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This AICPA course is a must for CPAs whose business clients or employers have, or are considering, option plans, addressing FASB ASC 718 [previously SFAS No. 123(R)] in detail. This course explains how to estimate the value of options based upon fair value at the grant date addressing both public and nonpublic companies with examples and worksheets. This course also reviews SEC guidance on equity related disclosures including SAB 107, insider trading considerations and tax-related issues. Benchmarks from research and recent filing are provided.
Objectives:Prerequisite: Basic understanding of accounting principles
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Share-based compensation can take a variety of forms and may involve payments to either employees1 or non-employees. These forms include stock options, stock appreciation rights, restricted shares, restricted stock units, and performance shares. The accounting treatment of such instruments strives to use fair market value when possible but acknowledges difficulties can arise that preclude such valuation. Generally, a measure intended to at least emulate fair market value is prescribed, the details of which vary by the type of instrument involved, as well as the type of transaction. With few exceptions the costs associated with grants of share-based compensation to employees are estimated using a fair market value-based measurement on the date of grant, where the grant date is that point in time at which an employer and an employee have a mutual understanding of the terms of a stock-based compensation award.2 The exceptions, which will be discussed later in this course, include equity instruments held by employee share ownership plans (ESOPs) and employee stock purchase plans (ESPPs) if they meet certain conditions, and share-based payments, where the grant is not expected to vest.
The methods of estimation will vary based upon the type of security issued, its classification as equity or liability, and whether the company is publicly traded or not. For example a publicly traded firm will value a grant of restricted or non-vested shares using the market price of the firm's non-restricted traded shares. In contrast while alternatives exist, for example the Employee Stock Option Appreciation Right Security (ESOARS) to be discussed later3, most companies value their employee stock options using option pricing models, which paragraphs 21 and 22 of FASB ASC 718-10-55 (paragraph A18 of SFAS 123R) require incorporating the following inputs: the market price of a share of stock, the exercise price, the expected term of the option, the volatility of the share price, the risk-free rate over the expected term of the option, and the dividend yield. Nonpublic companies, if unable to estimate volatility, may invoke a calculated value for that input. On rare occasions, an inability to apply such an alternative could lead to the use of intrinsic value (current stock price minus the exercise price), remeasured at each reporting date until exercise or other settlement. If this rarity arises, no change in method from the intrinsic method for such grants is permitted.
While in most cases share-based compensations are considered equity, in some cases they may be classified as a liability of the firm. If a liability instrument is granted, the general approach is to estimate the fair market value at the grant date and each subsequent reporting period and then reconcile that intermittent remeasurement to the actual settlement value. Hence, a key accounting distinction is grant-date valuation for equity transactions and settlement-date valuation for liabilities. Nonpublic entities are permitted to use intrinsic value for all liabilities under sharebased payment arrangements, only if a fair-value-based method has not previously been used, as it is deemed the preferable method for purposes of justifying a change in accounting principle under FASB ASC 250, Accounting Changes and Error Corrections (SFAS No. 154).
For grants classified as equity, the estimated cost on the employee grant date is generally not adjusted based on subsequent events. However, no expense is recognized for options that are forfeited. These forfeitures are estimated at the date of grant, may be adjusted to reflect changing facts and circumstances, and are eventually reconciled to actual forfeiture experience.
Share-based compensation normally contains service conditions that need to be satisfied before the employee has an unconditional right to those securities. Employers may, in addition, embed criteria tied to performance or market conditions. If service or performance restrictions lead to forfeiture of non-vested shares or options, their effect is not reflected in grant-date valuation, but instead is reflected in the estimate of forfeiture experience. This results in compensation cost being recognized only for awards for which employees render requisite service. In contrast, the likelihood of meeting a market condition must be incorporated into the grant date estimate of the option's value.
Thus, while the accruals of compensation cost for awards with performance conditions incorporate the probable or likely outcome of the conditions, it is done so via the estimate of the awards expected to be forfeited, not via the value of those shares/options. Any previously recognized compensation cost, once shares are vested - no longer contingent on satisfaction of either performance or service conditions - shall not be reversed. If the ability to retain or exercise an award was based solely on one or more market conditions, satisfied prior to the end of the requisite service period, then any unrecognized compensation cost would be recognized at that point in time and not subject to reversal. In other words, unexercised expirations, as distinct from forfeitures, do not alter the reality of compensation in the form of vested or exercisable instruments. Market conditions use exercisability in the same context as performance and service conditions use vesting. Regardless of the nature and number of conditions that must be satisfied, the existence of a market condition requires that compensation cost be recognized if the requisite service is rendered. This holds even if the market condition is never satisfied.
