Implementing 123(R), uncertain tax positions and GAAP hierarchy.

Implementation issues associated with FASB Statement No. 123(R), Share-Based Payment, is among the top matters on the financial reporting agenda for many companies. And, while that is quite significant, other issues on the standard-setting horizon can potentially affect financial reporting in the foreseeable future. Two of these projects nearing completion are the Financial Accounting Standards Board's (FASB) Proposed Interpretation, Accounting for Uncertain Tax Positions and Proposed Statement, The Hierarchy of Generally Accepted Accounting Principles.

Implementing Statement 123(R) Issues Companies have been required to provide information on a fair-value-based approach about their share-based payment arrangements since 1995. With the impending requirement to include this information in the financial statements, coupled with the changes made by FASB in adopting Statement 123(R), many implementation issues have arisen as companies prepare for its adoption.

Calendar-year Securities and Exchange Commission (SEC) registrants are not required to adopt the standard until Jan. 1, 2006. Those companies must begin to consider the implications of the statement on their financial reporting processes for many reasons, including, but not limited to: 1) "SAB 74" disclosure requirements; 2) internal control over financial reporting/Section 404 reporting requirements; and 3) the effect on future financial statements from awards granted prior to adoption of Statement 123(R).

Preparers and others have also identified a number of implementation issues associated with adoption. Among the more significant are:

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Determining the grant date: Some companies may need to consider making revisions to their grant process to provide for more timely notification of the terms and conditions of the awards to their employees;

Determining the pool of additional paid-in capital available to absorb tax "shortfalls" from option exercises: Because Statement 123(R) requires companies to use "excess tax benefits" from awards granted pursuant to Statement No. 123, Accounting for Stock-Based Compensation, (awards issued in periods beginning after Dec. 15, 1994), companies need to determine the available pool of excess tax benefits available for offset for any award exercises where the amount of the tax deduction is less than the compensation cost recognized for financial reporting purposes;

Estimation of forfeitures: Unlike Statement 123, which permitted companies to reflect forfeitures as they occurred, Statement 123(R) requires companies to estimate forfeitures in determining the amount of compensation cost to recognize each period. As a consequence, companies will need to develop, monitor and revise (as needed) estimates of forfeitures during the requisite service period of the award;

Attribution period of policy for awards: For awards with graded vesting schedules (an award vests 25 percent per year over a four-year period), companies are permitted as an accounting policy election to recognize compensation cost ratably or by vesting tranche. However, companies that elect to recognize awards ratably are subject to a "floor" (the cumulative compensation cost cannot be less than the awards that are legally vested at any point in time). Because forfeitures are likely to occur throughout the entire service period, the "floor" in the early periods may be greater than the ratable portion of the period, requiring that a greater amount of compensation be recognized during the earlier part of the service period.

Additionally, Statement 123(R) clarifies that awards that provide for immediate vesting (or continuing vesting) of unvested awards when an employee retires must be recognized from the grant date to the date where an employee is retirement-eligible. For such awards, a company with such a policy may find that it has a number of different requisite service periods (some employees are retirement-eligible, resulting in immediate recognition; others may become retirement-eligible six months after the grant date, and others may become retirement-eligible 18 months after grant date, etc.);

Classification of awards as liability or equity: Because Statement 123(R) has a more expansive approach to classifying an award as a liability, some awards that previously were equity-classified may become liability-classified upon adoption of Statement 123(R). Additionally, for those awards that were previously liability-classified (a cash-settled SAR), the award must be re-measured from intrinsic value to fair value upon adoption of Statement 123(R);

Valuation issues: While options are valued using at least six inputs (stock price, exercise price, expected volatility, expected term, expected dividend rate and risk-free rate), the two key drivers of the option's value are the expected volatility and the expected term. Companies will need to carefully analyze their historical experience and other relevant information (implied volatility for traded options) and support their assumptions that are used to value options.

Additionally, companies have begun granting more awards with market conditions (comparison of the company's total shareholder return to the total shareholder return for a group of peer companies). Such awards often must be valued using more sophisticated valuation approaches (Monte Carlo simulation) than the Black-Scholes-Merton model; and

Accounting for compensation cost (expense or capitalize): Share-based payment compensation cost should be accounted for in the same way as cash compensation. For many companies, some portion of the share-based payment cost should be included in one or more balance sheet amounts such as inventory, property, plant and equipment (for self-constructed assets), software costs, contract accounting costs, deferred acquisition costs or loan origination costs.

Uncertain Tax Positions

FASB has proposed a two-step model for recognition and derecognition of uncertain tax positions. Under the proposal, the tax benefit of an uncertain tax position would not be recognized unless it is "probable" that the tax position would be sustained upon examination by the tax authority. In the determination of "probable," the likelihood that the position will be examined or challenged by the tax authority is not considered.

For those uncertain tax positions that initially meet the probable threshold resulting in the recognition of the tax benefit, the benefit would not be derecognized unless it becomes more likely than not that the benefit will not be sustained. If a tax benefit does not meet the threshold for recognition, the company may need to record a tax liability for the tax effect on the difference between the "as-filed" amount and the tax benefit recognized.

FASB proposed that the Interpretation would be effective for 2005 reporting for calendar year-end reporting. However, the board has decided to hold a roundtable meeting to discuss the proposal (in addition to the comment letter process) so it appear unlikely that the Interpretation will be finalized in time to apply for 2005 year-end reporting.

GAAP Hierarchy

FASB has proposed bringing the GAAP hierarchy--currently found in the auditing literature (AU 411)--into the accounting literature. The board indicated in its proposal that this is the start of a process that will eventually lead to a hierarchy with two levels: authoritative and nonauthoritative. In the meantime, the board's proposal retains the multi-level hierarchy and updates the previous hierarchy to include more recent types of standards such as FASB Staff Positions (FSPs) and Derivatives Implementation Group (DIG) issues.

While this proposal is unlikely to have a significant impact on most companies' current financial reporting practices, the long-term consequences (including moving to a two-tiered hierarchy) from this and related projects (codification and conceptual framework projects) could affect future financial reporting practices. As a result, this project bears watching as the board begins to lay out its roadmap for the future.

Contributed by Paul Munter, partner in the Professional Practice of KPMG LLP in New York City. He can be reached at [e-mail].