H EADS UP TM ACCOUNTING, TAX AND REGULATORY DEVELOPMENTS AFFECTING CAPITAL MARKETS INSTRUMENTS AND STRATEGIES

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1 H EADS UP TM ACCOUNTING, TAX AND REGULATORY DEVELOPMENTS AFFECTING CAPITAL MARKETS INSTRUMENTS AND STRATEGIES In This Issue August 22, 2002, Vol. 9, Issue 3 Recording expense of stock options using the Fair Value Alternative prescribed in FAS 123 Final Interpretation to FASB Statements 5, 57, and 107 Attachment: FAS 123, Three Proposed Transition Approaches New Options for Options Revised Transition and Disclosure Rules Coming Considering whether to expense employee stock options? FAS 123 effective for transactions entered into after December 15, 1995 offers that approach as an alternative to recognizing zero expense for many types of option plans. Few companies have taken FASB up on its offer... that is, until recently. To improve financial statement transparency and credibility, a host of companies (e.g. General Motors, General Electric) have announced plans to start recording the expense of stock options using the fair value alternative prescribed in FAS 123. The fundamental issue is how to account for the change in accounting if a company chooses to newly adopt the fair value expense recognition alternative of FAS 123. At its August 14 meeting, FASB authorized the staff to amend FAS 123. Under this proposal, companies will be able to choose from one of three methods to recognize compensation expense for the year of change: 1. Recognize expense only for awards granted after the beginning of the fiscal year (regardless of when during the year the company decides to change), 2. Recognize expense in an amount equal to the amount that would have been recognized in the year of change had FAS 123 been adopted as of its effective date (i.e. the amount in 1 above plus the expense related to unvested, outstanding options as of the beginning of the year of change), or As developments warrant, Heads Up is edited by Jim Johnson and published by Deloitte & Touche s Global Markets Group (New York). Heads Up contains general information only; it is not a substitute for consultation with a professional. To receive copies, contact Kate Ingram at kaingram@deloitte.com or visit our website at (E-library: search for Heads Up). 3. Same as 2. Also, restate all prior year income statements presented to recognize expense in each year related to (1) options granted in each year plus (2) the expense related to unvested, outstanding options as of the beginning of the earliest year presented as though FAS 123 had been adopted as of its effective date. Method 1 tracks the purely prospective transition approach currently found in FAS 123. Methods 2 and 3 are novel, being part prospective and part retroactive. If you re so inclined, the attachment contains an example of the three methods.

2 H EADS UP Also look for additional disclosures that must appear in the Company s accounting policy footnote. The amendment will require that all companies, in their annual and interim financial statements, disclose: The method of accounting for stock based compensation (FAS 123 vs. Opinion 25) in each period, Details that reconcile the amounts recognized in the financial statements to pro forma amounts as if FAS 123 s fair value method had been applied to all awards granted after the initial adoption of FAS 123, and Pro forma earnings and earnings per share. Expect an exposure draft sometime this September. As proposed, the amendment would be effective upon issuance except for the quarterly disclosures. These are slotted to take effect in the first interim period of fiscal years beginning after December 15, Guarantees Given Green Light FASB Authorizes a Final Interpretation At its August 7 meeting, FASB authorized issuance of a final interpretation to FASB Statements 5, 57, and 107, Guarantor s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. Although FASB made some modifications to the original proposal, the final interpretation will retain the exposure draft s requirement that a guarantor record a liability for the guarantee. The Board noted (we predict the interpretation will note this too) that the objective of the initial measurement is the fair value of the guarantee at its inception. Disclosures under the interpretation will be required for interim or annual financial statements for periods ending after December 15, Guarantees (within the scope of the interpretation) issued after December 31, 2002, must be recognized at inception. For guarantees within its scope, the Interpretation requires disclosure of: 1. The nature of the guarantee (including how it arose and the performance triggers), 2. Excluding product warranties, the maximum potential undiscounted payments the guarantor could be required to make, 3. For product warranties: accounting policy and methodology and a tabular 2 August 22, 2002

3 H EADS UP reconciliation of changes in the product liability for the reporting period, 4. The current carrying amount of the liability, and 5. (i) The nature of any recourse provisions that would enable the guarantor to recover amounts paid and (ii) any assets (e.g. collateral) the guarantor could obtain and the approximate extent that liquidation proceeds would be expected to cover the amount in 2 above. What is a guarantee? It is a contract that meets any of four identified characteristics detailed in the exposure draft. Excluded from the scope are commercial letters of credit and other loan commitments; in a capital lease, a lessee s guarantee of the leased property s residual value; many guarantee or indemnification agreements issued by insurance companies; contingent rent under FAS 13; and vendor rebates. Other types of contracts (e.g. product warranties and guarantees accounted for as derivatives) are excluded only from the interpretation s initial recognition provisions. For an up-to-date summary, visit the FASB s website ( August 22,

4 A TTACHMENT Proposed Amendment FAS 123 Example Illustrating the Three Proposed Transition Approaches Recap of Transition Methods: The three transition methods are as follows: 1. Recognize expense only for awards granted after the beginning of the fiscal year, 2. Recognize expense in an amount equal to the amount that would have been recognized in the year of change had FAS 123 been adopted as of its effective date (i.e. the amount in 1 above plus the expense related to unvested, outstanding options as of the beginning of the year of change), or 3. Same as 2. Also, restate all prior year income statements presented to recognize expense in each year related to (i) options granted in each year plus (2) the expense related to unvested, outstanding options as of the beginning of the earliest year presented as though FAS 123 had been adopted as of its effective date. Example: On January 1, 1996, Steady Inc. first entered into a stock compensation plan for certain employees. On January 1, 2003, Steady Inc. changed its method of accounting for stock compensation by adopting the fair value approach of FAS 123. Assume Steady Inc. s net income (excluding stock compensation expense and related tax effects) is $10,000 for each of the five years ending December 31, Steady Inc. presents three year comparative income statements as required for public companies. Other information and the outcome of each of the transition methods is shown in the table below: FAS 123 Compensation Expense related to options:* Unvested and outstanding at the beginning of Granted 1/1/99 to 12/31/ Granted year ended 12/31/03 10 Total Beginning of year retained earnings as previously reported 75,000 85,000 95, , ,000 Attachment 1 1

5 A T T A C H M E N T Net Income: Method 1 10,000 10,000 9,990 Method 2 10,000 10,000 9,940 Method 3 9,970 9,960 9,940 Beginning of year retained earnings, after change to FAS 123 method: Method 1 95, , ,000 Method 2 95, , ,000 Method 3 95, , ,930 * Broadly speaking, compensation expense relates to the amortization of the fair value of the option at its grant date over the option s vesting period. Some observations regarding Method 3 follow: As the Table indicates, only Method 3 results in a restatement of earlier income statements (and balance sheets). Under the fair value method of FAS 123, Steady Inc. s total compensation expense for all years is 280 (the total expense for years ). However, the maximum compensation expense Steady Inc. recognizes (pursuant to Method 3) is 130 ( , , and ). Why the 150 difference? That s because Method 3 does not require Steady Inc. to recognize compensation expense related to years before the earliest financial statement presented. In other words, Steady Inc. will never recognize the total compensation expense that would have been recognized in 1999 and 2000 because these years precede the earliest year Steady Inc. presents for comparative purposes. However, the proposed amendment permits, but does not require, Steady Inc. to go further back and restate financial statements earlier than those presented. As a result of the preceding point, retained earnings as of the beginning of the earliest year presented remains unchanged. There is no cumulative effect of an accounting change. Attachment 1 2