This article is
reprinted with permission from the
June 01, 1999
New York Law Journal.
© 1999 NLP IP Company.
Proposed Accounting Interpretation on Stock Options
By Joseph E. Bachelder
THE FINANCIAL Accounting Standards Board (FASB) has issued a Proposed Interpretation of Accounting Principles Board (APB) Opinion No. 25 (1972). The Proposed Interpretation was issued as FASB Financial Accounting Series No. 195-B (March 31, 1999).
APB Opinion No. 25, together with the more recently issued FASB 123, sets forth basic rules for accounting for stock issued to employees. 1 The Proposed Interpretation applies to various forms of stock awards but this column will focus on its impact on stock options. Conversations with the Staff at the FASB indicate the thinking of the Staff is not final on a number of points in the proposal.
The Proposed Interpretation provides that the period for public comment expires June 30, 1999. 2 The news release that accompanied the Proposed Interpretation states that the FASB expects to issue the final version of the Proposed Interpretation in September. However, conversations with the FASB Staff indicate that the final version is more likely to be issued in October.
For public corporations generally the most important rule contained in APB Opinion No. 25 is the rule that a stock option does not result in a charge against earnings provided the requirements of that opinion are met. APB Opinion No. 25 was given close scrutiny by the FASB several years ago in its review of accounting for stock compensation that resulted in FASB 123. The FASB, under considerable pressure from industry, decided to continue the basic rule of APB Opinion No. 25 that no charge against earnings is required for stock options that comply with its requirements. (As indicated in Footnote 1 to this column, FASB 123 provides that employers may elect to treat stock option awards as a charge against earnings. Few corporations have made this election.)
The Proposed Interpretation represents the FASB's views as to when a stock award does or does not meet the requirements of APB Opinion No. 25. While the following discussion summarizes key points covered by the Proposed Interpretation, it is by no means a complete discussion of all the points raised and the actual release should be examined as to its applicability to a specific situation.
Application of APB Opinion No. 25
Under the Proposed Interpretation, APB Opinion No. 25 applies only to options granted to persons who come within the common law meaning of "employee." The Proposed Interpretation states at Paragraph 3 that this means the individual must work for "an entity [that] has the right to direct and control the individual's work...." (Generally speaking this means APB Opinion No. 25 applies only to persons who are "employees" for federal payroll tax purposes as the federal payroll tax currently is applied.)
On this basis, options granted to independent members of a board of directors (i.e., those who are not employees) will not be eligible for treatment under APB Opinion No. 25. This clarification may slow down the growing use of stock options to compensate outside directors. The Proposed Interpretation also discusses the accounting treatment if an employee for purposes of APB Opinion No. 25 ceases to be an eligible employee (or vice versa) while holding an option grant that is not yet fully vested.
That discussion is covered at Paragraphs 13-16 of the Proposed Interpretation. (Unless indicated otherwise, citations to paragraph numbers will refer to paragraphs of the Proposed Interpretation.)
Variable Award Treatment
If a stock option grant is treated as a variable award, there will be a charge against earnings equal to the spread between the exercise price of the option and the stock price on the date of exercise reduced by whatever amount has been charged in previous accounting periods. During the vesting period of the option, the spread between the exercise price and the stock price is determined at the end of each accounting period. Generally a ratable charge is made to the accounting period based on the increase, if any, in the spread during that accounting period. "Ratable" for this purpose ordinarily means the charge is spread over the remaining vesting period and the accounting period in question takes into account its pro rata share of that charge. Once the option vests, a full charge is made for any increase in value during any subsequent accounting period. If the stock price decreases (whether during or after the vesting period), there is a credit to the extent that compensation expense has been previously recognized.
