Accountants’ Handbook Special Industries and Special Topics 10th Edition_13

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36 48 PENSION PLANS AND OTHER POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS • Reconciliation of Funded Status 1. Actuarial Liability a. Disabled Participants ($12,000,000) b. Active Participants ($20,000,000) c. Total ($32,000,000) 2. Fair Value of Assets $0 3. Funded Status ($32,000,000) 4. Unrecognized Amount at Transition* $0 5. Unrecognized Net Loss/(Gain) $6,000,000 6. Unrecognized Prior Service Cost $0 7. (Accrued)/Prepaid Postemployment Beneﬁt Cost at Year End ($26,000,000) *SFAS No. 112 did not allow delayed recognition of the transition obligation. Change in (Accrued)/Prepaid Postemployment Beneﬁt Cost 1. (Accrued)/Prepaid Postemployment Beneﬁt Cost at Prior Year End ($24,400,000) 2. Expense During Year* a. Service Cost $2,200,000 b. Interest Cost $2,800,000 c. Amortization of Loss/(Gain) $600,000 d. Total Expense $5,600,000 3. Payouts During Year** $4,000,000 4. (Accrued)/Prepaid Postemployment Beneﬁt Cost at Current Year End ($26,000,000) *Since SFAS No. 43 applies to this plan, the annual expense is explicitly calculated as the sum of the service cost, interest cost, and amortization of unrecognized actuarial losses. Were this a SFAS No. 5 plan, the annual expense would equal the change in the actuarial reserve, adjusted for beneﬁt payments made during the year. ** Since the plan is unfunded, beneﬁt payments are treated as employer contributions. Exhibit 36.11 Illustration of SFAS No. 112 accounting. 36.8 SOURCES AND SUGGESTED REFERENCES American Academy of Actuaries, “An Actuary’s Guide to Compliance with Statement of Financial Accounting Standards No. 87.” AAA, Washington, DC, 1986. ______, “Actuarial Compliance Guideline for Statement of Financial Accounting Standards No. 88.” Actuarial Standards Board, Washington, DC, 1989. Accounting Principles Board, “Accounting for the Cost of Pension Plans,” APB Opinion No. 8. AICPA, New York, 1966. ______, “Accounting Changes,” APB Opinion No. 20. AICPA, New York, 1971. ______, “Reporting the Results of Operation—Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions,” APB Opinion No. 30. AICPA, New York, 1973. Accounting Standards Executive Committee, “Accounting for and Reporting of Postretirement Medical Beneﬁt (401(h)) Features of Deﬁned Beneﬁt Pension Plans,” Statement of Position 99-2. AICPA, New York, 1999. Financial Accounting Standards Board, “A Guide to Implementation of Statement 87 on Employers’ Accounting for Pensions: Questions and Answers.” FASB, Stamford, CT, 1986. ______, “A Guide to Implementation of Statement 88: Questions and Answers.” FASB, Norwalk, CT, 1988.
36.8 SOURCES AND SUGGESTED REFERENCES 36 49 • ______, “Accounting and Reporting by Deﬁned Beneﬁt Pension Plans,” Statement of Financial Accounting Stan- dards No. 35. FASB, Stamford, CT, 1980. ______, “Employers’ Accounting for Pensions,” Statement of Financial Accounting Standards No. 87. FASB, Stamford, CT, 1985. ______, “Employers’ Accounting for Settlements and Curtailments of Deferred Beneﬁt Pension Plans and for Termination Beneﬁts,” Statement of Financial Accounting Standards No. 88. FASB, Stamford, CT, 1985. ______, “Employers’ Accounting for Postretirement Beneﬁts Other than Pension,” Statement of Financial Ac- counting Standards No. 106. FASB, Norwalk, CT, 1990. ______, “Accounting for Income Taxes,” Statement of Financial Accounting Standards No. 109. FASB, Nor- walk, CT, 1992. ______, “Reporting by Deﬁned Beneﬁt Pension Plans of Investment Contracts,” Statement of Financial Ac- counting Standards No. 110. FASB, Norwalk, CT, 1992. ______, “Employers’ Accounting for Postemployment Beneﬁts,” Statement of Financial Accounting Standards No. 112. FASB, Norwalk, CT, 1992. ______, “Reporting Comprehensive Income,” Statement of Financial Accounting Standards No. 130. FASB, Norwalk, CT, 1997. ______, “Employers’ Disclosures about Pensions and Other Postretirement Beneﬁts,” Statement of Financial Ac- counting Standards No. 132. FASB, Norwalk, CT, 1998. ______, “Business Combinations,” Statement of Financial Accounting Standards No. 141. FASB, Norwalk, CT, 2001. Lorenson, Leonard, and Rosenﬁeld, Paul, “Vested Beneﬁts—A Company’s Only Pension Liability,” Journal of Accountancy, October 1983. Munnell, Alicia H., Economics of Private Pensions. The Brookings Institution, Washington, DC, 1982.
37 CHAPTER STOCK-BASED COMPENSATION Peter T. Chingos, CPA Mercer Human Resources Consulting Walton T. Conn, Jr., CPA KPMG Peat Marwick LLP John R. Deming, CPA KPMG Peat Marwick LLP (viii) Combination Plans and 37.1 HISTORY OF ACCOUNTING FOR Awards 19 STOCK-BASED COMPENSATION 2 (ix) Stock Option Pyramiding 21 (x) Stock Option Gain 37.2 SCOPE OF APB OPINION NO. 25 6 Deferrals 21 (xi) Use of Stock Option 37.3 APPLICATION OF APB OPINION Shares to Cover Required NO. 25 8 Tax Withholding 21 (d) Allocation of Compensation (a) Noncompensatory and Cost: Determining the Service Compensatory Plans 8 Period 22 (b) Measurement of Compensation: (i) Allocation of General Principle 9 Compensation Cost (c) Application of the Measurement Related to Fixed Awards 22 Principle 9 (ii) Allocation of (i) Measurement of Compensation Cost Compensation Cost Based Related to Variable Awards 22 on Cost of Treasury Stock 9 (e) Canceled or Forfeited Rights 22 (ii) Vesting Contingent on (f) Accounting for Income Taxes Continued Employment 10 under APB Opinion No. 25 23 (iii) Designation of (g) Other APB Opinion No. 25 Issues 24 Measurement Date 10 (i) Time Accelerated (iv) Impact of Renewals, Restricted Stock Extensions, and Other Award Plan 24 Modiﬁcations of Stock (ii) Applying APB Opinion Options and Purchase No. 25 to Nonemployees 24 Rights 10 (iii) Nominal Issuances 24 (v) Transfer of Stock or Assets to a Trustee, Agent, 37.4 EARNINGS PER SHARE UNDER or Other Third Party 16 APB OPINION NO. 25 24 (vi) Awards of Convertible (a) Basic Earnings per Share 25 Stock or Rights 16 (b) Diluted Earnings per Share 25 (vii) Settlement of Awards 16 37 1 •
37 2 STOCK-BASED COMPENSATION • (c) Diluted Earnings per Share (iii) Accounting by Employer Computations for Fixed Awards 26 for Federal Income Taxes 37 (d) Diluted Earnings per Share (iv) Accounting by Employer Computations for Variable for Earnings per Share 38 Awards Subject Only to (v) Illustration of a Formula Time-Based Vesting 26 Award 38 (e) Diluted Earnings per Share Computations for Variable 37.6 APPLICATION OF FASB Awards Subject to STATEMENT NO. 123 38 Performance-Based Vesting 27 (a) Scope of FASB Statement No. 123 39 37.5 ILLUSTRATIONS OF (b) Measurement of Awards 39 ACCOUNTING UNDER (c) Measurement Date 40 APB OPINION NO. 25 27 (d) Option Pricing Models 42 (a) Fixed Award 28 (i) Expected Volatility 43 (i) Deﬁnition 28 (ii) Expected Dividends 44 (ii) Accounting by Employer (iii) Expected Option Lives 44 for Compensation Expense 28 (iv) Minimum Value Method 44 (iii) Accounting by Employer (e) Recognition of Compensation for Federal Income Taxes 28 Cost 45 (iv) Accounting by Employer (f) Adjustments of Initial Estimates 46 for Earnings per Share 28 (g) Modiﬁcations to Grants 47 (v) Illustration of a Fixed (h) Options with Reload Features 48 Award 28 (i) Settlement of Awards 48 (b) Variable Award—Stock (j) Tandem Plans and Combination Appreciation Right 28 Plans 49 (i) Deﬁnition 28 (k) Employee Stock Purchase Plans 50 (ii) Accounting by Employer (l) Look-Back Options 51 for Compensation Expense 29 (m) Awards Requiring Settlement (iii) Accounting by Employer in Cash 51 for Federal Income Taxes 31 (n) Transactions with Nonemployees 52 (iv) Accounting by Employer (o) Accounting for Income Taxes for Earnings per Share 31 under FASB Statement No. 123 54 (v) Illustration of a Variable (p) Effective Date and Transition 54 Award 31 (c) Variable Award—Performance 37.7 EARNINGS PER SHARE UNDER Stock Option 31 FASB STATEMENT NO. 123 54 (i) Deﬁnition 31 (ii) Accounting by Employer 37.8 FINANCIAL STATEMENT for Compensation Expense 31 DISCLOSURES 57 (iii) Accounting by Employer (a) Disclosure Requirements for for Federal Income Taxes 32 All Companies 57 (iv) Accounting by Employer (b) Disclosures by Companies for Earnings per Share 32 That Continue to Apply the (v) Illustration of a Performance Provisions of APB Opinion Award 32 No. 25 57 (d) Book Value or Formula Award 37 (i) Deﬁnition 37 37.9 SOURCES AND SUGGESTED (ii) Accounting by Employer REFERENCES for Compensation Expense 37 58 37.1 HISTORY OF ACCOUNTING FOR STOCK-BASED COMPENSATION The nature and types of stock-based compensation plans and awards have constantly changed over the years. However, the two most signiﬁcant problems in determining the appropriate accounting for such awards have remained the same:
37.1 HISTORY OF ACCOUNTING FOR STOCK-BASED COMPENSATION 37 3 • 1. Measurement of compensation cost (i.e., the determination of total compensation cost to be al- located to expense for ﬁnancial reporting purposes) 2. Allocation of compensation cost (i.e., the determination of the period(s) over which total com- pensation cost should be allocated to expense and the method of allocation) To be sure, employees are compensated by being awarded stock options when they con- tribute services. However, their employers do not incur any cost in compensating them that way, any more than they do in issuing previously unissued shares of their stock when they re- ceive money from new stockholders. The preexisting stockholders are the ones who incur a cost when employees are awarded stock options, first a cost of contingent dilution of their ownership interest and later a cost of actual dilution of their ownership interest. A reporting entity should report the costs it incurs, not costs other entities incur. Ironically, after centering its consideration of reporting in connection with the awarding of employee stock options on the concept of compensation cost, the FASB implicitly agreed that the employers incur no cost when compensating the employees when awarding the options, though they do incur a cost in using up the services provided by the employees for which they are awarded options: “ . . . issuances of equity instruments result in the receipt of . . . services, which give rise to expenses as they are used in an entity’s operations.”1 Compensation cost is therefore a mis- nomer, and attempting to determine the amount and timing of such a nonexistent cost diverts attention away from determining the amount and timing of the cost of using up the services received from the employees. The AICPA Accounting Standards Division made that point to the FASB when the FASB was considering the issue. The FASB explicitly ignored that advice when it issued its Invitation to Comment: It stated that AcSEC’s analysis is “ . . . beyond the scope of this project.”2 The authoritative accounting literature addresses the accounting for stock-based compensation in two pronouncements which are as follows: 1. APB Opinion No. 25, “Accounting for Stock Issued to Employees” (AICPA, 1972). Also see Interpretation of APB Opinion No. 25, “Accounting for Stock Issued to Employees” (AICPA, 1973). 2. Statement of Financial Accounting Standard No. 123, “Accounting for Stock-Based Compen- sation” (FASB, 1995). The APB Opinion No. 25 is applicable “to all stock option, purchase, award and bonus rights granted by an employer corporation to an individual employee. . . .” The Opinion con- tains substantial guidance in the application of its provisions to such plans. Subsequent to the issuance of APB Opinion No. 25, the trend toward the adoption by enterprises of more complex plans and awards continued. Of particular signiﬁcance was the increase in the number of combination plans—plans that provide for the granting of two or more types of awards to individual employees. In many combination plans, the employee, or the enterprise, must make an election from alternative awards as to the award to be exercised, thereby canceling the other awards granted under the plan. Following the issuance of APB Opinion No. 25, there was also a signiﬁcant increase in the number of plans that provided for the granting of variable awards to employees. A variable award is one that at the date the grant is awarded, either (1) the number of shares of stock (or the amount of cash) an employee is entitled to receive, (2) the amount an employee is required to pay to ex- ercise his rights with respect to the award, or (3) both the number of shares an employee is 1 FASB, Statement of Standards No. 123, “Accounting for Stock-Based Compensation,” par. 89. 2 FASB, Invitation to Comment, Accounting for Compensation Plans Involving Certain Rights Granted to Employees, May 31, 1984, par. 155.
37 4 STOCK-BASED COMPENSATION • entitled to receive and the amount an employee is required to pay, are unknown. One of the most popular variable awards is the stock appreciation right (SAR). The SARs are rights granted that entitle an employee to receive, at a speciﬁed future date(s), the excess of the market value of a speciﬁed number of shares of the granting employer’s capital stock over a stated price. The form of payment for amounts earned under an award of SARs may be speciﬁed by the award (i.e., stock, cash, or a combination thereof), or the award may permit the employee or employer to elect the form of payment. Notwithstanding the guidance provided in APB Opinion No. 25, considerable disagree- ment continued to exist as to the appropriate method of accounting for variable awards. As a result, significant differences arose in the methods used by employers to account for variable awards, which led to numerous requests of the FASB for clarification. In December 1978, the FASB provided this clarification through the issuance of FASB Interpretation No. 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans,” an interpretation of APB Opinion No. 25. In paragraph No. 2 of the Interpretation, the FASB specifies that: APB Opinion No. 25 applies to plans for which the employer’s stock is issued as compensation or the amount of cash paid as compensation is determined by reference to the market price of the stock or to changes in its market price. Plans involving stock appreciation rights and other vari- able plan awards are included in those plans dealt with by [APB] Opinion No. 25. The Interpretation provides speciﬁc guidance in the application of APB Opinion No. 25 to vari- able awards, particularly in those more troublesome areas where the greatest divergence in account- ing existed prior to its issuance. However, APB Opinion No. 25, as interpreted, failed to incorporate criteria that can be consis- tently applied to all types of plans. As a result, as new types of plans have evolved and changes in the tax laws have occurred, new interpretations and guidance have been required, resulting in a steady stream of pronouncements by the FASB and the EITF since 1978, as shown in Exhibit 37.1. The nature and the frequency of these additional pronouncements underscore the difﬁculties in applying the primary pronouncements to the myriad of stock-based compensation awards that have arisen since their issuance. To address this problem, the FASB undertook a major project in 1984 to reconsider the accounting for stock-based compensation, whether issued to employees or issued to vendors, suppliers, or other nonemployees. In October 1995, the FASB issued FASB Statement No. 123, “Accounting for Stock- Based Compensation.” FASB Statement No. 123 allows companies to retain the current approach set forth in APB Opinion No. 25, as amended, interpreted, and clariﬁed; however, companies are encour- aged to adopt a new accounting method based on the estimated fair value of employee stock options. Companies that do not follow the fair value method are required to provide expanded disclosures in the footnotes. Thus, the FASB settled on a compromise solution to a complex issue that had become extremely politicized. The vast majority of entities have not elected the fair value method of account- ing for stock options. Therefore, the ﬁnancial statements of most companies include two presentations of a company’s results of operations rather than the normal presentation of a single net income. FASB Statement No. 123 was preceded by an exposure draft issued by the FASB that would have required a new accounting method that results in reporting expense in connection with vir- tually all stock options issued to employees. However, those who receive stock options believe a requirement to change to the new method could threaten their stock options: The Wall Street Journal reported that “FASB’s chairman . . . Dennis Beresford . . . says he scoffed at the dooms- day arguments during a heated discussion aboard one corporate jet. The executives he was de- bating invited him to exit the craft—at 20,000 feet.”3 And Beresford himself reported that “ . . . 3 John Helyar and Joann S. Lublin, “Corporate Coffers Gush with Currency of an Opulent Age,” The Wall Street Journal. August 10, 1998, p. B.5.
