Under Accounting Principles Board Opinion No. 25 ("APB 25"), companies have historically considered the effective date for grants of "equity instruments" (e.g., stock options, restricted stock, etc.) to be the date on which those awards are approved by the board of directors.1 This has been the case even where the fact of an award or its specific terms might not be communicated to grantees for some period of time following the approval. This approach has the advantage of administrative simplicity because there is an easily-ascertainable and uniform date of grant for awards, and for accounting purposes, fluctuations in the value of the underlying stock after board approval are disregarded. However, for purposes of Financial Accounting Standards Statement No. 123R ("FAS 123R"), the Financial Accounting Standards Board ("FASB") and at least one member of the "Big 4" accounting firms have signaled that this historical approach will not pass muster under FAS 123R.

In response to a recent inquiry, FASB representatives clarified their interpretation of a key aspect of FAS 123R’s fair value determination: what is the "date of grant" for an equity instrument? In contrast to historical accounting practice under APB 25, FASB representatives indicated their view that the value of an award is not fixed until both the company and the grantee have reached a mutual understanding about its terms. In other words, FASB now takes the position that the value of an award is not fixed for purposes of FAS 123R until it is actually communicated to the grantee. This approach appears to require only the communication of the terms of an award to fix its costs for accounting purposes; distribution of award agreements or acceptance by employees is not required. As quickly became apparent, FASB’s approach gives rise to a number of difficult administrative issues and raises the possibility of significant accounting and tax consequences where the terms of awards are not timely communicated to grantees. Note that FASB’s approach is not applicable until a company first becomes subject to FAS 123R.2

FASB’s interpretative approach has a number of important implications. For purposes of making fair value determinations, any fluctuations in share price following approval of an award but prior to its communication must be taken into account; for restricted stock grants, the effect can be particularly pronounced, generally resulting in a dollar-for-dollar increase or decrease in the company’s compensation expense.

In addition, most companies will be required to rethink their approach to communicating awards to employees, both in terms of the timing of communications and the process by which awards are communicated. Related to these issues, without careful calibration of the communications process, fluctuations in share price can result in either discount or premium awards. Employees typically do not favor awards granted at a premium, and awards issued at a discount can violate both the terms of an equity compensation plan and Section 422 of the Internal Revenue Code of 1986, as amended ("Code"), which for incentive stock options requires an exercise price of no less than 100% of the market value on the "date of grant." In addition, discounted options are likely to violate the limitations on deferred compensation arrangements imposed by Section 409A of the Code (subjecting the optionee to an additional 20% penalty tax). A less-obvious issue could arise if an executive or other employee is present at a board meeting during which awards are approved; awards to such an employee could have a different date of grant than those to employees who were not present at the meeting.

There are a number of possible approaches to mitigate the effects of FASB’s approach:

  • Same Day Communications. A company might choose to communicate the terms of awards on the same day that they are approved by the board. For larger or decentralized organizations, this approach may be difficult to implement.
  • Two-Part Communications. If a longer period of time between approval and communication is required, a company might choose to provide an initial notice to prospective grantees containing the key terms of awards in advance of the expected approval date. For options, the notice would state that the exercise price will be the closing market price of the stock on the date of approval. Then, on the date of approval, a shorter second notice would be provided confirming the approval of the grant and providing the exercise price. Under this approach, the date of the second notice would be used for purposes of the fair value determination. The second notice could be in the form of a "blast" e-mail or a notice on an internal website. This approach would reduce uncertainty regarding the costs of awards and would hopefully mitigate some of the administrative complexities in the award process of attempting to implement same day communication of all award terms. This approach should also prevent discounted awards, avoiding the issues under both Sections 409A and 422 of the Code.
  • Deferred Effective Date. Another alternative would be for a company to defer communicating and the effective date of awards to employees until after the board approval, subject only to the determination of the grant price at the effective date of the award. Under this alternative, the board would approve all of the material terms of an award while specifying that the effective date and the grant price will be set as of a specified date in the future (e.g., 15 days after board approval). During the period between board approval and the award effective date, managers can communicate the other terms of awards to employees.

These approaches and other, less practical approaches (e.g., separately tracking the grant date for each award as it is communicated) all pose the risk of disrupting and complicating existing award programs. For example, where prospective optionees receive an initial notice, they may develop an expectation about the their awards that the board feels constrained to honor, implicitly limiting its discretion. If the board does not approve awards that match expectations, employee morale may suffer. However, by establishing guidelines for equity awards by employee grade, the board can mitigate some of the issues inherent in providing advance notice of the award to employees. This is frequently the approach taken for offer letters provided to prospective new hires. Moreover, one-on-one contact between managers and options can continue even under the two-part communication alternative, albeit with a greater level of formality. Nevertheless, the secondary communication seems to be necessary in order to fix the cost of awards, adding administrative complexity.

