Critical Accounting Estimates for Share-Based Payment Arrangements

CPA Journal, The, Jun 2007 by O'Shaughnessy, John, Rashty, Josef

Disclosure Requirements Under SFAS 123(R)

The accounting for stock option compensation expenses has changed over the years. In 1972 the Accounting Principles Board (APB) issued APB Opinion 25, Accounting for Stock Issued to Employees, setting out relatively straightforward accounting rules for recognizing stock option compensation expense. APB Opinion 25 uses the intrinsic value method, which identifies the compensation expense of fixed stock options based on the difference, if any, on the date of the grant between the fair value of the company's stock and the exercise price of the option. An inherent problem with this application soon became apparent: Although stock options were widely granted in some industries, little or no compensation expense was reflected on the operating results of the publicly held companies. In 1993, FASB focused its attention on this seemingly inconsistent result and issued SFAS 123, Share-Based Payment, requiring companies to reflect stock-based compensation in their operating results. In the face of stiff opposition from special-interest groups and legislators, FASB quickly softened its position, requiring only footnote disclosures for share-based arrangements. In 2004 the standard was revised, requiring companies to incur stock option compensation expenses. SFAS 123 (R) has had a significant effect on corporate profits. Intel, for example, reported sharebased compensation totaling $706 million in the first half of 2006, compared to zero in the first half of 2005, because of the change in methodology. Likewise for Dell Inc., which had a stock-based compensation expense of $112 million for the three months ended May 5, 2006, compared to $5 million for the three months ended April 29, 2005.

The expense valuation methods that FASB requires are based upon option pricing models that are fairly complicated and require many assumptions and estimatessome of which, if wrong, could produce materially different results in the operating results of the companies. Financial statement users should pay attention to the disclosure of critical accounting estimates, as a supplement to footnote disclosures, for the share-based payment arrangements in SEC Forms 10-K and 10-Q, as based on recent SEC and FASB guidance, because the estimates used can have a significant impact on reported results.

Critical Accounting Policies and Estimates

The SEC requires management to discuss the dynamics of its operations and present a detailed narrative of the financial statements. The proper place for this discussion is in the Management Discussion and Analysis (MD&A) section of the 10-K and 10-Q. The current Sarbanes-Oxley Act (SOX) environment has necessitated enhanced corporate transparency and additional financial disclosure. With its December 2001 Release FR-60, Cautionary Advise Regarding Disclosure About Critical Accounting Policies, the SEC issued guidance on more robust and transparent financial discussions in the MD&A. The concept of critical accounting policies (CAP) came out of Release FR-60. CAP disclosures require management to present more indepth discussion of the policies, judgments, and estimates that could materially affect financial statements.

In May 2002, the SEC proposed a further enhancement to CAP disclosures: critical accounting estimates (CAE). Initially the technical application for CAEs was considered too complex and thus, never finalized. However, in December 2003, the SEC issued Release FR-72, Interpretation: Commission Guidance Regarding Management's Discussion and Analysis of Financial Condition and Results of Operations. Section V of FR-72 again addressed CAE. The guidance requires disclosures of the nature of any estimates or assumptions that could materially impact the financial condition or operating performance of an entity. These disclosures should supplement, not duplicate, the description of accounting policies and estimates that are already disclosed in the footnotes to the financial statements. The footnotes to the financial statements should generally describe the methods used to apply an accounting principle. The discussion of CAEs, on the other hand, should present management's analyses of the uncertainties involved in applying a principle or the variability that is reasonably likely to occur due to the principle's application. In the CAE disclosures, an entity should address how it has arrived at those estimates, how accurate they have been historically, and if they are subject to change in the future. The guidance also encourages companies to provide quantitative and qualitative MD&A disclosures (see Exhibit 1).

Share-Based Payment Arrangements

In December 2004, FASB revised SFAS 123 and issued SFAS 123(R), Share-Based Payment, which requires companies to expense the estimated fair value of employee stock options and similar awards. SFAS 123(R) replaced SFAS 123 and superseded APB Opinion 25. In March 2005, the SEC staff issued Staff Accounting Bulletin (SAB) 107, "Share-Based Payment" SAB 107 creates a framework premised on two overarching themes: