The Accounting Onion

Taking Stock of Christopher Cox: Part 2 of 2

In the previous post I listed and described the major SEC rulemaking initiatives that have come out since Christopher Cox took charge.  It looks like an impressive list, but most of the improvements to financial reporting regulation have been la natural outgrowth of technology enabling more efficient and rapid dissemination of information.  In other words, they were rules not born out of creativity or vision, but just ones for which their time had come.  The revisions to the executive compensation disclosure rules are, however, a significant exception.  If you're a tree, you'll give Cox an "A+" for the electronic delivery options that could spare your life.

Speaking of vision, when the SEC eliminated the IFRS-to-GAAP reconciliation requirement in the name of making listings on U.S. exchanges more attractive to foreign companies, I came to realize that Cox's philosophy of securities regulation is far different than Arthur Levitt's, the last chair who was around long enough, and was effective enough, to leave a lasting legacy. Levitt's financial reporting priorities were clearly driven by investor protection objectives.    Levitt oversaw and actively promoted major projects to modernize auditor independence rules, level the information playing field by restricting disclosures to selected analysts (Regulation FD), and he also fought  the good fight on many fronts against earnings management.  If anyone was a prophet of Enron and Worldcom, it was he. 

In stark contrast, Cox has presided without nary a whimper over budget and staff cuts (even in the wake of Enron); and worse, a partisan effort has taken place to move any investor protection agenda stage left.  Front and center are the interests of financial institutions and those who serve them: in part by relaxing rules that threaten their market dominance, but also, in part, by doing nothing or too little about shareholders' access to the proxy, registration of hedge funds, and the independence and competence of credit rating agencies. 

In my SEC (and FASB for that matter), the only thing that matters is investor protection.  Expansion of capital markets, even in the name of giving investors greater investment opportunities, should not even be in the game plan.  It's certainly not in the securities laws administered by the SEC.   

So, not being a tree, I give Cox a "C."

Taking Stock of Christopher Cox: Part 1 of 2

Christopher Cox, the current SEC chairman, is sure to head out the door soon after a new prez is inaugurated.  So, just as last night's State of the Union address stimulated debate about the incumbent's record and what his legacy would be, it's time for us financial reporting wonks to do the same for Cox. In this first of two posts, I'm going to inventory his major rule making initiatives affecting financial reporting.  I'll give Cox his report card in a second, and much briefer, post to follow in a day or two.

Revised and Expanded Executive Compensation Disclosures

After having received a record 20,000 comment letters on proposed rule changes, the SEC issued new disclosure rules to close loopholes and significantly expand executive compensation disclosures.  From an investor perspective, it may be the highlight of the Cox administration:

• The existing Summary Compensation Table was augmented by the total compensation for each “named executive officer” (NEO); additional tabular disclosures and a major new section entitled Compensation Discussion and Analysis (CD&A).
• The CD&A and all other narrative executive compensation disclosures are required to be written in “Plain English", a first for information included in '34 Act filings. 
• Disclosures regarding option grants (in general and to specific executives) were expanded, and revised since the proposing release to reflect concerns with backdating.
• Tabular and narrative disclosures of director compensation were added. 
• Form 8-K was modified to capture some employment arrangements with NEOs and any material amendments.

Securities Offering Reforms for Large Companies, and Stricter ’34 Act Requirements in the Process

The infamous 1998 Release (33-7606A) dubbed the ‘Aircraft Carrier’ was a noble, yet politically doomed attempt to revamp the entire registration system under the ’33 Act. The new set of rules (SEC Release 33-8591) is a much more modest attempt to eliminate “unnecessary and outmoded” hurdles to the offering process without goring too many of the securities industry’s oxen.  The following briefly describes some of the most notable rules changes:

