The FASB is at it again. As reported in a prior Cooley Alert, soon all companies, public and private, will need to account for share-based payments (e.g., stock options) based on their fair value at the date of grant. As many companies struggle to determine how to measure the fair value of a share-based payment, they will now also have to focus on when to make that measurement.
Historically, companies have measured the compensation expense of stock options on the date that the company took action (e.g., board or committee approval) to make the grant, even if the employee was informed of the stock option grant on a later date.1 That will change, however, under FAS 123(R).2
Consistent with the language in FAS 123 and FAS 123(R), the Financial Accounting Standards Board (the "FASB") recently confirmed that, in order to have a grant date and therefore measure the fair value of a share-based payment under FAS 123(R), the following must occur:
- Mutual Understanding. The employer and the employee have a mutual understanding of the key terms and conditions of the share-based compensation arrangement.
- Contingent Obligation. The company becomes obligated to issue shares or transfer assets to an employee if he or she fulfills vesting or other conditions.
- Potential for Benefit or Detriment. The employee begins to benefit from, or be adversely affected by, subsequent changes in the company’s stock price.
According to the FASB, the grant date for purposes of measuring the compensation charge associated with a stock option grant cannot occur until the date that the employee receiving the grant is informed of the grant, because it is not until that date that the employer and the employee have a "mutual understanding" of the award’s key terms and conditions. Although Appendix B to FAS 123(R) suggests that employees must "agree" to the key terms and conditions of an award, the FASB’s position in practice seems to be that it is sufficient to inform an employee of such terms and conditions.
A delay in the grant date because of a delay in informing an employee of the award’s key terms and conditions could result in changes in the underlying value of the company’s stock during the delay period. This, in turn, would affect the fair value calculation of the share-based payment and make it difficult for the company to gauge the "fair value" of the options at the time the company takes action to make the grants.
FASB’s position could require an employer to keep track of the date on which each employee is informed of the key terms and conditions of the stock grant, thus potentially resulting in multiple measurement dates for grants made on the same day. In addition, a delay in informing an employee of the award’s key terms and conditions could cause the company to begin accounting for the expense in a fiscal quarter later than that in which the company granting action occurred.
Suggested approaches to minimize the administrative burden associated with tracking multiple grant dates (and thus running multiple fair value calculations) include:
- E-mail blast. Companies could send a blast e-mail containing the key terms and conditions of the stock award to employees on the date of company action (or a specified later date). If the equity plan and form of agreement (including the standard vesting schedule) have already been distributed to the employees or posted on the company website, then the e-mail need only include the number of shares and the exercise price, if any (or the mechanism for determining the exercise price). This method is somewhat impersonal and could create employee relations issues if not managed properly. Additionally, with a large organization, it is almost a certainty that some employees will be on vacation, ill, or otherwise not checking emails on the communication date. It is unclear whether the employer would need to track employee receipt of such e-mail communications.
- Use estimates. Companies could estimate the fair value of share-based payments using assumptions regarding the stock price and the dates that the employees learned of the grants. The FASB staff has indicated that, if the employer determines that the difference in its stock price between the date of the company action and the date the award was communicated to substantially all employees is immaterial, then the company could use the average stock price for that period in computing its compensation expense.
It is likely that, over the next few months, grant communication practices will develop, and companies will receive greater direction from their accountants and from the FASB. In an effort to prompt such direction from the FASB, George Paulin, President of the Frederic W. Cook & Co. compensation consulting firm, sent a letter dated August 23, 2005 to Robert Herz, Chairman of the FASB, [www.fwcook.com] in which he recommended that the FASB consider a "grant date" to occur when a company discloses the key terms and conditions of aggregate stock awards on a particular date. In other words, the company would disclose all of the provisions typically covered in a grant agreement (for example, price, maximum term, vesting, payment, and treatment upon termination of employment) but not the actual number of shares granted to any particular individual. This would enable the company to publicize the essential terms of grants quickly and yet permit the company to individualize grant communications at a later date, without delaying the date on which fair value would be determined. Until the FASB accepts such an approach or clarifies what is necessary to establish the date of grant for accounting purposes, companies should assess how their employees have been informed of grants in the past and consider available methods of communicating essential grant terms promptly after grant.
1 This treatment is consistent with the Treasury Regulations governing incentive stock options, although an "unreasonable delay" in giving notice may delay the grant date until the date the notice is given. See Treas. Reg. §1.421-1(c)(1). Also, it is likely that the grant date under the incentive stock option regulations will be the grant date under Code §409A. Further guidance on Code §409A is expected later this month. For more information on Code §409A, please see the following Cooley Alerts on 409A:
"New Deferred Compensation Tax Rules: FAQs"
"Deferred Compensation: Initial Guidance on the New Tax Law"
"Nonqualified Deferred Compensation: New Legislation Imposes Stricter Rules and Penalties"
2 For a copy of FAS 123(R), click here.
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