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A Road Map for Share-based Compensation

As they implement the provisions of FASB Statement no. 123(R), companies should take a fresh look at their share-based employee compensation.

April 2007

from Journal of Accountancy

Before FASB issued Statement no. 123(R), Share-Based Payment, at-the-money options, with an exercise price equal to the market price on the grant date, were the most popular form of share-based compensation. Companies typically used the alternative intrinsic value method to value those options; with a grant-date intrinsic value of zero, the company recognized no compensation expense. Since the release of Statement no. 123(R), companies have had to recognize an expense equal to the option’s grant-date fair value. This article summarizes the valuation requirements of Statement no. 123(R) and provides information CPAs can use to help management choose the best share-based strategy for compensating employees.

Equity and Liability Award Instruments

Share-based compensation awards are classified as either equity instruments or liability instruments. Statement no. 123(R) provides criteria for the classification and guidance on applying FASB Statement no. 150, Accounting for Certain Instruments With Characteristics of Both Liabilities and Equity, to this issue.

Equity instruments require a company to issue equity shares to employees in a share-based payment arrangement. Common types of equity instruments include equity shares, share-settled stock units (also known as phantom stock), stock options and similar share-settled stock appreciation rights (share-settled SARs). Liability instruments generally require the entity to use cash or noncash assets to settle a share-based payment arrangement. The common liability instruments are cash-settled stock units and cash-settled SARs.

Although the best estimate of fair value for both types of awards is the observable price of identical or similar instruments in an active market, such information is generally not available. Consequently, companies need to estimate fair value. Statement no. 123(R) says the measurement date for equity instruments awarded to employees is the grant date; the measurement date for liability instruments is the settlement date. Because settlement occurs after the employee has rendered the services, companies must remeasure a liability instrument’s grant-date fair value at each reporting date until all award units are settled — either by forfeiture, exercise or expiration.

Valuation Measurement Guidelines

Whether a company is public or private will determine how it measures the value of share-based employee compensation awards. Here are some guidelines CPAs can use to value employee compensation awards commonly granted by the two types of companies. (Statement no. 123(R) does not change the accounting guidance for share-based transactions with nonemployees as prescribed in Statement no. 123 and EITF Issue no. 96-18.)

Equity Shares or Share-Settled Stock Units

Public entity. The fair value of equity shares or share-settled stock units awarded to public company employees is the grant-date market price. Nonvested shares are valued as if they were vested and issued on the grant date. For shares with a restriction on transferability after vesting, CPAs should include a discount reflecting that restriction in the estimated fair value.

Nonpublic entity. Due to the absence of an observable external market price for its shares, a nonpublic entity may use its internal price or a private transaction price if such information provides a reasonable basis to measure the grant-date fair value. Otherwise, CPAs can determine fair value using an appropriate valuation method. The 2004 AICPA Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, discusses three general approaches to valuation and various associated methods.

Stock Options or Share-Settled SARS

Public entity. Such companies must estimate the grant-date fair value of employee stock options and share-settled SARs using an option-pricing model or technique. The two most common are Black-Scholes-Merton (a closed-form option-pricing model) and a binomial model (a lattice option-pricing model). CPAs will encounter situations where a lattice model is more appropriate. These option-pricing models use a probability-based mathematical formula designed to estimate the fair value of options at a given time. Estimated fair value is not a forecast of the actual future value.
Statement no. 123(R) does not state a preference for one model or technique as long as the one a company uses:

  • Takes into account the exercise price; the expected term of the option; the current price, expected volatility and expected dividends of the underlying share; and the risk-free interest rate.
  • Is generally accepted in the field of financial economics in theory and practice.
  • Appropriately reflects the characteristics of the award instrument.

Estimating fair value involves making reasonable and supportable assumptions and judgments. Price valuation estimates should be performed by someone with the requisite expertise. Although FASB does not require that a third-party valuation professional perform the price modeling, companies often use one for this task.

In the case of a newly-public entity that lacks sufficient historical information on its own stock price, CPAs can estimate the expected volatility using the average volatility of similar public entities — comparable in industry sector, size, stage of life cycle and financial leverage — together with its own internal data. For example, the NASDAQ Indexes section of the NASDAQ Web site provides indexes, including some industry-specific ones. Each industry-specific index allows you to download to a spreadsheet a list of company names that make up the index, ticker symbols and descriptions filed with the SEC. CPAs can use this information to identify similar public entities.

Nonpublic entity. Such companies should estimate the fair value of stock options or share-settled SARs using the same option-pricing techniques required for public entities. However, if the expected volatility of a nonpublic entity’s share price cannot be reasonably estimated due to insufficient historical share information or because it is not possible to identify similar public entities, CPAs should use the historical volatility of an appropriate industry sector index. This is called the “calculated value” method. The NYSE Web site provides a list of 104 industry classification benchmark (ICB) subsectors. Dow Jones Indexes offers historical industry subsector index data with criteria specified by the user.

Current Trends

Based strictly on the amount of work required to implement fair value accounting, it is clear equity instruments are a more attractive alternative than liability instruments for companies today because the latter require remeasurement at each reporting date. Within the equity instrument category, shares or stock units are more attractive than stock options or option-like instruments, as options require companies to apply onerous pricing models for grant-date fair value measurement.

Deloitte’s 2005 Stock Compensation Survey said 75 percent of the public and private companies surveyed planned to cut back the number of stock options granted to minimize the expense they would have to recognize. The reduction would mostly target lower-level employees. Some 89 percent of public and 55 percent of private companies were considering alternative forms of equity-based compensation. Given all forms of equity-based compensation, the most popular choices mentioned by public companies were restricted stock or stock units with either a time-vested (52 percent) or performance-vested (40 percent) condition. At private companies, stock options continued to be the most popular choice, with either a time-vested (39 percent) or performance-vested (33 percent) condition.

It’s difficult for private companies to use stock or stock units as award instruments since they impose a financial burden on employees, who must pay taxes when the shares vest. Employees may have difficulty raising cash for taxes on the vesting date with shares that are not publicly traded. On the other hand, employee stock options are attractive as they normally are taxed on the exercise or sale date, and the option holder controls the timing of these dates. Private company employees typically exercise options when the company undergoes an IPO, merger or buyout, at which time the shares have a ready market value.

In January the SEC approved another market-based options model presented by Zions Bancorporation. The Zions model uses the public auctioning of tracking securities called Employee Stock Option Appreciation Rights Securities (ESOARS) to determine the fair value of underlying employee stock options. Reports in The Wall Street Journal and elsewhere indicate valuations using this new model may be lower than those produced by models such as Black-Scholes-Merton, thus reducing employers’ share-based compensation expense.

Whether either of these new models, or similar ones, will become popular is yet to be seen, but they bear watching.

Anne L. Leahey and Raymond A. Zimmermann are writers of the Journal of Accountancy. Their views as expressed in this article do not necessarily reflect the views of the AICPA or the Journal of Accountancy.