37.1 HISTORY OF ACCOUNTING FOR STOCK-BASED COMPENSATION 37 5 • FASB AND EITF PRONOUNCEMENTS SINCE 1978 Year Issued By Title 1982 FASB FASB Technical Bulletin No. 82-2: “Accounting for the Conversion of Stock Options into Incentive Stock Options as a Result of the Economic Recovery Tax Act of 1981” 1984 FASB FASB Interpretation No. 38: “Determining the Measurement Date for Stock Option, Purchase, and Award Plans Involving Junior Stock,” an interpretation of APB Opinion No. 25 1984 EITF EITF Issue No. 84-13: “Purchase of Stock Options and Stock Appreciation Rights in a Leveraged Buyout” 1984 EITF EITF Issue No. 84-18: “Stock Option Pyramiding” 1984 EITF EITF Issue No. 84-34: “Permanent Discount Restricted Stock Purchase Plans” 1985 EITF EITF Issue No. 85-45: “Business Combinations: Settlement of Stock Options and Awards” 1987 EITF EITF Issue No. 87-6: “Adjustments Relating to Stock Compensation Plans” 1987 EITF EITF Issue No. 87-23: “Book Value Stock Purchase Plans” 1987 EITF EITF Issue No. 87-33: “Stock Compensation Issues Related to Market Decline” 1988 EITF EITF Issue No. 88-6: “Book Value Stock Plans in an Initial Public Offering” 1990 EITF EITF Issue No. 90-7: “Accounting for a Reload Stock Option” 1990 EITF EITF Issue No. 90-9: “Changes to Fixed Employee Stock Option Plans as a Result of Equity Restructuring” 1994 EITF EITF Issue No. 94-6: “Accounting for the Buyout of Compensatory Stock Options” 1995 EITF EITF Issue No. 95-16: “Accounting for Stock Compensation Arrangements with Employer Loan Features under APB Opinion No. 25” 1995 FASB FASB Statement No. 123, “Accounting for Stock-Based Compensation” 1997 EITF 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” 1997 EITF EITF Issue No. 97-12, “Accounting for the Delayed Receipt of Option Shares upon Exercise under APB Opinion No. 25” 1997 EITF EITF Issue No. 97-12, “Accounting for Increased Share Authorizations in an IRS Section 423 Employee Stock Purchase Plan Under APB Opinion No. 25” 1997 FASB FASB Technical Bulletin 97-1, “Accounting under Statement 123 for Certain Employee Stock Purchase Plans with a Look-Back Option“ 1999 EITF EITF Topic No. D-83, “ Accounting for Payroll Taxes Associated with Stock Option Exercises” 2000 EITF EITF Issue No. 00-8, “Accounting by a Grantee for an Equity Instrument to Be Received in Conjunction with Providing Goods or Services” 2000 EITF EITF Issue No. 00-18, “Accounting Recognition for Certain Transactions Involving Equity Instruments Granted to Other Than Employees” 2000 FASB FASB Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation” 2000 EITF EITF Topic No. 91, “Application of APB Opinion No. 33 and FASB Interpretation No. 44 to an Indirect Repricing of a Stock Option” 2000 EITF EITF Issue No. 0012, “Accounting by an Investor for Stock-Based Compensation Granted to Employees of an Equity Method Investee” 2000 EITF EITF Issue No. 00-18, “Classiﬁcation in the Statement of Cash Flows of the Income Tax Beneﬁt Received by a Company upon Exercise of a Nonqualiﬁed Employee Stock Option” 2000 EITF EITF Issue No. 00-16, “Recognition and Measurement of Employer Payroll Taxes on Employee Stock-Based Compensation” 2001 EITF EITF Issue No. 00-23, “Issues Related to the Accounting for Stock Compensation under APB Opinion No. 25 and FASB Interpretation No. 44” 2001 EITF EITF Issue No. 01-1, “Accounting for a Convertible Instrument Granted or Issued to a Nonemployee for Goods or Services or a Combination of Goods or Services and Cash” 2001 EITF EITF Topic No. 93, “Accounting for Rescission of the Exercise of Employee Stock Options” Exhibit 37.1 Accounting pronouncements related to stock compensation plans and awards since 1978.
