Does the plan create equity interests or liabilities?

As noted in the next section, Statement 123(R) establishes different measurement dates for equity awards versus liability awards. Therefore, it is important for companies to properly identify the nature of their awards. Generally, plans that are settled by issuing shares to employees, including "cashless exercise" (net share settled) options, create equity interests, and plans that are settled by issuing cash to employees create liabilities. However, the model for distinguishing equity awards and liability awards under Statement 123(R) differs from the general guidance on liability versus equity classification in FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, and EITF Issue No. 00-19, "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock." Generally, the guidance in Statement 123(R) identifies more awards as equity than would be the case under the general guidance.

Statement 123(R) provides that once an employee no longer gains any benefit in an award from being employed, the classification of the award as equity or liability should be determined under the general guidance rather than the specialized guidance of the Statement. Generally, an employee no longer gains any benefit from being employed after (1) an award is vested and (2) any early exercise provisions (for example, a requirement to exercise an option within 90 days of termination of employment) have lapsed. The result would have been that common features of employee awards classified as equity under Statement 123(R) would have caused the awards to be reclassified to liabilities upon vesting. This requirement caught many companies by surprise. In response, in August 2005, the FASB released FASB Staff Position (FSP) FAS 123(R) - 1, "Classification and Measurement of Freestanding Financial Instruments Originally Issued in Exchange for Employee Services under FAS 123(R)," which essentially eliminates the requirement to apply the general guidance to an award when an employee no longer obtains a benefit from continued employment. Said differently, if an award is granted to an employee, its classification as equity versus liability continues to be covered by Statement 123(R) until expiration or modification. The guidance in this FSP is to be applied upon initial adoption of Statement 123(R).

Statement 123(R) also indicates that an employee award that requires cash settlement under any circumstance, regardless of how remote, should be classified as a liability. Although not common, some awards contain such provisions, for example, upon a change in control. In February 2006, the FASB released FSP FAS 123(R) - 4, "Classification of Options and Similar Instruments Issued as Employee Compensation That Allow for Cash Settlement upon the Occurrence of a Contingent Event," which amends Statement 123(R) and requires a company issuing employee stock options to classify the options as liabilities only when it becomes probable that some event outside the employee's control would require cash settlement. If an equity award becomes a liability because a contingent cash settlement event becomes probable of occurring, the change in classification is accounted for similar to a modification from an equity award to a liability award under Statement 123(R). The guidance in this FSP is to be applied upon initial adoption of Statement 123(R). We discuss accounting for modifications in a subsequent section.

Temporary equity
The SEC's rules about temporary equity apply to share-based payment awards that are classified as equity under Statement 123(R). SEC registrants classify share-based payment awards that are puttable to the employer or contingently settled in cash as temporary equity.

Nonemployee awards
In SAB 107, the SEC staff indicates that the guidance in Statement 123(R) about whether an award is classified as a liability or as an equity instrument should be applied to nonemployee awards.

How Statement 123(R) differs from Opinion 25
Opinion 25 does not distinguish between equity and liability awards.

How Statement 123(R) differs from Statement 123
Statement 123 made a similar distinction between equity and liability awards. Most, but not all, awards are classified similarly under Statement 123(R) as under Statement 123.

Continue Reading - If the plan is compensatory, when is compensation measured?

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