Background and Timeline

The vast majority of companies accounted for equity awards to employees in accordance with APB Opinion No. 25, Accounting for Stock Issued to Employees. Opinion 25 defines noncompensatory plans in substantially the same way as the Internal Revenue Code. As a result, broad-based employee stock purchase plans that are noncompensatory in accordance with Section 423 of the Code generally are also noncompensatory for financial statement purposes under Opinion 25. All other employee stock options are classified as compensatory under Opinion 25, but compensation is measured as the spread between the exercise price and the market price on date of grant, which usually is zero. As a result, under Opinion 25 no compensation expense is recorded for broad-based employee stock purchase plans or for most employee stock options./p>

In the early 1990s, the FASB proposed a new approach under which most broad-based employee stock purchase plans and all other employee stock options would be classified as compensatory, with compensation measured at fair value using an option-pricing model, like Black-Scholes-Merton. Under intense opposition, the FASB enacted a compromise (FASB Statement No. 123, Accounting for Stock-Based Compensation) under which companies were permitted to continue applying Opinion 25, with footnote disclosure of what earnings and earnings per share would have been under the new approach, or to apply the new approach. In recent years, about 800 companies, mainly larger public companies, have voluntarily adopted the new approach, but the majority of companies continue to follow Opinion 25.

Statement 123(R) requires companies to adopt the fair value approach. That is, it eliminates the choice of continuing to use Opinion 25 in the financial statements and disclosing the effects of the fair value method in the notes. However, rather than simply amending Statement 123 to eliminate the choice, the new standard makes a number of subtle changes to the approach introduced by the original Statement 123. In some cases these changes are improvements, for example, expanded guidance on the application of option pricing models and accounting for modifications. In other cases, these changes create additional complications (for example, the make-believe [derived] service period for awards with market conditions) or significant implementation issues (for example, the requirement that tax benefits for excess tax deductions may be recognized only when realized as a reduction of taxes payable).

Along with Statement 123(R), the FASB released a frequently asked questions (FAQ) document available at http://www.fasb.org/project/123r_faq.pdf in response to constituents' questions regarding the FASB's decisions included in the final standard. The FAQ explains the FASB's reasoning for issuing Statement 123(R) and summarizes the key issues discussed.

At the end of March 2005, the SEC staff followed suit and released Staff Accounting Bulletin No. 107 (SAB 107), providing guidance for implementing Statement 123(R). To summarize, SAB 107 covers the following:

• Overall support for the objectives and requirements of Statement 123(R)
• Choice of valuation models
• Assumption about expected volatility of stock price
• Assumption about expected term of employee options
• Analysis of prior credits to capital from excess tax benefits
• Interaction of Statement 123(R) with the SEC's redeemable equity rules
• Capitalization of compensation from share-based payment transactions in inventory or self-constructed assets
• Applicability of Statement 123(R) to options granted to nonemployees
• Acceleration of vesting before adopting Statement 123(R)
• Adoption of Statement 123(R) in the middle of a fiscal year
• Transition requirements for companies that become public companies after adopting Statement 123(R)
• Classification of compensation and non-GAAP financial measures

In addition, SAB 107 notes that the adoption of Statement 123(R), as well as changes to share-based payment arrangements that many companies are making, may affect the comparability of financial statements. Accordingly, SAB 107 encourages Management Discussion &Analysis (MD&A) disclosures to help readers understand how these changes affect the financial statements. We examine this point further in a subsequent section. For the complete text of SAB 107 refer to http://www.sec.gov/interps/account/sab107.pdf.

In April 2005 the SEC staff announced a delay in the effective date of Statement 123(R) for public companies to fiscal years beginning after June 15, 2005, rather than quarters beginning after June 15, 2005. For further information, refer to the SEC's press release at http://www.sec.gov/news/press/2005-57.htm.

As companies began to wrestle with the requirements of Statement 123(R), the FASB formed a Resource Group comprised of preparers, auditors and consultants, along with observers from the SEC and PCAOB staffs, to provide additional guidance around some narrowly focused topics, a few of which we will address in this Financial Reporting letter. If the Resource Group reaches consensus on an issue, the Resource Group members are expected to communicate the consensus to their constituencies. The Resource Group members from Financial Executives International (FEI) have posted their minutes on the FEI website at http://www.fei.org/news/finrep/fasb.cfm. (The minutes for the three meetings are dated June, August, and October 2005.)

In response to implementation issues discussed by the Resource Group or raised by others, the FASB issued four FASB Staff Positions to amend specific provisions of Statement 123(R). All four Staff Positions are discussed in this letter.

Statement 123(R) is a lengthy document whose appendices represent an integral part in implementation of the standard. We have prepared this letter to advise our clients and friends of the key accounting issues and their potential implications. We have aimed to capture the major issues and conclusions encompassed by Statement 123(R) and provide you with practical implementation considerations.

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