[Federal Register Volume 70, Number 62 (Friday, April 1, 2005)]
[Rules and Regulations]
[Pages 16693-16707]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 05-6457]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 211

[Release No. SAB 107]


Staff Accounting Bulletin No. 107

AGENCY: Securities and Exchange Commission.

ACTION: Publication of staff accounting bulletin.

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SUMMARY: The interpretations in this staff accounting bulletin 
(``SAB'') express views of the staff regarding the interaction between 
Statement of Financial Accounting Standards Statement No. 123 (revised 
2004), Share-Based Payment (``Statement

[[Page 16694]]

123R'' or the ``Statement'') and certain Securities and Exchange 
Commission (``SEC'') rules and regulations and provide the staff's 
views regarding the valuation of share-based payment arrangements for 
public companies. In particular, this SAB provides guidance related to 
share-based payment transactions with nonemployees, the transition from 
nonpublic to public entity status, valuation methods (including 
assumptions such as expected volatility and expected term), the 
accounting for certain redeemable financial instruments issued under 
share-based payment arrangements, the classification of compensation 
expense, non-GAAP financial measures, first-time adoption of Statement 
123R in an interim period, capitalization of compensation cost related 
to share-based payment arrangements, the accounting for income tax 
effects of share-based payment arrangements upon adoption of Statement 
123R, the modification of employee share options prior to adoption of 
Statement 123R and disclosures in Management's Discussion and Analysis 
(``MD&A'') subsequent to adoption of Statement 123R.

DATES: March 29, 2005.

FOR FURTHER INFORMATION CONTACT: Shan L. Benedict, Chad A. Kokenge, or 
Alison T. Spivey, Office of the Chief Accountant (202) 942-4400 or 
Craig Olinger, Division of Corporation Finance (202) 942-2960, 
Securities and Exchange Commission, 450 Fifth Street NW., Washington, 
DC 20549-1103.

SUPPLEMENTARY INFORMATION: The statements in staff accounting bulletins 
are not rules or interpretations of the Commission, nor are they 
published as bearing the Commission's official approval. They represent 
interpretations and practices followed by the Division of Corporation 
Finance and the Office of the Chief Accountant in administering the 
disclosure requirements of the Federal securities laws.

    Dated: March 29, 2005.
Margaret H. McFarland,
Deputy Secretary.

PART 211--[AMENDED]

0
Accordingly, part 211 of Title 17 of the Code of Federal Regulations is 
amended by adding Staff Accounting Bulletin No. 107 to the table found 
in subpart B.

[Note: The text of SAB 107 will not appear in the Code of Federal 
Regulations.]

Staff Accounting Bulletin No. 107

    The staff hereby adds Topic 14 to the staff accounting bulletin 
series. Topic 14 provides guidance regarding the application of 
Statement of Financial Accounting Standards No. 123 (revised 2004), 
Share-Based Payment. The staff also hereby amends the following staff 
accounting bulletins.
    1. Topic 4.D.2. is modified to update the references in footnote 4 
from APB Opinion No. 25, Accounting for Stock Issued to Employees 
(``Opinion 25'') and FASB Statement No. 123, Accounting for Stock-Based 
Compensation (``Statement 123'') to Statement 123R. Opinion 25 and 
Statement 123 were superseded by Statement 123R.
    2. Topic 4.E. is modified to delete the references and related 
guidance to compensation and deferred compensation. Statement 123R 
requires compensation costs to be recognized in the financial 
statements as services are provided by employees and does not permit 
those costs to be recognized as deferred compensation on the balance 
sheet before services are provided.
    3. Topic 5.T. is modified to update the references from ``AICPA 
Interpretation 1 to Opinion 25'' to ``paragraph 11 of Statement 123R.'' 
AICPA Interpretation 1 to Opinion 25 was superseded by Statement 123R.

Topic 14: Share-Based Payment

    The interpretations in this SAB express views of the staff 
regarding the interaction between Statement 123R and certain SEC rules 
and regulations and provide the staff's views regarding the valuation 
of share-based payment arrangements for public companies. Statement 
123R was issued by the Financial Accounting Standards Board (``FASB'') 
on December 16, 2004. Statement 123R is based on the underlying 
accounting principle that compensation cost resulting from share-based 
payment transactions be recognized in financial statements at fair 
value.\1\ Recognition of compensation cost at fair value will provide 
investors and other users of financial statements with more complete 
and comparable financial information.\2\
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    \1\ Statement 123R, paragraph 1.
    \2\ Statement 123R, page iv.
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    Statement 123R addresses a wide range of share-based compensation 
arrangements including share options, restricted share plans, 
performance-based awards, share appreciation rights, and employee share 
purchase plans.
    Statement 123R replaces Statement 123 and supersedes Opinion 25. 
Statement 123, as originally issued in 1995, established as preferable, 
but did not require, a fair-value-based method of accounting for share-
based payment transactions with employees.
    The staff believes the guidance in this SAB will assist issuers in 
their initial implementation of Statement 123R and enhance the 
information received by investors and other users of financial 
statements, thereby assisting them in making investment and other 
decisions. This SAB includes interpretive guidance related to share-
based payment transactions with nonemployees, the transition from 
nonpublic to public entity \3\ status, valuation methods (including 
assumptions such as expected volatility and expected term), the 
accounting for certain redeemable financial instruments issued under 
share-based payment arrangements, the classification of compensation 
expense, non-GAAP financial measures, first-time adoption of Statement 
123R in an interim period, capitalization of compensation cost related 
to share-based payment arrangements, the accounting for income tax 
effects of share-based payment arrangements upon adoption of Statement 
123R, the modification of employee share options prior to adoption of 
Statement 123R and disclosures in MD&A subsequent to adoption of 
Statement 123R.
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    \3\ Defined in Statement 123R, Appendix E.
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    The staff recognizes that there is a range of conduct that a 
reasonable issuer might use to make estimates and valuations and 
otherwise implement Statement 123R, and the interpretive guidance 
provided by this SAB, particularly during the period of the Statement's 
initial implementation. Thus, throughout this SAB the use of the terms 
``reasonable'' and ``reasonably'' is not meant to imply a single 
conclusion or methodology, but to encompass the full range of potential 
conduct, conclusions or methodologies upon which an issuer may 
reasonably base its valuation decisions. Different conduct, conclusions 
or methodologies by different issuers in a given situation does not of 
itself raise an inference that any of those issuers is acting 
unreasonably. While the zone of reasonable conduct is not unlimited, 
the staff expects that it will be rare when there is only one 
acceptable choice in estimating the fair value of share-based payment 
arrangements under the provisions of Statement 123R and the 
interpretive guidance provided by this SAB in any given situation. In 
addition, as discussed in the Interpretive Response to Question 1 of 
Section C, Valuation Methods, estimates of fair value are not intended 
to predict actual future events, and subsequent events are not 
indicative of the reasonableness of the original estimates of fair 
value made

[[Page 16695]]

under Statement 123R. Over time, as issuers and accountants gain more 
experience in applying Statement 123R and the guidance provided in this 
SAB, the staff anticipates that particular approaches may begin to 
emerge as best practices and that the range of reasonable conduct, 
conclusions and methodologies will likely narrow.
* * * * *

A. Share-Based Payment Transactions With Nonemployees

    Question: Are share-based payment transactions with nonemployees 
included in the scope of Statement 123R?
    Interpretive Response: Only certain aspects of the accounting for 
share-based payment transactions with nonemployees are explicitly 
addressed by Statement 123R. Statement 123R explicitly:
     Establishes fair value as the measurement objective in 
accounting for all share-based payments; \4\ and
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    \4\ Statement 123R, paragraph 7.
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     Requires that an entity record the value of a transaction 
with a nonemployee based on the more reliably measurable fair value of 
either the good or service received or the equity instrument issued.\5\
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    \5\ Ibid.
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    Statement 123R does not supersede any of the authoritative 
literature that specifically addresses accounting for share-based 
payments with nonemployees. For example, Statement 123R does not 
specify the measurement date for share-based payment transactions with 
nonemployees when the measurement of the transaction is based on the 
fair value of the equity instruments issued.\6\ For determining the 
measurement date of equity instruments issued in share-based 
transactions with nonemployees, a company should refer to Emerging 
Issues Task Force (``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.
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    \6\ Statement 123R, paragraph 8.
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    With respect to questions regarding nonemployee arrangements that 
are not specifically addressed in other authoritative literature, the 
staff believes that the application of guidance in Statement 123R would 
generally result in relevant and reliable financial statement 
information. As such, the staff believes it would generally be 
appropriate for entities to apply the guidance in Statement 123R by 
analogy to share-based payment transactions with nonemployees unless 
other authoritative accounting literature more clearly addresses the 
appropriate accounting, or the application of the guidance in Statement 
123R would be inconsistent with the terms of the instrument issued to a 
nonemployee in a share-based payment arrangement.\7\ For example, the 
staff believes the guidance in Statement 123R on certain transactions 
with related parties or other holders of an economic interest in the 
entity would generally be applicable to share-based payment 
transactions with nonemployees. The staff encourages registrants that 
have additional questions related to accounting for share-based payment 
transactions with nonemployees to discuss those questions with the 
staff.
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    \7\ For example, due to the nature of specific terms in employee 
share options, including nontransferability, nonhedgability and the 
truncation of the contractual term due to post-vesting service 
termination, Statement 123R requires that when valuing an employee 
share option under the Black-Scholes-Merton framework, the fair 
value of an employee share option be based on the option's expected 
term rather than the contractual term. If these features (i.e., 
nontransferability, nonhedgability and the truncation of the 
contractual term) were not present in a nonemployee share option 
arrangement, the use of an expected term assumption shorter than the 
contractual term would generally not be appropriate in estimating 
the fair value of the nonemployee share options.
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B. Transition From Nonpublic to Public Entity Status