The deferred effective date approach can avoid some of the foregoing difficulties by allowing the board to retain its traditional decision making authority in the awards process and giving managers a greater opportunity to conduct individual meetings with optionees. Despite its relative advantages, this approach does not completely eliminate uncertainty about the final cost of awards. However, as a compromise approach, for some companies it may offer the best balance of administrative costs and benefits.

At this point, it is not clear whether the Big 4 are in agreement regarding how to respond to FASB’s approach. At a minimum, companies should consult with their own accountants to determine how they propose to address FASB’s approach. Although there have been calls for the SEC to intervene to moderate FASB’s position (as it did with Staff Accounting Bulletin 107 earlier this year eliminating FASB’s proposal to apply FAS 123R in the middle of the year for calendar year public companies), unless and until that occurs, FASB’s interpretation will remain effective, and companies should be prepared to comply with it as they become subject to FAS 123R.

Although each of the compliance alternatives described above has its imperfections, at this point we believe that either the two-part notice or deferred effective date alternatives are the most workable administratively. Attached to this memorandum are sample initial and secondary award notices that can be used to implement these alternatives.

We hope this memorandum has been helpful to you. If you have any questions, please let us know.

Sample Initial Award Letter

[COMPANY LETTERHEAD]

[month] [day], 2005

Dear [option recipient]:

[We are recommending to the Board of Directors3 that you be granted] or [We are pleased to inform you that the Board of Directors has approved the grant of] a stock option under the Company's [year] Stock Incentive Plan. [Subject to approval by the Board of Directors,] your stock option grant will include the following terms and conditions.

Type of Option: ______ Incentive Stock Option

______ Non-Qualified Stock Option

Total Number of Shares Subject
to the Option: ____________________________________________

Vesting Commencement Date: ____________________________________________

Post-Termination Exercise Period: [3 months (12 months following termination due to death or disability)]

Term of the Option: [10 years]

Subject to your continued employment with the Company, your option will vest over [4] years in accordance with the following schedule: [25% of the shares subject to your option will vest 12 months after the Vesting Commencement Date, and 1/48 of the shares subject to your option will vest on each monthly anniversary of the Vesting Commencement Date thereafter.]

The exercise price of your option will be equal to the closing price of our common stock (as reported on [The Nasdaq National Market]) on [the date the Board of Directors approves your stock option grant] or [specify date certain].

On [the date the Board of Directors approves your stock option grant] or [specify date certain], you will receive a notification by [email]. To be eligible to receive your option, you must be an employee of the Company on [the date the Board of Directors approves your option] or [specify date certain]. [After approval of your stock option,] you will receive a Notice of Stock Option Award (the "Notice") and Stock Option Award Agreement (the "Agreement") containing the complete terms of your options.

If you have any questions regarding your proposed option grant, please contact ________.

Sincerely,

_______________

SAMPLE EMAIL NOTIFICATION OF OPTION GRANT

The purpose of the email is to inform you that the Board of Directors4 approved your stock option grant under the [year] Stock Incentive Plan as described in the letter previously delivered to you and dated [month] [date], 2005. The Board of Directors approved your stock option grant [with an effective date of] or [today], [month] [date], 2005. The exercise price of your stock option is $___ per share.

You will receive a Notice of Stock Option Award and Stock Option Award Agreement containing the complete terms of your options. Please sign the Notice of Stock Option Award and return a copy to ___________.

[Alternate language for electronic delivery of option agreements: You may access the Notice of Stock Option Award and Stock Option Award Agreement for your option grant through our intranet at the following address: ___________. Please access your option documentation and accept your option grant though the electronic acceptance procedure.]

Footnotes:

1. For ease of reference, we refer to the board of directors, but this same rule applies to grants made by the compensation committee or any other body or person at the company with the authority to grant equity awards.

2. FAS 123R is generally effective as of the first annual reporting period beginning on or after June 15, 2005 (i.e., July 1, 2005 for June 30 year companies and January 1, 2006 for calendar year companies) for most public companies and the first annual reporting period beginning after December 15, 2005 for non‑public companies. Companies that have already adopted FAS 123R are currently subject to FASB’s approach.

3. Replace Board of Directors with the Compensation Committee as appropriate.

4. Replace Board of Directors with the Compensation Committee as appropriate.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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