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Accounting for Stock-Based Compensation
ASC 718 (SFAS No. 123R) – Share-Based Payment
FASB 123R (ASC 718) requires companies to use the Fair Value Method
(For awhile, there was a choice between fair value and intrinsic value method under APB Opinion No. 25. The
intrinsic value method is no longer permitted)
Noncompensatory Employee Share Purchase Plans
No compensation expense is recognized if a plan meets the following conditions;
1. The purchase discount from market price is no more favorable than those available to
all shareholders or the purchase discount does not exceed the per-share amount that
would have been incurred in issuance cost in a public offering
Safe harbor rule – discount ≤ 5% of market price
2. Substantially all employees may participate on an equitable basis
3. There are no option features other than:
a. No more than 31 days after price is fixed to enroll
b. Purchase price is based solely on market price at date of purchase and
employees can cancel participation before purchase date and get a refund
Features that make the plan compensatory include:
Purchase price = lesser of equity share’s market price at date of grant or market price at date of purchase
Purchase price set at grant date but employee can cancel and get refund before the purchase date
All plans that do not meet these rules are classified as compensatory
Note that incentive stock options under the tax code have similar provisions and do not generate taxable income for
employees nor tax deductions for the employer. Therefore, it is possible that an employee share purchase plan might
be compensatory for accounting purposes but without any need for the accrual of deferred tax benefits.
Expense recognition
Recognize the goods acquired or services received when the goods are obtained or the
services are received (over the requisite service period)
Under certain conditions, the cost of services (or goods) might be capitalized as part of the cost to acquire or construct
another asset such as inventory and later recognized when that assets is consumed or disposed of.
The credit side of the entry is to an equity account or a liability account depending on the
classification of the award
What matters is the economic substance of the transaction – a non-recourse loan to employee
with company shares as collateral could be a substantive grant of equity share options
*
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Awards are classified as liability or equity
Awards classified as liability
Awards classified as equity
Remeasured at fair value on each balance sheet date until
the award is settled
Measurement date = settlement date
Award is classified as liability if the entity can be
required under any circumstances to settle the
option or similar instrument by transferring cash or
other assets
Measured at fair value at the grant date and not
subsequently remeasured
Measurement date = grant date (generally)
Award is classified as equity if it is an equity instrument
and the company cannot be required to settle the
option in cash under any circumstances.
Options that permit broker-assisted cashless exercise does
not result in liability classification if
a. Cashless exercise requires a valid exercise
b. The employee is the legal owner of the shares
Provisions to provide cash to meet minimum statutory
withholding requirements are also okay
Typical descriptions:
Share options with cliff vesting
Share options with graded vesting
Restricted stock offering
Junior stock offering
Performance-based awards with no cash settlement
option
Examples:
Stock appreciation rights with cash settlement option
Tandem Award (Share Options or Cash-Settled SARs)
Tandem Award (Phantom Shares or Share Options)
Fixed dollar amount awards settled in the company’s
stock
Puttable (or callable) share awards are classified as
liabilities if either of the following conditions are met:
a. A repurchase agreement permits employee to
avoid bearing the risks & rewards of ownership
for a reasonable period
b. It is probable that the employer would prevent
the employee from bearing those risks and
rewards for a reasonable period of time from the
date the share is issued.
Reasonable period = ≥ 6 months
Nonpublic companies may elect intrinsic value method or
fair value method
If it is impossible to estimate fair value of award, intrinsic
value is recognized at each reporting date until
settlement
Puttable or callable share awards are generally equity
securities unless the employee avoids risk/reward of
ownership through the feature or if it is probable that
the employer would prevent the employee from being
harmed for a period of 6 months or more after the
share is issued
Nonpublic companies that cannot estimate volatility use a
calculated value instead of fair value
If it is impossible to estimate fair value of award, intrinsic
value is recognized at each reporting date until
settlement
Once shares are classified as liability or equity, SFAS No. 132 rules apply until the employee
has rendered the required service and could terminate the employment relationship and still
receive that share. At that point, SFAS No. 133 or No. 150 may come into play.