    Facts: Company A is a nonpublic entity \8\ that first files a 
registration statement with the SEC to register its equity securities 
for sale in a public market on January 2, 20X8.\9\ As a nonpublic 
entity, Company A had been assigning value to its share options \10\ 
under the calculated value method prescribed by Statement 123R \11\ and 
had elected to measure its liability awards based on intrinsic value. 
Company A is considered a public entity on January 2, 20X8 when it 
makes its initial filing with the SEC in preparation for the sale of 
its shares in a public market.
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    \8\ Defined in Statement 123R, Appendix E.
    \9\ For the purposes of these illustrations, assume all of 
Company A's equity-based awards granted to its employees were 
granted after the adoption of Statement 123R.
    \10\ For purposes of this staff accounting bulletin, the phrase 
``share options'' is used to refer to ``share options or similar 
instruments.''
    \11\ Statement 123R, paragraph 23 requires a nonpublic entity to 
use the calculated value method when it is not able to reasonably 
estimate the fair value of its equity share options and similar 
instruments because it is not practicable for it to estimate the 
expected volatility of its share price. Statement 123R, paragraph 
A43 indicates that a nonpublic entity may be able to identify 
similar public entities for which share or option price information 
is available and may consider the historical, expected, or implied 
volatility of those entities' share prices in estimating expected 
volatility. The staff would expect an entity that becomes a public 
entity and had previously measured its share options under the 
calculated value method to be able to support its previous decision 
to use calculated value and to provide the disclosures required by 
paragraph A240(e)(2)(b) of Statement 123R.
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    Question 1: How should Company A account for the share options that 
were granted to its employees prior to January 2, 20X8 for which the 
requisite service has not been rendered by January 2, 20X8?
    Interpretive Response: Prior to becoming a public entity, Company A 
had been assigning value to its share options under the calculated 
value method. The staff believes that Company A should continue to 
follow that approach for those share options that were granted prior to 
January 2, 20X8, unless those share options are subsequently modified, 
repurchased or cancelled.\12\ If the share options are subsequently 
modified, repurchased or cancelled, Company A would assess the event 
under the public company provisions of Statement 123R. For example, if 
Company A modified the share options on February 1, 20X8, any 
incremental compensation cost would be measured under Statement 123R, 
paragraph 51(a), as the fair value of the modified share options over 
the fair value of the original share options measured immediately 
before the terms were modified.\13\
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    \12\ This view is consistent with the FASB's basis for rejecting 
full retrospective application of Statement 123R as described in 
Statement 123R, paragraph B251.
    \13\ Statement 123R, footnote 103. The staff believes that 
because Company A is a public entity as of the date of the 
modification, it would be inappropriate to use the calculated value 
method to measure the original share options immediately before the 
terms were modified.
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    Question 2: How should Company A account for its liability awards 
granted to its employees prior to January 2, 20X8 which are fully 
vested but have not been settled by January 2, 20X8?
    Interpretive Response: As a nonpublic entity, Company A had elected 
to measure its liability awards subject to Statement 123R at intrinsic 
value.\14\ When Company A becomes a public entity, it should measure 
the liability awards at their fair value determined in accordance with 
Statement 123R.\15\ In that reporting period there will be an 
incremental amount of measured cost for the difference between fair 
value as determined under Statement 123R and intrinsic value. For 
example, assume the intrinsic value in the period ended December 31, 
20X7 was $10 per award. At the end of the first reporting period

[[Page 16696]]

ending after January 2, 20X8 (when Company A becomes a public entity), 
assume the intrinsic value of the award is $12 and the fair value as 
determined in accordance with Statement 123R is $15. The measured cost 
in the first reporting period after December 31, 20X7 would be $5.\16\
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    \14\ Statement 123R, paragraph 38.
    \15\ Statement 123R, paragraph 37.
    \16\ $15 fair value less $10 intrinsic value equals $5 of 
incremental cost.
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    Question 3: After becoming a public entity, may Company A 
retrospectively apply the fair-value-based method to its awards that 
were granted prior to the date Company A became a public entity?
    Interpretive Response: No. Before becoming a public entity, Company 
A did not use the fair-value-based method for either its share options 
or its liability awards granted to the Company's employees. The staff 
does not believe it is appropriate for Company A to apply the fair-
value-based method on a retrospective basis, because it would require 
the entity to make estimates of a prior period, which, due to 
hindsight, may vary significantly from estimates that would have been 
made contemporaneously in prior periods.\17\
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    \17\ This view is consistent with the FASB's basis for rejecting 
full retrospective application of Statement 123R as described in 
Statement 123R, paragraph B251.
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    Question 4: Upon becoming a public entity, what disclosures should 
Company A consider in addition to those prescribed by Statement 123R? 
\18\
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    \18\ Statement 123R disclosure requirements are described in 
paragraphs 64, 65, A240, A241 and A242.
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    Interpretive Response: In the registration statement filed on 
January 2, 20X8, Company A should clearly describe in MD&A the change 
in accounting policy that will be required by Statement 123R in 
subsequent periods and the reasonably likely material future 
effects.\19\ In subsequent filings, Company A should provide financial 
statement disclosure of the effects of the changes in accounting 
policy. In addition, Company A should consider the applicability of SEC 
Release No. FR-60 \20\ and Section V, ``Critical Accounting 
Estimates,'' in SEC Release No. FR-72 \21\ regarding critical 
accounting policies and estimates in MD&A.
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    \19\ See generally SEC Release No. FR-72, ``Commission Guidance 
Regarding Management's Discussion and Analysis of Financial 
Condition and Results of Operations.''
    \20\ SEC Release No. FR-60, ``Cautionary Advice Regarding 
Disclosure About Critical Accounting Policies.''
    \21\ SEC Release No. FR-72, ``Commission Guidance Regarding 
Management's Discussion and Analysis of Financial Condition and 
Results of Operations.''
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C. Valuation Methods

    Statement 123R, paragraph 16, indicates that the measurement 
objective for equity instruments awarded to employees is to estimate at 
the grant date the fair value of the equity instruments the entity is 
obligated to issue when employees have rendered the requisite service 
and satisfied any other conditions necessary to earn the right to 
benefit from the instruments. The Statement also states that observable 
market prices of identical or similar equity or liability instruments 
in active markets are the best evidence of fair value and, if 
available, should be used as the basis for the measurement for equity 
and liability instruments awarded in a share-based payment transaction 
with employees.\22\ However, if observable market prices of identical 
or similar equity or liability instruments are not available, the fair 
value shall be estimated by using a valuation technique or model that 
complies with the measurement objective, as described in Statement 
123R.\23\
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    \22\ Statement 123R, paragraph A7.
    \23\ Statement 123R, paragraph A8.
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    Question 1: If a valuation technique or model is used to estimate 
fair value, to what extent will the staff consider a company's 
estimates of fair value to be materially misleading because the 
estimates of fair value do not correspond to the value ultimately 
realized by the employees who received the share options?
    Interpretive Response: The staff understands that estimates of fair 
value of employee share options, while derived from expected value 
calculations, cannot predict actual future events.\24\ The estimate of 
fair value represents the measurement of the cost of the employee 
services to the company. The estimate of fair value should reflect the 
assumptions marketplace participants would use in determining how much 
to pay for an instrument on the date of the measurement (generally the 
grant date for equity awards). For example, valuation techniques used 
in estimating the fair value of employee share options may consider 
information about a large number of possible share price paths, while, 
of course, only one share price path will ultimately emerge. If a 
company makes a good faith fair value estimate in accordance with the 
provisions of Statement 123R in a way that is designed to take into 
account the assumptions that underlie the instrument's value that 
marketplace participants would reasonably make, then subsequent future 
events that affect the instrument's value do not provide meaningful 
information about the quality of the original fair value estimate. As 
long as the share options were originally so measured, changes in an 
employee share option's value, no matter how significant, subsequent to 
its grant date do not call into question the reasonableness of the 
grant date fair value estimate.
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    \24\ Statement 123R, paragraph A12, states ``The fair value of 
those instruments at a single point in time is not a forecast of 
what the estimated fair value of those instruments may be in the 
future.''
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    Question 2: In order to meet the fair value measurement objective 
in Statement 123R, are certain valuation techniques preferred over 
others?
    Interpretive Response: Statement 123R, paragraph A14, clarifies 
that the Statement does not specify a preference for a particular 
valuation technique or model. As stated in Statement 123R, paragraph 
A8, in order to meet the fair value measurement objective, a company 
should select a valuation technique or model that (a) Is applied in a 
manner consistent with the fair value measurement objective and other 
requirements of Statement 123R, (b) is based on established principles 
of financial economic theory and generally applied in that field and 
(c) reflects all substantive characteristics of the instrument.
    The chosen valuation technique or model must meet all three of the 
requirements stated above. In valuing a particular instrument, certain 
techniques or models may meet the first and second criteria but may not 
meet the third criterion because the techniques or models are not 
designed to reflect certain characteristics contained in the 
instrument. For example, for a share option in which the exercisability 
is conditional on a specified increase in the price of the underlying 
shares, the Black-Scholes-Merton closed-form model would not generally 
be an appropriate valuation model because, while it meets both the 
first and second criteria, it is not designed to take into account that 
type of market condition.\25\
    Further, the staff understands that a company may consider multiple 
techniques or models that meet the fair value measurement objective 
before making its selection as to the appropriate technique or model. 
The staff would not object to a company's choice of a technique or 
model as long as the technique or model meets the fair value 
measurement objective. For example, a company is not required to use a 
lattice model simply because that

[[Page 16697]]

model was the most complex of the models the company considered.
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    \25\ See Statement 123R, paragraphs A13-17.
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    Question 3: In subsequent periods, may a company change the 
valuation technique or model chosen to value instruments with similar 
characteristics? \26\
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    \26\ Statement 123R, paragraph A14 and footnote 49, indicate 
that an entity may use different valuation techniques or models for 
instruments with different characteristics.
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    Interpretive Response: As long as the new technique or model meets 
the fair value measurement objective in Statement 123R as described in 
Question 2 above, the staff would not object to a company changing its 
valuation technique or model.\27\ A change in the valuation technique 
or model used to meet the fair value measurement objective would not be 
considered a change in accounting principle. As such, a company would 
not be required to file a preferability letter from its independent 
accountants as described in Rule 10-01(b)(6) of Regulation S-X when it 
changes valuation techniques or models.\28\ However, the staff would 
not expect that a company would frequently switch between valuation 
techniques or models, particularly in circumstances where there was no 
significant variation in the form of share-based payments being valued. 
Disclosure in the footnotes of the basis for any change in technique or 
model would be appropriate.\29\
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    \27\ The staff believes that a company should take into account 
the reason for the change in technique or model in determining 
whether the new technique or model meets the fair value measurement 
objective. For example, changing a technique or model from period to 
period for the sole purpose of lowering the fair value estimate of a 
share option would not meet the fair value measurement objective of 
the Statement.
    \28\ Statement 123R, paragraph A23.
    \29\ See generally Statement 123R, paragraph 64c.
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    Question 4: Must every company that issues share options or similar 
instruments hire an outside third party to assist in determining the 
fair value of the share options?
    Interpretive Response: No. However, the valuation of a company's 
share options or similar instruments should be performed by a person 
with the requisite expertise.