Performance and service conditions that affect factors other than vesting and exercisability and market conditions that affect factors other than vesting are reflected in grant-date fair value estimates. Essentially, fair value for each probable outcome of performance or service condition is estimated at the grant date and that estimate corresponding to actual outcome will be the final measure of compensation cost. Similarly, any form of dividend protection in the award is reflected in fair value estimates. Potential dilutive effect of increases to the number of shares outstanding due to option exercises should be considered in estimating fair value, although any adjustment would be rare for a public company. Restrictions after the employee has a vested right, such as prohibitions of exercise during blackout periods, are a component of the fair value estimation at grant.
Contingencies calling for possible return of equity instruments earned or realized gains from their sale at less than fair value upon transfer, such as clawback features functioning as noncompete mechanisms, are ignored in the grant-date estimation process. Only if and when the contingent event occurs, is its effect reflected in the accounts. Reload features are ignored in the initial instrument's grant-date valuation process and if triggered at a later date become separate option awards with their own grant-date valuation. Modification is similarly accounted for as an exchange of the original award for a new award. Other conditions such as indexing to a factor other than a market, performance, or service condition, are reflected in fair value estimation and result in classification of the award as a liability.
Since financial instruments may have characteristics of both liabilities and equity, guidance prescribes certain classifications, either via FASB ASC 718 [SFAS No. 123(R)] or by criteria in other applicable generally accepted accounting principles, recognizing such determination is a matter of judgment. Special considerations are detailed whereby a broker-assisted cashless exercise can avoid liability classification, as well as instances where classifications can be deferred under certain conditions. Concern is expressed that repurchase features could permit employees to avoid the risks and rewards of equity share ownership for even a reasonable period of time. If such time length is not at least six months, liability classification results, as it does if an entity can be required to settle the option or similar instrument by transferring cash or other assets. Repurchase features that can be exercised only upon the occurrence of a contingent event outside of an employee's control, such as an initial public offering, are an exception until it becomes probable that the event will occur within the reasonable period of time.
Amounts and timing of tax deductions are expected to differ from compensation cost recognized in financial statements, leading to both temporary differences and excess tax benefits. Temporary differences arise as costs are deducted for financial accounting purposes earlier than they are deducted for tax purposes. To the extent that the amount of the ultimate deduction differs from the cost estimated on the measurement date, the difference, excess tax benefits (assuming the tax deduction is greater) are to be reported as a financing cash inflow.
The nature and terms of share-based payment arrangements are to be disclosed, alongside potential effects to shareholders. Income statement and cash flow effects, alongside the method of estimating fair value, are minimum disclosure requirements.
Example 1-1 - Compensation Cost and Expense
A company issues 30,000 stock options to employees with a fair value of $10 that vest in five years, and have an exercise price of $20 which is equal to the grant date's stock price. Compensation cost will be a total of $300,000 - $10 fair value x 30,000 stock options, recognized as compensation expense at $60,000 per year of service - $300,000 divided by five years of service.
Summary of Stock-Based Compensation
Share-based payments are compensation that has a determinable value at the date of grant. Although share-based payments are made in widely diverse forms, with considerable complexities, the development of fair market value techniques facilitates derivation of grantdate- values in circumstances in which market prices are not accessible. An explicit "settling up" of estimates results from the prescription that no compensation cost can be recorded for instruments that fail to meet the requisite service period, which is commonly the vesting period. Any previously recorded compensation cost that is not vested is actually reversed. However, estimates must be made of forfeitures as of the day of grant, with adjustment of such estimates as judged necessary in light of relevant facts and circumstances.
