The FASBs Project on ShareBased Payment

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The FASBs Project on Share-Based Payment
Katherine Schipper Financial Accounting
Standards Board September 2004 The views
expressed in this presentation are my own, and do
not represent positions of the Financial
Accounting Standards Board. Positions of the
Financial Accounting Standards Board are arrived
at only after extensive due process and
deliberation.
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Overview

• The FASBs current project
• Background and process
• Summary of the accounting issues to be resolved
• Selected details of the Exposure Draft
• Comparisons to certain provisions of SFAS 123
• Results of certain redeliberations

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Background

• Reasons to reconsider the accounting for share
  based payment arrangements
• Requests from constituents
• Convergence with international standards (IFRS 2)
• Complex and voluminous guidance to maintain the
  APB Opinion 25 alternative in SFAS 123
• Under Opinion 25, at-the-money, fixed-plan
  options issued to employees created zero
  compensation cost. The zero cost outcome
  applied to one narrow class of share-based
  payment arrangements.
• Possible consequence similar arrangements are
  not accounted for in the same way. Possible
  tendency to use at-the-money, fixed-plan options
  even if other arrangements might have more
  desirable incentive properties
• Opinion 25 did not provide much application
  guidance
• Consequence Interpretation 44 (20 detailed
  questions) and EITF 00-23 (51 detailed
  questions). This guidance has been
  described as disjointed, rule-based and
  form-driven (SEC study on
  principles-based standards).

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Process

• Exposure draft issued March 2004
• Posted on the FASBs website fasb.org
• Comment deadline June 2004
• Roundtable discussions held in June 2004
• Palo Alto and Norwalk
• Extensive research, consultation with valuation
  experts and others (e.g., actuaries) and
  discussions with constituents
• Field visits with constituents to discuss the
  application of the proposals in the exposure
  draft
• Goal is to issue a final standard in fourth
  quarter 2004
• Proposed effective dates (per exposure draft)
• Public companies fiscal years beginning after
  12/15/04
• Nonpublic companies one year later

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Share based paymentAccounting issues

• How should the cost of employee services be
  accounted for?
• In general, accounting recognizes an expense for
  services as the services are consumed
• Should the accounting be determined by the form
  of payment?
• If a cost is to be recognized when the form of
  payment for employee services is share based, how
  should that cost be measured?
• Value of employee services received
• Value of the compensation provided
• If cost is measured as the value of the
  compensation provided, how should that
  compensation be measured?
• Fair value
• Intrinsic value
• Something else
• What is the appropriate (final) measurement date?
• Grant date
• Vesting date
• Exercise date

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Share based paymentAccounting issues

• Measurement issues
• If fair value is the measurement attribute, how
  should fair value be measured?
• Under what circumstances should the initial
  amount be remeasured?
• Accounting for share-based payment instruments
  that are liabilities
• Attributing cost to accounting periods
• Changes in the arrangements
• Modifications and settlements
• Tax effects

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Exposure draft on share based payment

• Scope
• All share-based payment transactions that involve
  the acquisition of goods and services in return
  for equity instruments or in return for liability
  instruments whose value is based at least in part
  on the entitys equity instruments or whose
  settlement may require the issuance of equity
  instruments
• Except for ESOPs
• Includes transactions with both employees and
  nonemployees
• Transactions with employees
• Employee is defined in the Exposure Draft.
  Definition based on common law and IRS rulings
• Transfer might be made by a related party or by a
  holder of an economic interest in the entity
• Cost of employee services received in exchange
  for awards of share-based compensation
  to be measured based on the fair
  value of the instruments granted

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Exposure draft on share based payment

• Transactions with employeesESPPs
• Exposure draft proposal Employee share purchase
  plans (ESPPs) are compensatory unless their terms
  are no more favorable than the terms offered to
  other holders of the same class of shares and
  substantially all employees can participate
• SFAS 123 permitted discounts to be extended to
  employees, without recognizing
  compensation cost and included a 5 safe harbor
  
• Result of redeliberations Employee share
  purchase plans are noncompensatory if they
• Incorporate no option features
• Extend participation on an equitable basis to
  substantially all employees that meet limited
  employment conditions
• Either meet the condition in the exposure draft
  or
• Provide a discount that results in proceeds to
  the employer that are not less than the
  proceeds that would have been
  received had the employer offered shares to third
  parties through other means
  (including a 5 safe harbor)
  

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Exposure draft on share based payment

• Measurement of the cost of employee services gt
  based on the fair value of the instruments
  awarded
• Measurement is to be based on observable prices
  if they are available. If not, then measurement
  is to be based on a pricing model that
  incorporates Exercise price, Expected term,
  Current price of the underlying share, Expected
  volatility, Expected dividends, Risk free rate
• Nonpublic entities. Per exposure draft, these
  entities may make an accounting policy decision
  to measure at fair value at grant date or to
  measure at intrinsic value, remeasured at each
  reporting date through settlement
• SFAS 123 allowed the minimum value method, which
  ignores volatility
• Public entities. Per exposure draft, if an
  entity is not able to measure fair value reliably
  it may measure at intrinsic value, remeasured at
  each reporting date through settlement. In
  redeliberations, the FASB concluded that such
  instances should be rare.

