Two Step's Private Company Equity Management Blog

On June 5th, John W. White, Director, Division of Corporation Finance, U.S. Securities & Exchange Commission, testified before the U.S. Senate Permanent Subcommittee on Investigations.  He covered a wide range of issues concerning stock options, executive compensation disclosure, option backdating, and FAS 123R.

In his testimony, White candidly admitted two areas of failure.  First, he stated that while Section 162(m) (added to the IRS Code by the Omnibus Reconciliation Tax Act in 1993) had been intended to curtail excessive compensation (in excess of $1 million) to top executives, instead it simply moved compensation from cash to stock options which were exempt from Section 162(m).  He quoted SEC Chairman Christopher Cox from his testimony to the Senate in 2006 when Cox admitted: “the stated purpose[of Section 162(m)] was to control the rate of growth in CEO pay. With complete hindsight, we can now all agree that this purpose was not achieved.”

And second, he acknowledged that the changes to the executive disclosure requirements for proxy statements added at the end of 2006were the first “significant revisions of its rules for executive and director compensation disclosure in more than thirteen years.”  He summed up by stating: “Simply put, the disclosure required of companies in their public reports failed to keep pace with changes in the marketplace.”

After these admissions, he went on in a good natured way to discuss some of the ways in which the disparity between the accounting treatment for tax and financial reporting of options, while potentially reduced, continues to exist even after the changes introduced by FAS123R which requires expensing of stock options.  A few segments from this part of his testimony follow:

… comparing the financial reporting and tax systems is a bit like comparing apples to oranges, it is more complicated than that. For the years prior to 2006, before FAS 123R was effective for most companies, the comparison was more like apples to automobiles. How a company calculated stock option compensation costs was based on a set of rules that differ significantly from those in place today. Before FAS 123R, most companies expensed options in accordance with Opinion 25, which in most cases meant that no expense was recognized because the option was granted at-the-money … Comparing how a company calculates stock option compensation costs and tax deductions for those costs after FAS 123Rtakes us back to the apples to oranges analogy.

“The compensation expense a company recognizes in its financial statements is tied to the fair market value of the option at the time of grant, whereas the tax deduction is tied to an option's intrinsic value at the exercise date....

“The adoption of FAS 123R by most companies in 2006 will no doubt reduce the book-to-tax differential, but the magnitude and timing of this impact is difficult to predict. That is because, under FAS 123R, companies will recognize the expense associated with an option grant in the financial statements (amortized over the vesting period) prior to any tax deduction being reflected on exercise of that option. If the tax system for companies was changed to bring it into conformity with the financial reporting system, one effect would be to accelerate the timing of a company's tax deductions.”

His full June 5th testimony can be read at: www.sec.gov/news/testimony/2007/ts060507jww.htm

I highly recommend reading his testimony.  It’s like a primer covering historical aspects of stock options, current stock option backdating issues, new executive compensation disclosures, FAS 123R, and tax and financial reporting.  Whether you’re a novice or an expert, looking to learn more about options or just learn the SEC’s latest thinking, you can get through it in one cup of coffee.   

This article was contributed by Bruce Brumberg
Editor-in-Chief and Co-Founder, myStockOptions.com

In mid-July the IRS released an internal Industry Director Directive on backdated options (the document is dated June 15, 2007), making  this a "Tier I" issue for IRS field agents. The memorandum shows the importance that the IRS, in its tax audits of companies and individuals, is placing on the topic of backdating.

This brief document (highly readable for the IRS) highlights a few of the tax issues the IRS will focus on:

• ISOs that are masquerading as NQSOs because the options were granted at less than the fair market value on the grant date, even if this was a mistake you weren't aware of at grant or at exercise
• Discounted stock options that trigger extra taxes and penalties under Section 409A of the tax code
• Options that no longer fit into the "qualified performance-based compensation" exception to the $1 million deduction limit for compensation paid to the CEO and the other very highly paid executives under Internal Revenue Code Section 162(m)

In the checklist attached to the directive, the IRS says that in audits it wants your company to provide details of any backdated options you may have exercised.

For details about the impact of backdating on rank-and-file employees, and the related taxation, see the relevant FAQ on myStockOptions.com.

In the July issue of The CPA Journal, professors Nancy T. Hill, John E. McEnroe, and Kevin T. Stevens of the College of Commerce at DePaul University, surveyed 2,700 CPAs engaged in audit, tax and advisory services to assess their views of Sarbanes-Oxley (SOX) now that it has been five years since adoption.  They found (based on 549 responses) that “differences in opinion seem to exist in all ranks and may indicate just how complex and far-reaching the implementation of SOX is … It could be the case that the day-to-day implementation issues at a particular client make it difficult to see the more intangible benefits that SOX may offer to the investing community.”

There was one partner from a big-four accounting firm who was quoted saying that SOX is a good thing and he forewarned that SOX was something that should not be ignored by those organizations that are not presently required to comply.

“The large majority of internal controls should be in place, regardless of public reporting requirements, to answer that the company is safeguarding its assets properly and that the larger organization is functioning in accordance with senior management’s and the board’s intent.  These controls must be independently reviewed or surely over time they will erode and become useless.  Hence, the bulk of the cost of a good system of internal control is part of the cost of doing business responsibly and should not be attributed to SOX!  Small companies have just as much responsibility to safeguard shareholder assets as do large ones.  The rewards to management for good results are huge.”

On the other side of the coin, a manager of a Big Four firm believes the costs outweigh the benefits:

“The only significant benefits to SOX have been to make auditors realize that their clients are the board of directors/shareholders and not management and [to eliminate] independence issues associated with many non-audit services that were obvious conflicts.  The remainder of SOX has resulted in minimal benefit (and possibly a net cost) to the public shareholders.  In my experience, SOX has resulted in a lot of meaningless flowcharts, checklists, procedures, etc.”

It’s clear that SOX is not going away.  In fact, we’ve seen no further easing of Section 404 requirements for small public companies and we’ve already seen it creeping into the lives of controllers and financial executives at non-public companies.  What if going public is on the horizon for the next year or two or five years out?  What will be the new requirements of your next round of financing?  When should SOX become an issue?  Wouldn’t it be better to consider your compliance issues now so it will not be an issue down the road?

As these two articles suggest -- Sarbanes-Oxley for Private Companies by Foley & Lardner and For Small Business, Procrastination is a Risky Option from the Boston Business Journal -- wouldn’t investors be more willing to become involved in a company that is already complying with the most important aspects of SOX than one that is ignoring it or hesitant to implement some of its best practices?