37 6 STOCK-BASED COMPENSATION • the CEO of one of America’s most successful companies . . . said that if the FASB was allowed to ﬁnalize the draft as proposed ‘it would end capitalism’ ”4 To prevent this “disaster,” the U.S. Congress prepared a bill entitled the Accounting Standards Reform Act, which, if enacted, would have required the SEC to pass on all new standards approved by the FASB. The bill stated, in part: “ . . . any new accounting standard or principle, and any modi- ﬁcation . . . shall become effective only following an afﬁrmative vote of a majority of a quorum of the member of the [Securities and Exchange] Commission.” The bill was proposed simply to pres- sure the SEC to prevent the FASB from making this particular exposure draft ﬁnal. When the FASB was considering accounting for stock-based compensation leading to the is- suance of FASB Statement No. 123, it did not address practice issues related to Opinion No. 25, because the Board had planned to supersede Opinion No. 25. Because FASB Statement No. 123 did not supersede Opinion No. 25, the FASB issued its Interpretation No. 44 to address issues on the application of Opinion No. 25 in a number of circumstances. Interpretation No. 44 was de- veloped within the framework of Opinion No. 25 and does not refer to the concepts in FASB Statement No. 123. Interpretation No. 44 became effective July 1, 2000. Except as noted next, it was to be ap- plied prospectively to new awards, exchanges of awards in business combinations, modiﬁca- tions to outstanding awards, and changes in grantee status that occurred on or after that date. The guidance about modiﬁcations to ﬁxed stock option awards that directly or indirectly re- duce the exercise price of an award apply to modiﬁcations made after December 15, 1998. The guidance about the deﬁnition of an employee apply to new awards granted after December 15, 1998. The guidance about modiﬁcations to ﬁxed stock option awards to add a reload feature apply to modiﬁcations made after January 12, 2000. To the extent that events covered by the In- terpretation discussed in this paragraph occur after the applicable date but before July 1, 2000, the effects of applying the Interpretation are to be recognized only prospectively. Accordingly, no adjustments are to be made on initial application of the Interpretation to ﬁnancial statements for periods before July 1, 2000. Additional compensation cost measured on initial application of the Interpretation attributable to periods before July 1, 2000, is not recognized. The initial application of the guidance for awards to an entity’s nonemployee board of direc- tors, if previously accounted for as awards to nonemployees and now required by the Interpreta- tion to be accounted for under Opinion No. 25, is to be reported as a cumulative effect of a change in accounting principle. Since companies continue to use the intrinsic value approach prescribed by APB Opinion No. 25, the authors have separated the chapter into two distinct parts. The ﬁrst part will cover the application of APB Opinion No. 25 and its related interpretations and Emerging Issues Task Force (EITF) issues. The remainder of the chapter will address the application of FASB Statement No. 123. 37.2 SCOPE OF APB OPINION NO. 25 FASB Interpretation No. 44 addresses questions that have been raised as to whether Opinion No. 25 applies to accounting by the grantor of stock compensation to independent contractors or other service providers not employees of the grantor. It states that Opinion No. 25 applies to grantor employers for only stock compensation to those who meet the deﬁnition of employee under Opinion No. 25 as ampliﬁed by Interpretation No. 44. For purposes of applying Opinion No. 25, a person is an employee if the grantor consistently represents the person to be an employee under common law, as illustrated in case law and under U.S. Internal Revenue Service Revenue Ruling 87-14. For such a person to be a common law employee, the grantor must represent the person as an employee for payroll tax purposes. How- 4 Dennis R. Beresford, “How to Succeed as a Standard Setter by Trying Really Hard,” Accounting Horizons, September 1997, p. 83.
37.2 SCOPE OF APB OPINION NO. 25 37 7 • ever, simply representing a person as an employee for payroll tax purposes is insufﬁcient to in- dicate that the person is an employee for purposes of Opinion No. 25. An exception to the guidance in the preceding paragraph involves a grantor of stock com- pensation to a person who provides services to the grantor under a lease or co-employment agreement between the grantor and another entity under which the grantor is not the employer of record for payroll tax purposes. Such a person is deemed to be an employee of the grantor under Opinion No. 25 if all of the following criteria are met: a. The person is a common law employee of the grantor, and the other entity is contractually re- quired to pay payroll taxes on the compensation paid to the person for services provided to the grantor. b. The grantor and the other entity agree in writing to all of the following: 1. The grantor has the exclusive right to grant stock compensation to the person for the per- son’s services to the grantor. 2. The grantor has a right to hire, ﬁre, and control the activities of the person. (The other en- tity may have the same right.) 3. The grantor has the exclusive right to determine the economic value of the services per- formed by the person (including wages and the number of units and value of stock com- pensation granted). 4. The person can participate in the grantor’s employee beneﬁt plans, if any, on the same basis as comparable employees of the grantor. 5. The grantor agrees to and does remit funds to the other entity sufﬁcient to cover the com- plete compensation of the person, including all payroll taxes, on or before a contractually agreed date or dates. A nonemployee member of a grantor’s board of directors ordinarily does not meet that deﬁnition of an employee. However, application of Opinion No. 25 is required to stock compensation granted to such a person for services provided as a director if the person (a) was elected by the grantor’s shareholders or (b) was appointed to a board position to be ﬁlled by shareholder election when the existing term expires. Employee status is not involved for awards granted to people for advisory or consulting services in a nonelected capacity or to nonemployee directors for services outside their role as directors, such as legal or investment banking advice or for loan guarantees. Except as indicated in the preceding paragraph, Opinion No. 25 does not apply to the accounting by a grantor for stock compensation granted to nonemployees. For example, it does not apply to the accounting by a corporate investor of an unconsolidated investee for stock options or awards granted by the investor to employees of the investee accounted for under the equity method. Whether a person is an employee under Opinion No. 25 is evaluated for consolidated ﬁnan- cial statements at the consolidated group level. Stock compensation based on the stock of any consolidated group member is accounted for under Opinion No. 25 if the person meets the deﬁ- nition of an employee for any entity in the consolidated group. For example, Opinion No. 25 ap- plies to the accounting in the consolidated ﬁnancial statements for awards based on parent stock granted to employees of a consolidated subsidiary, to awards in stock of a consolidated sub- sidiary granted to employees of the parent, and to awards based on a consolidated subsidiary’s stock granted to the employees of another consolidated subsidiary. Opinion No. 25 does not apply to accounting by an employer for stock compensation granted to its employees (a) by another entity, such as an investee, based on that entity’s stock or (b) by the employer based on the stock of another entity. Though that would seem to apply to awards based on the stock of a subsidiary for purposes of reporting in the separate ﬁnancial statements of the subsidiary, Opinion No. 25 does apply in such circumstances if the subsidiary is part of the consolidated group including the parent company for purposes of preparing its consolidated ﬁnancial statements. With a change in status of a grantee to or from that of an employee of the grantor while an
37 8 STOCK-BASED COMPENSATION • outstanding stock option or award is retained by the grantee with no modiﬁcation of any of its terms, compensation cost under Opinion No. 25 is measured as if the award were newly granted at the date of the change in status. Only the portion of the newly measured cost attributable to the remaining vesting (service) period is recognized as compensation cost prospectively from the date of the change in status. Further, no adjustment is made to compensation cost recognized by the grantor before the change in status unless the award is forfeited unvested because the grantee does not fulﬁll an obligation. A modiﬁcation made to a vested award’s terms as a result of a change in status has no effect. If the grantee terminates employment before vesting, the cu- mulative estimate of compensation cost recorded in previous periods is reduced to zero by de- creasing compensation cost in the period of forfeiture. If there is a change in status of a grantee to or from that of an employee of the grantor while an outstanding stock option or award is retained by the grantee with a modiﬁcation to the award at the time the status is changed, the modiﬁed award is treated under Opinion No. 25 as a new award appropriate to the new status of the grantee. Compensation cost thus measured is recog- nized in full over the remaining vesting (service) period, if any. Compensation cost previously recognized for the forfeited award, if any, is adjusted to zero in the period of forfeiture. A mod- iﬁcation is deemed made if its terms would have required it to be forfeited on the change in sta- tus and the terms are then modiﬁed to continue the award. The modiﬁcation in effect reinstates or extends the life of the award as a new award to the grantee immediately after the change in status. Similarly, a modiﬁcation and an effective reinstatement of an award is made if the terms of the award (or underlying plan) provide for the award to continue at the discretion of the grantor and the grantee retains the award after the change in status. As an exception, a change in grantee status from an employee to a nonemployee as a direct result of a spin-off does not change the grantor’s accounting under Opinion No. 25. This applies to only awards granted and outstanding, including adjustments to those awards, at the date of the spin-off. This exception does not apply to other kinds of transactions, such as sale by a par- ent company of a large enough percentage of the shares of a subsidiary requiring the parent company to deconsolidate the subsidiary. 37.3 APPLICATION OF APB OPINION NO. 25 (a) NONCOMPENSATORY AND COMPENSATORY PLANS. The APB Opinion No. 25 pro- vides that a plan must have the following four characteristics in order to be considered as noncom- pensatory: 1. Substantially all full-time employees meeting limited employment qualiﬁcations may partici- pate (employees owning a speciﬁed percentage of the outstanding stock and executives may be excluded). 2. Stock is offered to eligible employees equally on the basis of a uniform percentage of salary or wages (the plan may limit the number of shares of stock that an employee may purchase through the plan). 3. The time permitted for exercise of an option or purchase right is limited to a reasonable period. 4. The discount from the market price of the stock is no greater than would be reasonable in an offer of stock to stockholders or others. Because Opinion No. 25 refers to a plan that qualiﬁes under Section 423 of the U.S. Internal Revenue Code as a noncompensatory plan, which permits discounts of up to 15%, such a plan has the characteristic required under item 4. Further, for a stock option with an exercise price ﬁxed at the date of grant, a discount of the exercise price of no more than 15% from the stock price on that date is reasonable for application of item 4.