Historically, a number of circumstances have caused variable award treatment -- for example, if the exercise price or the number of shares subject to the option is not fixed at the time of grant, it is subject to variable award treatment under APB Opinion No. 25 until both those features become fixed. The Proposed Interpretation clarifies certain other situations in which variable award treatment applies to a stock option.
a. Repricing. If a stock option exercise price is changed the option becomes a variable award. (The Proposed Interpretation does not limit this clarification to circumstances in which the exercise price is reduced.) See Paragraphs 33-35. If a stock option is canceled and a new option is granted within six months thereafter at "a different exercise price" the two transactions are also treated as a repricing. (Again, the Proposed Interpretation does not limit this to a situation in which the new option is granted at a lower price than the one canceled.) Exception is made for price and share changes in connection with equity restructurings such as stock splits and stock dividends if the change, if any, in the fair value of the option is de minimis. No explanation of the meaning of de minimis is given.
b. Repurchase of Shares. With the exception of certain repurchases for tax withholding (see discussion below), the Proposed Interpretation requires variable award treatment for any stock option award that provides for the repurchase by the employer of shares acquired upon exercise of the option within a short time after exercise (e.g., within six months of date of exercise). See Paragraphs 36-37. In the case of a non-public company a similar rule applies although the Proposed Interpretation (Paragraph 38) does not specify six months as a minimum period for the optionee to hold the stock. (Instead it simply provides for variable award treatment if the stock is "repurchased shortly after option exercise.")
c. Tax Withholding. Stock repurchases (or withholding) upon exercise of a stock option equal in value to the required tax withholding do not affect the charge-free characteristic of the stock option. See Paragraph 40. For this purpose, "required tax withholding" is described by the Proposed Interpretation as "based on the minimum statutory withholding rates for federal and state tax purposes, including payroll taxes, that are applicable to such [gains]...."
Any stock option grant made after Dec. 31, 1999, resulting in tax withholding in excess of the "required tax withholding," or expected, based on past practice, to result in an excess over such required withholding, will result in variable award treatment. See Paragraphs 40-41. Prior to the Proposed Interpretation this issue had been the subject of a 1987 interpretation by the Emerging Issues Task Force (EITF). EITF Issue No. 87-6, § C, "Use of Stock Option Shares to Cover Tax Withholding." This interpretation was further clarified by the EITF at meetings held on March 24-25, 1999. The results of EITF Issue no. 87-6, § C, the March EITF meetings and the Proposed Interpretation are as follows:
(i) for options granted on or before Dec. 31, 1999, and exercised after March 25, 1999, there will be a charge against earnings equal to the amount of the withholding in excess of the minimum tax withholding required by law;
(ii) for options granted after Dec. 31, 1999, withholding in excess of the minimum tax withholding required by law (or a practice by the employer of allowing such excess withholding even if not elected by the optionee in a particular case) will result in variable award treatment.
d. Cash Bonus Linked to Option. A cash bonus associated with the grant of a stock option is accounted for as a combined variable award if payment by the employer or refund by the employee of the cash bonus is contingent upon either the vesting or exercise of the option. See Paragraphs 52-53.
If a modification of a fixed stock option results in an increase in value of that option that is more than de minimis a new measurement date is required. An example of a modification noted by the Proposed Interpretation is an amendment that accelerates the vesting date upon the occurrence of such an event as retirement, death, disability or a change in control. Again, the Proposed Interpretation does not make clear what is meant by de minimis.
For most options (granted with an exercise price equal to the market price at date of grant), a new measurement date means that to the extent the market price of the stock as of the new measurement date has gone up from what it was on the original grant date there will be a charge against earnings for that growth in value.
What is the new measurement date? If the modification is an amendment providing for acceleration of vesting based on an occurrence of such a future event as retirement, death, disability or a change in control (as noted above), the Proposed Interpretation indicates that the new measurement date is the date on which the event occurs. This means that there will be a charge against earnings equal to the spread between the exercise price of the stock option and the price of the stock on the date the event occurs.
What happens if the event never occurs? According to the FASB Staff, there never will be a charge against earnings in such a case. Unless and until the event occurs, there is no accounting consequence.
The staff apparently takes the view, not stated in the Proposed Interpretation, that acceleration of vesting that is strictly time-based does not result in a charge against earnings. Thus acceleration of vesting from, say, the third anniversary date of the grant (according to the terms of the original grant) to the second anniversary date of the grant does not result in a charge against earnings.
