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Changes to stock option plans and allocating basis to assets and liabilities acquired in a leveraged buyout.

This month's column discusses consensuses reached by the FASB Emerging Issues Task Force EITF or task force) concerning accounting for changes to fixed employee stock option plans resulting from an eqity restructuring, and concerning allocating basis to individual assets and liabilities acquired in certain leveraged buyout transactions.

EITF Abstracts, copysighted by the FASB, is available in softcover a loose-leaf versions a may be obtained by contacting the FASB order department at 401 Merfitt 7, .PO. Box 5116, Norwalk, Connecticut 06856-5116. Phone: (203) 847-0700. ISSUE NO. 90-9

This EITF issue, Changes to Fixed Employee Stock Option Plans as a Result of Equity Restructuring, illustrates the applicability of APB Opinion no. 25, Accounting for Stock Issued to Employees, when employers change the provisions of stock option plans following a spin-off or recapitalization.

While stock option grants generally contain antidilution provisions that explain how the exercise price and number of shares will be adjusted if the employer declares a stock dividend or stock split, most plans do not contain provisions for similar adjustments if an equity restructuring occurs. These special adjustments may include

n Reduction of the exercise price.

n Reduction of the exercise price and an increase in the number of shares under option.

* Cash payments to option holders.

* Issuance of stapled or nonstapled options after a spin-off-.

* Stapled options (options cannot be

separately exercised)-When exercised,

these options entitle the

holder to (1) a share of the continuing

entity and (2) the same number

of shares of the spun-off entity received

by each owner of a continuing


* Nonstapled options (options can

be separately exercised)-Entitle

the holder to a separately exercisable

option in the spun-off entity in

addition to the option in the continuing


* Equity restructurings include spin-offs and recapitalizations in the form of special large and nonrecurring dividends. A spin-off can take one of two forms:

* A corporation transfers a portion of its assets to a newly formed corporation in exchange for the latter's capital stock. The new corporation's capital stock then is distributed to the shareholders of the old corporation as a property dividend.

* A parent corporation distributes the stock of an existing subsidiary to the shareholders of the parent.

* Accounting issues. The three issues considered by the task force were

1. Do changes to a stock option plan resulting from an equity restructuring trigger a new measurement date?

2. If so, how would the additional compensation expense be measured?

3. Would an equity restructuring trigger a new measurement date if the fixed stock option grant already contains provisions for adjustments to the option terms in that event?

Arguments: On the issue of whether changes to the plan due to the restructuring would result in a new measurement date, some link the need for a new measurement date with the effect of the plan adjustments on the option holder's economic position.

One view is plan changes following a restructuring do nothing more than restore the option holder to the same economic position held prior to the restructuring. Proponents of this view see no substantive difference between these stock option adjustments and those made for stock dividends and stock splits. In practice, those equity transactions do not create a new measurement date.

Others contend the economic position of the option holder has changed because a restructuring and simultaneous adjustment of existing stock options often create a different economic entity in which the option holder now has the opportunity to invest. For example, in a spin-off, the original option no longer has the economic value it had prior to the restructuring, because the entities have been separated and the sum of the separate economic parts may not equal the original economic whole. The option holder's economic position may be improved or worsened depending on whether the spun-off entity was a poor or profitable performer.

If a new measurement date is appropriate, four different views arise as to how compensation should be measured at that date.

Some advocate a strict reading of Opinion no. 25 that, in their view, measures compensation expense by the difference between the current market value of the stock and the option price as of the new measurement date.

Others contend compensation expense shouldn't be determined based on market value appreciation prior to the restructuring date. T pose measuring the option value before and after the restructuring. The difference is the amount of compensation expense to recognize.

Others disagree and assert that option value is not used under existing guidelines for measuring compensation expense. They believe option valuation techniques are varied and unproven and could result in imprecise values.

Still others argue compensation should be measured as the amount related to the spun-off entity or other distribution made to option holders. The argue any compensation expense resulting from the restructuring comes from the spun-off entity-not from appreciation in value since the original grant date. Consensuses. The consensus reached by the task force links the required accounting to the method used by the employer to restore the option holder's economic position after the equity restructuring. The task force concluded a plan change resulting from an equity restructuring would not trigger a new measurement date, and therefore no additional compensation expense should be recognized, if the following criteria are met:

* The aggregate intrinsic value (difference between market value per share and exercise price) of the options immediately after the change is not greater than the aggregate intrinsic value of the options immediately before the change.

* The ratio of the exercise price per option to the market value per share is not reduced.

* The vesting provisions and option period of the original grant remain the same. For purposes of determining if the above criteria have been met, increases in market value attributable to events other than the equity restructuring should be excluded. The effects of such other events should be independent, determinable and verifiable to qualify for exclusion.

If all of those criteria are not met, compensation expense should be recognized and measured in accordance with the provisions of Opinion no. 25 but would not include any expense recorded at the original measurement date. To do so would result in a duplicate recognition of that cost. However, any compensation expense measured at the original measurement date but not yet amortized (recognized) as expense should not be reversed but rather should continue to be amortized.

To the extent cash or other consideration (excluding additional options issued that meet the specified criteria below) is provided to restore the option holder's economic position after an equity restructuring, compensation expense should be recognized when the employer agrees to do so.

If the fixed stock option grant also is changed and all the criteria above are met, no additional compensation expense beyond that related to the cash or other consideration would be recognized.