No specific model is prescribed or preferred, and further developments are anticipated, but generally the prescription is to be consistent with fair value following established principles of financial economic theory, including time value of money and risk-neutral valuation - at a minimum reflecting exercise price, term (contractual and expected exercise as well as postvesting employment termination behavior), share price, volatility, dividends, and risk-free rate. Note that FASB ASC 820, Fair Value Measurements and Disclosures (SFAS No. 157), does not apply to share-based payment transactions. FASB ASC 718 [SFAS No. 123 (R)] is generally consistent with the fair value measurement objective FASB ASC 820 (SFAS No. 157). However, for certain share-based payment transactions with employees, the measurements at the grant date are fair-value-based measurements, not fair value measurements. Hence, the exclusion from scope is for "practical reasons." In the fair market value measurement approach of FASB ASC 718 [SFAS No. 123(R)], certain vesting conditions and reload features are explicitly excluded from the modeling, yet other substantive characteristics of the instrument are reflected.
Although expected to be rare, should fair value estimates be impossible to derive, the entity may use intrinsic value at the date of grant and then remeasure that intrinsic value each reporting period until either exercise or settlement occurs. Note that reversion to a fair valuation, even should it become possible at a later date, is not permitted.
Nonpublic entities are expected, at times, to have difficulty in estimating their own stock's volatility and are permitted to shift from fair value to calculated value, meaning the volatility input in the valuation technique becomes an appropriate industry sector index.
Share-based estimates that are classified as liabilities are to be recorded at fair value; however, the measurement date is at settlement (rather than grant). The liabilities incurred under sharebased payment arrangements are remeasured at the end of each reporting period until settlement. Nonpublic entities are permitted a policy choice between fair value and intrinsic value for sharebased payments classified as liabilities, but must consistently apply such valuation across all such instruments. If a policy change is made, the preferable approach under FASB ASC 250, Accounting Changes and Error Corrections (SFAS No. 154), is specified to be fair value. This implies that a choice can be made initially, but once a change is made to fair value, then reversion to intrinsic value for share-based payments classified as liabilities would not be permitted under generally accepted accounting principles.
Accounting guidance for share-based payment transactions with parties other than employees remains consistent with the earlier SFAS No.123 and EITF Issue No. 96-18 Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, and has been codified as FASB ASC 505-50, Equity-Based Payments to Non-Employees. Accounting for employee share ownership plans is addressed in FASB ASC 718-40, Employee Stock Ownership Plans (SOP 93-6).
Transactions in which an entity incurs liabilities or exchanges equity instruments for goods or services, including changes in the classification of such instruments due to modifications, are addressed. Modifications can arise and will prompt comparison of fair value (or calculated value when applied) immediately before the modification to that fair value after the modification, deriving an incremental compensation. A distinction arises when the modification ties to performance, market, or service conditions that affect vesting. In that setting, compensation is not reversed if the original vesting hurdle would have been met, but for the modification. However, if the original vesting hurdle is not met, then no compensation cost would relate to the pre-modification time frame, and any costs would tie only to the post-modification requisite service period being met.
Employee Stock Purchase Plans may be considered noncompensatory under FASB ASC 718-50- 25-1 [par. 12(a)(2) of SFAS No. 123(R)] which specifies the discount from market price should be no greater than "the per-share amount of share issuance costs that would have been incurred to raise a significant amount of capital by a public offering. A purchase discount of 5% or less from the market price shall be considered to comply with this condition without further justification. A purchase discount greater than 5% that cannot be justified under this condition results in compensation cost for the entire amount of the discount."
When goods are acquired by issuing stock, the primary basis for the recognition of the transaction should be the fair value of the goods acquired.
1 Which, under FASB ASC 505-50, Equity-Based Payments to Non-Employees (SFAS 123R), includes share-based compensation given to non-employee directors for their services as directors.
2 For non-employee transactions, criteria for determining the measurement date are prescribed in FASB ASC 505- 50, Equity-Based Payments to Non-Employees (Emerging Issues Task Force (EITF) Issue No. 96-18) often resulting in the vesting date. Since the grant relates to goods or services, the associated cost of that grant is capitalized or expensed commensurate with the time frame in which such goods are used or services are received.
3 ESOARS were created by Zions Bancorporation and are "tracking" securities whose valuations are determined through an online auction open to all suitable investors, held on or near the option grant date, in exchange for payments when employees exercise their options. On October 26, 2007, the Securities and Exchange Commission (SEC) gave final clearance under SFAS 123(R) to this Market-Based Employee Stock Option Valuation Method.
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