• Amendments to Form 10-K—Two new items were added.  Item 1A requires risk factor disclosure (with updates for changes in risk factors disclosed in subsequent 10-Q’s).  Item 1B requires an accelerated filer, or a  “well-known seasoned issuer” (WKSI—a new term), to describe any material and unresolved written staff comments issued more than 180 days before the end of the fiscal year covered by the Form 10-K.  In addition, the cover page of the Form 10-K will include a check box to indicate whether the filer is a WKSI.
• Additional permissible communications during the “quiet period”—The new rules create exceptions to the filing requirements for electronic road shows and written communications.  For example, ‘tombstone’ offering announcements in business periodicals may now include information about the issuer and the securities being offered.  (WSJ must love this!)
• Prospectus delivery requirements are relaxed—Is the writing finally on the wall for the financial printing industry?  Trees are overjoyed to know that the new rules revise the prospectus delivery requirements so that electronic access to a prospectus can satisfy the delivery requirements under the Act.
• Shelf registrations—Many seasoned public companies offer securities on a continuous basis through “shelf registrations,” for which WKSIs will be afforded automatic effectiveness.  In addition, all companies eligible to make shelf registration may now register an unlimited number of securities.  (Prior to this release, the number of registered securities had been limited to the amount that could be reasonably expected to be sold within two years.)

Electronic Delivery of Proxy Materials

On January 22nd of this year, the SEC published its final rule permitting electronic delivery of proxy materials for most shareholder meetings, largely as proposed 14 months ago.  The framework for the new rules has been dubbed the “Notice and Access Model”, and is available for proxy solicitation by both management and others.  Under the model, “Notice of Internet Availability” of proxy materials must be sent out prior to the date of the shareholders’ meeting and content of the Notice is limited to ensure prominence of the information provided.   The Notice must also include a toll-free number and e-mail address for requesting hard copies.  If any of the permitted materials (e.g., notice of meeting, proxy statements, proxy card, annual reports, and amendments) are furnished on-line, then all must be furnished on line.

Note, however, that Internet delivery of proxy materials is not an option for meetings at which shareholder approval is needed for mergers and acquisitions, other business combinations, asset sales and exchange offers.

XBRL

The SEC recently announced the completion of all work on developing XBRL data tags for the entire system of U.S. GAAP.  Once EDGAR is transformed into the interactive data format and filers are required to include the tags, it will become possible for analysts to download financial reports directly into spreadsheets and to use other specialty software to do instant financial comparisons across any desired subset of firms.  The SEC also announced that the market capitalization of companies participating in the voluntary XBRL program now exceeds $2 trillion. 

New Reporting Flexibility for "Smaller Reporting Companies"

Since the inception in 1992 of the small business disclosure system, eligibility for the use of small business forms (SB-1, SB-2, 10-KSB and 10-QSB) and Regulation S-B had not changed from the dual $25 million revenue and public float tests.  Some of the most significant accommodations provided by the regime included the following:

• Only two years of GAAP financial statements, and an audited balance sheet for the most recent fiscal year-end;
• No five-year summary of selected financial data, or market-risk disclosures;
• Scaled-back MD&A, related party and corporate governance disclosures;
• No compensation committee interlock and insider participation disclosure; and
• Reduced executive compensation disclosure, most notably, Compensation Discussion & Analysis not required

The new SEC rules broaden the eligibility for the these accommodations to all non-shells whose public float is less than $75 million (to be adjusted for inflation every 5 years) as of the last business day of the previous second fiscal quarter.  By the SEC’s estimate, this creates a population of “smaller reporting companies” (a new term) that contains 1,600 more companies than the current “small business issuer” population, or more than 10% of all companies reporting to the SEC.

In addition to broadened eligibility, the new rules aim to broaden their use by transferring the accommodations directly into Regulation S-K, and allowing for them to be used on an “a la carte basis” by eligible reporting companies.  Regulation S-B and its associated forms are thereby eliminated, and a new check box is added to the cover pages of remaining forms for a reporting company to indicate whether it has elected to use any of the accommodations.

Two New Exemptions from Registration for Compensatory Employee Stock Options

The SEC has adopted two new exemptions from the registration requirements of the Securities Exchange Act of 1934 for certain stock options—one for private companies and another for public companies. 

