Ask FERF about ... implementing FAS 123(R), Share-Based Payments.

Companies gearing up to implement Financial Accounting Standards Board Statement of Financial Accounting Standards No. 123 (R), "Share-Based Payments," will find a recent publication of the Financial Executives Research Foundation (FERF) helpful in organizing their implementation efforts. The effective date of FAS 123 (R) is for interim and annual periods beginning on or after June 15, 2005 (an additional six months are provided for smaller public companies and nonpublic companies).

The FERF publication, Valuing Employee Stock Options and Other Share-Based Payments: Complying with FAS 123(R), was authored by Ronald D. Rudkin, Ph.D, and Rod A. Parsley, both of Analysis Group Inc., a financial consulting firm. According to the authors, "FAS 123(R) is expected to have profound effects on firm's financial statements, the manner in which companies value share-based payments and the types of instruments included in compensation programs."

Key points from the FERF report on implementing FAS123(R):

1. Conduct a thorough review of FAS 123(R). Rudkin and Parsley suggest initiating the implementation process at least four months prior to the effective date of FAS 123(R) to have time for at least one evaluation by the company's auditors prior to implementation.

2. Consider alternatives for using in-house expertise, outsourced consultants or a combination of the two, to provide valuation. Complexity, time requirements and cost of developing a model in-house would be considerations, as well as the importance of being able to assert that the firm's fair value estimates were developed by an objective third party.

3. Select the most appropriate valuation model for your company. Firms are responsible for selecting a valuation model that incorporates the substantive characteristics (blackout dates and performance conditions) of the instrument being valued, based on generally accepted economic and financial theory. Rudkin says, "This is a significant departure from FAS 123, which required firms to use one of two types of models."

4. Calculate model inputs. FAS 123(R)'s input guidelines are significantly more challenging than the old guidelines under FAS 123. Inputs are to be "forward looking" and reflect changes expected to occur during the instrument's contractual life (if a lattice model is used) or the expected term of the option (if a closed-form model such as Black-Scholes is used).

In addition, multiple estimates will need to be developed in order to reflect differences in factors influencing exercise and termination behavior (employee characteristics), for key inputs such as "expected term" and "departure rate."

5. Determination of vesting schedule and attribution method. Companies will need to determine the most appropriate combination of vesting schedule (cliff versus graded vesting) and attribution method (straight line for cliff vesting, or for instruments subject to graded vesting, the choice of either straight line or the FIN 28 "tranche-by-tranche" method). These decisions can have a significant effect on both the timing and magnitude of compensation expenses.

6. Changes in the type of equity compensation. Because of the changes associated with FAS 123(R), the authors recommend that companies take a fresh look at their compensation strategy, including the types of equity-based instruments offered to employees.

Many firms are already moving away from standard at-the-money options and toward restricted stock and non-traditional equity-based instruments. These instruments have the potential to reduce compensation expense, improve efficiency by minimizing the difference between the cost to the company and the value to the employee, and better align employee compensation with shareholder interests.

"However, when adopting non-traditional equity-based instruments, it is important that the valuation models used by the firm and by its advisors are capable of addressing their complex features," cautions Rod Parsley.

Further detail on the implementation guidance above can be found in the FERF report mentioned earlier, Valuing Employee Stock Options and Other Share-Based Payments: Complying with FAS 123R, which was published in February. It is available for purchase (with discounts to FEI members) through the online bookstore at: www.fei.org/rfbookstore/.

The Securities and Exchange Commission (SEC) is expected to issue guidance this spring. Check www.sec.gov.

Additional information on this topic is available in an earlier report authored by Rudkin and Parsley and published by FERF in June 2004 entitled, Valuation of Employee Stock Options and Other Equity-Based Instruments, which is also available in FERF's online bookstore. Further information about FERF's subscription program is available at: www.ferf.org.

Edith Orenstein ([e-mail]) is Manager of Research for Financial Executives Research Foundation (FERF).

contributed by FERF