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Staff Issues Accounting Bulletin on Estimating Term of Share Options

The SEC's Office of the Chief Accountant and the Division of Corporation Finance last week issued a staff accounting bulletin which extended the time during which companies may continue to use a simplified method to estimate the expected term of "plain vanilla" share options (Staff Accounting Bulletin No. 110, December 21, 2007). The bulletin may be used by public companies that are not able to estimate the expense of their stock options based on their historical experience. Many of the companies lacking historical data are smaller public companies.

SAB 110 amends and replaces previous staff views outlined in SAB 107. The simplified method permits a company to use the average of the vesting term and the original contractual term to determine the expected term for plain vanilla options. Plain vanilla options are those that are granted at-the-money in which the exercise is conditioned only on the employee's performance of service through the vesting date. Additional characteristics of a plain vanilla option are that the options are forfeited if the employee terminates service prior to vesting, the employee has a limited time to exercise the options if service is terminated and the options are nontransferable and nonhedgeable.

When the staff issued SAB 107, it expected that detailed information about exercise behavior would be available by December 31, 2007 and would provide the basis on which to calculate the expected term of share option grants. The staff has since learned that the information will not be widely available by that date, so it will continue to accept the simplified method under certain circumstances. Once more detailed information becomes available, the simplified method will no longer be permitted.

SAB 110 outlines the situations in which it may be appropriate to use the simplified method for expensing employee stock options. For example, a company may use the simplified method if it does not have enough historical exercise data to provide a reasonable basis on which to estimate the expected term due to the limited period of time its equity shares have been publicly traded. Another example is where a company significantly changes the terms of its option grants or the types of employees that receive the grants so that the historical exercise data no longer provides a reasonable basis for estimating the expected return.

The staff provided a third example in which a company has or expects to have significant structural changes in its business to the extent that its historical data no longer provides a reasonable basis upon which to estimate the expected return.

The staff also recognized that companies may have sufficient historical data for some of its share option grants but not for others. The staff will accept the use of the simplified method for the option grants for which sufficient historical data is lacking. A company does not have to consider using the lattice model before deciding that it is eligible to use the simplified method. The staff will not object to the use of the simplified method in periods prior to the time that a company's equity shares are traded in a public market.

SAB 110 advises that a company using the simplified method must disclose in the notes to its financial statements that is has used the simplified method and its reason for doing so. The company must disclose the types of option grants for which the method was used if it was not used for all of the share option grants, along with the periods for which the method was used. Companies that have enough historical data to estimate the expected term may not apply the simplified method.

The staff also notes that the simplified method is not intended to be used as a benchmark in evaluating whether it is appropriate to use a more refined estimate of the expected term.