Client Alert

Introduction
Partly in response to recent controversies regarding option grant practices, the Office of the Chief Accountant (the "OCA") of the Securities and Exchange Commission issued a letter earlier this month summarizing its views regarding the accounting for stock options in the historical financial statements of public companies. Prior to the adoption of Financial Accounting Standards Board ("FASB") Statement No. 123 (revised 2004), "Share-Based Payment" ("Statement No. 123R"), most public companies accounted for stock options under Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("Opinion 25"). The OCA letter discusses the accounting consequences under Opinion 25 of a variety of circumstances related to prior award grants. Notably, the letter addresses only the effect of these accounting issues on a company’s financial statements and footnotes and does not address disclosures outside of the financial statements or other actions that may be required with respect to possible violations of laws or regulations. The full text of the letter may be accessed at http://sec.gov/info/accountants/staffletters/fei_aicpa091906.htm.

Discussion of OCA’s Accounting Guidance

The OCA’s letter is particularly helpful since it notes that, although many of the recently-uncovered option grant practices have resulted in negative accounting consequences, the OCA acknowledges that, depending upon the facts and circumstances, there may be situations where “unimportant delays in the completion of administrative procedures” to document grants may have no accounting consequences as long as the grants were initially decided with finality and no misrepresentations were involved. A brief summary of the OCA’s principal guidance follows:

