United States: New Disclosures About Option Expensing

After much debate, expenses related to options and other share-based payments are now required to appear on companies’ income statements. This standard, the Financial Accounting Standards Board’s Statement of Financial Accounting Standards No. 123 (revised 2004), or FAS 123R, is effective for periods ending after June 15, 2005. Beyond the complicated and controversial accounting standard itself, public companies must consider the impact of FAS 123R on Management’s Discussion and Analysis of Financial Condition and Results of Operations, or MD&A.¹

As discussed in recent SEC interpretive guidance, MD&A is meant to present in narrative form a view of a company through the eyes of management, to provide the context within which financial information should be analyzed and to provide information about the quality of, and potential variability of, a company’s earnings and cash flow, so that investors can ascertain the likelihood that past performance is indicative of future performance. FAS 123R will have a material impact on the operating results of many public companies and, depending on the transition method used for its adoption, could make comparisons to prior periods more confusing. Therefore, companies should consider the following for their MD&A when FAS 123R becomes effective and, to the extent the adoption of FAS 123R constitutes a material known trend or uncertainty, before it becomes effective:

• Change in accounting policy. The adoption of FAS 123R may result in significant differences between the financial statements of periods before and after adoption. Accordingly, the SEC believes that companies should consider including material qualitative and quantitative information in MD&A about, among other things:
• the method used to account for share-based payments prior to adoption of FAS 123R;
• the transition method selected under FAS 123R and the impact in current and future reporting periods;
• differences in valuation methodologies or assumptions compared to those that were used in estimating fair value of options under prior accounting standards; and
• a discussion of the one-time effect, if any, of the adoption of FAS 123R, such as cumulative adjustments recorded in the financial statements.

• Other related changes. In transitioning to FAS 123R, if a company makes other material changes, the SEC has stated that the company should also consider describing in its MD&A the following:

• any modifications made to outstanding options prior to adoption of FAS 123R and the reasons therefore;
• changes in the quantity or type of instruments used, such as a shift from options to restricted stock;
• changes in terms of share-based payment arrangements, such as the addition of performance conditions; and
• total compensation cost related to nonvested awards not yet recognized and the weighted average period over which it is expected to be recognized.
• Critical accounting policy. The SEC through interpretive guidance expects companies to discuss their critical accounting policies in MD&A. These policies are the ones that management believes are most critical – they are both important to the portrayal of the company’s financial condition and results, and they require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. If FAS 123R is a critical accounting policy for a company, the company should explain the effects of the policy as applied, the judgments made in its application and the likelihood of materially different reported results if different assumptions or conditions were to prevail. For example, for companies for whom FAS 123R is a critical accounting policy, the SEC has stated that it expects disclosures to include an explanation of the method used to estimate expected volatility of share price, along with a description of the extent to which management utilized historical volatility, implied volatility or both in its estimates. If alternative estimates and judgments used would yield materially different results, this should also be discussed, along with the reasons for the chosen methodologies and assumptions.
• Cash and share-based payments. Where a company uses both cash and share-based payment arrangements to compensate employees, these must be presented in the same expense line on the income statement. However, the SEC has stated that companies should consider breaking out the amount of expense related to share-based payment arrangements within MD&A where such information would be important to assist investors in understanding the company’s performance. In addition, the SEC believes that companies should explain, if material, the reasons share-based payment expenses have fluctuated from period to period.

The SEC has made clear that a measure that excludes the expense related to FAS 123R (for example, net income before share-based payment charge) would be subject to the SEC’s Regulation G as a non-GAAP financial measure. However, if a company believes that presentation of this or a similar non-GAAP financial measure would be useful to investors, the company may present it.

Under SEC rules, a company will have the burden of demonstrating the usefulness of the measure and will need to disclose the reasons why management believes the non-GAAP financial measure provides useful information to investors and, to the extent material, any additional purposes for which management uses such measure. The SEC has noted that inclusion of a non-GAAP financial measure may be misleading absent disclosure about the economic substance behind management’s decision to use such a measure, the material limitations associated with use of the non-GAAP financial measure as compared to the use of the most directly comparable

GAAP financial measure, and the manner in which management compensates for these limitations when using the non-GAAP financial measure. A non-GAAP financial measure may not be presented on the face of the financial statements. Instead, the SEC believes that MD&A would be an appropriate place to present the measure and the required disclosures described above. In addition, SEC rules require reconciliation of the non-GAAP financial measure to the most directly comparable GAAP measure. Under SEC regulations, a company may not adjust a non-GAAP performance measure to eliminate or smooth items identified as non-recurring, infrequent or unusual if it is reasonably likely that a similar expense will recur within two years or there was a similar expense within the prior two years. In other words, if a company regularly grants equity compensation, it should generally not label the expense attributable to FAS 123R as a one-time or extraordinary expense.

For companies for which FAS 123R will have a material impact, careful consideration must be given not only to the application of the accounting rules themselves and changes to financial statements, but also to the disclosure to investors of their expected and actual impact. From period to period, these disclosures should be evaluated and updated to ensure that the public has a transparent view of the effects of FAS 123R.

© 2005 Sullivan & Worcester LLP