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Chief Accountant Addresses Appropriate Accounting for Past Stock Option Errors

The Office of the Chief Accountant ("OCA") has released a letter to Financial Executives International and the American Institute of Certified Public Accountants explaining the appropriate accounting measures for past stock option awards. Chief Accountant Conrad Hewitt observed that a number of companies have announced plans to restate their financial statements based on errors in their accounting for grants of stock options. Numerous other companies are examining their past practices relating to option grants. If companies determine that their prior accounting is in error and the errors are material, they should restate their financial statements, according to the guidance.

The chief accountant's letter addresses many of the circumstances involving option grants of which the staff has become aware, including the dating of option awards to predate the actual award date and the awarding of options with administrative delays. With respect to the latter, OCA noted that some companies have accounted for their option grants using a measurement date other than the date at which all required granting actions have been completed.

A conclusion that a measurement date occurred before the completion of required granting actions must be considered carefully, according to OCA. Any changes to an award subsequent to the completion of the required granting actions must be evaluated to determine whether a modification, such as a repricing, or a cancellation has occurred.

In some circumstances, OCA said that the validity of past option grants has been called into question, such as where the options did not comply with the terms of an options plan. OCA advised that the substantive arrangement that is mutually understood by both the company and its employees should serve as the basis for the company's accounting. If all of the conditions for the establishment of a measurement date have been satisfied, a company should account for the awards as fixed options with a measurement date on the date that the terms and the recipients were determined with finality.

If a company does not intend to honor an award, or is unable to honor the award or settle it in stock, OCA advised that a further analysis of the facts and circumstances is necessary to determine the appropriate accounting for the options. A legal analysis may be needed if the questions relate to the validity of grants made to senior officers who participated in the option granting process.

Some companies may have approved option awards before the number of options to be granted to individual employees was finalized. If management's role was limited to ensuring that an allocation was made in accordance with definitive instructions, the measurement date could be based on the date the award was approved. If management had the discretion to determine the number of options to be allocated to each employee, a measurement date could not occur prior to the date on which the allocation to the individual employees was finalized.

Some companies changed the list of recipients or the number of options allocated to each recipient subsequent to the preparation of the initial list at the award approval date. In that case, OCA said that companies should conclude either that the list that was prepared on the award approval date did not constitute a grant and the measurement date should be delayed until a final list is determined, or that the list constituted a grant and any subsequent changes must be evaluated to determine whether a modification or a cancellation occurred.

If an exercise price was set by reference to a future market price, variable accounting would be required from the award approval date until the future event or condition occurs. The measurement date would occur and the variable accounting would cease on the date the contingency is resolved or expires.

If the original terms of an award do not include provisions for the adjustment of the exercise price upon the occurrence of a contingent event, but the exercise price is reduced after the award approval date, OCA believes it would constitute a repricing of the award. Variable accounting would be appropriate from the date of the modification to the date the award is exercised, forfeited or expires unexercised.

OCA is aware of situations in which companies have determined the terms and conditions of awards to certain new employees prior to the commencement of their employment. If an individual provided no services to the company prior to commencing employment, the measurement date of the option grant generally cannot occur prior to the date that the employee begins rendering service in exchange for the stock options.

OCA said the lack of complete documentation does not necessarily result in a default to variable accounting or to treating the awards as if they had never been granted. A company may use all available relevant information to form a reasonable conclusion with respect to the most likely option granting actions that occurred and the dates upon which such actions took place. For example, OCA said that a pattern of past option grants with exercise prices close to the lowest price of the stock during the time period surrounding the grants could suggest that the terms of those grants were determined with hindsight. The lack of documentation may also provide evidence of fraudulent conduct.

To the extent that companies timed option grants, OCA advised that the compensation cost must be computed on the measurement date by reference to the unadjusted market price of a share of the same class that trades freely in an established market. If the terms an option grant were changed to reflect the release of new information, OCA believes a repricing occurred and that variable accounting should be applied to the option from the date of the modification to the date the award is exercised, forfeited or expires unexercised.

In cases where a company documented option exercises on dates other than the actual date of exercise, resulting in a reduction in the amount of income taxes due by the employee and a corresponding reduction in the income tax benefit received by the company, OCA believes the company should record the excess tax benefit it otherwise would have been entitled to receive on the actual exercise date as an addition to paid-in capital. Any benefit that was forgone by the company due to the mischaracterized exercise and any other tax obligations of the employee paid by the company should be recorded as a compensation cost to the employee.

When correcting material misstatements in their financial statements, OCA said it is important to discuss not only the accounting misstatements, but also the circumstances that led to the errors. Companies that intend to correct material errors for several years of filings without amending all previously filed reports should contact the Division of Corporation Finance. Companies do not have to amend previously filed reports to correct immaterial errors, but the corrections should be made the next time the registrant files the prior financial statements.