The exemption for private companies is set forth in Rule 12h-1(f), and is based on related no-action letters issued by the SEC prior to the adoption of the new rule.  It applies to stock options meeting the following conditions:

• The options are issued under formal compensatory plans.
• They are held by the issuer's employees, directors, consultants and similar parties.
• Transfer is restricted, together with the shares to be issued upon exercise of the stock options, with certain limited exceptions such as transfers to family members and change of control transactions

To further qualify for the exemption, the issuer must provide financial statements and information about the risks associated with holding the investment at least every six months.

The exemption available to public companies is set forth in Rule 12h-1(g) meeting the first two of the conditions listed above.  Issuers are not required to provide financial statements or other information to the holders of the options because there is already sufficient information publicly available, as they are already filing periodic reports to the SEC.

Access to Short-Form Registration and Shelf Offerings is Broadened

Acting on recommendations made in the final report of the Commission’s Advisory Committee on Smaller Public Companies to expand eligibility for short form registration and shelf offerings, the Commission revised eligibility for use of Forms S-3 and F-3.  Form S-3 has been the “short form” used by eligible domestic companies enabling incorporation by reference from previously filed documents for registering offerings under the Securities Act of 1933.  Form F-3 is the S-3 counterpart available to foreign private issuers. 

Both of these forms also enable companies to conduct offerings “off the shelf” under Rule 415, which can allow companies to have more control over timing of offerings, avoid delays and interruptions in the offering process and can reduce or even eliminate the costs of filing post-effective amendments to the registration statement.  However, shelf offerings of equity securities were capped at 20% of public float each year.

Until now, Forms S-3 and F-3 were available for primary offerings (i.e., proceeds from securities offered to be received for the company’s own account) only (1) by companies with a public float in excess of $75 million, or (2)  offerings of non-convertible investment grade securities, certain rights offerings, dividend reinvestment plans and conversions, and secondary offerings of securities registered on a national exchange. 

The changes to eligibility for use of the S-3 and F-3 are two:

1. The public float requirement has been eliminated, and in its place has been substituted the requirement that the company has a class of common equity securities listed on a national securities exchange.
2. The public float cap of 20% on primary offerings has been increased to one-third for all companies.

While the Committee recommended even broader reforms inspired by enhancements to market efficiency resulting from electronic access to company information, the SEC chose to act more cautiously.  Their primary concerns are that smaller companies have been much more susceptible to market and accounting manipulations, in part because they may not be followed as closely by the investor community.  Moreover additional risk has been created by the SEC itself by allowing smaller public companies to take advantage of the abbreviated disclosure requirements discussed above. 

Pension Accounting Reform Ducks for Cover Just When Investors Need It

The backdrop for today's post is the present dive in stock prices at the same time the Federal Reserve is trying to stimulate the economy by decreasing interest rates.  What I'm fixin' to describe is how it will -- and won't -- affect the reporting of pension costs.

The Chasm between the Economics of Pension Plans and their Reported Effects on Income

Most plans, if they have significant investments in equity securities are gonna get clobbered by current developments in the economy.  That's because the asset leg, representing investments set aside to pay pensioners, will go down with the decline in stock prices; and, the liability leg, representing the present value of expected payments to pensioners is going to go up as a lower interest rate is used to discount the expected cash outflows.  The chop to both legs is going to push down economic earnings -- a lot. 

But, as you may already know, owing to rules-based GAAP (IFRS is similar), the effect on reported earnings will be but a wee fraction of the total economic effect -- due to an artifice referred to in the trade as "corridor amortization."  Maybe a tenth, at most, of the actual loss will get recognized on the income statement.  It's really quite shameful that the gap between economic and GAAP income is like the Grand Canyon; and it's because the basic principles of pension plan accounting have been willfully ignored by the FASB.  These principles are as simple as this:

1. Calculate the net pension liability/asset as the difference between the fair value of plan assets and the actuarially determined projected benefit obligation.  This number goes on the balance sheet.
2. Report the change in the net pension liability/asset on the income statement.