This latter position is explained by the staff on the basis that FASB 123 does not treat vesting as affecting the value of an option. Therefore, acceleration of vesting based strictly on the passage of time should not affect the value of an option so as to cause a new measurement date. If that is so, why should a modification that simply accelerates vesting based on a future event like retirement result in a new measurement date and, therefore, a charge against earnings? It is hoped that the final version of the interpretation will provide a more complete statement of the staff's position, including its rationale, in regard to the treatment of accelerated vesting.
In the event of a modification to an option for which there is a charge against earnings, rather complicated rules apply to determine the amount of the charge and the period over which it is charged. See Paragraphs 28-30.
Section 423 of the Internal Revenue Code of 1986 permits employee stock purchase plans that qualify under that section to set the stock purchase price as low as 85 percent of the fair market value of the stock. Code § 423(b)(6) permits the price to be set at the lower of 85 percent of the fair market value on the date of grant or 85 percent of the fair market value on the date of exercise. This is called a "look-back option." The Proposed Interpretation provides that a look-back option that qualifies under Code § 423 does not cause the award to be a charge against earnings.
For noncompensatory plans other than § 423 plans a more general test, as set forth in APB Opinion No. 25, is incorporated into the Proposed Interpretation. It provides that "the discount from the market price of the stock [shall be] no greater than would be reasonable in an offer of stock to stockholders or others." Thus, noncompensatory plans other than those covered by Section 423 must be looked at on a case-by-case basis, applying the general rule just quoted. See Paragraphs 17-22 and Appendix A to the Proposed Interpretation, Paragraphs 63-65.
The Proposed Interpretation states that awards granted under a plan that is subject to shareholder approval will not be treated as granted until the approval is obtained. The only exception is for situations in which approval is essentially a formality (for example, in a case in which management and the board of directors control enough votes to obtain approval).
Otherwise, any required shareholder approval should be obtained prior to the grant date to ensure that the option exercise price and the stock price are the same and thus avoid a compensation charge for the "intrinsic value" -- that is the excess, if any, of the market price over the exercise price on the date on which the Proposed Interpretation would treat the option as granted -- the date on which shareholder approval is obtained. See Paragraphs 48-49.
The Proposed Interpretation contains rules for stock options involved in business combinations. These rules, which are too involved to be discussed in this column, are covered at Paragraphs 42-47.
Except for the effective dates for the rules on excess tax withholding, described above, the Proposed Interpretation applies to grants of stock options, modifications to outstanding options, and changes in employee status that occur after Dec. 15, 1998. To the extent that such events occur after Dec. 15, 1998, but before the final issuance of the Interpretation (which the staff currently expects to be in October), the effects of the Interpretation will be applied only prospectively.
For example, if a vested option was repriced on Jan. 31 to lower the exercise price to the then current stock price of $10, and the Interpretation is issued on Oct. 1, when the stock price has risen to $25, no compensation cost is recognized for the increase in stock price from $10 to $25. Compensation cost is recognized only to the extent that the stock price exceeds $25 after Oct. 1, 1999. On the other hand, if the option is unvested on the date the final Interpretation is issued, there will be a charge for the increase above $10 determined on a pro-rata basis reflecting the portion of the vesting period remaining after the date of such issuance. The Effective Date provisions are contained in Paragraph 54 and examples of the transition rules are provided in Appendix B to the Proposed Interpretation.
1 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 123 also permits employers to elect to treat the grant of a stock option as a charge against earnings. FASB 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 123 had been made.
2 According to the news release accompanying the Proposed Interpretation, during the comment period (ending June 30 as noted above), one copy of the proposal, "Accounting for Certain Transactions Involving Stock Compensation, An Interpretation of APB Opinion No. 25" (product code E151) is available without charge from the FASB Order Department, telephone (800) 748-0659. The proposal is also available at the FASB Web site under Exposure Drafts at www.fasb.org.