On the third issue, the task force decided the same accounting (discussed above) would apply whether the plan changes were made either in anticipation of the equity restructuring or after it.

The consensus includes examples illustrating the application of these accounting provisions. ISSUE NO. 90-12

This EITF issue, Allocating Basis to Individual Assets and Liabilities for Transactions within the Scope of Issue no. 88-16, supplements Issue no. 88-16, Basis in Leveraged Buyout Transactions (see JofA, Aug.89, page 24). EITF Issue no. 88-16 addresses how to determine the purchase price when NEWCO (a holding company with no substantive operations) acquires a 100% interest in OLDCO (an operating company) in a leveraged buyout transaction. EITF Issue no. 90-12 provides guidance on how to allocate that purchase price, or basis, to the individual assets and liabilities of OLDCO in order to prepare NEWCO's consolidated financial statements.

If NEWCO's basis is to be reflected at 100% fair value (no predecessor basis), the allocation process should follow the guidance in APB Opinion no. 16, Business Combinations, for acquisition of 100% of a subsidiary. However, under the consensus reached in EITF Issue no. 88-16, NEWCO's investment in OLDCO may often comprise part fair value and part predecessor basis (relating to the residual equity interests of certain NEWCO shareholders that were also OLDCO shareholders), but no guidance is available under that consensus on how to allocate that basis.

Accounting issues. The accounting issue is:

In a leveraged buyout transaction, how should NEWCO's investment in OLDCO be allocated to individual assets and liabilities of OLDCO if a portion of NEWCO's investment in OLDCO is valued at predecessor (historical cost) basis.

Arguments. The task force considered two alternative approaches: the partial purchase method and the full purchase method.

Under the partial purchase method, each asset and liability of OLDCO would be assigned an amount that is part fair value and part predecessor basis in the same proportions as NEWCO's investment in OLDCO. For example, if NEWCO's investment in OLDCO is based on 80% fair value and 20% predecessor basis, total net assets under the partial purchase method would equal [(80% x total fair value of OLDCO's net assets) + (20% x total book value of OLDCO's net assets)].

Under the full purchase method, the amount allocated to each identifiable asset or liability is based solely on the difference between the fair value of assets acquired and liabilities assumed and NEWCO's investment in OLDCO in accordance with Opinion no. 16.

Proponents of the partial purchase method believe leveraged buyout transactions that result in a partial carryover of basis are very similar to step acquisitions. (This premise was an important consideration in reaching the consensus for EITF Issue no. 88-16.) In a step acquisition, each asset and liability is revalued only to the extent of the ownership change resulting from that particular step. That accounting also is followed when a company acquires a majority interest, but not a 100% interest, in a subsidiary; the minority interest is not revalued. In addition, the proponents of the partial purchase method believe the manner in which NEWCO's investment in OLDCO is measured also should be used in measuring the individual assets and liabilities acquired.

Those supporting the full purchase method believe EITF Issue no. 88-16 addresses only the determination of the total investment in OLDCO (purchase price) but not the purchase price allocation. They claim the method of allocation should be consistent with the form of the transaccombination. In their view, not all leveraged buyout transactions are similar to step acquisitions, but based on EITF Issue no. 88-16, all leveraged buyout transactions should be accounted for under the same rules.

Application considerations. The partial purchase method can present application problems when OLDCO net operating loss carry forwards survive the acquisition by NEWCO. FASB Statement no. 96, Accounting for Income Taxes, specifies that, if not recognized at the acquisition date, the tax benefits of an acquired NOL carryforward recognized in the financial statements after the acquisition date shall first be applied to reduce to zero any goodwill and other noncurrent intangible assets related to the acquisition. Tax benefits from NOL carryforwards arising from prior year losses (not acquired NOL carryforwards) are accounted for as a reduction of income tax expense.

Under a literal interpretation of the partial purchase method, OLDCO's NOL carryforward would be split into two pieces: (1) an acquired NOL carryforward and (2) a carryforward arising from prior year losses applicable to the predecessor basis. The entire NOL carryforward is viewed as an acquired carryforward under the full purchase method, thus avoiding the problem.

Practice is uniform in reflecting retained earnings of zero in NEWCO's opening balance sheet, but conceptually it's inconsistent with the partial purchase method, which would seem to require carryover of OLDCO's retained earnings to the extent predecessor basis is used to determine NEWCO's investment in OLDCO. Similarly, the partial purchase method suggests a portion of OLDCO's accumulated depreciation be carried over to NEWCO. It would be unusual for the opening balance sheet of NEWCO to contain accumulated depreciation while also showing retained earnings. Such inconsistencies do not arise under the full purchase method.

Consensus. The task force concluded NEWCO's basis in OLDCO should be allocated to individual assets and liabilities in a manner similar to a step acquisition (that is, the partial purchase method).

The task force acknowledged, in practice, application of Issue no. 8816 sometimes results in zero retained earnings and accumulated depreciation after the allocation is made. This consensus is not intended to either require or change that practice.

However, the SEC observer noted the SEC staff would object to strict application of the partial purchase method if it split NOL carryforwards between those acquired and those arising from prior year losses (not acquired). They believe the entire NOL carryforward should be viewed as an acquired carryforward. n
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Article Details
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Author:Volkert, Linda A.
Publication:Journal of Accountancy
Date:Jul 1, 1991
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