37.3 APPLICATION OF APB OPINION NO. 25 37 9 • Section 423 of the U.S. Internal Revenue Code permits a qualiﬁed employee stock purchase plan to contain a look-back option. A look-back option, for example, is a provision in an em- ployee stock purchase plan that establishes the purchase price as the lesser of the stock’s market price at the grant date or its market price at the exercise (purchase) date. Because Opinion No. 25 states that a plan that qualiﬁes under Section 423 is noncompensatory, a plan with a look- back option qualiﬁes as noncompensatory under Opinion No. 25. A compensatory plan is any plan that does not have all four characteristics of a noncompensatory plan. It should be recognized, however, that awards granted under compensatory plans do not neces- sarily result in recognition of compensation expense by the employer. An employer recognizes com- pensation expense with respect to awards granted pursuant to a compensatory plan only if the application of the measurement principle results in the determination of compensation cost. (b) MEASUREMENT OF COMPENSATION: GENERAL PRINCIPLE. Paragraph 10 of APB Opinion No. 25 sets forth the following “measurement principle” for the measurement of compensa- tion cost related to stock option, purchase, and award plans: Measurement Principle—Compensation for services that a corporation receives as consideration for stock issued through employee stock option, purchase, and award plans should be measured by the quoted market price of the stock at the measurement date less the amount, if any, that the em- ployee is required to pay. . . . If a quoted market price is unavailable, the best estimate of the market value of the stock should be used to measure compensation. . . . The measurement date for deter- mining compensation cost in stock option, purchase, and award plans is the ﬁrst date on which are known both (1) the number of shares that an individual employee is entitled to receive, and (2) the option or purchase price, if any. When both of the factors speciﬁed in paragraph 10 of APB Opinion No. 25 are known at the grant or award date (i.e., a ﬁxed award), total compensation cost for an award is measured at the grant date. However, when either or both of these factors are not known at the grant or award date (i.e., a variable award), an employer should estimate total compensation cost each period from the date of grant or award to the measurement date based on the quoted market price of the employer’s capital stock at the end of each period. This latter point is clariﬁed in FASB Interpretation No. 28, which deﬁnes the compensation related to variable plan awards as: The amount by which the quoted market value of the shares of the employer’s stock covered by the grant exceeds the option price or value speciﬁed, by reference to a market price or otherwise, sub- ject to any appreciation limitations under the plan. Changes, either increases or decreases, in the quoted market value of those shares between the date of grant and the measurement date [as deﬁned in APB Opinion No. 25] result in a change in the measure of compensation for the right or award. (c) APPLICATION OF THE MEASUREMENT PRINCIPLE. A proper understanding of the mea- surement principle of APB Opinion No. 25 (including the clariﬁcation set forth in FASB Interpreta- tion No. 28) is essential to determining the appropriate accounting, including the amount of compensation expense to be recognized. Paragraphs 11(a) through 11(h) of APB Opinion No. 25, as well as subsequent FASB and EITF pronouncements, contain guidance on the application of the measurement principle, as discussed in the following paragraphs. (i) Measurement of Compensation Cost Based on Cost of Treasury Stock. Paragraph 11(a) states: Measuring compensation by the cost to an employer corporation of reacquired (treasury) stock that is distributed through a stock option, purchase, or award plan is not acceptable practice. The only excep- tion is that compensation cost under a plan with all the provisions described in paragraph 11(c) may be measured by the cost of stock that the corporation (1) reacquires during the ﬁscal period for which the stock is to be awarded and (2) awards shortly thereafter to employees for services during that period.
37 10 STOCK-BASED COMPENSATION • Thus compensation cost of an award of stock for current services may be measured by the cost of reacquired treasury stock only if the above conditions and those speciﬁed in paragraph 11(c) (see below) of the Opinion are met. Otherwise, compensation cost should be measured as of the measurement date otherwise determined in accordance with the criterion set forth in paragraph 10 of the Opinion. (ii) Vesting Contingent on Continued Employment. Paragraph 11(b) states: The measurement date is not changed from the grant or award date to a later date solely by provi- sions that termination of employment reduces the number of shares of stock that may be issued to an employee. This paragraph makes it clear that a requirement that an employee remain employed by the grant- ing enterprise for a speciﬁed period of time in order for his rights to become vested under a stock- based compensation award does not preclude a determination, as of the grant or award date, of the total compensation cost to be recognized as an expense by the granting employer. (iii) Designation of Measurement Date. Paragraph 11(c) states: The measurement date of an award of stock for current service may be the end of the ﬁscal period, which is normally the effective date of the award, instead of the date that the award to an employee is determined if (1) the award is provided for by the terms of an established formal plan, (2) the plan designates the factors that determine the total dollar amount of awards to employees for the period (for example, a percent of income), although the total amount or the individual awards may not be known at the end of the period, and (3) the award pertains to current service of the em- ployee for the period. The effect of this paragraph is to allow the designation of the end of a ﬁscal period as the mea- surement date when all of the conditions speciﬁed in paragraph 11(c) are met, even though the actual awards to individual employees may not be determined until after the close of the ﬁscal period. (iv) Impact of Renewals, Extensions, and Other Modiﬁcations of Stock Options and Purchase Rights. Paragraph 11(d) states: Renewing a stock option or purchase right or extending its period establishes a new measurement date as if the right were newly granted. This paragraph reﬂects a very important concept. Its application could result in measurement of compensation cost with respect to outstanding stock option or purchase rights upon their renewal or extension, even though no compensation cost was ascribable to the original award under the mea- surement principle of APB Opinion No. 25. For example, any excess of the quoted market price of an employer’s capital stock over the exercise price of a stock option at the date of renewal or extension is compensation cost; this may require recognition of compensation cost in addition to any compen- sation cost associated with the original award. Paragraph 11(d) addresses “renewals” and “extensions” of stock purchase rights. There are mod- iﬁcations other than renewals and extensions that could also have an impact on the accounting for previously granted awards. The EITF Issue No. 87-33, “Stock Compensation Issues Related to Market Decline,” addresses a series of issues related to modiﬁcations to stock option and award plans as a result of market decline. The EITF’s consensus on these issues generally precludes reversals of previously recognized com- pensation expense when outstanding awards are modiﬁed because of market value declines and, in many instances, require measurement and recognition of compensation cost for both the original and the modiﬁed award.