As I reported in an earlier post, FAS 87, the grandaddy of pension accounting rules, was a blatant and outright rejection of principles.  It was passed by a 4 - 3 vote and was an unmitigated disaster -- an artifice designed to appease the country's largest employers by hiding liabilities and overstating income.  But, predictably, and undeniably, FAS 87 allowed companies to pretend to ignore the risky and ultimately dire straits their pension plans were in until the companies, along with their plans, became insolvent.  How much wealth destruction and personal hardship would have been prevented if one more member of the FASB had voted against FAS 87?  Somebody should be losing sleep over it.

Now comes a study by Charles Mulford, a professor at Georgia Tech, et. al. showing for the largest of these companies that if the change in the net pension amount were reported on the income statement, then reported income would be much more volatile.  Big Duh.  That's why FAS 158, though fast-tracked to avoid the appearance of a complete sham, stopped well short of a comprehensive fix.  I'm guessting that many of the companies Mulford and his colleagues studied were among the major whiners for the FASB to protect their income statements.      

Phase 2 of the Pension Project Hasn't Left the Gate 

This I guarantee (but can't prove): if timely recognition of losses on pension plans were required by accounting standards, pension portfolios of today would be less volatile, and interest rate risks would be hedged; and the exposure of wage earners to the crisis that the economy now faces would be less.  FASB members past and present know this reality -- that accounting actually affects cash flow, and not just the other way around. 

So, you would think that Phase 2 of the project should be fast-tracked as well.  Actually, it is being hobbled by diversionary tactics. I'll let the minutes of the FASB's August 2007 meeting speak for themselves concerning the issues the FASB says they will address in Phase 2:

"a. How changes in postretirement benefit assets and obligations should be reported in the context of the presentation framework and principles being developed in the joint financial statement presentation project. That is, the Board will identify the discrete items that cause changes in plan assets and benefit liabilities and analyze how each item should be presented, in the period they occur, within the framework of the joint financial statement presentation project. That framework presumes that the concepts of other comprehensive income and recycling have been eliminated. Once those standards are developed, the Board will consider whether some or all of them should be implemented before the financial statement presentation project is completed and any new standards become effective.

b. How the reporting of an employer’s obligations associated with participation in a multiemployer plan might be improved. The Board expressed tentative support for the staff’s recommendation that phase 2 initially focus on improving disclosures in the notes to financial statements, pending the staff’s additional analysis of reasons for that recommendation (that is, the staff’s rationale for initially focusing on disclosure rather than recognition and measurement of plan obligations).

c. Whether and how to improve disclosures about risks inherent in plan investments, for example, sponsor’s use of derivatives. This step would reexamine the guidance in FASB Statement No. 132...."

Why do these lower-priorty and loosely related issues like income statement presentation, disclosure, esoteric forms of pension plans, and even convergence with IFRS (elsewhere in the minutes) have to be resolved at the same time as the glaring wart of failure to recognize the full amount of pension costs in income?  The answer is so obvious that it may explain why we haven't heard a peep out of the FASB since that August meeting.  No tentative decisions on any of these issues have been announced. 

Even "glacial speed" is too generous a description of the FASB's progress on the putative second phase of their pensions project.  "Frozen in time" seems dead on. 

Peeling the Onion on the New Business Combination Standards: FAS 141R and FAS 160

This post examines the onion skin, if you will, of the new business combination standards. I'm going to explain the differences between the so-called 'purchase' method of accounting and the new 'acquisition' method. As is my habit, let's begin with a simple example.

Assume that ParentCo acquires 70% of the outstanding shares of SubCo for $1,000. Additional facts are as follows:

• ParentCo estimates that the fair value of 100% of SubCo is $1,405:
  • You should note that the fair value of SubCo may not ordinarily be calculated by extrapolating the purchase price paid to the remaining shares outstanding (i.e., $1,000/70% = $1,429 is not ordinarily the fair value). The reason is that a portion of the purchase price contains a payment for the ability to exercise control.
  • In this case, the control premium would be $55, calculated as follows:

($1000 - .7($1405))/(1-.7) = $55

• It may be difficult to estimate the control premium, because it may have to be derived from an estimate of the full fair value of the acquired company, as above.
• The book value of SubCo's assets and liabilities approximate their fair value, except for one asset with a remaining useful life of 10 years. For that asset, the fair value exceeds the book value by $100.

