Basic Principles in the New Accounting for Stock Options
A Roadmap for Navigating SFAS 123(R)

By Robert A. Dyson

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SFAS 123(R) requires public companies to recognize compensation cost from most share-based payment arrangements with employees. Companies will not be able to simply recognize the pro forma cost currently calculated under the original SFAS 123, however, because SFAS 123(R) modifies certain assumptions for computing that cost; for example, it requires expected rather than historical volatility. (Although the original SFAS 123 theoretically required the use of expected volatility, the computations presented in its Appendix B were based primarily on historical volatility.) In addition, companies must recognize an incremental cost associated with modified stock option awards rather than account for them as variable options according to FASB Interpretation (FIN) 44, Accounting for Certain Transactions Involving Stock Compensation. Finally, in calculating total compensation cost, companies are required to estimate the number of instruments for which the requisite service is expected to be rendered, rather than account for forfeitures as they occur.

Although public companies can no longer apply the intrinsic method, nonpublic entities may continue to do so if it is not practicable to estimate the fair value of their stock options. Nonpublic companies applying the intrinsic method, however, must measure the stock options each reporting period and recognize changes in intrinsic value as compensation cost. Otherwise, nonpublic companies are required to measure awards of equity instruments at fair value.

SFAS 123(R) also requires excess tax benefits to be reported as a financing cash inflow on the statement of cash flows rather than as a reduction to income tax paid.

Basic Concepts

With limited exceptions, SFAS 123(R) applies to share-based payment arrangements, whereby suppliers of goods and services, including both employees and nonemployees, receive equity instruments, such as shares or stock options, as payment. Share-based payment arrangements also include transactions where the entity incurs liabilities in amounts based on the price of the company’s shares or other equity instruments, or liabilities that might require settlement by issuing the company’s shares.

SFAS 123(R) defines an employee as an individual over whom the grantor of a share-based compensation award exercises or has the right to exercise sufficient control to establish an employer-employee relationship based on common law and applicable IRS revenue rulings. This definition includes nonemployee directors acting in their role as members of the entity’s board of directors, and certain leased employees.

SFAS 123(R) does not apply to employee share option plans that are noncompensatory or to capital contributions. A plan is noncompensatory if substantially all employees meeting limited qualifications may participate, the plan incorporates no option features (with limited exceptions), and its terms are no more favorable than those available to all holders of the same class of shares, or if any purchase discount from the market price is 5% or less. Companies must justify the classification of plans with purchase discounts greater than 5% as noncompensatory every year.

Except as described above, SFAS 123(R) requires reporting entities to recognize in their financial statements the costs resulting from all share-based payment transactions at fair value. Companies engaging in share-based arrangements with employees recognize the cost of services received over the requisite service period, while entities engaging in share-based arrangements with nonemployees recognize the cost of goods acquired or services received. The accounting for goods acquired or services received in share-based arrangements, whether from employees or nonemployees, is the same regardless of settlement by cash or equity securities. For example, a company constructing a building would capitalize the architect’s fees regardless of whether those fees are settled in cash, stock, or stock options. In addition to recording the costs of the goods acquired or services received, companies should record a corresponding increase in equity or liability. Companies issuing equity instruments before receiving the actual goods or services should record a prepaid expense.

Calculation of Compensation Cost

The basic calculation of compensation cost incurred to employees in a stock option plan consists of the following steps:

• Estimate the fair value of one option at the measurement date, assuming that the option is already vested. This fair value does not change during the life of the award, unless the option’s terms are modified or the measurement date is changed.
• Calculate the total compensation cost, which is the fair value of one option multiplied by the number of options expected to vest.
• Determine the requisite service period.
• Allocate the total compensation cost over the requisite service period (or to the period when specified conditions are met).
• Estimate any income-tax effect.
• Adjust the total compensation cost and income-tax effect as a change in estimate to reflect any changes in the number of options expected to vest.

Sidebar 1 presents a standard example for accounting for stock options issued to employees.

Accounting for Share-Based Transactions with Nonemployees

The recording of goods acquired or services received occurs when the company obtains those goods or receives those services, but not necessarily when the equity instruments are issued. These transactions are measured at the fair value of the goods acquired or services received if those fair values are more reliably measurable (generally, at the market price) than the fair value of the equity instruments issued in exchange. The company should measure the transaction at the fair value of the equity instruments issued if that fair value is more reliably measured.

If the fair value method is applied to the equity instruments issued, the measurement date is the earlier of 1) the date at which a commitment for performance by the nonemployee to earn the equity instruments is reached, or 2) the date at which the nonemployee’s performance is complete. Additional guidance in determining a measurement date is presented in EITF Issue 96-18, Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.