37.3 APPLICATION OF APB OPINION NO. 25 37 11 • FASB Interpretation No. 44 addresses several issues related to modiﬁcations to stock option and award plans that change the life of the award through an extension of the exercise period or a renewal, decreases the exercise or purchase price of the award, or increases the number of shares the grantee is entitled to receive, including the addition of a reload feature. A modiﬁcation that renews a ﬁxed award or extends the award’s period (life), including a modiﬁcation contingent on a future separation from employment, results in a new measurement of compensation cost the same as a newly granted award. Any intrinsic value at the modiﬁcation date in excess of the amount measured at the original measurement date is recognized as com- pensation cost over the remaining future service period if the award is unvested, or immediately if the award is vested, for any employee who could beneﬁt from the modiﬁcation. A modiﬁcation that increases the life of an option award on separation from employment, but not beyond the original maximum contractual life of the award, is an extension of the award at the date the separation occurs and the life of the award is extended. The intrinsic value of the award is measured at the date of the modiﬁcation, and any intrinsic value in excess of the amount measured at the original measurement date is recognized as compensation cost if the separation occurs. If the award vests and is exercised before the separation, any incremental in- trinsic value at the date of the modiﬁcation is not recognized, because the life of the award has not been extended. Attribution of additional compensation cost may require estimates, and ad- justment of the estimates may be necessary in later periods. If the original terms of the award provide for vesting to be accelerated at the discretion of the grantor (or on some other discretionary basis), subsequent acceleration of vesting is a modiﬁca- tion. In contrast, if vesting is accelerated based on the occurrence of a speciﬁc event or condi- tion in accordance with the original terms of the award, for example, if the original terms of an award specify that vesting is accelerated on retirement, death, or disability, no modiﬁcation has been made and no new measurement of compensation cost is required. A ﬁxed stock option award may be subject to a modiﬁcation by having its exercise price re- duced (commonly called repricing). The exercise price has been reduced if the fair value of the consideration required to be remitted by the grantee on exercise is less than or potentially less than the fair value of the consideration required of the grantee according to the original terms of the award. Such an award is accounted for as variable from the date of the modiﬁcation to the date the award is exercised, forfeited, or expires unexercised. An exercise price can be reduced indirectly. For example, the grantor can give the grantee a cash bonus arrangement that is paid only if and when the award is exercised. This is an example of a combined stock award and cash bonus arrangement, discussed below. Or the grantor can allow the grantee to exercise the award with a full-recourse note that does not bear the market interest rate. If the exercise price has been reduced indirectly, the guidance in the preceding paragraph applies. A grantor can directly or indirectly modify an award by reducing the exercise price contin- gent on the occurrence of a speciﬁed future event or condition, for example, if a certain earnings target or stock price is achieved in the future. Such a modiﬁcation causes the award to be vari- able for the remainder of its outstanding life regardless of whether the triggering event occurs or the contingency provisions expires without the contingency occurring. In contrast, the original terms of a stock option award may provide for a reduction to the award’s exercise price if a speciﬁed future event or condition occurs. If so, variable accounting is applied from the date of grant. A measurement date would occur and variable accounting would stop when the contin- gency is resolved or the contingency provision expires. A grantor can, in effect, cancel an option award, for example, by modifying its terms to re- duce or eliminate the likelihood that the grantee will exercise the option, such as by increasing the exercise price or curtailing the remaining life of the award. Any such modiﬁcation is a can- cellation. A grantor can indirectly reduce the exercise price of a ﬁxed stock option award by canceling or effectively canceling it or settling it for cash or other consideration and granting a replacement award at a lower exercise price, either before or after the cancellation or effective cancellation. If a
37 12 STOCK-BASED COMPENSATION • cancellation and an award are combined that way, the replacement award is given variable account- ing until it is exercised, is forfeited, or expires unexercised. An option award cancellation is combined with another option award with a lower exercise price and results in an indirect reduction to the exercise price of the combined award if the other award is granted to the grantee within one of the following periods: a. The period before the date of the cancellation that is the shorter of six months or the period from the date of the grant of the canceled option b. The period ending six months after the date of the cancellation To identify the replacement award that becomes subject to variable accounting on the can- cellation of an award, the grantor ﬁrst looks back in the period before the cancellation described in (a) above. If the award was granted during that period with an exercise price below that of the canceled award, the award and the canceled award are combined. If canceled options remain that were not combined with a replacement award in the look-back period, the grantor then looks forward to the period described in (b) above. If an award is granted during that period at an exercise price below that of the canceled award, the award and the canceled award are com- bined. When looking backward and then forward, options granted at dates closest to the date of cancellation are ﬁrst identiﬁed as the replacement award. If the replacement award is identiﬁed in the look-back period, variable accounting for the award begins at the cancellation date. Prior- period ﬁnancial statements are not restated if the award was accounted for as a ﬁxed award in those statements. Nevertheless, an oral or written agreement or implied promise by the grantor to compensate the grantee for any increase in the market price of the stock after a cancellation but before grant of a replacement award requires variable accounting for the replacement award regardless of the amount of time between the cancellation and the replacement grant. Any agreement between the grantor and the grantee when an option award is granted to cancel at a future date another out- standing option award requires variable accounting for the newly granted award from the date of grant. The preceding also applies to the cancellation of an option award that has been accounted for as variable because of a reduction to that award’s exercise price through a prior modiﬁcation. But any option award granted during the look-back and look-forward periods, regardless of the exercise price of the replacement award, is eligible to be the replacement award. Thus, any re- placement or modiﬁed award that has been accounted for as a variable award retains that status. A cancellation of a ﬁxed stock option award and the grant of stock results in a new measurement of compensation cost for the stock grant. The exercise price has been effectively reduced to zero. Variable accounting does not therefore apply to the replacement award. Any excess of the number of shares underlying the canceled ﬁxed stock option award over the number of shares of the replace- ment stock award is subject to the guidance in the immediately preceding paragraphs. An equity restructuring is a nonreciprocal transaction between an entity and its shareholders, such as a stock dividend, spin-off, stock split, rights offering, or recapitalization through a spe- cial, large, nonrecurring dividend that causes the market value per share of the stock underlying the option award to decrease. Such a restructuring may adjust the exercise price, the number of shares, or both of outstanding stock options or awards. (Ordinary cash dividends or distributions are not equity restructurings for this purpose.) The grantor may reduce the exercise price, in- crease the numbers of shares under the award, or both, to offset the decrease in the per share price of the stock underlying the award. No accounting consequence results from such an equity restructuring if both of the following are met: 1. The aggregate intrinsic value of the award immediately after the change is not greater than the aggregate intrinsic award immediately before the change. 2. The ratio of the exercise price per share to the market value per share is not reduced.
