By Anne Sherry, J.D.
SEC staff released new guidance showing a focus on the accounting treatment of spring-loaded options, or non-routine options granted while the company possesses material non-public information. The guidance calls for companies to consider the additional value from the impending announcement when recognizing the cost of the awards. SEC Chair Gary Gensler said that companies’ books and disclosures should “reflect the economics and terms of these compensation arrangements,” a position that “gets to the SEC’s remit to protect investors” (Staff Accounting Bulletin No. 120, Release No. SAB 120, November 24, 2021).
The guidance explains that staff observed companies granting spring-loaded options and other compensation while possessing material non-public information expected to have a positive effect on stock price. When using a fair-value-based method to estimate the cost of these transactions, companies should consider whether they need to adjust the current price of the underlying share or the expected volatility for the term of the award. The guidance stresses companies’ corporate governance obligations; GAAP disclosure obligations; and obligations to maintain effective internal control over financial reporting. It also includes examples where such adjustments may be necessary.
Under FASB ASC Topic 718 (Compensation—Stock Compensation), companies using the fair value measurement objective for equity instruments are to estimate the grant-date fair value taking into account (1) the expected volatility of the company’s share price; (2) the expected term of the option; and (3) the current price of the underlying share. SEC staff believes that a consistently applied method to determine the current price of the underlying share should include consideration of whether adjustments to observable market prices (e.g., the closing share price or the share price at another specified time) are required. Such adjustments may be required, for example, when the observable market price does not reflect certain material information known to the company but not to the public.
The guidance acknowledges that companies generally do hold nonpublic information when they issue options and other share-based payments and that the observable market price on the grant date is generally a reasonable and supportable estimate of the current price of the underlying share for routine, not-spring-loaded grants. “However, companies should carefully consider whether an adjustment to the observable market price is required, for example, when share-based payments arrangements are entered into in contemplation of or shortly before a planned release of material non-public information, and such information is expected to result in a material increase in share price.” If the stock price does materially improve upon the announcement, this indicates that market participants would have considered adjusting the observable market price on the measurement date.
In one example in the guidance, a public company awards share options to its executives shortly before announcing a material contract with a customer. In this scenario, the staff expects the company to consider whether the awards are consistent with its policies and procedures, including the compensation plan approved by shareholders. In estimating the fair value of the options, the usual accounting policy of using the closing share price on the day of the grant would not be a reasonable and supportable estimate of grant-date fair value.
As for disclosure, at a minimum the company should add in a footnote to its financial statements how it determined the current price of underlying shares for purposes of determining grant-date fair value. For example, the staff would expect the company to disclose its accounting policy related to how it identifies when an adjustment to the closing price is required, how it determined the amount of the adjustment to the closing share price, and any significant assumptions used to determine such adjustment, if material. The characteristics of the share options may differ from the company’s other share-based payment arrangements to such an extent that it should disclose information regarding spring-loaded options separately from other share-based payment arrangements. Additionally, the company should consider the applicability of MD&A and other disclosure requirements.
This is Release No. SAB 120.