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Exposure draft on share based payment

• Subsequent measurement
• If the instrument is classified as equity, no
  remeasurement after grant date, consistent with
  the general accounting treatment of an entitys
  own equity
• An alternative perspective would view share-based
  instruments awarded to employees as
  other-than-equity and would remeasure the
  instruments at fair value through settlement
• In the case of options that are exercised, the
  final measurement would be the intrinsic value at
  exercise (because at that point the time value is
  extinguished)
• The FASBs conclusion is not consistent with how
  the US tax code measures the tax deduction for
  certain share-based payments
• Tax deduction to employer (and taxable income to
  employee) is based on the intrinsic
  value of the instrument at exercise

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Exposure draft on share based payment

• Comments on measurement
• SFAS 123 does not specify a model (or formula) or
  computational approach, but does specify a fair
  value measurement objective and the inputs to be
  considered. Some commentators interpreted the
  exposure draft as requiring the use of a binomial
  (lattice) computational method. As a result of
  redeliberations, the FASB will clarify that there
  is no requirement to use a particular measurement
  approach.
• Distinguish use of a formula (e.g., the Black
  Scholes formula) from a computational approach
  (e.g., the binomial approach).
• Both are based on the same theory.
• A computational approach offers greater
  flexibility to accommodate the specific terms of
  arrangements
• Nontransferability gt early exercise. Patterns of
  early exercise can be estimated from past data
• Blackout periods and other idiosyncratic features

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Exposure draft on share based payment

• Comments on measurement
• Does the fair-value-based approach in the
  exposure draft lead to sufficiently reliable
  measures?
• In evaluating a measurement attribute for use in
  a standard, the FASB must always evaluate the
  reliability of the attribute. In this case, the
  FASB has done extensive research and engaged in
  extensive consultation.
• Intrinsic value measurements and minimum value
  measurements both omit significant components of
  value
• Over 700 listed enterprises have adopted the fair
  value measurement alternative of SFAS 123. All
  listed companies have provided fair value pro
  forma disclosures for several years.

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Exposure draft on share based payment

• Measurement objective gt fair value of the
  instruments to which the employee becomes
  entitled upon satisfying vesting conditions
• Measurement includes the effects of restrictions
  that continue after vesting (e.g., inability to
  transfer instruments)
• Effects of restrictions implied by vesting
  conditions are taken into account by recognizing
  cost only for instruments for which the requisite
  service has been rendered (that is, the employee
  has completed the requisite service period).
• Observation Although it is at least in
  principle possible to use past data to estimate
  the effects of employee forfeitures during the
  vesting period, the initial measurement of the
  instruments proposed in the exposure draft does
  not take account of these forfeitures.
• Observation SFAS 123 did not use the notion of
  a requisite service period.

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Exposure draft on share based payment

• Requisite service period
• Time period over which an employee is required to
  perform service in exchange for an award under a
  share-based payment arrangement
• Explicit, defined in the terms of the arrangement
• Example instruments that will vest in 3 years.
  The requisite service period is 3 years.
• Implicit, inferred from analysis of the terms of
  the arrangement
• Example instruments that will vest upon the
  occurrence of an event whose timing can be
  estimated. The requisite service period is based
  on the estimated timing of the event.
• Derived, from certain valuation techniques
• Applies to market conditions.
• The requisite service period is derived from
  analysis of the possible paths of the
  employers stock price

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Exposure draft on share based payment

• Cost attribution
• Cost is based on the number of instruments for
  which the requisite service is rendered. No
  compensation cost for instruments that do not
  vest because the employee did not render the
  requisite service
• Fail to satisfy service or performance conditions
• Fail to satisfy (derived) requisite service
  period associated with a market condition
• Initial accruals gt Estimate the instruments
  expected to vest
• Adjust in light of new information. Revisions
  are changes in estimates, with effects recognized
  in the current period
• SFAS 123 approach entities could choose either
  the method in the current exposure draft or
  initially assume that all instruments would vest
  and recognize forfeitures as they occur.
• Exposure draft treatment will increase
  comparability and will incorporate more recent
  information about vesting expectations
• Recognize cost over the requisite service period
• Debit to compensation cost (which may be an
  expense)
• Credit to paid in capital

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Exposure draft on share based payment

• Cost attributionspecial cases
• Performance conditions
• Base accruals on the probable outcome (if it is
  not probable that a performance condition will be
  met, then no cost is recognized).
• If conditions change, or the arrangement is
  modified, so that the likelihood of performance
  changes from improbable to probable then
  enterprise will begin to recognize compensation
  cost
• Probable is used in the SFAS 5 sense (something
  that is likely to occur). The uncertainty
  associated with a performance condition affects
  the recognition of compensation cost.

