FASB substantially rewrote rules with FASB 123R  2004

• Requires fixed price options to be expensed

• Covers share-based payments to employees and directors
• Revised rules for non-employees and ESOPs are to follow

• SEC press release  12.16.04
• FASB press release  12.16.04
• Historical Background

SEC summaries

• SEC disclosure issues summary  12.01.05
• SEC speech  12.05.05
• SEC speech  12.05.05

FASB 123R valuations are referenced by S-K 402

• SEC disclosure item for executive compensation
• Executive Compensation Disclosure and S-K 402
• Disclosure of valuation assumptions in Summary Compensation Table

FASB 123R applies only to companies with public equity

• Doesn't apply to companies with only public debt
• e.g., high yield debt issuers that are voluntary filers

SEC issues SAB 110

• See SAB 110 below

Google transferable stock option TSO program provides alternative to traditional option program

• Google TSO Program topic page 
• Google used Black-Scholes-Merton option-pricing model for fiscal year 2006

Zions Bancorporation ESOARs provide alternative valuation method

• ESOARs 

Stock option backdating scandal

• Typically involves a company not satisfying the technical  requirements for favorable accounting treatment allowed by FASB 123 (predecessor to FASB 123R)
• Stock Option Backdating

PCAOB issues audit-related FAQs

• Press release 10.17.06
• FAQs

SEC issued interpretive advice with SAB 107  2005

FASB 123 - Revised  2004
Share-Based Payment

• Revises FASB 123
• Supercedes APB 25
• FASB summary
• FASB status

FASB FAQs

FASB webpage

FASB Staff Positions

Commentary

• FW Cook summary  11.11.05

SEC staff issues year-end help for expensing employee stock options

• Regarding the use of a "simplified" method in developing an estimate of expected term of "plain vanilla" share options in accordance with FAS 123
• Text

• SEC website
• Federal Register  Forthcoming

• SEC press release  12.21.07

Table of Contents

1. Re: Nonemployees

2. Transition from nonpublic to public entity status

3. Valuation methods

4. Assumptions used in valuation methods

   • Expected Volatility

   • Expected Term

5. Certain redeemable financial instruments

6. Classification of compensation expense

7. Non-GAAP financial measures

8. First time adoption in an interim period

9. Capitalization of compensation cost

10. Accounting for income tax effects

11. Modification of employee share options

12. Application to foreign private issuers

13. Disclosures in MD&A

Provides SEC guidance on applying FASB 123R

• SEC press release  3.29.05
• SEC memo  3.18.05
• Client mailing
• SEC summary  12.01.05

Modified grant date approach

Value is determined upon grant ...

• Fair value of award at time of grant
• Valued as if a freely-traded market instrument
• Without regard for vesting or other performance conditions
• Thus, value reflects market risk that award may never be
  in-the-money
• But not the risk of performance-related forfeiture
• Generally, value is unchanged by subsequent events

... but recognized as an expense
over the requisite service period

• Must estimate forfeiture rates from vesting schedule and other performance-related factors
• Recognition is adjusted as forfeiture estimates change
• So that unvested awards aren't recognized as an expense

Fair value determination

• FASB 123R doesn't prescribe a valuation model
• Paragraph A7 of FAS 123R states observable market prices of identical or similar equity instruments in active markets are the best evidence of fair value ...
• Most companies use one of following:

• Black-Scholes model
• Binomial model
• "Monte-Carlo" simulation (lattice model)

• Assumptions about share price volatility can have a significant impact on results
• Model should be used consistently
• ESOARs Alternative valuation method

Per FASB 123R, valuation model should reflect:

• Exercise price
• Expected term
• Current stock price
• Expected volatility
• Expected dividends
• Risk-free interest rate

SEC commentary

• SEC summary  12.01.05
• SEC Chairman speech  9.09.05
• SEC OEA memo  8.31.05

ISS analysis

• Corporate Governance Blog  2.20.07

Other commentary

• Aon Consulting / Towers Perrin  7.10.07

Modifications / Repricings

Cash settlement

Tax issues

Employee Stock Purchase Plans  ESPPs

Merrill Lynch  2006  

Walt Disney  2005

SEC_CODE_REF_0090001192884

Brocade Communications  2005

Employee Stock Option Appreciation Rights Securities

Derivative securities that are used to establish the
fair market value of employee stock options