D. Certain Assumptions Used in Valuation Methods

    Statement 123R's fair value measurement objective for equity 
instruments awarded to employees is to estimate the grant-date fair 
value of the equity instruments that the entity is obligated to issue 
when employees have rendered the requisite service and satisfied any 
other conditions necessary to earn the right to benefit from the 
instruments.\30\ In order to meet this fair value measurement 
objective, management will be required to develop estimates regarding 
the expected volatility of its company's share price and the exercise 
behavior of its employees. The staff is providing guidance in the 
following sections related to the expected volatility and expected term 
assumptions to assist public entities in applying those requirements.
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    \30\ Statement 123R, paragraph A2.
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    The staff understands that companies may refine their estimates of 
expected volatility and expected term as a result of the guidance 
provided in Statement 123R and in sections (1) and (2) below. Changes 
in assumptions during the periods presented in the financial statements 
should be disclosed in the footnotes.\31\
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    \31\ Statement 123R, paragraph A240(e).
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1. Expected Volatility
    Statement 123R, paragraph A31, states, ``Volatility is a measure of 
the amount by which a financial variable, such as share price, has 
fluctuated (historical volatility) or is expected to fluctuate 
(expected volatility) during a period. Option-pricing models require an 
estimate of expected volatility as an assumption because an option's 
value is dependent on potential share returns over the option's term. 
The higher the volatility, the more the returns on the share can be 
expected to vary--up or down. Because an option's value is unaffected 
by expected negative returns on the shares, other things [being] equal, 
an option on a share with higher volatility is worth more than an 
option on a share with lower volatility.''
    Facts: Company B is a public entity whose common shares have been 
publicly traded for over twenty years. Company B also has multiple 
options on its shares outstanding that are traded on an exchange 
(``traded options''). Company B grants share options on January 2, 
20X6.
    Question 1: What should Company B consider when estimating expected 
volatility for purposes of measuring the fair value of its share 
options?
    Interpretive Response: Statement 123R does not specify a particular 
method of estimating expected volatility. However, the Statement does 
clarify that the objective in estimating expected volatility is to 
ascertain the assumption about expected volatility that marketplace 
participants would likely use in determining an exchange price for an 
option.\32\ Statement 123R provides a list of factors entities should 
consider in estimating expected volatility.\33\ Company B may begin its 
process of estimating expected volatility by considering its historical 
volatility.\34\ However, Company B should also then consider, based on 
available information, how the expected volatility of its share price 
may differ from historical volatility.\35\ Implied volatility \36\ can 
be useful in estimating expected volatility because it is generally 
reflective of both historical volatility and expectations of how future 
volatility will differ from historical volatility.
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    \32\ Statement 123R, paragraph B86.
    \33\ Statement 123R, paragraph A32.
    \34\ Statement 123R, paragraph A34.
    \35\ Ibid.
    \36\ Implied volatility is the volatility assumption inherent in 
the market prices of a company's traded options or other financial 
instruments that have option-like features. Implied volatility is 
derived by entering the market price of the traded financial 
instrument, along with assumptions specific to the financial options 
being valued, into a model based on a constant volatility estimate 
(e.g., the Black-Scholes-Merton closed-form model) and solving for 
the unknown assumption of volatility.
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    The staff believes that companies should make good faith efforts to 
identify and use sufficient information in determining whether taking 
historical volatility, implied volatility or a combination of both into 
account will result in the best estimate of expected volatility. The 
staff believes companies that have appropriate traded financial 
instruments from which they can derive an implied volatility should 
generally consider this measure. The extent of the ultimate reliance on 
implied volatility will depend on a company's facts and circumstances; 
however, the staff believes that a company with actively traded options 
or other financial instruments with embedded options \37\ generally 
could place greater (or even exclusive) reliance on implied volatility. 
(See the Interpretive Responses to Questions 3 and 4 below.)
    The process used to gather and review available information to 
estimate expected volatility should be applied consistently from period 
to period. When circumstances indicate the availability of new or 
different information that would be useful in estimating expected 
volatility, a

[[Page 16698]]

company should incorporate that information.
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    \37\ The staff believes implied volatility derived from embedded 
options can be utilized in determining expected volatility if, in 
deriving the implied volatility, the company considers all relevant 
features of the instruments (e.g., value of the host instrument, 
value of the option, etc.). The staff believes the derivation of 
implied volatility from other than simple instruments (e.g., a 
simple convertible bond) can, in some cases, be impracticable due to 
the complexity of multiple features.
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    Question 2: What should Company B consider if computing historical 
volatility?\38\
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    \38\ See Statement 123R, paragraph A32.
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    Interpretive Response: The following should be considered in the 
computation of historical volatility:
    1. Method of Computing Historical Volatility--The staff believes 
the method selected by Company B to compute its historical volatility 
should produce an estimate that is representative of Company B's 
expectations about its future volatility over the expected (if using a 
Black-Scholes-Merton closed-form model) or contractual (if using a 
lattice model) term \39\ of its employee share options. Certain methods 
may not be appropriate for longer term employee share options if they 
weight the most recent periods of Company B's historical volatility 
much more heavily than earlier periods.\40\ For example, a method that 
applies a factor to certain historical price intervals to reflect a 
decay or loss of relevance of that historical information emphasizes 
the most recent historical periods and thus would likely bias the 
estimate to this recent history.\41\
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    \39\ For purposes of this staff accounting bulletin, the phrase 
``expected or contractual term, as applicable'' has the same meaning 
as the phrase ``expected (if using a Black-Scholes-Merton closed-
form model) or contractual (if using a lattice model) term of an 
employee share option.''
    \40\ Statement 123R, paragraph A32(a), states that entities 
should consider historical volatility over a period generally 
commensurate with the expected or contractual term, as applicable, 
of the share option. Accordingly, the staff believes methods that 
place extreme emphasis on the most recent periods may be 
inconsistent with this guidance.
    \41\ Generalized Autoregressive Conditional Heteroskedasticity 
(``GARCH'') is an example of a method that demonstrates this 
characteristic.
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    2. Amount of Historical Data--Statement 123R, paragraph A32(a), 
indicates entities should consider historical volatility over a period 
generally commensurate with the expected or contractual term, as 
applicable, of the share option. The staff believes Company B could 
utilize a period of historical data longer than the expected or 
contractual term, as applicable, if it reasonably believes the 
additional historical information will improve the estimate. For 
example, assume Company B decided to utilize a Black-Scholes-Merton 
closed-form model to estimate the value of the share options granted on 
January 2, 20X6 and determined that the expected term was six years. 
Company B would not be precluded from using historical data longer than 
six years if it concludes that data would be relevant.
    3. Frequency of Price Observations--Statement 123R, paragraph 
A32(d), indicates an entity should use appropriate and regular 
intervals for price observations based on facts and circumstances that 
provide the basis for a reasonable fair value estimate. Accordingly, 
the staff believes Company B should consider the frequency of the 
trading of its shares and the length of its trading history in 
determining the appropriate frequency of price observations. The staff 
believes using daily, weekly or monthly price observations may provide 
a sufficient basis to estimate expected volatility if the history 
provides enough data points on which to base the estimate.\42\ Company 
B should select a consistent point in time within each interval when 
selecting data points.\43\
---------------------------------------------------------------------------

    \42\ Further, if shares of a company are thinly traded the staff 
believes the use of weekly or monthly price observations would 
generally be more appropriate than the use of daily price 
observations. The volatility calculation using daily observations 
for such shares could be artificially inflated due to a larger 
spread between the bid and asked quotes and lack of consistent 
trading in the market.
    \43\ Statement 123R, paragraph A34, states that a company should 
establish a process for estimating expected volatility and apply 
that process consistently from period to period. In addition, 
Statement 123R, paragraph A23, indicates that assumptions used to 
estimate the fair value of instruments granted to employees should 
be determined in a consistent manner from period to period.
---------------------------------------------------------------------------

    4. Consideration of Future Events--The objective in estimating 
expected volatility is to ascertain the assumptions that marketplace 
participants would likely use in determining an exchange price for an 
option.\44\ Accordingly, the staff believes that Company B should 
consider those future events that it reasonably concludes a marketplace 
participant would also consider in making the estimation. For example, 
if Company B has recently announced a merger with a company that would 
change its business risk in the future, then it should consider the 
impact of the merger in estimating the expected volatility if it 
reasonably believes a marketplace participant would also consider this 
event.
---------------------------------------------------------------------------

    \44\ Statement 123R, paragraph B86.
---------------------------------------------------------------------------

    5. Exclusion of Periods of Historical Data--In some instances, due 
to a company's particular business situations, a period of historical 
volatility data may not be relevant in evaluating expected 
volatility.\45\ In these instances, that period should be disregarded. 
The staff believes that if Company B disregards a period of historical 
volatility, it should be prepared to support its conclusion that its 
historical share price during that previous period is not relevant to 
estimating expected volatility due to one or more discrete and specific 
historical events and that similar events are not expected to occur 
during the expected term of the share option. The staff believes these 
situations would be rare.
---------------------------------------------------------------------------

    \45\ Statement 123R, paragraph A32(a).
---------------------------------------------------------------------------

    Question 3: What should Company B consider when evaluating the 
extent of its reliance on the implied volatility derived from its 
traded options?
    Interpretive Response: To achieve the objective of estimating 
expected volatility as stated in paragraph B86 of Statement 123R, the 
staff believes Company B generally should consider the following in its 
evaluation: (1) The volume of market activity of the underlying shares 
and traded options; (2) the ability to synchronize the variables used 
to derive implied volatility; (3) the similarity of the exercise prices 
of the traded options to the exercise price of the employee share 
options; and (4) the similarity of the length of the term of the traded 
and employee share options.\46\
---------------------------------------------------------------------------

    \46\ See generally Options, Futures, and Other Derivatives by 
John C. Hull (Prentice Hall, 5th Edition, 2003).
---------------------------------------------------------------------------

    1. Volume of Market Activity--The staff believes Company B should 
consider the volume of trading in its underlying shares as well as the 
traded options. For example, prices for instruments in actively traded 
markets are more likely to reflect a marketplace participant's 
expectations regarding expected volatility.
    2. Synchronization of the Variables--Company B should synchronize 
the variables used to derive implied volatility. For example, to the 
extent reasonably practicable, Company B should use market prices 
(either traded prices or the average of bid and asked quotes) of the 
traded options and its shares measured at the same point in time. This 
measurement should also be synchronized with the grant of the employee 
share options; however, when this is not reasonably practicable, the 
staff believes Company B should derive implied volatility as of a point 
in time as close to the grant of the employee share options as 
reasonably practicable.
    3. Similarity of the Exercise Prices--The staff believes that when 
valuing an at-the-money employee share option, the implied volatility 
derived from at- or near-the-money traded options generally would be 
most relevant.\47\ If, however,

[[Page 16699]]

it is not possible to find at- or near-the-money traded options, 
Company B should select multiple traded options with an average 
exercise price close to the exercise price of the employee share 
option.\48\
---------------------------------------------------------------------------

    \47\ Implied volatilities of options differ systematically over 
the ``moneyness'' of the option. This pattern of implied 
volatilities across exercise prices is known as the ``volatility 
smile'' or ``volatility skew.'' Studies such as ``Implied 
Volatility'' by Stewart Mayhew, Financial Analysts Journal, July-
August 1995, have found that implied volatilities based on near-the-
money options do as well as sophisticated weighted implied 
volatilities in estimating expected volatility. In addition, the 
staff believes that because near-the-money options are generally 
more actively traded, they may provide a better basis for deriving 
implied volatility.
    \48\ The staff believes a company could use a weighted-average 
implied volatility based on traded options that are either in-the-
money or out-of-the-money. For example, if the employee share option 
has an exercise price of $52, but the only traded options available 
have exercise prices of $50 and $55, then the staff believes that it 
is appropriate to use a weighted average based on the implied 
volatilities from the two traded options; for this example, a 40% 
weight on the implied volatility calculated from the option with an 
exercise price of $55 and a 60% weight on the option with an 
exercise price of $50.
---------------------------------------------------------------------------

    4. Similarity of Length of Terms--The staff believes that when 
valuing an employee share option with a given expected or contractual 
term, as applicable, the implied volatility derived from a traded 
option with a similar term would be the most relevant. However, if 
there are no traded options with maturities that are similar to the 
share option's contractual or expected term, as applicable, then the 
staff believes Company B could consider traded options with a remaining 
maturity of six months or greater.\49\ However, when using traded 
options with a term of less than one year,\50\ the staff would expect 
the company to also consider other relevant information in estimating 
expected volatility. In general, the staff believes more reliance on 
the implied volatility derived from a traded option would be expected 
the closer the remaining term of the traded option is to the expected 
or contractual term, as applicable, of the employee share option.
---------------------------------------------------------------------------