See flowchart ASC 718-10-55-66
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Requisite Service Period
The period during which an employee is required to provide service in exchange for an award
under a share-based payment arrangement.
For awards that contain only a service condition, the requisite service period is presumed to
be the vesting period.
The requisite service period generally (but not always) starts on the grant date.
Grant date: Assuming shareholder approval has been obtained, the grant date is the date on which
the employer and the employee reach a mutual understanding of the key terms and conditions.
Employer is contingently obligated on the grant date to issue equity instruments or assets to
employees who meet the conditions. For equity instruments, the grant date begins the period during
which an employee begins to benefit from or be adversely affected by changes in the company’s
stock.
The requisite service period generally (but not always) ends on the date the options vest.
Vest, vesting, vested. A share-based payment award becomes vested at the date that the employee’s
right to receive or retain shares, other instruments, or cash under the award is no longer contingent
on satisfaction of either a service condition or a performance condition.
FASB uses “restricted share” in a narrow sense – compare definitions of restricted share and nonvested share in the glossary
to FASB 123 (rev. 2004).
Requisite service period may be explicit, implicit or derived:
Explicit service period: Stated in the terms of a share-based payment award.
Implicit service period: Not explicitly stated but inferred from an analysis of the terms and other
facts and circumstances.
Derived service period: A service period for an award with a market condition that is inferred from
the application of certain valuation techniques used to estimate fair value.
There may be more than one implicit, explicit or derived service period
“Or” conditions – requisite service period is the shortest of the possible periods
“And” conditions – requisite service period is the longest of the possible periods
The complications are likely when there is both a service condition and one or more performance
conditions and maybe a market condition specified or implied by the terms of the award
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Types of Conditions
Conditions may impact vesting, exercisability, exercise price, and other features that affect
the fair value of an award
Service condition
Depends solely on an employee rendering service to the employer for the requisite service
period.
A condition that results in the acceleration of vesting in the event of an employee’s death, disability, or
termination without cause is a service condition.
Performance condition
Relates to both (a) an employee’s rendering service for a specified (either explicitly or
implicitly) period of time and (b) achieving a specified performance target that is defined
solely by reference to the employer’s own operations (or activities) and not to market
conditions such as changes in stock prices.
Accrual of compensation expense begins at the inception of the requisite service period if it
is probable that the performance condition will be achieved. If achievement is not
probable at inception, compensation expense accrual begins when achievement
becomes probable
Examples:
Attaining a specified growth rate in return on assets
Meeting sales growth or market share target
Obtaining regulatory approval to market a specified product
Selling shares in an initial public offering or other financing event
A change in control
Performance targets defined by reference to another entity or group of entities
Performance targets limited to part of the enterprise (division or individual employee)
Market condition
Relates to the achievement of
(1) a specified price of the issuer’s shares or a specified amount of intrinsic value
indexed solely to the issuer’s shares or
(2) a specified price of the issuer’s shares in terms of similar equity securities such
as a market index.
If market conditions are not achieved but all service conditions are achieved, the
compensation expense is not reversed.
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Recognizing Compensation
Recognized based on the number of awards that eventually vest.
Before the vesting date, compensation is accrued based on the estimated number of awards that are expected
to vest. The estimates are adjusted as necessary using the prospective method (that is, changes in current and
future period with no adjustment to previously reported numbers).
At the vesting date, adjustments are made so that only the compensation related to vested awards remains on
the books – in other words, earlier estimates are adjusted to actual.
Compensation expense is reversed if employee fails to vest (quits before end of service period, fails to
achieve performance target, etc.)
Compensation expense is NOT reversed if employee vests but does not exercise the award before the
expiration date. For example, the award may be “out-of-the-money” (worthless) during the exercise period.
