U.S. Securities & Exchange Commission
SEC Seal
Home | Previous Page
U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks before the 2007 AICPA National Conference on Current SEC and PCAOB Developments


Mark Barrysmith

Professional Accounting Fellow, Office of the Chief Accountant
U.S. Securities and Exchange Commission

Washington, D.C.
December 10, 2007

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author's colleagues upon the staff of the Commission.


Good afternoon. Today I would like to first spend some time talking about market instruments used to measure employee share options under Statement 123R1 and then I'll move on to a couple matters related to the recognition and presentation of revenue.

Market Instruments

As many of you are likely aware, Zions Bancorporation and the staff of OCA have posted correspondence on our respective websites related to the progress that Zions has made in identifying a suitable market instrument for the purpose of measuring employee share-based payments. There has been some public debate on this topic and I'd like to take this opportunity to further explain the basis for some of our views on the instrument sold by Zions.

Let me first set the stage by pointing out that Statement 123R explicitly states that observable market prices of identical or similar equity or liability instruments in active markets are the best evidence of fair value and, if available, should be used as the basis for measuring share-based payment transactions with employees. The standard goes on to state that only in the absence of such observable market prices should other valuation techniques be used (e.g., modeling techniques).2 In the past, we have discussed ways in which one might design an equity or liability instrument in order to meet the measurement objective of Statement 123R; in particular, we have discussed: 1) instruments that layoff an employers' obligation related to share-based payments to a third party, and 2) instruments sold into an open market that track the payout to recipients of a share-based payment.

For simplicity, I'll refer to these two instruments as the layoff instrument and the tracking instrument. Some have rightfully pointed out that the tracking instrument has the potential to result in a downward biased price because the investor is motivated to pay as little as possible to acquire the instrument. Conversely, the layoff instrument has the potential to result in an upward biased price because the third party willing to assume the obligation to employees would be motivated to collect as much compensation as possible for assuming those obligations.

While we have discussed the particulars of instrument design with a number of registrants, as far as we know, Zions is the only company that has actually sold one of these instruments in a market place.3 What we have noticed is that the pricing biases associated with the layoff and tracking instruments have the potential to result in a substantial pricing spread between these two instruments.

Given that Statement 123R suggests the use of either equity or liability instruments to measure share-based payments and we understand the pricing biases associated with the layoff and tracking instruments, the questions that arise are: How large can the pricing spread between these instruments be, while still allowing for the assertion that both are representative of fair value? And, what price or range of prices within the spread is acceptable for the purpose of measuring employee share options?

The answers to theses questions are a matter of judgment. However, before you avail yourself of the notion of exercising boundless judgment, you need to be sure that your incentives are in order. If your motivation for using a market instrument to price employee share options is solely to produce lower compensation cost, your incentives are misaligned. In fact, if you're selling a tracking instrument, your incentives become aligned with that of the investors, which is unusual from an economic perspective (e.g., both the buyer and seller want a low price). If the seller in these situations does not create sufficient competition amongst buyers to mitigate the aligned incentives, it's very likely that the spread will be substantial; thereby, indicating a failure in either the instrument design or marketing approach. On the other hand, if your motivation is to get a more refined estimate of the fair value of your employee share options and you focus on instrument design and creating a competitive market for your instrument, we do believe that it is possible to reasonably minimize the pricing spread. The result of which may be a reasonable estimate of fair value based on the measurement objective of Statement 123R.

As an example, consider the Zions instrument. Between its first and second auction, Zions corrected flaws that were identified in its instrument design and market pricing mechanism. While the Company's stock price and model valuations remained relatively constant from the first auction to the second, the market clearing price for its instrument significantly increased in the second auction, as compared to the first. This translated to a substantial decrease in the estimated pricing spread.

Undoubtedly, a pricing spread between the layoff and tracking instruments will continue to exist for some time, especially given their early state of development. We would like to think that the spread will become smaller as a market for these instruments matures, but we will never know unless we continue to encourage further development in this area.

In the meantime, and in the absence of a secondary market for these instruments that supports the assumption that the clearing price is within a reasonable spread, companies will need to somehow benchmark the market clearing price for these instruments in relation to the estimated spread. Most recently, we have accepted a comparison to prices derived through broadly accepted modeling techniques as a means to benchmark. However, let me be clear in stating that we do recognize that the goal is to benchmark the clearing price and not to reconcile it to a model price. Provided that the spread is not affected by flaws in the instrument design or the issuer's marketing approach, we are willing to accept prices that fall within a reasonable spread, as Statement 123R does not specify which price or range of prices within the spread should be used to measurement share-based payments.