    \49\ The staff believes it may also be appropriate to consider 
the entire term structure of volatility provided by traded options 
with a variety of remaining maturities. If a company considers the 
entire term structure in deriving implied volatility, the staff 
would expect a company to include some options in the term structure 
with a remaining maturity of six months or greater.
    \50\ The staff believes the implied volatility derived from a 
traded option with a term of one year or greater would typically not 
be significantly different from the implied volatility that would be 
derived from a traded option with a significantly longer term.
---------------------------------------------------------------------------

    The staff believes Company B's evaluation of the factors above 
should assist in determining whether the implied volatility 
appropriately reflects the market's expectations of future volatility 
and thus the extent of reliance that Company B reasonably places on the 
implied volatility.
    Question 4: Are there situations in which it is acceptable for 
Company B to rely exclusively on either implied volatility or 
historical volatility in its estimate of expected volatility?
    Interpretive Response: As stated above, Statement 123R does not 
specify a method of estimating expected volatility; rather, it provides 
a list of factors that should be considered and requires that an 
entity's estimate of expected volatility be reasonable and 
supportable.\51\ Many of the factors listed in Statement 123R are 
discussed in Questions 2 and 3 above. The objective of estimating 
volatility, as stated in Statement 123R, is to ascertain the assumption 
about expected volatility that marketplace participants would likely 
use in determining a price for an option.\52\ The staff believes that a 
company, after considering the factors listed in Statement 123R, could, 
in certain situations, reasonably conclude that exclusive reliance on 
either historical or implied volatility would provide an estimate of 
expected volatility that meets this stated objective.
---------------------------------------------------------------------------

    \51\ Statement 123R, paragraphs A31-A32.
    \52\ Statement 123R, paragraph B86.
---------------------------------------------------------------------------

    The staff would not object to Company B placing exclusive reliance 
on implied volatility when the following factors are present, as long 
as the methodology is consistently applied:
     Company B utilizes a valuation model that is based upon a 
constant volatility assumption to value its employee share options; 
\53\
---------------------------------------------------------------------------

    \53\ Statement 123R, paragraphs A15 and A33, discuss the 
incorporation of a range of expected volatilities into option 
pricing models. The staff believes that a company that utilizes an 
option pricing model that incorporates a range of expected 
volatilities over the option's contractual term should consider the 
factors listed in Statement 123R, and those discussed in the 
Interpretive Responses to Questions 2 and 3 above, to determine the 
extent of its reliance (including exclusive reliance) on the derived 
implied volatility.
---------------------------------------------------------------------------

     The implied volatility is derived from options that are 
actively traded;
     The market prices (trades or quotes) of both the traded 
options and underlying shares are measured at a similar point in time 
to each other and on a date reasonably close to the grant date of the 
employee share options;
     The traded options have exercise prices that are both (a) 
near-the-money and (b) close to the exercise price of the employee 
share options; \54\ and
---------------------------------------------------------------------------

    \54\ When near-the-money options are not available, the staff 
believes the use of a weighted-average approach, as noted in a 
previous footnote, may be appropriate.
---------------------------------------------------------------------------

     The remaining maturities of the traded options on which 
the estimate is based are at least one year.
    The staff would not object to Company B placing exclusive reliance 
on historical volatility when the following factors are present, so 
long as the methodology is consistently applied:
     Company B has no reason to believe that its future 
volatility over the expected or contractual term, as applicable, is 
likely to differ from its past; \55\
---------------------------------------------------------------------------

    \55\ See Statement 123R, paragraph B87. A change in a company's 
business model that results in a material alteration to the 
company's risk profile is an example of a circumstance in which the 
company's future volatility would be expected to differ from its 
past volatility. Other examples may include, but are not limited to, 
the introduction of a new product that is central to a company's 
business model or the receipt of U.S. Food and Drug Administration 
approval for the sale of a new prescription drug.
---------------------------------------------------------------------------

     The computation of historical volatility uses a simple 
average calculation method;
     A sequential period of historical data at least equal to 
the expected or contractual term of the share option, as applicable, is 
used; and
     A reasonably sufficient number of price observations are 
used, measured at a consistent point throughout the applicable 
historical period.\56\
---------------------------------------------------------------------------

    \56\ If the expected or contractual term, as applicable, of the 
employee share option is less than three years, the staff believes 
monthly price observations would not provide a sufficient amount of 
data.
---------------------------------------------------------------------------

    Question 5: What disclosures would the staff expect Company B to 
include in its financial statements and MD&A regarding its assumption 
of expected volatility?
    Interpretive Response: Statement 123R, paragraph A240, prescribes 
the minimum information needed to achieve the Statement's disclosure 
objectives.\57\ Under that guidance, Company B is required to disclose 
the expected volatility and the method used to estimate it.\58\ 
Accordingly, the staff expects that at a minimum Company B would 
disclose in a footnote to its financial statements how it determined 
the expected volatility assumption for purposes of determining the fair 
value of its share options in accordance with Statement 123R. For 
example, at a minimum, the staff would expect Company B to disclose 
whether it used only implied volatility, historical volatility, or a 
combination of both.
---------------------------------------------------------------------------

    \57\ Statement 123R disclosure requirements are included in 
paragraphs 64, 65, A240, A241, and A242.
    \58\ Statement 123R, paragraph A240(e)(2)(b).
---------------------------------------------------------------------------

    In addition, Company B should consider the applicability of SEC 
Release No. FR-60 and Section V,

[[Page 16700]]

``Critical Accounting Estimates,'' in SEC Release No. FR-72 regarding 
critical accounting policies and estimates in MD&A. The staff would 
expect such disclosures to include an explanation of the method used to 
estimate the expected volatility of its share price. This explanation 
generally should include a discussion of the basis for the company's 
conclusions regarding the extent to which it used historical 
volatility, implied volatility or a combination of both. A company 
could consider summarizing its evaluation of the factors listed in 
Questions 2 and 3 of this section as part of these disclosures in MD&A.
    Facts: Company C is a newly public entity with limited historical 
data on the price of its publicly traded shares and no other traded 
financial instruments. Company C believes that it does not have 
sufficient company specific information regarding the volatility of its 
share price on which to base an estimate of expected volatility.
    Question 6: What other sources of information should Company C 
consider in order to estimate the expected volatility of its share 
price?
    Interpretive Response: Statement 123R provides guidance on 
estimating expected volatility for newly public and nonpublic entities 
that do not have company specific historical or implied volatility 
information available.\59\ Company C may base its estimate of expected 
volatility on the historical, expected or implied volatility of similar 
entities whose share or option prices are publicly available. In making 
its determination as to similarity, Company C would likely consider the 
industry, stage of life cycle, size and financial leverage of such 
other entities.\60\
---------------------------------------------------------------------------

    \59\ Statement 123R, paragraphs A22 and A43.
    \60\ Statement 123R, paragraph A22.
---------------------------------------------------------------------------

    The staff would not object to Company C looking to an industry 
sector index (e.g., NASDAQ Computer Index) that is representative of 
Company C's industry, and possibly its size, to identify one or more 
similar entities.\61\ Once Company C has identified similar entities, 
it would substitute a measure of the individual volatilities of the 
similar entities for the expected volatility of its share price as an 
assumption in its valuation model.\62\ Because of the effects of 
diversification that are present in an industry sector index, Company C 
should not substitute the volatility of an index for the expected 
volatility of its share price as an assumption in its valuation 
model.\63\
---------------------------------------------------------------------------

    \61\ If a company operates in a number of different industries, 
it could look to several industry indices. However, when considering 
the volatilities of multiple companies, each operating only in a 
single industry, the staff believes a company should take into 
account its own leverage, the leverages of each of the entities, and 
the correlation of the entities' stock returns.
    \62\ Statement 123R, paragraph A45.
    \63\ Statement 123R, paragraph A22.
---------------------------------------------------------------------------

    After similar entities have been identified, Company C should 
continue to consider the volatilities of those entities unless 
circumstances change such that the identified entities are no longer 
similar to Company C. Until Company C has sufficient information 
available, the staff would not object to Company C basing its estimate 
of expected volatility on the volatility of similar entities for those 
periods for which it does not have sufficient information 
available.\64\ Until Company C has either a sufficient amount of 
historical information regarding the volatility of its share price or 
other traded financial instruments are available to derive an implied 
volatility to support an estimate of expected volatility, it should 
consistently apply a process as described above to estimate expected 
volatility based on the volatilities of similar entities.\65\
---------------------------------------------------------------------------

    \64\ Statement 123R, paragraph A32(c). The staff believes that 
at least two years of daily or weekly historical data could provide 
a reasonable basis on which to base an estimate of expected 
volatility if a company has no reason to believe that its future 
volatility will differ materially during the expected or contractual 
term, as applicable, from the volatility calculated from this past 
information. If the expected or contractual term, as applicable, of 
a share option is shorter than two years, the staff believes a 
company should use daily or weekly historical data for at least the 
length of that applicable term.
    \65\ Statement 123R, paragraph A34.
---------------------------------------------------------------------------

2. Expected Term
    Statement 123R, paragraph A26, states ``The fair value of a traded 
(or transferable) share option is based on its contractual term because 
rarely is it economically advantageous to the holder to exercise, 
rather than sell, a transferable share option before the end of its 
contractual term. Employee share options generally differ from 
transferable [or tradable] share options in that employees cannot sell 
(or hedge) their share options--they can only exercise them; because of 
this, employees generally exercise their options before the end of the 
options' contractual term. Thus, the inability to sell or hedge an 
employee share option effectively reduces the option's value [compared 
to a transferable option] because exercise prior to the option's 
expiration terminates its remaining life and thus its remaining time 
value.'' Accordingly, Statement 123R requires that when valuing an 
employee share option under the Black-Scholes-Merton framework the fair 
value of employee share options be based on the share options' expected 
term rather than the contractual term.
    The staff believes the estimate of expected term should be based on 
the facts and circumstances available in each particular case. 
Consistent with our guidance regarding reasonableness immediately 
preceding Topic 14.A, the fact that other possible estimates are later 
determined to have more accurately reflected the term does not 
necessarily mean that the particular choice was unreasonable. The staff 
reminds registrants of the expected term disclosure requirements 
described in Statement 123R, paragraph A240(e)(2)(a).
    Facts: Company D utilizes the Black-Scholes-Merton closed-form 
model to value its share options for the purposes of determining the 
fair value of the options under Statement 123R. Company D recently 
granted share options to its employees. Based on its review of various 
factors, Company D determines that the expected term of the options is 
six years, which is less than the contractual term of ten years.
    Question 1: When determining the fair value of the share options in 
accordance with Statement 123R, should Company D consider an additional 
discount for nonhedgability and nontransferability?
    Interpretive Response: No. Statement 123R, paragraphs A26 and B82, 
indicates that nonhedgability and nontransferability have the effect of 
increasing the likelihood that an employee share option will be 
exercised before the end of its contractual term. Nonhedgability and 
nontransferability therefore factor into the expected term assumption 
(in this case reducing the term assumption from ten years to six 
years), and the expected term reasonably adjusts for the effect of 
these factors. Accordingly, the staff believes that no additional 
reduction in the term assumption or other discount to the estimated 
fair value is appropriate for these particular factors.\66\
---------------------------------------------------------------------------

