April 01, 2007
Many public companies have been reporting compensation expense under the requirements of Statement 123R, Share-Based Payment, for almost a year. However, nonpublic companies that issue only annual financial statements may just now be addressing the requirements of the new pronouncement. For nonpublic entities, the Statement is effective at the beginning of the first annual period that begins after December 15, 2005. Accordingly, a calendar year nonpublic entity would have to apply Statement 123R in its 2006 financial statements.
Although there is much overlap between the requirements of Statement 123R for public and nonpublic entities, nonpublic companies have several unique considerations and accounting choices not pertinent to public companies.
Under Statement 123R, a nonpublic entity includes any entity that does not have domestic or foreign publicly traded equity securities; has not filed an initial prospectus in preparation to publicly sell equity securities; and is not controlled by a public company. Therefore, an entity with only publicly traded debt securities is a nonpublic entity for Statement 123R purposes. However, a subsidiary of a private equity fund that is controlled by a public company would be considered a public company.
The most important difference between the adoption of Statement 123R for public and nonpublic companies may be in the transition provisions. Most nonpublic entities used the minimum value method for recognition or disclosure purposes under Statement 123, Accounting for Stock-Based Compensation. This means they valued stock options without considering the expected volatility of the underlying stock. Minimum value is not considered fair value. Entities that used minimum values must apply Statement 123R prospectively as of the required effective date.
Prospective transition means that new awards and awards modified, repurchased, or cancelled after the required effective date should be accounted for under Statement 123R’s provisions. However, any portion of awards outstanding on the required effective date should continue to be accounted for using the accounting principles originally applied to those awards (either the provisions of Opinion 25, Accounting for Stock Issued to Employees, or the minimum value method).
A nonpublic entity that used the minimum value method cannot apply the fair-value-based method to awards unvested on adoption (and also cannot apply the modified retrospective application method to years prior to its required effective date) because it does not have contemporaneous fair value information relative to the award’s grant. The good news about prospective transition is that a company that, prior to the Statement 123R adoption date, granted at-the-money options accounted for as fixed awards under Opinion 25 would not have any compensation expense for those awards unless they are modified, repurchased, or cancelled subsequent to the adoption of Statement 123R. The bad news is that awards that were accounted for using variable accounting prior to the adoption of Statement 123R—that is, the cost associated with the award was adjusted each period to the difference between the underlying stock and the option price—would continue to be accounted for using variable accounting.
Those nonpublic entities that used the fair-value-based method for either measurement or the pro forma disclosures under Statement 123 are required to adopt Statement 123R using the modified prospective application as of the required effective date, the same as public companies. This means that a company has to not only apply the requirements of Statement 123R to all new share-based awards and to previously issued awards that are modified, repurchased, or cancelled after the adoption date, but it also has to recognize compensation cost for awards outstanding at the required effective date for which the requisite service has not been rendered (such as awards that are unvested because service requirements have not been completed) as the service is subsequently rendered. The compensation cost will be based on the grant-date fair value of the award determined under Statement 123 for either recognition or pro forma disclosures. These entities also have the choice of applying modified retrospective application to periods before the required effective date. In such cases the entity would adjust its prior financial statements consistent with the amounts shown using the fair-value-based method of accounting included in the pro forma disclosures for prior periods that were previously required.
Valuation. Nonpublic entities face unique valuation issues in applying Statement 123R because, in most cases, there are not observable market prices for their equity securities. In order to meet Statement 123R’s measurement requirements, nonpublic entities will typically need to determine the fair value of their stock as of the grant date of an equity-classified share or option (current stock price is an input in option valuation models) awarded to an employee and at the end of the fiscal period for liability awards.
The Statement 123R Resource Group reached a consensus at its July 21, 2005, meeting that, for nonpublic entities, either the requisite expertise to determine the fair value of share-based payment awards should exist internally, or entities should use the services of valuation professionals. The assessment of whether an employee has the requisite expertise will depend on an entity’s specific situation; however, the AICPA Practice Aid “Valuation of Privately-Held Company Equity Securities Issued as Compensation,” recommends obtaining valuations from independent valuation specialists for reasons of increased objectivity.
Calculated value. If it is not practicable for a nonpublic entity to estimate the expected volatility of its share price, Statement 123R requires the entity to estimate the value of its options and similar instruments using the calculated value method.
Use of the calculated value method is not optional. In order to use it, a nonpublic entity must first prove that it is not practicable to estimate the expected value of its share price volatility without undue cost and effort. To determine this, the entity has to demonstrate both of the following:
- It does not have sufficient historical information about its share price volatility to estimate expected volatility
- It is not able to identify one or more similar entities, even after considering the similarity of companies that are components of appropriate industry sector indices
As such, use of the calculated value method to determine volatility is anticipated to be rare.
Expected term. At its meeting on September 13, 2005, the Statement 123R Resource Group reached a consensus that nonpublic entities could also use the simplified method described in Staff Accounting Bulletin 107 (SAB 107), Share-Based Payment, for estimating the expected term of certain options for awards granted on or before December 31, 2007. The SEC staff indicated that for “plain vanilla” options, it would permit a registrant to use an expected term that is the average of the vesting period and the original contractual term. In applying this concept, nonpublic entities should consider repurchase features, which need to be evaluated in the determination of whether the options meet the definition of plain vanilla options. The Resource Group concluded that a fair value repurchase feature would likely meet the definition of plain vanilla, but others, such as certain book value repurchase features, would not.
If a company elects to use this method, it should be applied to all plain vanilla employee share options, and the method should be disclosed in the notes to the financial statements. Nonpublic entities maymake more refined estimates of expected term and do not have to apply the simplified method. Additionally, the simplified method is not a benchmark to evaluate the appropriateness of more refined estimates of expected term.
Liability awards. Nonpublic entities have a choice of methods for accounting for their share-based payment awards that require classification as a liability. They can account for them at fair value (or calculated value, if applicable) or intrinsic value. Therefore, a nonpublic entity that has awards that require liability classification has to make a policy decision about its accounting method for these awards and apply the policy consistently to all share-based payment liability awards it issues.
APIC pool. Nonpublic entities that used the minimum value method for recognition or pro forma purposes under Statement 123 (and that are therefore required to use the prospective method of adopting Statement 123R) will not have a beginning APIC pool balance on adoption. The APIC pool is important because it absorbs the tax effects of situations where the company’s tax deduction for an award is less than its book expense; otherwise, the tax effects of the difference increase the financial statement tax expense. However, a company that was a nonpublic entity as of the effective date of Statement 123, that subsequently became public prior to the required adoption date of Statement 123R, would be permitted (but not required) to compute its beginning APIC pool using minimum value for those awards that were valued using that method for recognition or pro forma purposes.
Disclosures. Nonpublic entities that used the minimum value method for their pro forma disclosures required by Statement 123, as amended, should discontinue providing those disclosures after adopting Statement 123R.
Nonpublic entities that used the fair value method for disclosure purposes and that accounted for share-based payment arrangements with employees using the intrinsic value method of Opinion 25 are required to continue providing the pro forma financial information for periods prior to adoption of Statement 123R.
Under prospective application, awards modified, repurchased, or cancelled after the required effective date should be accounted for using Statement 123R. At the May 26, 2005 Statement 123R Resource Group meeting, the Group agreed that if an award granted before the effective date is modified after the effective date, any remaining unrecognized intrinsic value on the modification date (that is, the spread between the stock’s fair value and the option price, which quite often was zero under previous accounting) should be added to the incremental value resulting from the modification (the excess of the fair value of the modified award over the fair value of the original award determined immediately before the modification) and recognized over the remaining requisite service period.