I'll now move on to a couple revenue topics:

Joint Steering Committees

We have received a number of questions concerning the accounting, or lack thereof, for participation on a joint steering committee that is established through a collaborative research and development arrangement in the biotechnology industry. As we understand, joint steering committees are often created through the collaborative R&D agreements to ensure that the parties reach the goals of collaboration. For example, joint steering committees may be tasked with developing and evaluating R&D, manufacturing and/or marketing for collaborative products.

The questions we have received centered on whether or not a vendor's participation on a joint steering committee constitutes a deliverable that ought to be considered in the context of EITF 00-21 and SAB 104.4 Our response has been that if a revenue contract or a related agreement requires the vendor to participate on the joint steering committee or if the vendor's failure to participate on the joint steering committee would question the vendor's performance under the arrangement, a presumption exists that the vendor's participation is obligatory and, therefore, should be evaluated as a potential deliverable under the arrangement.

In evaluating a collaborative arrangement, we generally start by identifying the vendor's rights and obligations under the arrangement. What we often find is that when a vendor is obligated to participate on the joint steering committee, they're obligated because they bring unique skills or know-how that will help the companies reach their collaboration goals. On the other hand, participation on the joint steering committee may be optional to the vendor. In these cases, participation may be viewed as a right from the vendor's perspective and a vendor may choose to participate, in light of the fact that their participation has no bearing on the arrangement fee, because they perceive participation as a means to govern or protect their interest.

When determining whether or not participation on a steering committee rises to the level of a deliverable, we would expect vendors to focus on the nature of their obligations under the arrangement. In recognizing that the term "deliverable" is not defined in accounting literature, we understand that some have considered a deliverable to be an item that 1) is explicitly referred to as an obligation of the vendor in a contractual arrangement, 2) requires a distinct action by the vendor, 3) if not completed by the vendor would result in a significant contractual penalty, or 4) if included or excluded from the arrangement would cause the arrangement fee to vary by more than an insignificant amount. We agree that these criteria are a helpful starting point and if you consider them in conjunction with my earlier presumptive statement and the discussion of inconsequential or perfunctory deliverables in SAB 104, we believe you'll find a general principle to follow. If based on this principle, a vendor concludes that participation on a joint steering committee rises to the level of a deliverable under the arrangement, we would expect that the deliverable be considered when the vendor assesses its allocation of revenue in a multiple element arrangement.

Product and Service Revenue

Moving on to a revenue presentation matter: Rule 5-03(b) of Regulation S-X requires, among other categories, that product and service revenue be displayed separately on the income statement. We realize that the question often arises as to how a vendor might adhere to the requirements of Rule 5-03(b) when the vendor is unable to separate its multiple element arrangement under the applicable revenue recognition guidance, such as EITF 00-21 or SOP 97-2.5,6

In recognizing the importance that investors may place on the ability to distinguish between product and service revenue and the added transparency this breakout can provide, we do not believe that a vendor should be precluded from separately displaying product and service revenue solely because they are unable to separate the deliverables for recognition purposes. I focus on product and service revenue, but our views may be applicable to other categories of revenue.

Accordingly, we would not object to the separate presentation of product and service revenue stemming from an arrangement that could not be separated for recognition purposes, when a vendor has a reasonable basis for developing a separation methodology, so long as the method of separating is consistently applied, clearly disclosed and not misleading.

When determining how to separate product and service revenue, we would expect registrants to apply reasonable judgment. Purely a systematic allocation with no basis other than consistency or one based on contractually stated amounts would seem insufficient. However, rational and systematic estimates may result in a reasonable allocation of product and service revenue. For example, estimates based on verifiable inputs used to derive a reasonable approximation of fair value of the deliverables. Likewise, for arrangements within the scope of SOP 97-2, a comparison to peers (i.e., third-party evidence of fair value) with sufficiently comparable product and/or service offerings or the use of the residual method when a vendor customizes its core product may result in a reasonable allocation of product and service revenue.

In summary, we believe that a vendor's basis for separately presenting product and service revenue will be a matter of judgment, dependent on the vendor's specific facts and circumstances, including consideration of which form of presentation would be most meaningful to investors. And once again, we are willing to accept the use of judgment, so long as the vendor's basis is reasonably grounded, consistently applied and clearly disclosed.

And, that concludes my prepared remarks.



Modified: 12/10/2007