• Dating an Option Award to Predate the Actual Award Date. Under Opinion 25, the measurement date for determining the compensation cost of a stock option is the first date on which both of the following are known: (1) the number of options that an individual employee is entitled to receive and (2) the option or purchase price. Thus, even if the option grant documents are dated as of an earlier date, the measurement date cannot occur until the date the terms of the award and its recipient are actually determined. 
• Option Grants with Administrative Delays. Typically, a company’s corporate governance provisions, stock option plans and applicable laws specify the actions required in order to effect the grant of a stock option, and the date on which these actions are completed is considered the measurement date. However, some companies have used a different measurement date when, for example, the company has delegated the granting authority to an officer, who designated the grants within specific parameters previously determined by the board and obtained the appropriate approvals at a later date. In these cases, some companies have argued that the measurement date occurred before the required granting actions were completed because all option terms and recipients were final at an earlier date, and the completion of the required granting actions represented only an administrative delay. The OCA states that the measurement date cannot occur until the persons empowered to make the grants have determined with finality the terms and recipients of those awards. Thus, if a company operated as if the terms of its awards were not final prior to the completion of all required granting actions (such as by retracting awards or changing their terms), the measurement date for all of that company’s awards (including those that were not changed) would be delayed until the completion of all required granting actions. On the other hand, in certain instances where a company’s facts, circumstances and pattern of conduct evidence that the terms and recipients of a stock award were determined with finality on an earlier date before completion of all required granting actions, it may be appropriate to determine that a measurement date occurred prior to the completion of these actions. 
• Validity of Prior Grants. In the case where the validity of past option grants has been called into question (such as when awards were granted in excess of a plan’s award limitation), the OCA believes that the substantive arrangement that is mutually understood by both the company and its employees represents the underlying economic substance of the past option grants and should serve as the basis for the company’s accounting. Thus, assuming all other conditions for the establishment of a measurement date have been satisfied, it is appropriate to account for the awards as fixed options with a measurement date on the date that the terms and recipients were determined with finality. 
• Uncertainty as to Individual Award Recipients. Some companies have approved option awards before the number of options to be granted to each individual employee was finalized. The OCA states that, in certain circumstances, the award may contain sufficient specificity to determine the number of options to be allocated to individual employees, notwithstanding the absence of a detailed employee list. For example, if management’s role was limited to ensuring that an allocation was made in accordance with definitive instructions (e.g., the approved award specified the number of options to be granted based on rank within the company), the measurement date could be the date the award was approved. However, if management had discretion to determine the number of options to be allocated to each individual employee, the measurement date could not occur prior to the date on which the allocation was finalized. 
• Exercise Price Set by Reference to a Future Market Price. Some companies have awarded options that contain a formula for establishing the exercise price, for instance, based on a 30-day average of the stock price following the grant date. If the original terms of a stock option provide for a reduction to the exercise price if a specified future event or condition occurs, variable accounting would be required from the award approval date until that uncertainty is resolved. A measurement date would occur and variable accounting would cease at the date the contingency is resolved or expires. On the other hand, if the original terms of the award do not contain an adjustment contingency and the exercise price is nonetheless reduced after the award approval date, a repricing has occurred. Variable accounting would therefore be appropriate from the date of the modification to the date the award is exercised, is forfeited or expires unexercised. 
• Grants Prior to the Commencement of Employment. In some cases, companies have determined the terms and conditions of awards to new employees before the commencement of their employment (for instance, by fixing the option price in the offer letter prior to the date the person became an employee). If the individual provided no services to the company prior to commencing employment, generally a measurement date cannot occur prior to the date that the individual began rendering employee service. However, if the employee rendered services to the company prior to commencement of employment, FASB Statement No. 123, "Accounting for Stock-Based Compensation" (“Statement No. 123”) and EITF Issue No. 96-18, "Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services," should be applied. 
• Documentation of Option Granting Activities is Incomplete or Cannot be Located. The OCA states that the appropriate accounting where records documenting grants cannot be found or may be inaccurate will depend upon the facts and circumstances. The OCA does not believe that a company’s ability to locate complete option grant documentation several years after the grant dates should necessarily result in a default to variable accounting or to treating the awards as if they had never been granted. Rather, a company must use all available relevant information to form a reasonable conclusion as to the most likely option granting actions that occurred and the dates on which such actions occurred in determining the proper accounting. 
• Timing of Option Grants. For companies that have engaged in techniques to select their award dates in coordination with the disclosure of information to the public, questions have arisen as to whether an adjustment would be necessary to the market price of the stock at the measurement date for the purpose of measuring compensation cost. The OCA believes that compensation cost must be computed on the measurement date by reference to the unadjusted market price of a share of stock of the same class that trades freely in an established market. 
• Changes to Option Grants Due to the Release of New Information. For companies that have changed the terms of previously granted awards (for instance, lowered option prices) due to the release of new information to the public, the OCA believes that a repricing has occurred and variable accounting should be applied to the option from the date of modification to the date the award is exercised, is forfeited or expires unexercised. 
• Income Tax Benefits Related to Options. Some companies may have documented option exercises as though such exercises occurred as of a date other than the actual date of exercise, which resulted in a reduction of the amount of income taxes due by the employee and a corresponding reduction in the income tax benefit received by the company. The OCA believes that the company should record the excess tax benefit it otherwise would have been entitled to receive on the actual exercise date as an addition to paid-in capital. Any amount of such benefit forgone by the company due to the mischaracterized exercise, and any other tax obligations of the employee paid by the company, should be recorded as compensation cost to the employee. 
• Restatements and Amendments of Periodic Reports. Companies that determine that their prior accounting contained material errors should restate their financial statements to reflect the correction of those errors. Materiality is based on the facts and circumstances, and the OCA states that even quantitatively small amounts may be material, for instance, if due to intentional error. Where restatements are made, companies must also disclose the circumstances that gave rise to the errors. In addition, previously filed periodic reports containing financial statements determined to be materially misstated will require amendment. Companies proposing to correct material errors without amending all affected reports should contact the SEC’s Division of Corporation Finance for guidance. Amendments are not necessary to correct immaterial errors; such corrections may be made in future filings containing the affected financial statements. Finally, registrants that have applied Opinion 25 in historical periods for recognition purposes and provided the footnote disclosures required by Statement No. 123 may determine that the amount of pro forma compensation cost previously disclosed pursuant to Statement No. 123 was erroneous. The OCA’s views regarding Opinion 25 are not necessarily representative of its views with respect to the determination of the grant date and measurement date under Statement No. 123R.

Conclusion; Contact Information
Companies should keep in mind that many of the scenarios described above may raise not only accounting issues but also issues related to the validity of equity awards, for instance, if awards were made on terms inconsistent with plan documents. Companies are encouraged to contact the OCA if they have questions regarding accounting issues related to option grant practices.