The table below displays the following: (1) respective balance sheets of ParentCo and Subco at the date of acquisition, (2) consolidated results under the purchase and acquisition methods, and (3) the goodwill calculations under each method.

The purchase method had a lot of warts, but it took the FASB decades to replace it. In essence, it was nothing more than a slavish application of the historic cost principle to mute the future effect of an acquisition on operating expenses. The idea was that if you purchased 70 percent of the outstanding shares of another company, then revaluation of assets would take place only to the extent of the shares purchased. Among other things, this meant that the basis of the assets of a subsidiary acquired in business combination transaction would be the sum of the fair value of the portion acquired and the historic cost of the portion not acquired. This is illustrated above by the calculation of consolidated assets: $2,000 + $800 + .7($900 - 800) = $2,870. The mix of fair value and historic cost to measure one asset reminds me of something my father would say when someone (mainly me) was less than fully committed to a principle: "you can't be half pregnant."

The acquisition method represents a full commitment to fair value, yet ironically, the FASB still doesn't require fair value for all assets and liabilities assumed (more on that in another post). In other words, if the transaction results in the acquisition of control of an entity, assets acquired and liabilities assumed will be initially measured at 100% of their fair value--even if less than 100% of the outstanding shares are purchased. That's why consolidated assets are $30 higher in the illustration under the acquisition method.

The example also illustrates two other important differences between the methods:

• The consolidated amount attributed in consolidation to the non-selling shareholders was� termed 'minority interests' under the purchase method. It was reported on the balance sheet between liabilities and shareholders' equity'; and following the same reasoning allowing half-pregnant measures of consolidated assets and liabilities, was measured based on the historic costs of the subsidiary. 'Noncontrolling interests' (NCI), has replaced minority interests, and are now measured on the same basis as the 'controlling interests', and firmly categorized as part of shareholders equity.
  • Well, maybe not so firm. See my post on the FASB's recently issued Preliminary Views document entitled Financial Instruments with Characteristics of Equity, which proposes to move NCI to liabilities. In fact, one intrepid FASB member objected to the issuance of FAS 141R until the FASB could actually enunciate clear principles for distinguishing between liabilities and equity. Until then, it's just another rule that's subject to change.
• "Goodwill" is higher under the acquisition method, because as can be seen by comparing the calculations, it now includes amounts attributable to NCI.
  • What hasn't changed, though, is that goodwill is still a euphonious sobriquet for a random number masquerading on the balance sheet as an asset measurement. (I'll write more about this in a post soon to come.) Under the purchase method, it's the difference between the purchase price and amounts for the other assets and liabilities recorded. Under the acquisition method, it's fair value of SubCo (equivalently, purchase price plus amount recognized for noncontrolling interests) minus the amounts for the other assets and liabilities recorded. SFAS 141R may describe goodwill in more dignified terms, but the way I just did is more accurate. At least I'm not as blunt as Walter Schuetze, former SEC Chief Accountant, who is fond of calling goodwill "the lump left over." I smile to myself every time I think of that.

Since only balance sheet differences are illustrated above, I have only told part of the story so far. The table below extends the illustration to the end of the first year subsequent to the acquisition of SubCo.

The foregoing illustrates that there is an additional step on the income statement. It may be hard for some people to get used to, but net income is no longer the bottom line. In fact, the bottom line doesn't change in this case, because $3 of additional depreciation expense is recorded, but it is taken out of the earnings attributed to NCI. If you are familiar with the SEC's required presentation of 'net income applicable to common stock (SAB Topic 6.B.1), you will know that the idea is not new.

Well, that's all for now. If you want to look at my spreadsheet, you can get it by clicking here. I'll have a lot more to say about goodwill and accounting for business combinations in the near future, and it won't be pretty.

Note: The original version of this post contained an error in the calculation of the control premium. Thanks to Wallace Enman of Moody's for pointing out the error, and for helping me to get it right. Thanks also to Barb Foerster of Western Union for finding another technical error that I have now corrected.

