Topic: Accounting for the Rescission of the Exercise of Employee Stock Options

Transcription

1 Topic No. D-93 Topic: Accounting for the Rescission of the Exercise of Employee Stock Options [Nullified by FAS 123(R) except for entities within the scope of paragraph 83 of FAS 123(R)] Date Discussed: January 17 18, 2001 The SEC staff has been asked to consider the accounting, under APB Opinion No. 25, Accounting for Stock Issued to Employees, for a transaction described as the rescission of the previous exercise of a stock option. An example of such a transaction is as follows: An employee has 1,000 nonqualified vested stock options exercisable at $5 per share. The employee exercises those options when the stock has a quoted market value of $50 per share. The exercise generates a tax liability to the individual of $15,000 and a tax benefit for the company of $15,000, 1 which the company records as a deferred tax asset, or a reduction in current taxes payable. Following the exercise, the stock issued to the employee is reflected in the financial statements as issued and fully paid-for shares. The employee does not sell the newly acquired shares. Later, but within the same tax year, the quoted market price of the underlying stock declines to $8 per share. At that time, the board of directors and the employee agree to rescind the exercise of the options. Therefore, the company issues 1,000 options with an exercise price of $5 per share and the same terms as the options originally exercised. In addition, the company returns to the employee the $5,000 exercise price previously paid, the employee returns to the company any dividends received during the period the shares were outstanding, and the employee returns to the company the 1,000 shares held since they were issued upon the earlier exercise of the options. For income tax purposes, both the company and the employee assert that the exercise and the subsequent rescission within the same tax year are treated as if neither had occurred. Thus, it has been represented to the SEC staff that the company will no longer be entitled to an income tax deduction and the Page 1

2 employee will avoid any income tax liability from the exercise as a result of the subsequent rescission. In the rescission, the company has, in essence, agreed to reacquire shares issued upon exercise that the employee desires to put back at a price that either was, or could have been, at other than fair value on the date the shares were put to the company. 2 Under paragraph 70 of FASB Interpretation No. 44, Accounting for Certain Transactions involving Stock Compensation, and Issue 23(d) of Issue No , Issues Related to the Accounting for Stock Compensation under APB Opinion No. 25 and FASB Interpretation No. 44, this type of repurchase (rescission) feature in the terms of an option award causes variable accounting for the award. The SEC staff believes that because the company has participated in such a repurchase, the substantive terms of the options issued in the rescission transaction should be considered to include the same repurchase (rescission) feature. [Note: This announcement has been nullified by FASB Statement 123 (revised 2004), Share- Based Payment. See Subsequent Developments section below.] Under Interpretation 44 and Issue 00-23, that type of repurchase feature always is expected to be exercised. Accordingly, variable accounting applies to the options issued in the transaction. Variable accounting continues until the earlier of (a) expiration of the repurchase feature or (b) exercise of the repurchase feature. In this case, the repurchase feature is 1 For simplicity, we have assumed both the employee and the company have 33 percent tax rates. 2 Even if the calculation in a particular instance results in no compensation expense at the time of the rescission, variable accounting still applies for the new options because the repurchase price could have been in excess of fair value (for example, if the stock price had been below the exercise price of the original options at the time of the rescission ). Page 2

3 deemed to expire when it is not possible to rescind the exercise of the new options for tax purposes. For example, this might occur upon (a) the expiration or forfeiture of the new options or (b) the end of the tax year in which the new options are exercised, although that assessment would need to be made based upon the relevant income tax rules and regulations. If a public company has engaged in an option exercise rescission transaction like this prior to January 1, 2001, and the employee delivers to the company the same shares issued upon the option exercise, the SEC staff will not object to accounting for the rescission transaction under Opinion 25 as a modification of the original options that results in a new measurement date (rather than variable accounting). [Note: This announcement has been nullified by Statement 123(R). See Subsequent Developments section below.] This modification would result in the recording of additional compensation cost to the extent that the sum of (a) the cash paid ($5,000 in the example), (b) the positive intrinsic value 3 of the new options issued ($3,000), and (c) the tax benefit ($15,000) that must now be written off, as it will no longer be received, 4 exceeds the fair value ($8,000) of the repurchased shares. 5 Thus, in this example, $15,000 in additional compensation cost would be recognized on the date of the rescission. Even if variable accounting will be applied to the new options, a 3 Negative intrinsic value should not be included in the calculation. 4 If the option were an incentive stock option (that is not disqualified) whose exercise generates no tax benefit to the company, or if the company was in a net operating loss position for tax purposes with a full valuation allowance on all net operating loss carryforwards, this component of the calculation would be zero. 5 Assumes there were no dividends paid during the period the shares were outstanding. Page 3

4 similar calculation should be used to calculate compensation expense on the date of the rescission. Registrants are reminded to consider the effects of a rescission transaction, such as the one described in this announcement, on the disclosure requirements of generally accepted accounting principles. FASB Statement No. 123, Accounting for StockBased Compensation, requires that the terms of significant modifications of outstanding awards be disclosed. [Note: This announcement has been nullified by FASB Statement 123(R). See Subsequent Developments section below.] The SEC staff believes that a stock option exercise that is subsequently rescinded is a significant modification that would be considered material information to an investor and accordingly, the terms of the rescission should be clearly disclosed. Statement 123 also requires disclosure of the number and weighted-average exercise prices of options exercised and granted during the year and the weighted-average fair values of options granted during the year. In addition, pursuant to APB Opinion No. 12, Omnibus Opinion 1967, and SEC Regulation S-X, Rule 3-04, the statement of changes in stockholders equity should 6 Regulation S-X, Rule 3-04 states, An analysis of the changes in each caption of other stockholders equity presented in the balance sheets shall be given in a note or separate statement. This analysis shall be presented in the form of a reconciliation of the beginning balance to the ending balance for each period for which an income statement is required to be filed with all significant reconciling items described by appropriate captions. Further, APB Opinion No. 12, Omnibus Opinion 1967, specifies that when both financial position and results of operations are presented, disclosure of changes in the separate accounts comprising stockholders equity (in addition to retained earnings) and of the changes in the number of shares of equity securities during at least the most recent annual fiscal period and any subsequent interim period presented is required. Page 4

5 separately identify the initial exercise of the option and the subsequent rescission and repurchase of the shares that had been issued upon exercise. 6 Under FASB Statement No. 128, Earnings per Share, basic earnings per share is computed by dividing the income available to common stockholders by the weighted-average number of common shares outstanding during the period. If a company enters into a rescission transaction such as the one described herein, its basic earnings per share computation should reflect the dilutive effect of the option exercise until it is rescinded. In some instances, those rescission transactions could have cash consequences on companies that enter into them because of the loss of a previously reported income tax benefit. Accordingly, disclosure in Management s Discussion and Analysis may be warranted. Subsequent Developments Statement 123(R) was issued in December Statement 123(R) supersedes Opinion 25 and Interpretation 44, thereby nullifying this announcement. However, this announcement would still apply to those entities that continue to account for awards under Opinion 25 and its related interpretive guidance pursuant to paragraph 83 of Statement 123(R). Page 5