As we initially reported in our August 22, 2005 Legal Update, Grant Date of Equity Awards under FAS 123R , the Financial Accounting Standards Board ("FASB") and at least one "Big 4" accounting firm recently questioned the prevailing approach to valuing "equity instruments" (e.g., stock options, restricted stock, etc.) and suggested that this approach might not pass muster under Financial Accounting Standards Statement No. 123R ("FAS 123R").  In response to the significant administrative concerns raised by this interpretative change, FASB has now reconsidered its interpretation of FAS 123R’s "mutual understanding" requirement and on September 14, 2005, approved the issuance of proposed FASB Staff Position ("FSP") No. FAS 123(R)-b to be effective upon an entity’s adoption of FAS 123R.[fn1]

Historically, under Accounting Principles Board Opinion No. 25 ("APB 25"), companies have considered the effective date for grants of equity instruments to be the date on which those awards are approved by the board of directors.[fn2]  This has been the case even where the fact of an award or its specific terms might not be communicated to grantees for some period of time following the approval.  This approach has the advantage of administrative simplicity because there is an easily-ascertainable and uniform date of grant for awards, and for accounting purposes, fluctuations in the value of the underlying stock after board approval are disregarded.

As noted above, FASB representatives caused significant concern in the equity compensation community when they recently indicated that, contrary to prevailing practices, the value of an award is not fixed until both the company and the grantee have reached a mutual understanding about its terms.  This interpretation requires actual communication of the terms of an award to a grantee in order to fix the value of the underlying stock for purposes of FAS 123R.

In proposed FSP 123(R)-b, FASB acknowledges the prevailing practices for valuing equity awards and discusses several of the key administrative difficulties that would have been generated by its initial interpretive change.  Considered in the light of these difficulties, the proposed FSP indicates FASB’s belief that a more practical approach to the "mutual understanding" component of the FAS 123R fair value determination is warranted.

Under the proposed FSP, a "mutual understanding" of the key terms and conditions of an equity award subject to FAS 123R will be deemed to exist on the date of board approval if: 

• The grantee does not have the ability to individually negotiate the key terms and conditions with the employer; and
• The key terms of the award are expected to be communicated to all grantees within a "relatively short period" of time from the date of approval.

FASB further clarifies that a "relatively short period" is the period during which an employer could plausibly complete all actions necessary to communicate awards in accordance with its usual human resources practices.  This approach will allow more time for communicating awards to large groups of grantees or to grantees in remote locations than for smaller, more discrete groups of grantees.

Although the proposed FSP will eliminate many of the communication and other administrative issues associated with FASB’s initial interpretation of the "mutual understanding" requirement, for equity awards that do not satisfy the foregoing requirements (0awards to executive employees who are able to negotiate the key terms and conditions), these issues will continue to have an impact.  However, companies should now be better able to manage these issues because of the smaller number of grantees who are likely to be affected.

Footnotes:

1:  FAS 123R is generally effective as of the first annual reporting period beginning on or after June 15, 2005 (i.e., July 1, 2005, for June 30 year companies and January 1, 2006, for calendar year companies) for most public companies and the first annual reporting period beginning after December 15, 2005, for non public companies.  Companies that have already adopted FAS 123R are currently subject to FASB’s approach.  An entity that has already adopted FAS 123R is directed to apply the proposed FSP in the first reporting period beginning after September 16, 2005.

2: For ease of reference, we refer to the board of directors, but this same rule applies to grants made by the compensation committee or any other body or person at the company with the authority to grant equity awards.