Derivatives Implementation Group

Statement 133 Implementation Issue No. G1

QUESTION

May a public company designate a cash-settled purchased call option indexed to its own stock (that is classified as an asset) as a hedging instrument in a cash flow hedge of the exposure to variability in expected future cash flows associated with unrecognized, nonvested stock appreciation rights (SARs)?

BACKGROUND

An SAR is an award entitling employees to receive cash, stock, or a combination of cash and stock in an amount equivalent to any excess of the fair value of a stated number of shares of the employer’s stock over a stated price. Various factors, including the method of settlement, determine whether the issuer accounts for the SAR under FASB Statement No. 123 (revised 2004), Share-Based Payment, as a liability or an equity instrument. For a public company, an SAR that is a liability is adjusted to fair value each reporting period rather than to an amount equivalent to the excess of the then current fair value of the stated number of shares over a stated price (that is, the intrinsic value). An SAR generally has vesting provisions, for example, pro rata vesting over a requisite service period. Compensation cost is recognized over the service period for the portion of the SAR that is not yet vested (that is, for which the requisite service period has not been rendered) based on changes in the fair value of the SAR during that period.

RESPONSE

Yes, to the extent that vesting of the SARs is probable, a purchased call option indexed to a company’s own stock that is recorded as an asset and accounted for as a derivative under Statement 133 may be designated as the hedging instrument in a hedge of cash flow variability of expected future obligations associated with unrecognized, nonvested SARs. (An unrecognized, nonvested SAR relates to the portion of the SAR liability that has not yet been accrued. It does not refer to future fair value changes in the recognized liability for the vested portion of the SAR.) Presumably, when using this strategy, hedge effectiveness typically would be assessed based on changes in the entire value of the purchased call option, rather than just the intrinsic value of the option because the fair value of the unrecognized, nonvested SARs likewise consists of a time value portion and an intrinsic value portion.

A purchased call option on a company’s own stock may be designated as a hedge of the cash flow variability of expected future obligations associated with unrecognized, nonvested SARs if the option is classified as an asset in the company’s financial statements and the option is a derivative contract subject to Statement 133. Paragraph 11(a) of Statement 133 indicates that contracts that are issued or held by an entity that are both indexed to its own stock and classified in stockholders’ equity in its statement of financial position are not considered to be derivative instruments for the purposes of the Statement. FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, and EITF Issue No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock,” as partially nullified by Statement 150, contain the relevant guidance for determining whether a contract indexed to a company’s own stock involving a choice of settlement methods is classified as an asset or liability or an equity instrument. Only contracts that are classified as an asset or liability as required by Statement 150 or Issue 00-19 and are accounted for as derivative contracts under Statement 133 are permitted to be designated as hedging instruments in a cash flow hedge of unrecognized, nonvested SARs. Other types of contracts covered by Issue 00-19 are initially measured at fair value and may be either reported in permanent equity with an amount equal to the required cash redemption amount transferred to temporary equity or reported in permanent equity (without such a transfer to temporary equity). Because of their equity classification, those contracts would not be considered derivatives under Statement 133 and would not be eligible to be designated as hedging instruments.

Because an unrecognized, nonvested SAR results in exposure to cash flow variability of expected future obligations that affects reported earnings, it is eligible to be designated as being hedged. An SAR that is recognized as a liability may not be designated as being hedged in a cash flow hedge because the hedged cash flow variability in a recognized SAR relates to a liability that is remeasured with changes in fair value reported currently in earnings.

The hedge of exposure to cash flow variability in an unrecognized, nonvested SAR could be expected to be highly effective. The company’s stock price is the underlying for both the unrecognized, nonvested SAR and the option on the company’s own stock. Changes in fair value of the purchased call option on the company’s own stock would be recorded in other comprehensive income consistent with paragraph 30 of Statement 133. As required by paragraph 31, the amount in other comprehensive income would be reclassified into earnings concurrent with the recognition in earnings of compensation cost on the SAR that relates to those fair value changes that occurred during the hedge period over the requisite service period.

EFFECTIVE DATE

The revisions made on December 15, 2004, reflect the issuance of Statement 123(R). The effective date of the December 15, 2004, revisions to the implementation guidance in this Issue for each reporting entity is the first day of the fiscal quarter in which that entity initially adopts Statement 123(R).

The above response has been authored by the FASB staff and represents the staff’s views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.