Fair Value v. Replacement Cost: A Working Paper

A few weeks ago, I wrote a post entitled "FAS 157: Fair Value Has left the Station--But Is It on the Wrong Track?"  Walter Teets of Gonzaga University and I have converted it to a working paper.  The new title is "Does FASB Statement No. 157 Provide 'The Most Relevant Information for Financial Decision Making?'"The main changes are an expanded and improved analysis of the rules-based details of FAS 157; and a more academic style (i.e., absence of wit and biting sarcasm).

As always, comments and suggestions, are most appreciated.  I have set up a discussion page using GroveSite (shameless plug: that's my software company) that will allow everyone to see your comments, and also, my responses.  I'm hoping to have a real dialogue that will eventually lead to a better paper.

The Fallout from SAB 108: A Concrete Illustration of the Need for Mandatory Audit Firm Rotation

I'm going to write about auditing in this post, and my remarks are motivated by a report published by Audit Analytics on the number of restatements engendered by the adoption of SEC Staff Accounting Bulletin No. 108 (SAB 108) on materiality. 

If you're an SEC geek, you'll probably be saying to yourself that materiality in financial statements was comprehensively addressed in SAB 99.  You would be right, but the SEC nontheless was compelled to issue SAB 108 to address a specific aspect of materiality for issuers who were either too obtuse or too obdurate to apply the principles-based SAB 99 properly.  The topic of SAB 108 as stated reads as pretentiously as the title of a PhD dissertation: "Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements."  But, as I'll explain below the situations it addresses are more akin to games played by mean children than graduate studies.

SAB 108 in a Nutshell

“The provisions of this Statement need not be applied to immaterial items.”  So states every Statement of Financial Accounting Standards.  If a company appeals to materiality because the cost of implementing a standard would be too burdensome, that’s OK.  But, if you are appealing to materiality to avoid implementing a standard because you don’t like the financial statement impact, principles-based SAB 99 says that’s not OK -- but who’s gonna know, just so long as you apply the rules for testing materiality as literally as you possibly can.

Here’s what can happen when you put your rose-colored materiality glasses on.  Imagine that a company has understated an expense by an ‘immaterial’ amount, say $20,000 per year for the past five years, accumulating to an understated liability of $100,000.  Now, in the fifth year, the company, having blithely ignored the pending accumulation, has a material unrecognized liability on its hands:

• Should it restate all prior periods, thereby sending an open invitation for scrutiny to the SEC and prospecting private attorneys? 
• Should it make a $100,000 correction to the income statement of the current year, and effectively compound earlier white lies with a big lie (material understatement of income) in the current year? 
• Should it do nothing -- as it has for the past five years?

In SAB 108, the SEC needed to tell everyone, as if they didn't know already, that the only way out of the pickle, once you are in it, is full restatement -- except for an amnesty to companies that cleaned up their act by a prior period adjustment to retained earnings in their annual report for fiscal years ending before November 16, 2006. 

Back to Auditing

The Audit Analytics report has a bunch of really interesting statistics about the corrections made during the SAB 108 amnesty period. There are a number of interesting statistics about the frequency (too many, including over 200 accelerated filers) of companies and the kind of accounting issues, but the juciest statistics were the distribution of error corrections over each of the Big Four auditors.   KPMG lead the way with 13.7% -- about one in seven -- of their SEC clients making corrections.  The other three weren’t even close to KPMG, all having less than 3%.  KPMG also leads the way by a fair amount in the average size of a correction.   

Perhaps too much can be made of one case, but with the KPMG's Xerox debacle fresh in my mind, I can't say that I am shocked by the results.  In the Xerox case, KPMG was found to have improperly permitted billions in earnings manipulations, and responsibility for assisting in the fraud extended to the most senior partners. 

Those of you who have had occasion to read some of my earlier posts may recall that I am an avid fan of mandatory audit firm rotation (Would Someone Please Audit the Auditor?). How many of these restatements would have been permitted or caught at an earlier stage if another firm, especially one less tolerant of the games children play, succeeded KPMG?  Would the consequences of the busted Xerox audit have been prevented, or at least mitigated?