    \66\ The staff notes the existence of academic literature that 
supports the assertion that the Black-Scholes-Merton closed-form 
model, with expected term as an input, can produce reasonable 
estimates of fair value. Such literature includes J. Carpenter, 
``The exercise and valuation of executive stock options,'' Journal 
of Financial Economics, May 1998, pp.127-158; C. Marquardt, ``The 
Cost of Employee Stock Option Grants: An Empirical Analysis,'' 
Journal of Accounting Research, September 2002, p. 1191-1217); and 
J. Bettis, J. Bizjak and M. Lemmon, ``Exercise behavior, valuation, 
and the incentive effect of employee stock options,'' Journal of 
Financial Economics, forthcoming, 2005.
---------------------------------------------------------------------------

    Question 2: Should forfeitures or terms that stem from 
forfeitability be

[[Page 16701]]

factored into the determination of expected term?
    Interpretive Response: No. Statement 123R indicates that the 
expected term that is utilized as an assumption in a closed-form 
option-pricing model or a resulting output of a lattice option pricing 
model when determining the fair value of the share options should not 
incorporate restrictions or other terms that stem from the pre-vesting 
forfeitability of the instruments. Under Statement 123R, these pre-
vesting restrictions or other terms are taken into account by 
ultimately recognizing compensation cost only for awards for which 
employees render the requisite service.\67\
---------------------------------------------------------------------------

    \67\ Statement 123R, paragraph 18.
---------------------------------------------------------------------------

    Question 3: Can a company's estimate of expected term ever be 
shorter than the vesting period?
    Interpretive Response: No. The vesting period forms the lower bound 
of the estimate of expected term.\68\
---------------------------------------------------------------------------

    \68\ Statement 123R, paragraph A28a.
---------------------------------------------------------------------------

    Question 4: Statement 123R, paragraph A30, indicates that an entity 
shall aggregate individual awards into relatively homogenous groups 
with respect to exercise and post-vesting employment termination 
behaviors for the purpose of determining expected term, regardless of 
the valuation technique or model used to estimate the fair value. How 
many groupings are typically considered sufficient?
    Interpretive Response: As it relates to employee groupings, the 
staff believes that an entity may generally make a reasonable fair 
value estimate with as few as one or two groupings.\69\
---------------------------------------------------------------------------

    \69\ The staff believes the focus should be on groups of 
employees with significantly different expected exercise behavior. 
Academic research suggests two such groups might be executives and 
non-executives. A study by S. Huddart found executives and other 
senior managers to be significantly more patient in their exercise 
behavior than more junior employees. (Employee rank was proxied for 
by the number of options issued to that employee.) See S. Huddart, 
``Patterns of stock option exercise in the United States,'' in: J. 
Carpenter and D. Yermack, eds., Executive Compensation and 
Shareholder Value: Theory and Evidence (Kluwer, Boston, MA, 1999), 
pp. 115-142. See also S. Huddart and M. Lang, ``Employee stock 
option exercises: An empirical analysis,'' Journal of Accounting and 
Economics, 1996, pp. 5-43.
---------------------------------------------------------------------------

    Question 5: What approaches could a company use to estimate the 
expected term of its employee share options?
    Interpretive Response: A company should use an approach that is 
reasonable and supportable under Statement 123R's fair value 
measurement objective, which establishes that assumptions and 
measurement techniques should be consistent with those that marketplace 
participants would be likely to use in determining an exchange price 
for the share options.\70\ If, in developing its estimate of expected 
term, a company determines that its historical share option exercise 
experience is the best estimate of future exercise patterns, the staff 
will not object to the use of the historical share option exercise 
experience to estimate expected term.\71\
---------------------------------------------------------------------------

    \70\ Statement 123R, paragraph A10.
    \71\ Historical share option exercise experience encompasses 
data related to share option exercise, post-vesting termination, and 
share option contractual term expiration.
---------------------------------------------------------------------------

    A company may also conclude that its historical share option 
exercise experience does not provide a reasonable basis upon which to 
estimate expected term. This may be the case for a variety of reasons, 
including, but not limited to, the life of the company and its relative 
stage of development, past or expected structural changes in the 
business, differences in terms of past equity-based share option 
grants,\72\ or a lack of variety of price paths that the company may 
have experienced.\73\
---------------------------------------------------------------------------

    \72\ For example, if a company had historically granted share 
options that were always in-the-money, and will grant at-the-money 
options prospectively, the exercise behavior related to the in-the-
money options may not be sufficient as the sole basis to form the 
estimate of expected term for the at-the-money grants.
    \73\ For example, if a company had a history of previous equity-
based share option grants and exercises only in periods in which the 
company's share price was rising, the exercise behavior related to 
those options may not be sufficient as the sole basis to form the 
estimate of expected term for current option grants.
---------------------------------------------------------------------------

    Statement 123R describes other alternative sources of information 
that might be used in those cases when a company determines that its 
historical share option exercise experience does not provide a 
reasonable basis upon which to estimate expected term. For example, a 
lattice model (which by definition incorporates multiple price paths) 
can be used to estimate expected term as an input into a Black-Scholes-
Merton closed-form model.\74\ In addition, Statement 123R, paragraph 
A29, states ``* * * expected term might be estimated in some other 
manner, taking into account whatever relevant and supportable 
information is available, including industry averages and other 
pertinent evidence such as published academic research.'' For example, 
data about exercise patterns of employees in similar industries and/or 
situations as the company's might be used. While such comparative 
information may not be widely available at present, the staff 
understands that various parties, including actuaries, valuation 
professionals and others are gathering such data.
---------------------------------------------------------------------------

    \74\ Statement 123R, paragraph A27.
---------------------------------------------------------------------------

    Facts: Company E grants equity share options to its employees that 
have the following basic characteristics: \75\
---------------------------------------------------------------------------

    \75\ Employee share options with these features are sometimes 
referred to as ``plain-vanilla'' options.
---------------------------------------------------------------------------

     The share options are granted at-the-money;
     Exercisability is conditional only on performing service 
through the vesting date; \76\
---------------------------------------------------------------------------

    \76\ In this fact pattern the requisite service period equals 
the vesting period.
---------------------------------------------------------------------------

     If an employee terminates service prior to vesting, the 
employee would forfeit the share options;
     If an employee terminates service after vesting, the 
employee would have a limited time to exercise the share options 
(typically 30-90 days); and
     The share options are nontransferable and nonhedgeable.
    Company E utilizes the Black-Scholes-Merton closed-form model for 
valuing its employee share options.
    Question 6: As share options with these ``plain-vanilla'' 
characteristics have been granted in significant quantities by many 
companies in the past, is the staff aware of any ``simple'' 
methodologies that can be used to estimate expected term?
    Interpretive Response: As noted above, the staff understands that 
an entity that chooses not to rely on its historical exercise data may 
find that certain alternative information, such as exercise data 
relating to employees of other companies, is not easily obtainable. As 
such, in the short term, some companies may encounter difficulties in 
making a refined estimate of expected term. Accordingly, the staff will 
accept the following ``simplified'' method for ``plain vanilla'' 
options consistent with those in the fact set above: expected term = 
((vesting term + original contractual term) / 2). Assuming a ten year 
original contractual term and graded vesting over four years (25% of 
the options in each grant vest annually) for the share options in the 
fact set described above, the resultant expected term would be 6.25 
years.\77\
---------------------------------------------------------------------------

    \77\ Calculated as [[[1 year vesting term (for the first 25% 
vested) plus 2 year vesting term (for the second 25% vested) plus 3 
year vesting term (for the third 25% vested) plus 4 year vesting 
term (for the last 25% vested)] divided by 4 total years of vesting] 
plus 10 year contractual life] divided by 2; that is, (((1+2+3+4)/4) 
+ 10) /2 = 6.25 years.
---------------------------------------------------------------------------

    Academic research on the exercise of options issued to executives 
provides some general support for outcomes that would be produced by 
the application of this method.\78\ If a company elects to

[[Page 16702]]

use this method, it should be applied consistently to all ``plain 
vanilla'' employee share options, and the company should disclose the 
use of the method in the notes to its financial statements. Companies 
that have the information (from whatever source) to make more refined 
estimates of expected term may choose not to apply this simplified 
method. In addition, this simplified method is not intended to be 
applied as a benchmark in evaluating the appropriateness of more 
refined estimates of expected term.
---------------------------------------------------------------------------

    \78\ J.N. Carpenter, ``The exercise and valuation of executive 
stock options,'' Journal of Financial Economics, 1998, pp.127-158 
studies a sample of 40 NYSE and AMEX firms over the period 1979-1994 
with share option terms reasonably consistent to the terms presented 
in the fact set and example. The mean time to exercise after grant 
was 5.83 years and the median was 6.08 years. The ``mean time to 
exercise'' is shorter than expected term since the study's sample 
included only exercised options. Other research on executive options 
includes (but is not limited to) J. Carr Bettis; John M. Bizjak; and 
Michael L. Lemmon, ``Exercise behavior, valuation, and the incentive 
effects of employee stock options,'' forthcoming in the Journal of 
Financial Economics. One of the few studies on nonexecutive employee 
options the staff is aware of is S. Huddart, ``Patterns of stock 
option exercise in the United States,'' in: J. Carpenter and D. 
Yermack, eds., Executive Compensation and Shareholder Value: Theory 
and Evidence (Kluwer, Boston, MA, 1999), pp. 115-142.
---------------------------------------------------------------------------

    Also, as noted above, the staff believes that more detailed 
information about exercise behavior will, over time, become readily 
available to companies. As such, the staff does not expect that such a 
simplified method would be used for share option grants after December 
31, 2007, as more detailed information should be widely available by 
then.

E. Statement 123R and Certain Redeemable Financial Instruments

    Certain financial instruments awarded in conjunction with share-
based payment arrangements have redemption features that require 
settlement by cash or other assets upon the occurrence of events that 
are outside the control of the issuer.\79\ Statement 123R provides 
guidance for determining whether instruments granted in conjunction 
with share-based payment arrangements should be classified as liability 
or equity instruments. Under that guidance, most instruments with 
redemption features that are outside the control of the issuer are 
required to be classified as liabilities; however, some redeemable 
instruments will qualify for equity classification.\80\ SEC Accounting 
Series Release No. 268, Presentation in Financial Statements of 
``Redeemable Preferred Stocks,''\81\ (``ASR 268'') and related guidance 
\82\ address the classification and measurement of certain redeemable 
equity instruments.
---------------------------------------------------------------------------

    \79\ The terminology ``outside the control of the issuer'' is 
used to refer to any of the three redemption conditions described in 
Rule 5-02.28 of Regulation S-X that would require classification 
outside permanent equity. That rule requires preferred securities 
that are redeemable for cash or other assets to be classified 
outside of permanent equity if they are redeemable (1) at a fixed or 
determinable price on a fixed or determinable date, (2) at the 
option of the holder, or (3) upon the occurrence of an event that is 
not solely within the control of the issuer.
    \80\ Statement 123R, paragraphs 28-35 and A225-A232.
    \81\ ASR 268, July 27, 1979, Rule 5-02.28 of Regulation S-X.
    \82\ Related guidance includes EITF Abstracts Topic No. D-98, 
Classification and Measurement of Redeemable Securities (``Topic D-
98'').
---------------------------------------------------------------------------

