercise period beyond the original term of an award (¶¶30- 31).

4. Settlement of an award in cash or in stock (for illustration, see ¶¶170-171).

Consequence of New Measurement Date. The occurrence of a new measurement date means that - except in certain cases noted in the next section - any excess of (i) the spread on the date of the modification over (ii) the spread, if any, on the original grant date (the original "measurement date") becomes a charge against earnings (¶35). "Spread" for this purpose means the excess, if any, of the fair market value of the option shares over the exercise price of the option (sometimes referred to as the "intrinsic value" of the option on the measurement date).

Paragraphs 34 through 36 of FASB Interpretation No. 44 address the question of when the charge, measured by the "spread," or "intrinsic value," is to be made. Unfortunately, the language used in the Interpretation is not as clear as it might be. If, on the one hand, it is certain, or at least very likely, that one or more option holders will receive a benefit from the modification (meaning their options will vest or they will receive an extended period for exercise) that they would not otherwise obtain, a charge will be made at the time of modification (or expensed over the period of vesting if full vesting does not take place in the accounting period in which the modification is made). On the other hand, if it is uncertain whether the option holder(s) will ever benefit from the modification, the employer may defer the charge until the occurrence of the event that triggers the vesting or extension of the exercise period. Applying the Interpretation to particular circumstances may not always be a simple matter (and may require adjustments at a later date).

Paragraphs 159 and 160 of the Interpretation give an example indicating that the employer should estimate the likelihood of the benefit being realized and base the charge on the likelihood of that benefit being realized, adjusting in later periods for actual experience. (The examples indicate that statistical information should be used to determine the number of employee option holders who may benefit from the modification rather than looking at likelihood in terms of an individual option holder. The principle, however, of measuring likelihood of benefit occurring in an individual case would seem to be the same.)

In terms of a specific example, if the modification provides for accelerated vesting in the event of death, the modification ordinarily would not appear to require a charge against earnings until and unless death occurs prior to the time the option otherwise would have vested. In all cases, regardless of when the charge is to be made, the amount of charge is based on the "intrinsic value" (the spread) as of the date on which the modification was made by the employer (the new "measurement date").

Award Modifications that Cause Variable Accounting. FASB Interpretation No. 44 significantly changes the accounting treatment of stock options that are modified, directly or indirectly, to reduce the exercise price. If an option is repriced, the award is subject to "variable accounting" from the date of the modification to the date the award is exercised, is forfeited or expires unexercised (¶39). Variable accounting means that for each accounting period there is a charge which is equal to the increase in the "intrinsic value," or spread, since the applicable measurement date, less the amount that has been charged for such increase in previous accounting periods. In the event of a decrease in "intrinsic value" there would be a credit for that amount. This is sometimes expressed by saying that the option must be "marked to market" (reflecting the increase or decrease in the spread) until the option is exercised. Thus an option, subject to no charge to earnings when "fixed" at date of grant, becomes subject to a charge for its increasing spread until exercised. Most corporations will not accept such an open-ended risk.

An award is considered to be "indirectly" repriced, resulting in variable accounting, if the outstanding option award is cancelled (or settled for cash or other consideration) and, within six months before or after the cancellation (or settlement), is replaced with an award with a lower exercise price (¶¶43, 45). If the grantor promises, in writing, orally, or even implicitly, to compensate the grantee for any increase in the market price of the stock after a cancellation, the grant of a replacement award requires variable accounting even if the award is granted more than six months after the cancellation (¶47). Any modification to the terms of an option award which reduces the likelihood that the grantee will exercise the option, including, for example, an increase in the exercise price, is considered a "cancellation" of the award for purposes of an "indirect" repricing (¶44). Other examples of "indirect" repricing include providing the grantee with a cash bonus arrangement that is to be paid only if the option is exercised and permitting the grantee to exercise the option with a full-recourse note that does not bear a market interest rate (¶40).

Variable accounting is also required if an option award is modified to increase the number of shares to be issued under the award, which would include adding a "reload" feature. A reload feature provides for the grant of a new option award upon the exercise of an existing award (¶58). Generally speaking, a reload feature provides for the grant of a new option at the then market price for a number of shares equal to the number of shares tendered by the option holder in a stock-for-stock exercise (¶59). Options that provide for reload features in their original terms are not affected by this interpretation related to a modification that provides a reload feature.

Other Award Features that Cause Variable Accounting. In addition to the rules relating to option modifications that result in variable accounting treatment, FASB Interpretation No. 44 identifies provisions that, if contained in original option grants, will result in variable accounting. For example, variable accounting treatment will be required if the terms of a stock option award provide for a reduction in the award's exercise price if a specified future event, such as the achievement of an earnings target or stock price, occurs (¶42). The variable accounting treatment would cease on the date the event occurs or the provision expires. (If an award is modified to reduce the exercise price contingent upon the occurrence of a specified future event, variable accounting is required at the time of the modification (¶41).)

Variable accounting is also required if a stock option has a share repurchase feature (such as a put, call or right of first refusal) if it is expected that the shares will be repurchased within six months after option exercise (¶¶67-80). Variable accounting is not required, however, for shares expected to be repurchased only to satisfy required tax withholding (¶75). Required tax withholding is the employer's minimum statutory withholding (normally 28 percent in respect of Federal income tax, together with FICA and state income tax, if any) (¶76).

