Share-Based Compensation Update to SEC’s Financial Reporting Manual

In February 2014, the Securities and Exchange Commission’s (SEC) Division of Corporation Finance updated Section 9520 of its Financial Reporting Manual. Section 9520 is part of Topic 9, which provides guidance for Management’s Discussion and Analysis of Financial Condition and Results of Operation, or MD&A. In particular, Section 9520 relates to the disclosure of critical accounting estimates for share-based compensation in the prospectus for a company’s initial public offering (IPO).

As discussed in Section 9520, estimating the fair value of underlying shares of a pre-IPO company can be highly complex and subjective because the shares are not yet publicly traded. Therefore, such estimates are often considered critical, prompting enhanced discussion and analysis. 

Before the update, Section 9520 indicated that when estimates used to determine stock-based compensation were considered critical,  the SEC’s practice was to request that companies consider providing a table that disclosed certain detailed information about the award instruments. For instance, the tabular disclosure would specify (1) the number of instruments granted during the twelve-month period preceding the most recent balance sheet date, (2) the exercise price of these instruments, (3) the fair value of the stock underlying the instruments, and (4) the fair value of these instruments. Additionally, under the previous Section 9520, companies were asked to consider providing narrative disclosures that would describe factors contributing to any significant changes in the fair values of the underlying stock during the twelve-month period preceding the most recent balance sheet date and any changes in assumptions that affected the fair value of the underlying stock.

As updated, Section 9520 deletes the reference to the tabular and narrative disclosure. Instead, Section 9520 indicates that when a company is performing estimates of the value of share-based compensation, the  SEC will consider whether the company is providing the following disclosures in its IPO prospectus relating to critical accounting estimates:

1. The methods that management used to determine the fair value of the company’s shares and the nature of the material assumptions involved.
2. The extent to which such estimates are considered highly complex and subjective.
3. The fact that once the company’s shares begin trading, the estimates will no longer be necessary to determine the fair value of any new awards.

As a result, revised Section 9520 contemplates less detailed disclosure regarding the methodology used to estimate the values of pre-IPO share-based compensation awards. However, Section 9520.2 specifically notes that the SEC may issue comment letters asking a company to explain the reasons for valuations if the valuations appear unusual. For instance, an abnormally steep increase in the fair value of the underlying shares leading up to the IPO could possibly trigger such a comment. According to the Financial Reporting Manual, the intent of such comments is to draw further analyses from the company that will help the SEC confirm whether the company has appropriately accounted for the share-based compensation. In addition to critical accounting estimates, revised Section 9520 indicates that the SEC will also consider whether the MD&A relating to share-based compensation sufficiently discloses the possible effects of any known trends or uncertainties, such as the impact on operating results and taxes.

Although the Financial Reporting Manual is informal and creates no substantive disclosure rules, it serves as a useful resource for practitioners who are assisting companies in the preparation of SEC filings. Accordingly, when preparing an IPO prospectus, a company should consider the updated guidance relating to share-based compensation. Notwithstanding this update, in some cases, such as when the IPO price of a company’s equity securities significantly exceeds their estimated fair value shortly before the IPO, a company may decide that the tabular and narrative disclosure similar to that previously suggested in prior Section 9520 provides the SEC with the desired assurance that the company has properly accounted for share-based compensation expense. Indeed, by preemptively providing the SEC with such detailed information, the company may avoid delays resulting from comment letters.

 

Topics:  Equity Compensation, Executive Compensation, IPO, SEC, Stocks

Published In: General Business Updates, Finance & Banking Updates, Securities Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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