    Facts: Under a share-based payment arrangement, Company F grants to 
an employee shares (or share options) that all vest at the end of four 
years (cliff vest).
    The shares (or shares underlying the share options) are redeemable 
for cash at fair value at the holder's option, but only after six 
months from the date of share issuance (as defined in Statement 123R). 
Company F has determined that the shares (or share options) would be 
classified as equity instruments under the guidance of Statement 123R. 
However, under ASR 268 and related guidance, the instruments would be 
considered to be redeemable for cash or other assets upon the 
occurrence of events (e.g., redemption at the option of the holder) 
that are outside the control of the issuer.
    Question 1: While the instruments are subject to Statement 
123R,\83\ is ASR 268 and related guidance applicable to instruments 
issued under share-based payment arrangements that are classified as 
equity instruments under Statements 123R?
---------------------------------------------------------------------------

    \83\ Statement 123R, paragraph A231, states that an instrument 
ceases to be subject to Statement 123R when ``the rights conveyed by 
the instrument to the holder are no longer dependent on the holder 
being an employee of the entity (that is, no longer dependent on 
providing service).''
---------------------------------------------------------------------------

    Interpretive Response: Yes. The staff believes that registrants 
must evaluate whether the terms of instruments granted in conjunction 
with share-based payment arrangements with employees that are not 
classified as liabilities under Statement 123R result in the need to 
present certain amounts outside of permanent equity (also referred to 
as being presented in ``temporary equity'') in accordance with ASR 268 
and related guidance.\84\
---------------------------------------------------------------------------

    \84\ Instruments granted in conjunction with share-based payment 
arrangements with employees that do not by their terms require 
redemption for cash or other assets (at a fixed or determinable 
price on a fixed or determinable date, at the option of the holder, 
or upon the occurrence of an event that is not solely within the 
control of the issuer) would not be assumed by the staff to require 
net cash settlement for purposes of applying ASR 268 in 
circumstances in which paragraphs 14-18 of EITF Issue 00-19, 
Accounting for Derivative Financial Instruments Indexed to, and 
Potentially Settled in, a Company's Own Stock, would otherwise 
require the assumption of net cash settlement. See Statement 123R, 
footnote 152 to paragraph B121, which states, in part: ``* * *Issue 
00-19 specifies that events or actions necessary to deliver 
registered shares are not controlled by a company and, therefore, 
except under limited circumstances, such provisions would require a 
company to assume that the contract would be net-cash settled. * * * 
Thus, employee share options might be classified as substantive 
liabilities if they were subject to Issue 00-19; however, for 
purposes of this Statement, the Board does not believe that employee 
share options should be classified as liabilities based solely on 
that notion.'' See also Statement 123R, footnote 20.
---------------------------------------------------------------------------

    When an instrument ceases to be subject to Statement 123R and 
becomes subject to the recognition and measurement requirements of 
other applicable GAAP, the staff believes that the company should 
reassess the classification of the instrument as a liability or equity 
at that time and consequently may need to reconsider the applicability 
of ASR 268.
    Question 2: How should Company F apply ASR 268 and related guidance 
to the shares (or share options) granted under the share-based payment 
arrangements with employees that may be unvested at the date of grant?
    Interpretive Response: Under Statement 123R, when compensation cost 
is recognized for instruments classified as equity instruments, 
additional paid-in-capital \85\ is increased. If the award is not fully 
vested at the grant date, compensation cost is recognized and 
additional paid-in-capital is increased over time as services are 
rendered over the requisite service period. A similar pattern of 
recognition should be used to reflect the amount presented as temporary 
equity for share-based payment awards that have redemption features 
that are outside the issuer's control but are classified as equity 
instruments under Statement 123R.
---------------------------------------------------------------------------

    \85\ Depending on the fact pattern, this may be recorded as 
common stock and additional paid in capital.
---------------------------------------------------------------------------

    The staff believes Company F should present as temporary equity at 
each balance sheet date an amount that is based on the redemption 
amount of the instrument, but takes into account the proportion of 
consideration received in the form of employee services. Thus, for 
example, if a nonvested share that qualifies for equity classification 
under Statement 123R is redeemable at fair value more than six months 
after vesting, and that nonvested share is 75% vested at the balance 
sheet date, an amount equal to 75% of the fair value of the share 
should be presented as temporary equity at that date. Similarly, if an 
option on a share of redeemable

[[Page 16703]]

stock that qualifies for equity classification under Statement 123R is 
75% vested at the balance sheet date, an amount equal to 75% of the 
intrinsic \86\ value of the option should be presented as temporary 
equity at that date.
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    \86\ The potential redemption amount of the share option in this 
illustration is its intrinsic value because the holder would pay the 
exercise price upon exercise of the option and then, upon redemption 
of the underlying shares, the company would pay the holder the fair 
value of those shares. Thus, the net cash outflow from the 
arrangement would be equal to the intrinsic value of the share 
option. In situations where there would be no cash inflows from the 
share option holder, the cash required to be paid to redeem the 
underlying shares upon the exercise of the put option would be the 
redemption value.
---------------------------------------------------------------------------

    Question 3: Would the methodology described for employee awards in 
the Interpretive Response to Question 2 above apply to nonemployee 
awards to be issued in exchange for goods or services with similar 
terms to those described above?
    Interpretive Response: See Topic 14.A for a discussion of the 
application of the principles in Statement 123R to nonemployee awards. 
The staff believes it would generally be appropriate to apply the 
methodology described in the Interpretive Response to Question 2 above 
to nonemployee awards.

F. Classification of Compensation Expense Associated With Share-Based 
Payment Arrangements

    Facts: Company G utilizes both cash and share-based payment 
arrangements to compensate its employees and nonemployee service 
providers. Company G would like to emphasize in its income statement 
the amount of its compensation that did not involve a cash outlay.
    Question: How should Company G present in its income statement the 
non-cash nature of its expense related to share-based payment 
arrangements?
    Interpretive Response: The staff believes Company G should present 
the expense related to share-based payment arrangements in the same 
line or lines as cash compensation paid to the same employees.\87\ The 
staff believes a company could consider disclosing the amount of 
expense related to share-based payment arrangements included in 
specific line items in the financial statements. Disclosure of this 
information might be appropriate in a parenthetical note to the 
appropriate income statement line items, on the cash flow statement, in 
the footnotes to the financial statements, or within MD&A.
---------------------------------------------------------------------------

    \87\ Statement 123R does not identify a specific line item in 
the income statement for presentation of the expense related to 
share-based payment arrangements.
---------------------------------------------------------------------------

G. Non-GAAP Financial Measures

    Facts: Company H, a calendar year company, adopts Statement 123R as 
of July 1, 2005. Company H has issued share options to its employees 
each year since issuing publicly traded stock twenty years ago. In the 
MD&A section of its 2005 Form 10-K, Company H believes it would be 
useful to investors to disclose what net income would be before 
considering the effect of accounting for share-based payment 
transactions in accordance with Statement 123R.
    Question 1: Does the resulting measure, ``Net Income Before Share-
Based Payment Charge,'' or an equivalent measure, meet the definition 
of a non-GAAP measure in Regulation G and Item 10(e) of Regulation S-K? 
\88\
---------------------------------------------------------------------------

    \88\ 17 CFR 229.10(e). All references to Item 10(e) of 
Regulation S-K also includes corresponding provisions of Item 10(h) 
of Regulation S-B with respect to small business issuers as well as 
U.S. GAAP information of foreign private issuers under General 
Instruction C(e) of Form 20-F.
---------------------------------------------------------------------------

    Interpretive Response: Yes. Because the financial measure Company H 
is considering excludes an amount (share-based payment expense) that is 
included in the most directly comparable measure calculated and 
presented in accordance with GAAP (net income), it would be considered 
a non-GAAP financial measure pursuant to the provisions of Regulation G 
and Item 10(e) of Regulation S-K.
    Question 2: Is the measure ``Net Income Before Share-Based Payment 
Charge,'' or an equivalent measure, a prohibited non-GAAP measure 
pursuant to Item 10(e) of Regulation S-K?
    Interpretive Response: Item 10(e) prohibits the inclusion of 
certain non-GAAP financial measures and also mandates specific 
disclosures for registrants that include permitted non-GAAP financial 
measures in filings. Generally, under Item 10(e) of Regulation S-K, a 
company may not present a non-GAAP performance measure that removes an 
expense from net income by identifying that expense as non-recurring, 
infrequent, or unusual if it is reasonably likely that the expense will 
recur within two years or if the company had a similar expense within 
the prior two years. The staff issued Frequently Asked Questions 
Regarding the Use of Non-GAAP Measures in June of 2003. Question 8 
discusses whether it is appropriate to eliminate or smooth an item that 
is identified as recurring. The staff answered the question in part by 
stating ``Companies should never use a non-GAAP financial measure in an 
attempt to smooth earnings. Further, while there is no per se 
prohibition against removing a recurring item, companies must meet the 
burden of demonstrating the usefulness of any measure that excludes 
recurring items, especially if the non-GAAP financial measure is used 
to evaluate performance.''
    The staff believes that a measure used by the management of Company 
H that excludes share-based payments internally to evaluate performance 
may be relevant disclosure for investors. In these cases, if Company H 
determines that the non-GAAP financial measure ``Net Income Before 
Share-Based Payment Charge'' does not violate any of the prohibitions 
from inclusion in filings with the Commission outlined in Item 10(e) of 
Regulation S-K, Company H's management would be required to disclose, 
among other items, the following:
     The reasons that the company's management believes that 
presentation of the non-GAAP financial measure provides useful 
information to investors regarding the company's financial condition 
and results of operations; and
     To the extent material, the additional purposes, if any, 
for which the company's management uses the non-GAAP financial measure 
that are not otherwise disclosed.\89\
---------------------------------------------------------------------------

    \89\ 17 CFR 229.10(e)(1).
---------------------------------------------------------------------------

    In addition, the staff's response to Question 8 included in 
Frequently Asked Questions Regarding the Use of Non-GAAP Measures in 
June of 2003 notes that the inclusion of a non-GAAP financial measure 
may be misleading absent the following disclosures:
     The manner in which management uses the non-GAAP measure 
to conduct or evaluate its business;
     The economic substance behind management's decision to use 
such a measure;
     The material limitations associated with use of the non-
GAAP financial measure as compared to the use of the most directly 
comparable GAAP financial measure;
     The manner in which management compensates for these 
limitations when using the non-GAAP financial measure; and
     The substantive reasons why management believes the non-
GAAP financial measure provides useful information to investors.
    Question 3: How could Company H demonstrate the effect of 
accounting for share-based payment transactions in accordance with 
Statement 123R and Regulation G and Item 10(e) of Regulation S-K in its 
Form 10-K?

