Accounting for Share-Based Payment

Many companies will find their compensation strategies are no longer aligned with their goals as a result of the American Jobs Creation Act and/or changes in accounting rules. One or both sets of changes is likely to affect your company's senior-level executives and directors, and the effects are likely to be significant since accounting and tax effects are generally prominent considerations when balancing the goals of compensation plans.

Do the company's executive compensation plans still meet its objectives?

Existing compensation plans may no longer meet the company's objectives because the Act imposes numerous requirements on non-qualified deferred compensation plans.

The new tax requirements limit the flexibility of executives and directors by making it more difficult for them to defer compensation through a variety of techniques. For example, several provisions of the Act establish limitations and harsher penalties for withdrawals from deferred compensation plans. The intent was to address concerns that executives, but not rank-and-file employees, were permitted to withdraw funds from deferred compensation plans of failing companies.

Executive stock option plans are generally not affected directly by the changes in the tax law. But they are affected by changes in accounting rules under FASB Statement No. 123, Share-Based Payment (revised 2004).

Known as Statement 123R, the revised accounting standard was released in December 2004. It changes the accounting for transactions in which a company receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise's equity instruments or that may be settled by the issuance of such equity instruments.

Importantly, the FASB Statement eliminates the ability to account for equity-based compensation transactions using APB Opinion No. 25, Accounting for Stock Issued to Employees, and generally requires instead that such transactions be expensed using a fair-value-based method.

The changes introduced in Statement 123R level the playing field for stock options and alternative forms of compensation. The changes are not required for 2004 financial statements. Based on input from preparers, auditors, valuation firms and the SEC staff, the FASB decided to delay its effective date until 2005. This delay gives companies more time to review and evaluate the alternatives to determine if employee stock options still are the best way to meet the company's objectives.

Do employee stock options still meet the company's objectives?

Some companies have expressed concern about the long-term impact of the higher costs associated with expensing stock options, for example, the competitiveness of the company and its ability to create and maintain jobs in the years ahead. In an aggregate economic sense, these concerns may be partially offset by the tax relief provided by the Act. But the net effect of the Act and Statement 123R will likely vary by company and industry.

Under Statement 123R, alternative compensation strategies may better achieve a company's objectives. Here are a few to consider:

• Restricted stock is an alternative to stock options, though the tax and incentive effects should be weighed carefully.
• Performance plans. Statement 123R removes the detrimental accounting effects of performance conditions in option plans. Including performance conditions can enhance and target the incentive effects of stock options and restricted stock.
• Cashless exercise features. Statement 123R removes the detrimental accounting effects of stock options with cashless exercise features or stock appreciation rights settled in shares. These features make exercise more convenient for employees by eliminating their cash outlay.
• Restructuring non-compensatory plans is another alternative. Statement 123R narrows the conditions for non-compensatory plans. Employers may want to restructure their existing broad-based employee stock purchase plans to meet the new conditions, so that they continue to be non-compensatory.
• The technique of accelerated vesting has been publicized in the media as a way to deal with underwater options prior to the adoption of Statement 123R. If used, accelerated vesting should be accompanied by a heavy dose of disclosures. The SEC staff has said that companies need to adequately disclose their rationale for executing this strategy in anticipation of the adoption of Statement 123R, and the disclosures should be detailed and robust.

Is the company on track to meet both current and future reporting requirements?

For public companies other than small business issuers, Statement 123R is effective for interim or annual periods beginning after June 15, 2005. Small business issuers must adopt in fiscal periods beginning after December 15, 2005, and private companies must adopt in fiscal years beginning after December 15, 2005.

Congress might yet act to delay the effective date of the standard, and the SEC has indicated it may issue additional guidance.

To help companies determine whether they are on track to meet the new requirements, BDO USA plans to issue a Financial Reporting letter devoted exclusively to Statement 123R in the near future. The letter will be available on our web site at http://www.bdo.com/services/assurance/index.asp.

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