FAS 123(R) and SAB 107 Disclosure Checklist

Steve Quinlivan and Jeff Cotter
October 14, 2005 — 2,501 views  
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As companies move toward the required adoption of Financial Accounting Standard 123(R) (FAS 123(R)), early thought should be given to disclosures to be made in the Form 10-K immediately preceding the adoption of FAS 123(R) and in the first Form 10-Q following adoption.

In the immediately preceding 10-K, disclosure of the anticipated effect of the required adoption of FAS 123(R) will need to be made. The 10-K will be closely followed by announcement of the first quarter results of operations and the resulting 10-Q to which FAS 123(R) will have become operative. As a result, a high level of accuracy should be attained in the 10-K disclosure. Public companies should also consult Staff Accounting Bulletin No. 107 (SAB 107), which sets forth the SEC’s views on financial statement disclosure and other disclosures, such as MD&A. The quantum of disclosures required by SAB 107 may influence a public company’s modifications to benefit plans in anticipation of FAS 123(R) and other actions it takes to implement FAS 123(R).

Currently Effective Disclosures

Prior to adoption of FAS 123(R), registrants should make the disclosures required by SAB Topic 11M, Disclosure of the Impact That Recently Issued Accounting Standards Will Have On the Financial Statements of a Registrant When Adopted in a Future Period, in interim and annual financial statements. These disclosures are required in Form 10-Ks and Form 10-Qs filed prior to adoption, and one would expect the disclosures to become more refined as the adoption date draws near. Topic 11M says the following disclosures should generally be considered:

• A brief description of the new standard, the date that adoption is required and the date that the registrant plans to adopt, if earlier.

• A discussion of the methods of adoption allowed by the standard and the method expected to be utilized by the registrant, if determined.

• A discussion of the impact that adoption of the standard is expected to have on the financial statements of the registrant, unless not known or not reasonably estimable. In that case, a statement to that effect may be made.

• Disclosure of the potential impact of other significant matters that the registrant believes might result from the adoption of the standard (such as technical violations of debt covenant agreements, planned or intended changes in business practices, etc.) is encouraged.

Disclosures in MD&A After Adoption

SAB 107 suggests information should be included in the MD&A that will help users understand the comparability of financial statements before and after the adoption of FAS 123(R). SAB 107 suggests this would include the following:

• Transition method selected (e.g., modified prospective application or modified retrospective application) and the resulting financial statement impact in current and future reporting periods.

• Method utilized by the company to account for share-based payment arrangements in periods prior to the adoption of FAS 123(R) and the impact, or lack thereof, on the prior period financial statements.

• Modifications made to outstanding share options prior to the adoption of FAS 123(R) and the reason(s) for the modification.

• Differences in valuation methodologies or assumptions compared to those that were used in estimating the fair value of share options under FAS 123(R).

• Changes in the quantity or type of instruments used in share-based payment programs, such as a shift from share options to restricted shares.

• Changes in the terms of share-based payment arrangements, such as the addition of performance conditions.

• A discussion of the one-time effect, if any, of the adoption of FAS 123(R), such as any cumulative adjustments recorded in the financial statements.

• Total compensation cost related to non-vested awards not yet recognized and the weighted average period over which it is expected to be recognized

SAB 107 also suggests that the following be disclosed:

• Volatility. FAS 123(R) requires disclosure in financial statement footnotes of the expected volatility and the related estimation methods used. Accordingly, the staff expects that at a minimum an issuer will disclose in its financial statement footnotes how the company determined its expected volatility assumption. For example, at a minimum, the staff would expect a company to disclose whether it used implied volatility, historical volatility, or a combination of both. In addition, companies should consider the applicability of SEC Release No. FR-60 and Section V, "Critical Accounting Estimates," in SEC Release No. FR-72, regarding critical accounting policies and estimates in MD&A. The staff would expect such disclosures to include an explanation of the method used to estimate the expected volatility of a company’s share price. This explanation generally should include a discussion of the basis for the company’s conclusions regarding the extent to which it used historical volatility, implied volatility or a combination of both.

• Classification of Expense. The staff believes a company should present the expense related to share-based payment arrangements in the same line or lines as cash compensation paid to the same employees. The staff believes a company could consider disclosing the amount of expense related to share-based payment arrangements included in specific line items in the financial statements. Disclosure of this information might be appropriate in a parenthetical note to the appropriate income statement line items, on the cash flow statement, in the footnotes to the financial statements, or within MD&A.

• Variations in Expense. The staff understands that expenses from share-based payments might vary in different ways and for different reasons than would other expenses. In particular, the staff believes investors would be well- served by disclosure in MD&A that explains the components of the company’s expenses, including, if material, identification of the amount of expense associated with share-based payment transactions and discussion of the reasons why such amounts have fluctuated from period to period.

Financial Statement Disclosure in First Form 10-Q

Finally, SAB 107 also states that all disclosures required by FAS 123(R) should be made in the first Form 10-Q filed following adoption. FAS 123(R) requires detailed disclosures that go beyond what many would consider appropriate for quarterly financial statements. However, Rule 10.01(5) of Regulation S-X supports the staff position in SAB 107, stating: "Disclosures should encompass, for example, significant changes since the end of the most recently completed fiscal year in such items as: accounting principles and practices . . ."

Further, the sample disclosure included in FAS 123(R) assumes that compensation costs have been recognized in accordance with FAS 123(R) for several years. As such, the sample disclosure may not be a useful model. In addition, companies will need to continue to disclose the tabular presentation required by FAS 123 (i.e., the pro forma effect on income if options had been expensed) for comparative periods prior to the adoption of FAS 123(R), unless the entity elects to restate prior periods using the modified retrospective transition method. As such, and for the reasons also set forth above, early attention should be paid to the disclosures to be included in the first Form 10-Q after the required adoption of FAS 123(R).

This article was originally printed in Leonard, Street and Deinard's Securities and Mergers & Acquisitions newsletter.

Steve Quinlivan and Jeff Cotter

Leonard, Street and Deinard