Developed and marketed by Zions Bancorporation

Initially "cleared" by SEC Chief Accountant,
 subject to caveats about auction process

Received final clearance of ESOARS auction model

Zions Bancorporation ESOARS  Auctions

2006 auction

2007 auction 

SEC materials

• Office of Economic Analysis memo  8.31.05
• Chief accountant's speech  9.09.05
• Chairman Cox statement  9.09.05

Other methods

• Cisco failed to get SEC approval for its 2005 proposal

• CFO article  9.12.05
• At the time, former SEC Chief accountant was skeptical of derivative-based initiatives

• Other banks have initiatives, including JP Morgan Chase

CII Opposition

• Letter to SEC  2.05.07
• CII in the News  2.06.07
• Letter to SEC  4.02.07
• Testimony of CII General Counsel  6.05.07

Commentary

• CFO article  1.30.07
• Latham & Watkins memo  2.05.07

• ISS Corporate Governance Blog  2.20.07

• Cleary Gottlieb  3.28.07
• Compensation Valuation, Inc.  3.30.07
• Speech by SEC Staff  6.01.07

• Aon Consulting / Towers Perrin  7.10.07
• Deseret Morning News  7.23.07

Timeline

• FASB issued APB 25 in 1972

• Required most equity-based compensation to be expensed
• But not stock options with a fixed exercise price

• FASB issued FASB 123 in 1993

• Original proposal would have required expensing
  of fixed price options
• Instead, only required financial footnote disclosure
• Encouraged but did not require expensing

• FASB issued FASB 148 in 2002

• Many companies voluntarily expensed per FASB 148 when it became clear that  FASB 123(R) would be adopted

• FASB adopted FASB 123R in Dec 2004

• Requires fixed price options to be expensed
• Covers share-based payments to employees and directors
• Rules for non-employees and ESOPs to follow

Accounting for equity-based compensation has been a long-standing controversy

• At various points, Congress has threatened to legislate accounting rules for stock options
• Until adoption of FASB 123R, rules favored fixed-price stock options

• GAAP didn't require compensation expense
• Options got favorable tax treatment
• Other forms of equity-compensations
  didn't have these advantages

• Controversy has centered on accounting, although true concern may be with the way options have been used as compensation

• While compensatory options are clearly an economic cost to the issuer, it's not clear that they should be an accounting expense
• Options have no effect on actual cash earnings
  (except for tax ramifications), but are dilutive to other equity holders
• An affect that was already recognized in fully-diluted EPS calculations
• While markets can accurately value freely-traded options on liquid stocks, compensatory options are more difficult to accurately value
• Timing of expense recognition, and how to deal with performance-related forfeitures, are unavoidable complications

Applies to all awards granted, modified or settled after the Implementation Date

SEC delayed application of FASB 123R

• SEC press release  4.14.05
• SEC release  4.15.05
• SEC summary  12.01.05
• Amended S-X Rule 4-01(a)
• For most companies, a six month reprieve

Implementation Date - Generally

• First interim or annual reporting period
  beginning after 6.15.05

• i.e., beginning with 3Q 2005 for calendar year companies

Implementation Date - Small business issuers  SBIs

• First interim or annual reporting period
  beginning after 12.15.05

• i.e., beginning with 2006 for calendar year companies

FASB 148  2002

• Transition and Disclosure - Amended FASB 123
• FASB 148
• FASB summary
• FASB status
• Provided alternative methods for voluntary transition from the intrinsic value- based approach of APB 25 to the fair value-based approach of FASB 123
• Requires more prominent disclosures in quarterly and annual reports of effects of all stock-based compensation

FASB 123  1995

• Accounting for Stock-Based Compensation
• FASB 123
• FASB summary
• FASB status
• Introduced fair value method of accounting for stock options, but allowed companies to instead continue to use APB 25's intrinsic value method provided that fair value method was included in footnote disclosure
• Fair value of options at time of grant is recognized as compensation expense over the employee's service period (usually the vesting period)

APB 25  1972

• Intrinsic value method
• No compensation expense is recognized for fixed-price option plans if option exercise price equals or exceeds the fair market value of the underlying common stock on the date of grant
• i.e. only recognize compensation expense to extent options are in-the-money at the time of grant

Accounting Issues

Executive Compensation Disclosure

Stock Option Backdating