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ASC 718: Equity Compensation
CPE March 17, 2010
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Agenda
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Overview
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Fair Value
Measurement
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Case
Study
Disclosure
Equity Compensation Overview
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Overview of
ASC 718
» Measure or estimate fair value
of share-based compensation
at grant date
» Record expense as services are
received (over requisite service
period)
Recognition Principle
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» Recognize compensation expense as the employee services
are received with corresponding increase in equity or liability
» Recognize cost as services are consumed
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Grant Date
As a “practical
accommodation”, grant
date is generally presumed
to be the date share-based
awards are approved
Equity vs. Liability Classification
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» Some instruments granted as equity compensation are
reported as liabilities, rather than equity, on the issuing
company’s balance sheet
» Specific rules are complex and beyond our scope today. In
general, if the issuing company is (or can be) required to settle
the obligation with cash, rather than the issuance of stock, the
instrument will be classified as a liability
 Stock Options: Equity
 Stock Appreciation Rights: Liability
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Fair Value
Based
» Equity compensation cost is
generally measured based
on the fair value of
instruments issued
» Sometimes “calculated
value” or “intrinsic value”
Fair Value
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» For most applications fair value is defined in
ASC Topic 820; not for accounting for equity
compensation
» Under Topic 718, fair value is defined as:
“The amount at which an asset (or liability) could be
bought (or incurred) or sold (or settled) in a current
transaction between willing parties, that is, other than in
a forced or liquidation sale.”
Requisite Service Period
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» The period or periods during which an employee is required
to provide service in exchange for the award
 Service condition only: typically the vesting period
» Types of requisite service periods
 Explicit service period: stated in terms of share-based award
 Implicit service period: not stated, but may be inferred from terms of
share-based award
 Derived service period: for awards with market conditions, inferred by
application of valuation techniques
Measurement Objective
» Estimate fair value at the grant date of equity
instruments the entity is obligated to issue once
employees have 1) rendered requisite services and
2) satisfied any other conditions
» Estimate is based on inputs at the grant date
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Vesting vs. Nontransferability
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» Restrictions that continue after instruments have
been issued to employee (or vested) are considered
in fair value measurement
» Example: Restrictions on transfer of vested options
or sale of vested shares (e.g., Restricted Stock)
Forfeitability
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» Restrictions related to forfeitability of unearned
(unvested) instruments are not reflected in fair value
estimate at grant date
» These restrictions are taken into account by only
recognizing compensation cost for awards that
ultimately vest
» Depends on type of condition
Service Conditions
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» A condition affecting the value of the award that
depends solely on an employee rendering service to
the employer for the requisite service period
» Example: Time-vesting schedule
» Not considered in measuring grant date fair value
Performance Conditions
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» A condition affecting the value of the award that
depends on achievement of specified performance
target defined by reference to employer’s operations
» Example: Vesting based on EBITDA targets
» Not considered in measuring grant date fair value
Market Conditions
» A condition affecting the value of the award that
depends on the price of issuer’s shares or amount
indexed to issuer’s shares
» Example: Share price hurdle
» Considered in measuring grant date fair value
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Requisite Service Period
» Estimate requisite service period at the grant date
and accrue compensation cost over this period
» Estimate should incorporate the probability that
performance or service (but not market) conditions
will be satisfied
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Private Companies
» Fair Value vs. Calculated Value
» Primary difference is that calculated value is based
on measure of historical volatility, rather than
implied volatility
» Similar to Level 1 vs. Level 3 inputs under ASC 820
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Option Pricing Model Assumptions
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» Exercise price
» Expected option term (consideration of contractual term and
expected exercise behavior)
» Current price of underlying share
» Expected volatility of underlying share price (for expected term)
» Expected dividends on underlying share (for expected term)
» Risk-free rate (for expected term)
Application Consistency
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» Consistency in assumptions / valuation techniques
from period to period is important
» Valuation technique / assumptions should not be
changed unless expected to produce “better
estimate of fair value”
» Change in valuation technique represents change in
accounting estimate for purposes of ASC Topic 250
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Selecting
Risk-free Rate
U.S. entity should use implied
yields currently available from
the U.S. Treasury zero-coupon
yield curve over the expected
term of option
Estimating Expected Term
» Contractual Term vs. Expected Term
» Employee stock options not transferable / hedgeable
» Depends on model (lattice vs. closed form)
» Considers the following:
 Vesting period
 Historical exercise / post-vesting employment termination behavior
 Expected volatility / share pricing
 Blackout periods / other restrictions
 Employee demographics (age, length of service, etc.)
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Estimating Expected Volatility
» Objective is to determine the assumption about
expected volatility that marketplace participants
would likely use.
» Higher volatility  Higher option fair value
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Estimating Expected Volatility
» Estimate of expected volatility should consider:
 Historical volatility over period similar to expected term
 Implied volatility based on publicly traded options
 Historical volatility of similar entities in terms of:
»
»
»
»
Industry
Stage of life cycle
Size
Financial leverage
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Estimating Expected Dividends
» Depending on model, estimate either:
 Yield
 Payments
» Consider trends in historical dividends
» Objective is to determine the assumption about
expected dividends that marketplace participants
would likely use
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Case Study – Stock Grant
with Market Conditions
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» GrantCo approves grant of 1,000,000 shares to employees on
March 17, 2010
» Before employees receive title to the shares, two vesting
conditions must be met:
 Condition 1: The 20-trading-day average stock price must exceed
certain hurdles. Once this condition is met, shares are considered
outstanding and receive dividends as declared and paid
 Condition 2: The grantee (i) completes 15 years of continuous
employment, (ii) reaches age 64, or (iii) dies or become disabled
Case Study – Continued
» Grant Date: 3/17/2010
» Condition 1 is a market condition, and must be
incorporated into the fair value of the award
» Condition 2 is a service condition, and is not
reflected in the fair value of the award
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Case Study – Continued
» The market condition is not conducive to a closed-form
(i.e., Black-Scholes) solution
» Binomial analysis also difficult to implement (not only
eventual outcome, but price path matters)
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Case Study – Continued
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Case Study – Resolution
» Develop a simulation model that takes into account unique features of
instrument, and calculate average outcome from many iterations
» Inputs to model:
 Expected Volatility: 30%
 Risk-Free Rate: 4.58%
 Expected Dividend Yield: 0.62%
» Fair Value: $6.58 per unit
» Compensation Cost: $6.58 x 900,000 (number of shares expected
to meet Condition 2)
» Requisite Service Period: 11 years, based on census data regarding
grantees
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Disclosures
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» Must disclose information so that financial statement users
understand:
 Nature and terms of share-based payment arrangements
(and effect on shareholders)
 Effect of compensation cost on the income statement
 Method of estimating grant date fair value
 Cash flow effects resulting from share-based payment arrangements
Disclosures
Example: Apple, Inc. 10-K
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Questions
Matthew R. Crow, ASA, CFA
901.322.9728
crowm@mercercapital.com
Mercer Capital
5860 Ridgeway Center Parkway, Suite 400
Memphis, TN 38120
901.685.2120
www.mercercapital.com
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