MODIFICATION OF AWARDS
Modification of terms or conditions is treated as exchange of original award for a new award
Triggers re-measurement of fair value of
The original award immediately before modification
The modified award
(using same share price and other factors to do FV measurements)
To the extent that the fair value of the modified award exceeds the remeasured fair value of the original
award, additional compensation expense is recognized
Total recognized compensation shall at least equal the fair value of the original award at the grant
date (unless performance or service conditions are not expected to be satisfied)
Inducements
A short-term inducement (for example, to exercise early) counts as a modification of only the awards
of employees who accept the inducement
Exception for modifications to add an antidilution provision
Does not trigger remeasurement or result in additional compensation expense
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DETERMINATION OF FAIR VALUE
Measurement requires use of computer models
Closed-form models [e.g., Black-Scholes-Merton formula]
Lattice models [e.g., binomial pricing model]
Variables used in the models include
exercise price of the option
expected term (until exercise/expiration)
current market price of underlying shares (or estimated fair value for nonpublic entities)
expected volatility of stock prices
expected dividend on underlying shares
risk free interest rate (U.S. Treasury zero-coupon issues with a remaining term equal to the expected term)
Note:
For shares classified as equity, the original fair value estimate it is not revised to take into account changes in
the variables used in the models
For shares classified as liability, new fair values using revised assumptions, as appropriate, are computed on
each reporting date.
The underlying theory is based on present value concepts:
If we knew what the price would be when the option was exercised, the fair value would be the current stock
price less the present value of the exercise price.
Therefore, options are worth more when
1.
Stock price is high
2
Exercise price is low
3.
Interest rate is high
4.
The exercise period is longer
Under FAS123r, the effect of vesting conditions and other restrictions that apply only during the requisite service
period do not affect the fair value estimation models – however, the amount of compensation recognized is based on
the probability of achievement of service and performance conditions and restrictions.
Exceptions to Fair Value Reporting:
Nonpublic entities with awards classified as liabilities
They can choose between fair value and intrinsic value methods.
Fair values of stock must be estimated for each reporting date in order to determine the intrinsic
value
Terms that make estimating fair value at grant date impossible
Situation should be rare but could be caused by complexity of terms.
Use intrinsic value remeasured at each reporting date through settlement
Nonpublic entities that can’t estimate volatility of their shares
Use calculated value method (using volatility of a relevant stock index)
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TERMINOLOGY
Intrinsic value - The amount by which the fair value of the underlying stock exceeds the exercise price of an
option.
Example:
An option has an exercise price of $30 on a stock
The current market price of the stock is $40
Therefore, the intrinsic value on that date is $10
Time value of an option is the portion of the fair value of an option that exceeds its intrinsic value.
Example:
An option has an exercise price of $30 on a stock
The current market price of the stock is $40
The fair value is $14 and the intrinsic value is $10 ($40 - $30)
The time value is $4 or the fair value minus the intrinsic value ($14 – $10)
Measurement date - The date at which the equity share price and other pertinent factors, such as expected
volatility, that enter into measurement of the total recognized amount of compensation cost for an award of
share-based payment are fixed.
Measurement date is often the grant date as well as the inception of service period. However, the
requisite service period may begin before the grant date if shareholder approval is pending.
Grant date - The date at which an employer and an employee reach a mutual understanding of the key terms
and conditions of a share-based payment award. The employer becomes contingently obligated on the grant
date to issue equity instruments or
transfer assets to an employee who renders the requisite service.
Awards made under an arrangement that is subject to shareholder or board of directors’ approval are
not deemed to be granted until that approval is obtained unless approval is essentially a formality (or
perfunctory)
The grant date for an award of equity instruments is the date that an employee begins to benefit
from, or be adversely affected by, subsequent changes in the price of the employer’s equity shares.
Volatility - A measure of the amount by which a financial variable such as a share price has fluctuated
(historical volatility) or is expected to fluctuate (expected volatility) during a period. Volatility is typically
expressed in annualized terms.
Volatility also may be defined as a probability-weighted measure of the dispersion of returns about
the mean. The volatility of a share price is the standard deviation of the continuously compounded
rates of return on the share over a specified period. That is the same as the standard deviation of the
differences in the natural logarithms of the stock prices plus dividends, if any, over the period.
Share units - A contract under which the holder has the right to convert each unit into a specified number of
shares of the issuing entity.
Modification - A change in any of the terms or conditions of a share-based payment award.
Tranche – a group of shares with same features
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