No one can say for sure what the answers to these question are, and I am more confident that the Big Four doesn't want anyone to know.

By the way, I received a copy of the Audit Analytics report via a private email, and I have been unable to find a public URL source for it.  Therefore, I am hesitant to post it here for fear of violating copyright laws.  If anyone knows of a legitimate public source, please contact me and I'll add a link to it here.

SEC's “Simplified Method” for Estimating Stock Option Cost is Ripe for Manipulation

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Call me cynical, but I am wary of accommodations that permit companies to freely choose between their best estimates and something less.  Even significant restrictions on the ability to elect a simplified approach may not be effective in preventing manipulation. Witness, for example, the  abuse of the short-cut method for demonstrating hedge effectiveness under FAS 133 by Fannie Mae et. al.  Accommodation may result in relief that is elected in good faith by many, but for some, it's just another opportunity to manage financial reporting.  The latest example is SEC Staff Accounting Bulletin 110, and the related earlier SAB 107.

Background

FAS 123R requires a company to estimate the grant-date fair value of its options, which in turn necessitates estimation of the expected exercise date of the options.  For companies that did not have access to adequate historical data about employee exercise behavior in order to make a realiable estimate of when options will be exercised, the SEC issued SAB 107 in March 2005, permitting use of a simplified approach until December 31, 2007.  The simplified approach was further restricted to options that meet criteria collectively referred to as “plain vanilla,” and essentially allowed companies to assume that the exercise date of an option would be halfway between its vesting date and the expiration date.

SAB 107 made the the simplified approach available only through December 31, 2007 – at which time the SEC staff expected companies to have sufficient historical data with which to more precisely estimate the expected exercise date.  As the Dec. 31, 2007 deadline in SAB 107 approached, the SEC staff was persuaded the detailed information about exercise behavior was still not readily available for many companies. Accordingly, SAB 110 was issued on December 12, 2007 to allow the continued use of the simplified method—provided a company concludes that its own historical share option exercise experience does not provide a reasonable basis for estimating expected term.

The Earnings Management Tactic

By the way, I am not a big fan of FAS 123R, because grant-date valuation often understates the actual costs of stock options.  It would make more sense to value the options on the date they are effectively 'issued' to employees, which is the vesting date.  But given that grant date valuation is the law of the land, I suppose that it is theoretically correct to base the valuation on the expected exercise date as opposed to the expiration date.   

Having said that, valuation based on assumed exercise at the expiration date -- as opposed to estimating an earlier exercise date -- would yield higher measures of compensation cost; and, especially given the concerns that the SEC has expressed in SABs 107 and 110, result in greater consistency of measurement.  It would also remove one very significant element that management could manipulate -- which is a big reason why companies lobbied for using the expected exercise date in the first place.  The simplified approach temporarily permitted by SAB 107 and extended by SAB 110 sweetens the deal.

Here's how the earnings management game works. Assume that (1) management of a company desires to minimize reported compensation cost, and (2) the expected exercise date of options is on the later side of the halfway point between vesting and expiration.  In this case, one would expect management to try their best to convince their auditors that they are unable to reliably estimate the exercise date -- that's because the simplified approach would produce lower compensation cost.  But, if the expected exercise date were on the earlier side of the midpoint, we would see just the opposite kind of self-interested rationalization: management trying to convince their auditor that their SWAG is practically as good as carved in stone.

Finally, why is the SEC making more work for itself?  Unlike SAB 107, there is no specific expiration date of the simplified approach in SAB 110.  The SAB 110 release states that once relevant detailed external information about exercise behavior becomes widely available for companies to make more refined estimates of expected term, the staff will no longer accept use of the simplified method.  In the interim, I suppose the SEC will be selectively asking companies to justify why they continue to use the simplified approach.  That's not a good use of anyone's time. 

If a company cannot make a reliable estimate of the exercise date, the SEC should require them to assume exercise at expiration.  That should get their attention -- and protect investors by cutting the legs out from under an obvious earnings management opportunity.

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