PCAOB Audit Practice Alert: Timing and Accounting for Stock Options Grants
July 28, 2006
FEI Summary
On July 28, 2006, the Public Company Accounting Oversight Board (PCAOB) announced issuance of an Audit Practice Alert entitled, “Matters Relating to Timing and Accounting for Options Grants (the “APA”). The APA was issued two days after the U.S. Securities and Exchange Commission (SEC) approved final rules for disclosure of Executive Compensation, including disclosures relating to options grants.
Why the APA was issued
- PCAOB states in its press release the APA was prompted by recent reports and disclosures about issuer practices relating to granting of stock options, including "backdating" of such grants, and that these reports and disclosures indicate some issuers’ actual practices in granting options might not have been consistent with the manner in which the transactions were initially recorded and disclosed.
- PCAOB also notes some issuers have announced restatements of previously issued financial statements as a result of these practices.
- In addition, PCAOB notes, “some of these practices could result in legal and other contingencies that may require recognition of additional expense or disclosure in financial statements.”
- The APA, prepared by the PCAOB’s Office of Research and Analysis in conjunction with the PCAOB’s Office of Chief Auditor, “advises auditors that these practices may have implications for audits of financial statements or of internal control over financial reporting (ICFR) and discusses factors that may be relevant in assessing the risks related to these matters.”
Examples of options timing practices (not all-inclusive) noted in APA
§ The application of provisions in option plans that allow for:
o the selection of exercise prices based on market prices on dates earlier than the grant date, or
o the award of options that allow the option holder to obtain an exercise price equal to the lower of the market price of the stock at the grant date or during a specified period of time subsequent to the grant date.
§ Preparation, or subsequent modification, of option documentation for purposes of indicating a lower exercise price than the market price at the actual grant date.
§ Treating a date as the grant date when, in fact, all of the prerequisites to a grant had not yet occurred.
General matters for auditor consideration identified in APA
§ Auditors planning or performing an audit should be alert to the risk that the issuer may not have properly accounted for stock option grants and, as a result
o may have materially misstated its financial statements or
o may have deficiencies in its ICFR.
§ For audits currently underway or to be performed in the future, the auditor should
o acquire sufficient information to allow him or her to assess the nature and potential magnitude of these risks, and
o must use professional judgment in
§ making these assessments and
§ determining whether to apply additional procedures in response.
§ In making these judgments, the auditor should be mindful of:
o Accounting standards, including FAS123R, FAS123, and APB 25 [See NOTE], in accounting for.
§ discounted options
§ variable plans
§ contingencies (including under FAS 5 [See NOTE], and
§ tax effects
o Consideration of materiality, and
o Possible illegal acts
APA provides detailed guidance for auditors to consider effects of options-related matters in:
§ planned or ongoing audits,
§ auditor involvement in registration statements, and
§ previously issued opinions (reference is made to AU sec. 561, “Subsequent Discovery of Facts Existing at the Date of the Auditor’s Report.”)
NOTE: FASB and APB Standards abbreviated above are: Financial Accounting Standards Board (FASB) Statement No. 123R, Accounting for Share-Based Payment (FAS123R), Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), FAS No. 123, Accounting for Stock-Based Compensation, FAS 5, Accounting for Contingencies
Prepared July 28, 2006 by Edith Orenstein (eorenstein@FinancialExecutives.org), Director, Technical Policy Analysis, Financial Executives International (FEI). This summary does not represent FEI opinion, unless specifically noted above