[[Page 16704]]

    Interpretive Response: The staff believes that including a 
discussion in MD&A addressing significant trends and variability of a 
company's earnings and changes in the significant components of certain 
line items is important to assist an investor in understanding the 
company's performance. The staff also understands that expenses from 
share-based payments might vary in different ways and for different 
reasons than would other expenses. In particular, the staff believes 
Company H's investors would be well served by disclosure in MD&A that 
explains the components of the company's expenses, including, if 
material, identification of the amount of expense associated with 
share-based payment transactions and discussion of the reasons why such 
amounts have fluctuated from period to period.
    Question 4: Would the staff object to Company H including a pro-
forma income statement in its SEC filings that removes from net income 
the effects of accounting for share-based payment arrangements in 
accordance with Statement 123R?
    Interpretive Response: Yes. Removal of the effects of accounting 
for share-based payment arrangements in accordance with Statement 123R 
would not meet any of the conditions in Rule 11-01(a) of Regulation S-X 
for presentation of pro forma financial information. Further, the 
removal of the effects of accounting for share-based payment 
arrangements in accordance with Statement 123R would not meet any of 
the conditions in Rule 11-02(b)(6) of Regulation S-X to be reflected as 
a pro forma adjustment in circumstances where pro forma financial 
information is required under Rule 11-01(a) of Regulation S-X for other 
transactions such as recent or probable business combinations.
    In addition, Item 10(e) of Regulation S-X prohibits presenting non-
GAAP financial measures on the face of any pro forma financial 
information required to be disclosed by Article 11 of Regulation S-X. 
Further, a company may not present non-GAAP financial measures on the 
face of the company's financial statements prepared in accordance with 
GAAP or in the accompanying notes.

H. First Time Adoption of Statement 123R in an Interim Period

    Facts: Company I's fiscal year begins on January 1, 2005. Company I 
plans to adopt Statement 123R on July 1, 2005, which is the beginning 
of its first interim period following the effective date. Company I 
previously recognized share-based payment compensation in accordance 
with Opinion 25.
    Question 1: What disclosures are required in Company I's Form 10-Q 
for the third quarter of 2005?
    Interpretive Response: The disclosures required by paragraphs 64-
65, 84, and A240-242 of Statement 123R should be included in the Form 
10-Q for the interim period when Statement 123R is first adopted. If 
Company I applies the modified retrospective method \90\ in other than 
the first interim period of a fiscal year, the staff believes that the 
Form 10-Q for the period of adoption should include disclosure of the 
effects of the adoption of Statement 123R on previously reported 
interim periods.\91\ If Company I applies the modified prospective 
method,\92\ the financial statements for Company I's prior interim 
periods and fiscal years will not reflect any restated amounts. The 
staff believes that Company I should disclose this fact. Regardless of 
the transition method chosen, Company I should also provide the 
disclosures required by SAB Topic 11M, Disclosure Of The Impact That 
Recently Issued Accounting Standards Will Have On The Financial 
Statements Of The Registrant When Adopted In A Future Period, in 
interim and annual financial statements preceding the adoption of 
Statement 123R.
---------------------------------------------------------------------------

    \90\ Statement 123R, paragraph 76.
    \91\ See Statement 123R, paragraph 77.
    \92\ Statement 123R, paragraph 74.
---------------------------------------------------------------------------

    Facts: Company J plans to adopt Statement 123R by applying the 
modified retrospective method only to the preceding interim periods of 
its current fiscal year. Company J anticipates recording an adjustment 
upon the adoption of Statement 123R to reflect the cumulative effect of 
reclassifying certain share-based payment arrangements as liabilities.
    Question 2: Would Company J be required to apply the cumulative 
effect adjustment to the beginning of the fiscal year and to reflect 
the change in classification from liabilities to equity to its interim 
periods preceding adoption in accordance with Statement 3,\93\ 
paragraph 10?
---------------------------------------------------------------------------

    \93\ Statement of Financial Accounting Standards No. 3, 
Reporting Accounting Changes in Interim Financial Statements 
(``Statement 3'').
---------------------------------------------------------------------------

    Interpretive Response: No. Statement 123R, paragraph 76, limits 
retrospective application to recording compensation cost for unvested 
awards based on the amounts previously determined under Statement 123 
for pro forma footnote disclosure. Any adjustments to be recorded as a 
cumulative effect of a change in accounting principle should be 
recorded as of the date of adoption of Statement 123R, which may occur 
after the beginning of the fiscal year. Therefore, based on the 
guidance in Statement 123R, paragraphs 79-82, registrants are not 
required to apply the provisions of Statement 3, paragraph 10.

I. Capitalization of Compensation Cost Related to Share-Based Payment 
Arrangements

    Facts: Company K is a manufacturing company that grants share 
options to its production employees. Company K has determined that the 
cost of the production employees' service is an inventoriable cost. As 
such, Company K is required to initially capitalize the cost of the 
share option grants to these production employees as inventory and 
later recognize the cost in the income statement when the inventory is 
consumed.\94\
---------------------------------------------------------------------------

    \94\ Statement 123R, paragraph 5.
---------------------------------------------------------------------------

    Question: If Company K elects to adjust its period end inventory 
balance for the allocable amount of share-option cost through a period 
end adjustment to its financial statements, instead of incorporating 
the share-option cost through its inventory costing system, would this 
be considered a deficiency in internal controls?
    Interpretive Response: No. Statement 123R does not prescribe the 
mechanism a company should use to incorporate a portion of share-option 
costs in an inventory-costing system. The staff believes Company K may 
accomplish this through a period end adjustment to its financial 
statements. Company K should establish appropriate controls surrounding 
the calculation and recording of this period end adjustment, as it 
would any other period end adjustment. The fact that the entry is 
recorded as a period end adjustment, by itself, should not impact 
management's ability to determine that the internal control over 
financial reporting, as defined by the SEC's rules implementing Section 
404 of the Sarbanes-Oxley Act of 2002,\95\ is effective.
---------------------------------------------------------------------------

    \95\ Release No. 34-47986, June 5, 2003, Management's Report on 
Internal Control Over Financial Reporting and Certification of 
Disclosure in Exchange Act Period Reports.
---------------------------------------------------------------------------

J. Accounting for Income Tax Effects of Share-Based Payment 
Arrangements Upon Adoption of Statement 123R

    Facts: In accordance with Statement 123R, reporting entities will 
need to determine whether deductions reported on tax returns for share-
based payment awards exceed or are less than the cumulative 
compensation cost recognized for financial reporting. If the deductions 
exceed the cumulative compensation cost recognized for

[[Page 16705]]

financial reporting, the entity generally should record any resulting 
excess tax benefits as additional paid-in capital. If deductions are 
less than the cumulative compensation cost recognized for financial 
reporting, the entity should record the write-off of the deferred tax 
asset, net of the related valuation allowance, against any remaining 
additional paid-in capital from previous awards accounted for in 
accordance with the fair value method of Statement 123 or Statement 
123R, as applicable. The remaining balance, if any, of the write-off of 
the deferred tax asset shall be recognized in the income statement.\96\
---------------------------------------------------------------------------

    \96\ Statement 123R, paragraph 63.
---------------------------------------------------------------------------

    Company L is an entity that previously recognized employee share-
based payment costs under the intrinsic value method of Opinion 25. In 
this situation, Statement 123R states that Company L ``shall calculate 
the amount available for offset [in additional paid-in capital] as the 
net amount of excess tax benefits that would have qualified as such had 
it instead adopted Statement 123 for recognition purposes pursuant to 
Statement 123's original effective date and transition method.'' \97\
---------------------------------------------------------------------------

    \97\ Ibid.
---------------------------------------------------------------------------

    Question: When is Company L required to calculate the additional 
paid-in capital from previous share-based payment awards that is 
available for offset against the write-off of a deferred tax asset?
    Interpretive Response: Statement 123R will necessitate the tracking 
of tax attributes relating to share-based payment transactions with 
employees for a number of reasons, including the requirements related 
to any required write-off of excess deferred tax assets upon settlement 
of a share option. While it is important that appropriate detailed 
information be available when needed for consideration, the timing as 
to when such information actually affects financial reporting will vary 
from company to company. In preparation for the adoption of Statement 
123R, Company L should evaluate the level of detail which may be 
required considering its particular facts and circumstances.
    Statement 123R is silent as to when the additional paid-in capital 
available for offset should be calculated. However, the staff notes 
that Company L would not be required to calculate the additional paid-
in capital available for offset by the date it adopts Statement 123R. 
In addition, the staff notes that Statement 123R does not require 
disclosure of the additional paid-in capital available for offset.\98\ 
The staff believes that Company L need only calculate the additional 
paid-in capital available for offset if and when Company L faces a 
situation in which deductions reported on its tax return are less than 
the relevant deferred tax asset. In addition, Company L need only 
perform the calculations periodically to the extent necessary to 
conclude that sufficient paid-in capital is available for the offset of 
the deduction shortfall.
---------------------------------------------------------------------------

    \98\ Statement 123R's disclosure requirements are described in 
paragraphs 64, 65, A240, A241 and A242.
---------------------------------------------------------------------------

K. Modification of Employee Share Options Prior to Adoption of 
Statement 123R

    Facts: Company M is a public entity that historically applied the 
recognition provisions of Opinion 25 and intends to transition to 
Statement 123R under the modified prospective method of 
application.\99\ In prior periods, Company M granted at-the-money share 
options to its employees in which the exercisability of the options is 
conditional only on performing service through the vesting date.\100\ 
Since the time of grant, Company M's share price has fallen such that 
the share options are out-of-the-money. Prior to adoption of Statement 
123R the share options are still unvested, and Company M intends to 
modify these unvested share options to accelerate the vesting. Company 
M has determined that the modification to accelerate vesting will not 
require recognition of compensation cost in its financial statements in 
the period of the modification under the provisions of Opinion 25.\101\ 
However, Company M intends to reflect the compensation cost related to 
the modification in its fair value pro forma disclosures under 
Statement 123,\102\ in the period the modification is made.
---------------------------------------------------------------------------

    \99\ Statement 123R, paragraph 74.
    \100\ The terms of these share options do not define the service 
period as being other than the vesting period.
    \101\ See FASB Interpretation No. 44, Accounting for Certain 
Transactions Involving Stock Compensation, paragraph 36, which 
requires the recognition of compensation expense under Opinion 25 
due to a modification of a share-based payment award only if, absent 
the acceleration of vesting, the award would have otherwise been 
forfeited during the vesting period pursuant to its original terms.
    \102\ Statement 123, paragraph 45, as amended by Statement 148, 
Accounting for Stock-Based Compensation--Transition and Disclosure 
(``Statement 148'').
---------------------------------------------------------------------------

    Question: Would the staff object to Company M reflecting the 
remaining compensation cost related to these share options in the fair 
value pro forma disclosures required under Statement 123 as a result of 
the modification in the period in which the modification was enacted?
    Interpretive Response: No. The staff believes that an acceptable 
interpretation of Statement 123 is that the modification to accelerate 
the vesting of such share options would result in the recognition of 
the remaining amount of compensation cost in the period the 
modification is made, so long as the acceleration of vesting permits 
employees to exercise the share options in a circumstance when they 
would not otherwise have been able to do so absent the modification. 
The staff notes that the service period definition in Statement 123 
\103\ indicates, ``If the service period is not defined as an earlier 
or shorter period, it shall be presumed to be the vesting period.'' 
After the modification, Company M's share options will be vested 
pursuant to the awards' terms. Accordingly, under this interpretation, 
there is no remaining service period and any remaining unrecognized 
service cost for those share options should be recognized at the date 
of the modification. The staff believes that since the remaining 
unrecognized compensation cost is accelerated and recognized at the 
date of modification, no compensation cost would be recognized for 
these modified share options in the income statement in the periods 
after adoption of Statement 123R, absent any further modifications.
---------------------------------------------------------------------------

    \103\ Statement 123, Appendix E.
---------------------------------------------------------------------------

    The staff reminds public entities that Statement 123, paragraph 47, 
indicates that for each year an income statement is provided, the terms 
of significant modifications of outstanding awards shall be disclosed. 
In order to inform investors about modification transactions and 
management's reasons for entering into those transactions, the staff 
believes that public entities should specifically disclose any 
modifications to accelerate the vesting of out-of-the-money share 
options in anticipation of adopting Statement 123R, including the 
reasons for modifying the option terms.