Variable accounting is also required when a cash bonus that is not fixed in amount is contingent upon the exercise of an option award (¶91). A cash bonus fixed in amount that is contingent upon the exercise of an option award does not require variable accounting but is to be accounted for as part of a combined award in which the cash bonus reduces the stated exercise price of the option (¶91). Thus, in the latter case, the spread between the value of the stock on the date of grant and the deemed exercise price must be expensed over the vesting period.5

Effective Dates

The principal effective date for FASB Interpretation No. 44 is July 1, 2000. With exceptions noted below, new guidance reflected in the Interpretation will not affect actions (e.g., certain types of option modifications) taken prior to that date.

There are two tiers of special effective dates that precede July 1, 2000. These effective dates apply as follows:

A. To an award granted to a nonemployee after Dec. 15, 1998 or to an option repriced after Dec. 15, 1998

There will be no charge for any period prior to July 1, 2000. There will be a prospective charge for the portion of the new accounting charges attributable to services rendered during periods after June 30, 2000.

Comment on A.
Awards granted to nonemployees prior to Dec. 16, 1998 or options repriced prior to Dec. 16, 1998 are grandfathered - there will be no charge against earnings. For awards granted or options repriced after Dec. 15, 1998, there will be no charge if the options vest (in the case of awards to nonemployees) or, in the case of repriced options, the options are exercised, prior to July 1, 2000.

B. To a modification of an option after Jan. 12, 2000 to add a reload feature

There will be no charge for any period prior to July 1, 2000. After June 30, there will be a prospective charge only, for the cost attributable to services rendered during periods after June 30.

Comment on B.
A modification to add a reload feature made on or prior to Jan. 12, 2000 is grandfathered - there will be no charge against earnings. For any modification to add a reload feature after Jan. 12, 2000, there will be no charge against earnings if the reload option vests or is exercised prior to July 1, 2000.

FASB Interpretation No. 44 contains illustrations of how the transition rules described above work (¶¶209-217).

Planning Opportunities

1. To the extent modifications - other than those noted above - are made before July 1, 2000, they will be grandfathered from the new rules. These include modifications that

a. accelerate vesting

b. extend post-termination exercise (but not beyond the original expiration date)

In some but not all cases existing guidance is more favorable than that provided under FASB Interpretation No. 44, in which cases prompt action may be advisable.

2. To the extent options granted after Dec. 15, 1998 are held by nonemployees (anything granted prior to Dec. 16, 1998 is grandfathered), the options will not result in a charge against earnings if they vest prior to July 1, 2000.

3. To the extent a repriced option is exercised prior to July 1, 2000, it will not be subject to variable award accounting.

4. To the extent a reload option vests or is exercised prior to July 1, 2000, it will not be subject to variable award accounting.

5. If an employer permits share withholding in excess of minimum statutory tax withholding rates (i.e., withholding in respect of federal income tax (currently 28 percent) and state income tax, together with applicable payroll taxes), this practice should be changed (including, if necessary, amendment to any plan containing provisions permitting such excess withholding) so that the withholding may be made only up to the minimum required tax withholding amounts. The rule adopted in FASB Interpretation No. 44 (¶¶77-79) confirms current interpretations.


FOOTNOTES:

1 The author wishes to express his appreciation to his partner Leonard Epstein and to Paula Todd of Towers Perrin for their assistance in connection with the preparation of this column. The proposed Interpretation, which was issued as FASB Financial Accounting Series No. 195-B (March 31, 1999), was discussed in this column on June 1, 1999. A related column by the author, entitled "Repricing Stock Options," appeared on Sept. 29, 1998.

2 FASB Statement No. 123, Accounting for Stock-Based Compensation (October 1995) recognizes the continuing right of employers granting stock options to follow the accounting treatment under APB Opinion No. 25. FASB Statement 123 also permits employers to elect to treat the grant of a stock option as a charge against earnings. FASB Statement 123 requires that employers who continue to follow APB Opinion No. 25 report in a footnote to their financial statements what would have been the charge against earnings if an election to report under FASB Statement 123 had been made.

3 Discussion of the consequences of change of status from employee to nonemployee is set forth in Paragraphs 15-23 of the Interpretation. An illustration of the treatment of stock options which are granted to an employee who becomes a non-employee is set forth in Paragraphs 156-157 of the Interpretation.

4 Ordinarily the grant date of an option is its measurement date. The measurement date of an option is the date on which the charge against earnings is determined. If the exercise price of the option is fixed at an amount at least equal to the fair market value of the stock on the measurement date, there is no charge against earnings. If the exercise price is less than the fair market value of the stock on the measurement date, the difference between the value of the stock on the measurement date and the exercise price becomes a charge against earnings. In a case in which the grant of an option precedes shareholder approval of the underlying stock option plan, the Interpretation confirms that the measurement date is deferred to the date of shareholder approval (¶¶86-87). In such case, any increase in the price of stock between the grant date and the measurement date would be a charge against earnings.

5 Apart from modifications, an accounting issue being discussed with increasing frequency is whether the use of a promissory note to exercise an option, with forgiveness of the note to be made in the future, results in a charge against earnings. If the amount to be forgiven is not fixed (e.g., the forgiveness is contingent on some future event), should the option be subject to variable accounting treatment until the forgiveness occurs (and thus becomes "fixed")? FASB Interpretation No. 44 discusses a similar issue relating to the accounting treatment of fixed and non-fixed cash bonuses which are contingent on the exercise of an option award (¶¶90-91). While the author's experience regarding this issue is limited, it appears that prevailing accounting practice does not require variable accounting treatment for an option in respect of which a forgivable promissory note may be given as consideration for its exercise. For advice on a specific situation, an employer should consult with its auditors.