37.3 APPLICATION OF APB OPINION NO. 25 37 13 • If those criteria are not met, the modiﬁed award is accounted for under Opinion No. 25 as variable from the date of the modiﬁcation to the date the award is exercised, is forfeited, or expires unexercised. If they are met but the terms of the original award have also been modiﬁed to either accelerate the vest- ing or extend the life of the award, a new measurement of compensation cost is made at the date of the modiﬁcation as if the award were newly granted. Cash or other consideration provided to restore the eco- nomic position of the grantee as a result of an equity restructuring transaction is recognized as compen- sation cost. The guidance concerning restructuring is applied without regard to whether the provisions of the stock option or award provide for adjustments to the terms in the event of an equity restructuring. A modiﬁcation that increases the number of shares to be issued under a ﬁxed stock option award requires the award to be accounted for as variable from the date of the modiﬁcation to the date the award is exercised, is forfeited, or expires unexercised. A grantor that modiﬁes a ﬁxed stock option award to add a reload feature, which provides for the grant of a new option award on the exercise of an existing award if speciﬁed conditions are met, applies variable accounting for the modiﬁed award from the date of the modiﬁcation to the date the award is exercised, is forfeited, or expires unexercised. The methods used to determine the exercise price, the number of shares, and the life of the reload grant are irrelevant. Variable accounting is required for each additional grant that includes a reload feature under a reload fea- ture that provides for multiple subsequent grants through further reloads. Total compensation cost is measured as the sum of the following if a ﬁxed stock option or award is canceled or modiﬁed and a new measurement of compensation cost or variable ac- counting is required as a result of the modiﬁcation: a. The intrinsic value of the award (if any) at the original measurement date b. The intrinsic value of the modiﬁed (or variable) award that exceeds the lesser of the intrinsic value of the original award (1) at the original measurement date or (2) immediately before the modiﬁcation When a stock option or award is modiﬁed and a new measurement of compensation cost or variable accounting is required, the remaining unrecognized original intrinsic value, if any, plus any additional compensation cost measured under (b) above is recognized over the remaining vesting (service) period, if any. If the modiﬁed award is fully vested at the date of the modiﬁca- tion, any additional compensation cost to be recognized is recognized immediately. Recognized compensation cost for an award forfeited because an employee does not fulﬁll an obligation is reduced to zero by decreasing compensation cost in the period of the forfeiture. Additional compensation cost measured as of the modiﬁcation date for modiﬁcations to acceler- ate vesting or to extend the life of an award on a speciﬁed future separation from employment (but not beyond the award’s original maximum contractual life) for all awards for which the modiﬁcation results in an effective term extension or an effective renewal. Attribution of additional compensation cost may require estimates and adjustments of the estimates in later periods. Compensation cost is adjusted for increases or decreases in the intrinsic value of a modiﬁed award that requires variable accounting in subsequent periods until the award is exercised, is forfeited, or expires unexercised. Compensation cost is not, however, adjusted below the intrin- sic value (if any) of the modiﬁed stock option or award at the original measurement date unless the award is forfeited because the employee does not fulﬁll an obligation. If cash is paid to an employee to settle an outstanding stock option, to settle an earlier grant of a stock award within six months after vesting, or to repurchase shares within six months after exercise of an option or issuance, total compensation cost is measured as the sum of the following: • The intrinsic value of the stock option or award (if any) at the original measurement date • The amount of cash paid to the employee (reduced by any amount of cash paid by the employee to acquire the shares) that exceeds the lesser of the intrinsic value (if any) of the award (1) at the original measurement date or (2) immediately before the cash settlement
37 14 STOCK-BASED COMPENSATION • The following guidance differs on whether the entity is a public entity or a private entity for this purpose. For this purpose, a public entity is any entity (a) whose securities trade in a public market either on a stock exchange (domestic or foreign) or in an over-the-counter market, in- cluding securities quoted only locally or regionally, (b) that makes a ﬁling with a regulatory agency in preparation for the sale of any class of equity securities in a public market, or (c) that is controlled by an entity that meets criterion (a) or (b). A subsidiary of a public entity or a pub- lic entity with thinly traded stock follows the accounting for the public entity. But an entity with publicly traded debt but no publicly traded equity securities follows the accounting for a non- public entity. For public reporting entities other than for shares expected to be repurchased at fair value for required tax withholding, variable accounting is required for a stock option or award with a share repurchase feature if the shares are expected to be repurchased within six months after op- tion exercise or issuance of the shares. For a repurchase feature that is a right held by the em- ployee to sell the shares back to the entity, variable accounting is required for the award if the right can be exercised within six months of issuance of the shares. After an option is exercised, the employee bears the risks and rewards of ownership with respect to those shares (except that if the consideration for exercise is a nonrecourse note, the substance is the same as a stock op- tion and the employee bears no risks or rewards of ownership in the shares received). A subse- quent repurchase of the shares by the entity (except within six months after option exercise or share issuance) thus represents a separate transaction to acquire treasury stock that is accounted for apart from the original stock option or award. If the grantor repurchases shares within six months of issuance or option exercise and the re- purchase was not expected by the grantor before the date of the repurchase, the grantor follows the preceding guidance for cash settlement of an earlier award. If a share repurchase feature gives the employee the right to sell the shares back to the grantor after option exercise or share issuance for a premium that is not ﬁxed or determinable over the then-current stock price, that feature creates an arrangement that requires variable ac- counting, even if the share cannot be sold back to the entity within six months after option exer- cise or issuance. If such a feature gives the employee the right to sell shares back to the entity for a ﬁxed dollar amount over the stock price but not within six months of issuance of the shares, the ﬁxed premium is recognized as additional compensation cost over the vesting (ser- vice) period. For nonpublic reporting entities, variable accounting is not required for a stock option or award with one of these share repurchase features: • The stated share repurchase price is equal to the fair value of the shares at the date of repur- chase, the employee cannot require the entity to repurchase the shares within six months of op- tion exercise or share issuance, and the shares are not expected to be repurchased within six months after exercise or share issuance. • The stated share repurchase price is not the fair value of the shares at the date of repurchase, but the employee has made a substantial investment and must bear risks and rewards normally as- sociated with share ownership for at least six months. • Shares are repurchased for tax-withholding purposes at the grantor’s minimum statutory with- holding rates, including payroll taxes, applicable to supplemental taxable income. A substantial investment has been made for purposes of an award that contains a repurchase fea- ture at other than fair value when the employee invests in a form other than services rendered to the entity an amount equal to 100% of the stated share repurchase price calculated at the date of grant. If the award is an option, a substantial investment therefore cannot be made before exercise of the op- tion. Because the award is variable, compensation cost is recognized for any intrinsic value of the op- tion from the date of grant to the date a substantial investment has been made. For purposes of paragraph 11(g) of Opinion No. 25 for both public and nonpublic entities, to
37.3 APPLICATION OF APB OPINION NO. 25 37 15 • determine the variable amount not required, required tax withholding is deﬁned as the em- ployer’s minimum statutory withholding rates for federal and state tax purposes, including pay- roll taxes applicable to such supplemental taxable income. Withheld amounts in excess of that rate do not represent the employer’s required tax withholding for this purpose. If an election to repurchase shares on exercise in excess of the number necessary to satisfy the employer’s required tax withholding is at the discretion of the employee, variable account- ing is required from the date the award is granted to the date the award is exercised, is forfeited, or expires unexercised. If the terms of an award are silent on tax withholding, or if the repur- chase of shares for tax withholding in excess of the number necessary to satisfy the employer’s required tax withholding is at the discretion of the employer, variable accounting is not re- quired. However, in either circumstance, if the employer exhibits a pattern of consistently ap- proving repurchases of excess shares, variable accounting is required from the date of grant for all awards under the plan. If shares are repurchased on exercise of a ﬁxed option award in excess of the number neces- sary to satisfy the employer’s required tax withholding, a new measurement of compensation cost is required for the entire award. Changes to the exercise price or the number of share of a ﬁxed stock option award as a result of an exchange of ﬁxed stock option awards in a business combination accounted for by the pooling of interests method have no accounting consequence if both of the following are met at the date