Financial Reporting Financial Reporting
  March 2006   

 Issues Covered



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What are other implementation issues to consider?

Previously, we noted that Statement 123(R) requires companies to record no compensation expense for forfeitures of awards and on an ongoing basis to estimate how many forfeitures it anticipates. In the end, forfeitures will be adjusted to actual experience. The hurdle here is adequately estimating forfeitures and recognizing that actual experience may differ from estimates and may have a significant impact on compensation recorded.

Consideration of the quality of the data available to estimate the expected terms of options and the expected volatility of the company's stock price is another implementation issue that may pose difficulties for some companies. For example, both estimates would require careful analysis of periods in which swings in stock price or exercise behavior may have been influenced by or attributable to extraordinary market conditions or events that are infrequent in nature and should be excluded from consideration. Employee exercise and termination behavior may differ among various groups of workers (e.g., salaried versus hourly). Blackout periods as well as non-transferability or other restrictions on awards are additional factors that may affect the expected term of options.

A company also may encounter situations in which the grant date of an award may differ from the date the employee begins rendering service. For example, an employee may begin rendering service before some of the critical terms of the award have been set. Under this scenario, a company would begin accruing compensation even though the grant date has not yet occurred (assuming all necessary approvals to grant the award have been obtained). Alternatively, the directors may have granted an award subject to shareholder approval, and the employee may begin to render service. Under this scenario, a company would not start accruing compensation until shareholder approval is obtained, unless approval is a formality because the directors own a majority of the outstanding shares.

If a company grants share-based payment awards to employees whose compensation is capitalized in inventory, self-constructed assets, internally developed software, etc., then the compensation from their share-based payments awards should be capitalized to the same extent as their cash salary and fringe benefits. Companies may need to develop new systems to capture the amounts to be capitalized. Alternatively, as suggested in SAB 107, it may be possible to make reasonable approximations of the amount of share-based compensation to be capitalized without revising existing cost capitalization systems.

In terms of processes to consider when implementing Statement 123(R), the monitoring and tracking of option information (e.g., exercise behavior, consideration of blackout periods when formulating lattice model estimates, impact of post-vesting behavior, etc.) along with the estimation of service and performance condition outcomes (e.g., employee turnover or forfeiture rates, likelihood of performance criteria being satisfied, etc.) require a company to assess how well its processes are designed and how well they may be working. Considerations in this area become especially important in light of the internal control reporting requirements under Section 404 of the Sarbanes-Oxley Act.

Other more obvious considerations include the appropriateness of software being used to value the options and spread compensation expense and whether the award agreements have been thoroughly read and their provisions captured in the valuation methodology being employed.

Finally, companies will need to consider the impact that fair value accounting for share-based payment awards will have on financial ratios, including compliance with debt covenants, and budgets during their corporate planning processes.

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Copyright © 2006, BDO USA,LLP. Material discussed in this Financial Reporting newsletter is meant to provide general information and should not be acted upon without first obtaining professional advice appropriately tailored to your individual facts and circumstances.