L. Application of the Measurement Provisions of Statement 123R to 
Foreign Private Issuers \104\
---------------------------------------------------------------------------

    \104\ As defined in Regulation C Sec.  230.405.
---------------------------------------------------------------------------

    Question: Does the staff believe there are differences in the 
measurement provisions for share-based payment arrangements with 
employees under International Accounting Standards Board International 
Financial Reporting Standard 2, Share-based Payment (``IFRS 2'') and 
Statement 123R that would result in a reconciling item under Item 17 or 
18 of Form 20-F?

[[Page 16706]]

    Interpretive Response: The staff believes that application of the 
guidance provided by IFRS 2 regarding the measurement of employee share 
options would generally result in a fair value measurement that is 
consistent with the fair value objective stated in Statement 123R.\105\ 
Accordingly, the staff believes that application of Statement 123R's 
measurement guidance would not generally result in a reconciling item 
required to be reported under Item 17 or 18 of Form 20-F for a foreign 
private issuer that has complied with the provisions of IFRS 2 for 
share-based payment transactions with employees. However, the staff 
reminds foreign private issuers that there are certain differences 
between the guidance in IFRS 2 and Statement 123R that may result in 
reconciling items.\106\
---------------------------------------------------------------------------

    \105\ Statement 123R, paragraph A2.
    \106\ Statement 123R, paragraphs B258-B269, identify the more 
significant differences between IFRS 2 and Statement 123R.
---------------------------------------------------------------------------

M. Disclosures in MD&A Subsequent to Adoption of Statement 123R

    Question: What disclosures should companies consider including in 
MD&A to highlight the effects of (1) Differences between the accounting 
for share-based payment arrangements before and after the adoption of 
Statement 123R and (2) changes to share-based payment arrangements?
    Interpretive Response: As stated in SEC Release FR-72, the 
principal objectives of MD&A are to give readers a view of a company 
through the eyes of management, to provide the context within which 
financial information should be analyzed and to provide information 
about the quality of, and potential variability of, a company's 
earnings and cash flow, so that investors can ascertain the likelihood 
that past performance is indicative of future performance. The adoption 
of Statement 123R may result in significant differences between the 
financial statements of periods before and after the adoption, 
especially for companies with significant share-based compensation 
programs that have followed the recognition provisions of Opinion 25 or 
that adopted the fair-value-based method for financial statement 
recognition in accordance with Statement 123 using the prospective 
method permitted by Statement 148. Furthermore, the staff understands 
that companies may refine their estimates of assumptions as a result of 
implementing Statement 123R and the interpretive guidance provided in 
this SAB. In addition, the staff understands that many companies are 
evaluating their share-based payment arrangements and making changes to 
those arrangements.
    Each of these situations may affect the comparability of financial 
statements. Accordingly, to assist investors and other users of 
financial statements in understanding the financial results of a 
company that has adopted Statement 123R, the staff believes that 
companies should consider including in MD&A material qualitative and 
quantitative information about any of the following, as well as other 
information that could affect comparability of financial statements 
from period to period:
     Transition method selected (e.g., modified prospective 
application or modified retrospective application) and the resulting 
financial statement impact in current and future reporting periods;
     Method utilized by the company to account for share-based 
payment arrangements in periods prior to the adoption of Statement 123R 
and the impact, or lack thereof, on the prior period financial 
statements;
     Modifications made to outstanding share options prior to 
the adoption of Statement 123R and the reason(s) for the modification;
     Differences in valuation methodologies or assumptions 
compared to those that were used in estimating the fair value of share 
options under Statement 123;
     Changes in the quantity or type of instruments used in 
share-based payment programs, such as a shift from share options to 
restricted shares;
     Changes in the terms of share-based payment arrangements, 
such as the addition of performance conditions;
     A discussion of the one-time effect, if any, of the 
adoption of Statement 123R, such as any cumulative adjustments recorded 
in the financial statements; and
     Total compensation cost related to nonvested awards not 
yet recognized and the weighted average period over which it is 
expected to be recognized.

End Topic 14

* * * * *

Amendments to Codification of Staff Accounting Bulletins

    The Codification of Staff Accounting Bulletins is amended to revise 
Question 2 and the related interpretive response in Topic 4.D., all of 
Topic 4.E., and all of Topic 5.T. as follows:

Topic 4: Equity Accounts

* * * * *

D. Earnings Per Share Computations in an Initial Public Offering

* * * * *
    Question 2: Does reflecting nominal issuances as outstanding for 
all historical periods in the computation of earnings per share alter 
the registrant's responsibility to determine whether compensation 
expense must be recognized for such issuances to employees?
    Interpretive Response: No. Registrants must follow GAAP in 
determining whether the recognition of compensation expense for any 
issuances of equity instruments to employees is necessary.\107\ 
Reflecting nominal issuances as outstanding for all historical periods 
in the computation of earnings per share does not alter that existing 
responsibility under GAAP.
---------------------------------------------------------------------------

    \107\ As prescribed by Statement 123R.
---------------------------------------------------------------------------

* * * * *

E. Receivables From Sale of Stock

    Facts: Capital stock is sometimes issued to officers or other 
employees before the cash payment is received.
    Question: How should the receivables from the officers or other 
employees be presented in the balance sheet?
    Interpretive Response: The amount recorded as a receivable should 
be presented in the balance sheet as a deduction from stockholders' 
equity. This is generally consistent with Rule 5-02.30 of Regulation S-
X which states that accounts or notes receivable arising from 
transactions involving the registrant's capital stock should be 
presented as deductions from stockholders' equity and not as assets.
    It should be noted generally that all amounts receivable from 
officers and directors resulting from sales of stock or from other 
transactions (other than expense advances or sales on normal trade 
terms) should be separately stated in the balance sheet irrespective of 
whether such amounts may be shown as assets or are required to be 
reported as deductions from stockholders' equity.
    The staff will not suggest that a receivable from an officer or 
director be deducted from stockholders' equity if the receivable was 
paid in cash prior to the publication of the financial statements and 
the payment date is stated in a note to the financial statements. 
However, the staff would consider the subsequent return of such cash 
payment to the officer or director to be part of a scheme or plan to 
evade the registration or reporting requirements of the securities 
laws.
* * * * *

Topic 5: Miscellaneous Accounting

* * * * *

[[Page 16707]]

T. Accounting for Expenses or Liabilities Paid by Principal 
Stockholder(s)

    Facts: Company X was a defendant in litigation for which the 
company had not recorded a liability in accordance with Statement 5. A 
principal stockholder \108\ of the company transfers a portion of his 
shares to the plaintiff to settle such litigation. If the company had 
settled the litigation directly, the company would have recorded the 
settlement as an expense.
---------------------------------------------------------------------------

    \108\ Statement 57, paragraph 24e, defines principal owners as 
``owners of record or known beneficial owners of more than 10 
percent of the voting interests of the enterprise.''
---------------------------------------------------------------------------

    Question: Must the settlement be reflected as an expense in the 
company's financial statements, and if so, how?
    Interpretive Response: Yes. The value of the shares transferred 
should be reflected as an expense in the company's financial statements 
with a corresponding credit to contributed (paid-in) capital.
    The staff believes that such a transaction is similar to those 
described in paragraph 11 of Statement of Financial Accounting 
Standards Statement No. 123 (revised 2004), Share-Based Payment 
(Statement 123R), which states that ``share-based payments awarded to 
an employee of the reporting entity by a related party or other holder 
of an economic interest \109\ in the entity as compensation for 
services provided to the entity are share-based payment transactions to 
be accounted for under this Statement unless the transfer is clearly 
for a purpose other than compensation for services to the reporting 
entity.'' As explained in paragraph 11 of Statement 123R, the substance 
of such a transaction is that the economic interest holder makes a 
capital contribution to the reporting entity, and the reporting entity 
makes a share-based payment to its employee in exchange for services 
rendered.
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    \109\ Statement 123R defines an economic interest in an entity 
as ``any type or form of pecuniary interest or arrangement that an 
entity could issue or be a party to, including equity securities; 
financial instruments with characteristics of equity, liabilities or 
both; long-term debt and other debt-financing arrangements; leases; 
and contractual arrangements such as management contracts, service 
contracts, or intellectual property licenses.'' Accordingly, a 
principal stockholder would be considered a holder of an economic 
interest in an entity.
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    The staff believes that the problem of separating the benefit to 
the principal stockholder from the benefit to the company cited in 
Statement 123R is not limited to transactions involving stock 
compensation. Therefore, similar accounting is required in this and 
other \110\ transactions where a principal stockholder pays an expense 
for the company, unless the stockholder's action is caused by a 
relationship or obligation completely unrelated to his position as a 
stockholder or such action clearly does not benefit the company.
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    \110\ For example, SAB Topic 1.B indicates that the separate 
financial statements of a subsidiary should reflect any costs of its 
operations which are incurred by the parent on its behalf. 
Additionally, the staff notes that AICPA Technical Practice Aids 
Sec.  4160 also indicates that the payment by principal stockholders 
of a company's debt should be accounted for as a capital 
contribution.
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    Some registrants and their accountants have taken the position that 
since Statement 57 applies to these transactions and requires only the 
disclosure of material related party transactions, the staff should not 
analogize to the accounting called for by Statement 123R, paragraph 11 
for transactions other than those specifically covered by it. The staff 
notes, however, that Statement 57 does not address the measurement of 
related party transactions and that, as a result, such transactions are 
generally recorded at the amounts indicated by their terms.\111\ 
However, the staff believes that transactions of the type described 
above differ from the typical related party transactions.
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    \111\ However, in some circumstances it is necessary to reflect, 
either in the historical financial statements or a pro forma 
presentation (depending on the circumstances), related party 
transactions at amounts other than those indicated by their terms. 
Two such circumstances are addressed in Staff Accounting Bulletin 
Topic 1.B.1, Questions 3 and 4. Another example is where the terms 
of a material contract with a related party are expected to change 
upon the completion of an offering (i.e., the principal shareholder 
requires payment for services which had previously been contributed 
by the shareholder to the company).
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    The transactions for which Statement 57 requires disclosure 
generally are those in which a company receives goods or services 
directly from, or provides goods or services directly to, a related 
party, and the form and terms of such transactions may be structured to 
produce either a direct or indirect benefit to the related party. The 
participation of a related party in such a transaction negates the 
presumption that transactions reflected in the financial statements 
have been consummated at arm's length. Disclosure is therefore required 
to compensate for the fact that, due to the related party's 
involvement, the terms of the transaction may produce an accounting 
measurement for which a more faithful measurement may not be 
determinable.
    However, transactions of the type discussed in the facts given do 
not have such problems of measurement and appear to be transacted to 
provide a benefit to the stockholder through the enhancement or 
maintenance of the value of the stockholder's investment. The staff 
believes that the substance of such transactions is the payment of an 
expense of the company through contributions by the stockholder. 
Therefore, the staff believes it would be inappropriate to account for 
such transactions according to the form of the transaction.

[FR Doc. 05-6457 Filed 3-31-05; 8:45 am]
BILLING CODE 8010-01-P