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Exposure draft on share based payment

• Cost attributionspecial cases
• Graded vesting gt portions of an award vest at
  specific times Example an award of 1000
  options will vest at 250 options per year for 4
  years
• Exposure draft requirement gt measure and
  recognize cost separately for each separately
  vesting part of the award
• Result of redeliberations gt revert to
  requirements of SFAS 123
• If the fair value of an award is based on
  different expected lives for options that vest
  each period (e.g., year), then apply FIN 28
• If the expected life or lives are determined in
  another matter, then use a straight line method
  or apply FIN 28

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Exposure draft on share based payment

• Treatment of instruments that are liabilities
• Guidance for determining whether an instrument is
  a liability
• Analyze substantive terms
• Take account of past practice (e.g., a practice
  of settling in cash whenever an employee requests
  it, even though the terms of the arrangement
  state that the choice of settlement is the
  employers)
• Apply SFAS 150 (including its deferral
  provisions)
• If the instrument is classified as liability,
  remeasure at every reporting date through
  settlement
• Examples cash settled stock appreciation right
  (SAR)
• Observation SFAS 123 provided relatively
  little discussion of share based payment
  instruments that are liabilities.

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Exposure draft on share based payment

• What is the most appropriate measurement date?
• Grant date gt time when both parties to the
  arrangement understand the terms and conditions
  all necessary approvals have been obtained
• Service inception date gt start of the requisite
  service period
• Vesting date gt time when the employee has
  satisfied conditions and can exercise
• Exercise date gt time when the employee exercises
  options
• Grant date
• Employer is obligated to issue instruments to
  employees who meet conditions, so this is the
  inception of the transaction
• Observation grant date is usually the service
  inception date.
• Vesting date
• Employer has received the requisite service. The
  exchange transaction is complete.

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Exposure draft on share based payment

• What is the most appropriate measurement date?
• The Exposure Draft specifies grant date as the
  measurement date.
• Grant date is the inception of the transaction
• Terms of the award are mutually understood on
  that date
• Observation this provision was carried forward
  from SFAS 123 and the FASBs reasoning parallels
  that in SFAS 123s basis for conclusions
• Alternative approaches
• Initially measure at grant date and remeasure
  through vesting date
• Final measure of compensation cost would be based
  on conditions at the vesting date
• Would be consistent with the view that an
  instrument (e.g., options or shares) is
  transferred from employer to employee at vesting
  and the final measurement should be made when the
  exchange is completed
• Initially measure at grant date and remeasure
  through settlement
• Would continually take account of new information
  that affects the value of the
  award
• Would be consistent with the view that an option
  is, from the perspective of other shareholders, a
  liability

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Exposure draft on share based payment

• Reloads, modifications and settlements
• Reload gt additional options granted at exercise
  of previously granted options, if employee pays
  the exercise price in shares not cash. The
  employee is granted a replacement option (a
  reload) for the shares used to exercise.
• Treat each award separately (the reload
  provision does not affect the measurement at the
  inception of the arrangement)
• Accounting is based on practical expediency
• Modification gt incremental compensation cost
  increase in fair value of the new award (compared
  to the original award)
• Cancellation replacement modification
• Settlement gt no additional compensation cost
  unless amount paid gt fair value of instruments
  settled

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Exposure draft on share based payment

• Income taxes
• Tax expense and deferred tax assets
• Deductible temporary difference gt deferred tax
  asset based on fair value of award for financial
  reporting purposes.
• Cumulative financial statement compensation cost
  gives rise to a deferred tax asset
• Exposure draft gt Exercise is viewed as a
  transaction with an owner
• Tax deduction to employer taxable income to
  employee intrinsic value of option at exercise
• Excess tax benefits difference between tax
  deduction and amount recognized for financial
  reporting purposes
• Excess tax benefits of option exercise are
  displayed in owners equity and their cash flow
  effects are financing cash flows.
• If the tax deduction lt deferred tax asset, the
  exposure draft requires that the asset be
  written off to income

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Exposure draft on share based payment

• Income taxes current practice and results of
  redeliberations
• Current practice displays excess tax benefits as
  operating cash flows and as increases in paid-in
  capital, and writes off certain deferred tax
  assets against paid-in capital.
• Results of redeliberations
• Confirm exposure draft treatment of excess tax
  benefits in the Statement of Cash Flows (display
  in financing section)
• Revert to the SFAS 123 method of accounting for
  excess tax benefits or tax benefit deficiencies
• Excess tax benefits gt owners equity
• Tax benefit deficiency (tax benefit lt deferred
  tax asset) gt write off to income statement
  except to the extent that there is remaining
  additional paid in capital from excess tax
  benefits associated with previous share based
  payment awards

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Exposure draft on share based payment

• Proposed transition
• Public companies the exposure draft required
  modified prospective transition. Apply
  prospectively as if all share-based compensation
  awards granted, modified or settled after
  12/15/94 had been accounted for using the
  fair-value-based method.
• Results of redeliberations either modified
  prospective transition or modified retrospective
  application (based on the pro forma disclosed
  numbers per SFAS 123)
• Nonpublic companies prospective transition