of exchange: a. The aggregate intrinsic value of the options immediately after the exchange is no greater than the aggregate intrinsic value of the options immediately before the exchange. b. The ratio of the exercise price per option to the market value per share is not reduced. If those criteria are not met, a new measurement of compensation cost is required. Vested stock options or awards issued by an acquirer in a business combination accounted for by the purchase method in exchange for outstanding awards held by employees of the ac- quiree are considered to be part of the purchase price paid by the acquirer for the acquiree and accounted for under FASB Statement No. 141. The fair value of the new (acquirer) awards are included as part of the purchase price. Unvested stock options or awards granted by an acquirer in a business combination ac- counted for by the purchase method in exchange for stock options or awards held by employees of the acquiree are considered to be part of the purchase price for the acquiree, and the fair value of the new (acquirer) awards are included in the purchase price. However, to the extent that ser- vice is required after the consummation date of the acquisition in order to vest in the replace- ment awards, a portion of the intrinsic value (if any) of the unvested awards is allocated to unearned compensation and recognized as compensation cost over the remaining future vesting (service) period. The amount allocated is based on the portion of the intrinsic value at the con- summation date related to the future vesting (service) period. The amount is calculated as the in- trinsic value of the replacement awards at the consummation date multiplied by the fraction that is the remaining future vesting (service) period divided by the total vesting (service) period, which is the vesting period before the consummation date plus the remaining future period re- quired to vest in the replacement award. Any intrinsic value of the replacement awards allocated to unearned compensation cost is deducted from the fair value of the awards for purposes of the allocation of the purchase price to the other assets acquired. Awards granted under a plan subject to shareholder approval generally are not deemed granted until approval is obtained, and, therefore, no measurement date can occur before then. However, if management and the members of the board of directors control sufﬁcient votes to approve the plan, a grant date and therefore a measurement date may be deemed to have oc- curred before shareholder approval, because approval then is merely a formality. Deferred tax assets recognized for temporary differences related to stock options or awards under
37 16 STOCK-BASED COMPENSATION • Opinion No. 25 should not be adjusted for subsequent declines in the stock price. Such assets are de- termined by the compensation expense recognized for ﬁnancial reporting rather than by reference to the expected future tax deduction, which would be estimated using the current intrinsic value of the award. A valuation allowance to reduce the carrying amount of the assets is established only if the grantor expects future taxable income to be insufﬁcient to recover the assets in the periods in which the deduction would otherwise be recognized for tax purposes. A cash bonus and a stock option award are accounted for as a combined award if payment by the grantor or refund by the employee of the cash bonus is contingent on exercise of the option award. A cash bonus that is not ﬁxed and that is contingent on exercise of an option award is ac- counted for as a variable award. A ﬁxed cash bonus that is contingent on exercise of a ﬁxed op- tion award is accounted for as a combined ﬁxed award with the cash bonus reducing the stated exercise price of the option award. A cash bonus, regardless of whether it is ﬁxed or variable, that is contingent on vesting of a stock option or award is accounted for as compensation cost separate from the stock option or award. (v) Transfer of Stock or Assets to a Trustee, Agent, or Other Third Party. Paragraph 11(e) states: Transferring stock or assets to a trustee, agent, or other third party for distribution of stock to employees under the terms of an option, purchase, or award plan does not change the measurement date from a later date to the date of transfer unless the terms of the transfer provide that the stock (1) will not revert to the corporation, (2) will not be granted or awarded later to the same employee on terms different from or for services other than those speciﬁed in the original grant or award, and (3) will not be granted or awarded later to an- other employee. This paragraph reinforces the principle that the measurement date is the ﬁrst date on which are known both (1) the number of shares that an individual employee is entitled to receive and (2) the op- tion or purchase price, if any. The authors are not aware of any awards that have been structured in a manner that has resulted in an acceleration of the otherwise determined measurement date as a result of the application of paragraph 11(e). (vi) Awards of Convertible Stock or Rights. Paragraph 11(f) states: The measurement date for a grant or award of convertible stock (or stock that is otherwise ex- changeable for other securities of the corporation) is the date in which the ratio of conversion (or exchange) is known unless other terms are variable at that date (paragraph 10b). The higher of the quoted market price at the measurement date of (1) the convertible stock granted or awarded or (2) the securities into which the original grant or award is convertible should be used to mea- sure compensation. Awards to employees of convertible stock or rights to purchase convertible stock are not com- mon. Nevertheless, this paragraph provides guidance in measuring the compensation cost of such awards. Further guidance can be found in FASB Interpretation No. 38, “Determining the Measure- ment Date for Stock Option, Purchase, and Award Plans Involving Junior Stock,” an interpretation of APB Opinion No. 25. (vii) Settlement of Awards. Paragraph 11(g) states: Cash paid to an employee to settle an earlier award of stock or to settle a grant of option to the em- ployee should measure compensation cost. If the cash payment differs from the earlier measure of the award of stock or grant of option, compensation cost should be adjusted (par. 15). The amount that a corporation pays to an employee through a compensation plan is “cash paid to an employee to settle an earlier award of stock or to settle a grant of option” if stock is reacquired shortly after is-
37.3 APPLICATION OF APB OPINION NO. 25 37 17 • suance. Cash proceeds that a corporation receives from sale of awarded stock or stock issued on ex- ercise of an option and remits to the taxing authorities to cover required withholding of income taxes on an award is not “cash paid to an employee to settle an earlier award of stock or to settle a grant of option” in measuring compensation cost. The intent of this paragraph seems quite clear. If an earlier award of stock or stock options is ul- timately settled by cash payment to the employee, the amount actually paid is the ﬁnal measure of compensation cost to be recognized by the employer, regardless of the amount of compensation cost previously determined. However, in practice, application of this paragraph has often proved difﬁcult and, as a result, a number of EITF Issues have dealt with cash settlements of awards, as discussed in the following paragraph. EITF Issue No. 84-13, “Purchase of Stock Options and Stock Appreciation Rights in a Lever- aged Buyout.” This pronouncement sets forth the EITF’s consensus that the “target company” in a leveraged buyout should recognize compensation expense in the amount of cash paid by the target company to acquire outstanding stock options and stock appreciation rights. EITF Issue No. 85-45, “Business Combinations: Settlement of Stock Options and Awards.” Similar to the consensus in EITF Issue No. 84-13, this consensus indicates that when a target company settles outstanding stock options or awards “voluntarily, at the direc- tion of the acquiring company, or as part of the plan of acquisition, APB Opinion No. 25 re- quires that the settlement be accounted for as compensation expense in the separate ﬁnancial statements of the target company.” EITF Issue No. 87-6, “Adjustments Relating to Stock Compensation Plans.” This consensus addresses stock option plans that contain a cash bonus feature that provides for a reimbursement to employees of the taxes payable as a result of the exercise of a nonqualiﬁed stock option (a “tax- offset bonus”). The consensus indicates that awards under such plans are variable awards. Thus, the existence of a tax-offset bonus related to a stock option award requires that the entire award (the stock option plus the cash bonus feature) be accounted for as a variable award, as the option and the tax-offset bonus are viewed as a single variable award. This consensus is consistent with footnote 1 to FASB Interpretation No. 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans” which states, in part, “Plans under which an employee may receive cash in lieu of stock or additional cash upon the exercise of a stock option are variable plans for purposes of the Interpretation as the amount is contingent upon the occurrence of future events.” The signiﬁcant point here is that two different awards, one being a ﬁxed award and the other a variable award, should be accounted for as a single, variable award. EITF Issue No. 87-23, “Book Value Stock Purchase Plans.” This consensus provides much- needed guidance in accounting for formula-based plans, under which employees purchase shares, or are granted options to acquire shares, of the employer’s common stock at a formula price. The formula price is usually based on book value, a multiple of book value, or earnings. Additionally, the employee must sell the acquired shares back to the employer upon retirement or other termination of employment, at a selling price determined in the same manner as the original purchase price. Privately held companies only: No compensation expense should be recognized for changes in the formula price during the em- ployment period “if the employee makes a substantive investment that will be at risk for a rea- sonable period of time.” This consensus applies to plans where the employee is allowed to resell all or a portion of the acquired shares to the company at ﬁxed or determinable dates, as well as plans where the shares are resold to the company only upon retirement or other termination of employment.