In an apparent attempt to quiet the frenzy over stock option accounting problems, the chief accountant of the Securities and Exchange Commission issued an open letter last week to address a variety of issues companies are hitting as they cull through their historical records.
Foremost, the guidance points out that Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees—long the rule of the day on stock options, until its successor Financial Accounting Standards Board issued more recent rules—requires companies to determine compensation costs for option grants by starting with the measurement date. That is the first date when the company knows both the number of shares that an individual employee is entitled to receive and the option or purchase price, if any.
Bishop
That is crucially different than FASB’s subsequent rules, which address the grant date of an option award. Keith Bishop, a partner at the law firm Buchalter Nemer, says companies have been confused on this point, focusing on the language of FAS 123(R), Share-Based Payments, and applying its strictures to accounting practices that predate the rule.
“The guidance correctly focuses on the term ‘measurement date,’” he says. “There may have been a tendency to anachronistically impose the concept of the grant date rather than the measurement date. This guidance should help to correct any confusion in this regard.”
More than 100 companies are under investigation either by regulators or internally for possible wrongdoing with stock option awards. Backdated options, if not properly accounted, give the option holder an instant compensation benefit that in many cases hasn’t been recorded properly, either because of poor recordkeeping or deliberate manipulation.
In his letter, SEC Chief Accountant Conrad Hewitt said the SEC staff believes many issues raised in recent disclosures and investigations have involved the grant of discounted, “in the money” options and therefore have an accounting consequence under APB 25. He also acknowledged that in many cases companies are finding they granted normal, “at the money” options but experienced unimportant delays in the related administrative tasks that reflect no attempt at manipulation.
“In those situations, if compensation cost would not have otherwise been recorded pursuant to Opinion 25, short delays in completing the administrative procedures to finalize the grant would not result in an accounting consequence,” he wrote.
Hewitt devotes a great deal of attention to the determination of the measurement date, leaning on the definition in APB 25 and reminding companies that the measurement date is set only after all granting actions have been completed.
“If a company operates 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 staff believes the company should conclude that the measurement date for all of its awards (including those awards that were not changed) would be delayed until the completion of all required granting actions,” he wrote.
Put Guidance In Perspective
Hewitt continued, however, to caution companies to consider all the circumstances of their own particular practices. If they operated as if the awards were fixed and unchangeable before all granting actions were completed, it might be appropriate to consider the measurement date for an earlier time, he wrote.
SUMMARY
The excerpt below is from the Sept. 19, 2006, letter from SEC Chief Accountant Conrad Hewitt to Lawrence Silva at Financial Executives International, and Sam Ranzilla of the AICPA's Center for Public Company Audit Firms:
Documentation of Option Granting Activities is Incomplete or Cannot be Located
We understand that, in the course of reviewing their option-granting activities several years after the fact, some registrants have not been able to locate definitive and complete documentation evidencing certain of their past option granting activities. For example, (a) the legal documents evidencing past grants may not exist in the company's records, (b) contemporaneous documentation of the date on which a telephonic or in-person meeting of the compensation committee was held may not have been prepared, (c) written documentation includes only “as of” dates, and not the dates the documentation was actually prepared and approved, or (d) the company may have reason to believe that the documentation that is contained in the company's records is not accurate.
The appropriate accounting in circumstances where records cannot be located or may be inaccurate will depend on the particular facts and circumstances. We understand that, in some cases, the lack of documentation or existence of contradictory documentation may lead a company to conclude either that the terms of options cannot reasonably be considered fixed, resulting in the application of variable accounting, or that awards do not substantively exist until the board of directors affirms which awards will be honored. However, the staff does not believe that the lack of complete documentation being available several years after the activities occurred 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 what to account for. The existence of a pattern of past option grants with an exercise price equal to or near the lowest price of the entity’s stock during the time period surrounding those grants could indicate that the terms of those grants were determined with hindsight. Further, in some cases, the absence of documentation, in combination with other relevant factors, may provide evidence of fraudulent conduct. The staff expresses no view in this letter as to the manner in which various facts and forms of evidence should be evaluated under Opinion 25 to determine whether a company’s historical accounting records are accurate. We encourage companies to discuss unique facts and circumstances with the staff.
Source
Letter From Conrad Hewitt To Larry Salva And Sam Ranzilla (Sept. 19. 2006)
The letter is addressed to Lawrence Salva, chairman of the Committee on Corporate Reporting for the Financial Executives International, and Sam Ranzilla, chairman of the Center for Public Company Audit Firms at the American Institute of Certified Public Accountants. Neither the FEI nor the AICPA responded to Compliance Week’s request to discuss the guidance.
Hewitt stresses that the letter is not approved specifically by the SEC commissioners, which is common for staff guidance. In testimony before Congress recently, SEC Chairman Christopher Cox promised that guidance on backdating of stock options would be hitting the market “very soon.”
The letter proceeds to address a number of points that have been raised as companies continue their own internal reviews, including: the validity of prior grants and grants made prior to an employee’s start date; uncertainty about how aggregate awards would be awarded ultimately to individual employees and surrounding terms of the exercise price; and concerns over incomplete or lost documentation, the timing of grants around company news, changes in the terms of previously awarded options, and income taxes.
Hewitt says that when companies find material errors, they need to restate, and the evaluation of materiality should take into consideration whether mistakes were deliberate.
“Qualitative factors (for example, if the error is intentional) may cause misstatements of quantitatively small amounts to be material,” he wrote. “When disclosures of these issues are made, it is important that the registrant discuss not only the accounting restatements, but also the circumstances that gave rise to the errors.”
Hewitt also cautioned companies to look carefully at all affected periods. “Companies that propose to correct material errors without amending all previously filed reports should contact the staff of the Division of Corporation Finance,” he wrote.
Bishop says the letter is sufficiently broad and detailed to prove very useful to companies as they analyze their records. “The term ‘backdating’ has been used to cover a variety of stock option granting practices,” he says. “No two companies are likely to have exactly the same backdating questions. Many companies with stock option questions will find that their questions fit within the practices discussed in the guidance.”
Henke
Josh Henke, a senior consultant with compensation firm Longnecker & Associates, says the guidance is definitive for companies that have found themselves in murky water. “It take[s] an extremely gray issue and makes it more black and white,” he says.
A copy of the letter from SEC Chief Accountant Conrad Hewitt, as well as other resources and related coverage, can be found in the box above, right.
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