Measurement Date of Share-Based Transactions

The company begins recognizing compensation cost as of the service inception date, which is the beginning of the period during which the employee performs the services for which he is compensated (the requisite service period). The service inception date is usually the grant date, or the date on which an employer and an employee reach a mutual understanding of the key terms and conditions of a stock-based payment award. At the grant date, the employer becomes contingently liable to issue equity instruments or to transfer assets to an employee who renders the required service.

The service inception date may precede the grant date if an award is authorized, if service begins before both parties reach a mutual understanding of the key terms, and if certain other conditions are met. This can occur when an employee is working during a period that counts as part of the vesting period, but before the final understanding on matters such as exercise price is completed. In these circumstances, the company recognizes compensation costs over the requisite service period based on the fair value of the options as of the service inception date, measures a new fair value as of the grant date, and then adjusts the cumulative compensation cost to reflect the new fair value. Sidebar 1, “Accounting for Stock Options with Service Condition,” presents an example of accounting for an adjusted total compensation cost.

Recognition of Share-Based Transactions

The objective of accounting for transactions under share-based arrangements with employees is to recognize compensation costs related to employee services received in exchange for equity instruments issued or liabilities incurred. The total compensation cost is the fair value of the instruments issued multiplied by the number of instruments that actually vest. This cost is recognized over the requisite service period with a corresponding credit to equity (generally paid-in capital). The number of instruments expected to vest is estimated at the service inception date, and is revised during the requisite service period to reflect subsequent information. Total compensation cost is also revised accordingly.

Awards of share-based employee compensation vest when an employee earns the right to benefit from the award by satisfying a specific service or performance condition, or both. A service condition is based solely on an employee’s rendering service to the employer for the requisite service period. A performance condition pertains to an employee’s both rendering service for a specified period of time and achieving a specified performance target defined solely by the employer’s own operations (for example, a requirement that a division sell a certain number of units within a specified period in order for an award to vest). The requirement that an individual remain an employee for that period is a service condition.

The award may also include a market condition, which specifies a share price or a target in terms of a similar equity security or an index that must be achieved. A market condition affects the determination of the fair value of a share-based employee compensation award, but is not a vesting condition.

The requisite service period for an award that has only a service condition is presumed to be the vesting period, unless there is clear evidence to the contrary. Considering such evidence requires the classification of the requisite service period as explicit, implicit, or derived. An explicit service period is explicitly stated in the terms of a share-based award (e.g., three years of continuous employee service from January 3, 2005). An implicit service period is not explicitly stated in the terms of a share-based award, but can be inferred from an analysis of those terms or consideration of a performance condition (e.g., for an award with a service inception date of January 1, 2006, that vests when new software is ready for market, expected at June 30, 2007, the implicit service period is 18 months). A derived service period for an award with a market condition is inferred from the application of certain valuation techniques used to estimate fair value. For example, an award that vests only if the market share price increases by at least 40% for a period of not less than one year over the next five years can be inferred from certain valuation techniques, such as the lattice model (as discussed below).

For accounting purposes, only one requisite service period can be used for each award. An award having a combination of market, performance, and service conditions may have two or even all three types of service periods: explicit, implicit, and derived. If the vesting of an award is based on satisfying both a market condition and a performance or service condition and it is probable that the latter will be satisfied, the initial estimate of the requisite service period should be the longest of the periods. If the vesting of an award is based on satisfying either a market condition or a performance or service condition and it is probable that the performance or service condition will be satisfied, the initial estimate of the requisite service period should be the shortest of the periods.

During the requisite service period, awards with a performance condition are measured based on the probable outcome of that performance condition. An award with a performance condition is accrued if it is probable that a performance condition will be achieved. If the company concludes that a required performance condition will not be met, it will not recognize any compensation cost even if the award contains other conditions that probably will be satisfied. Companies should reverse any compensation cost recognized on an award whose performance condition is ultimately not achieved. If, during the requisite service period, the company changes its mind and concludes that a performance condition will likely be met after all, it will recognize cumulative compensation cost in the current period as a change in estimate in a manner similar to that presented in Sidebar 1.

Sidebar 2 presents an example.

Measurement of Share-Based Arrangements Classified as Equity
Equity instruments awarded to employees are measured at fair value as of the grant date. Unless the award is modified or the measurement date changed, the estimated fair value of each unit of the equity instrument is not remeasured in subsequent periods.

The estimated fair value of each equity instrument is based on either observable market prices of identical or similar equity or liability instruments in active markets, or on an established valuation technique. Because employee stock options generally cannot be bought and sold on the open market, they cannot be compared to actively traded options. In those cases, the company should apply a valuation technique consistent with SFAS 123(R) requirements, reflecting all substantive (again, with certain exceptions) characteristics of the instrument. For example, restrictions that remain in effect after the company issued the instruments, such as the inability to sell vested stock options to third parties, or restrictions on selling exercised shares for a specified period of time, should be reflected in the measurement of fair value.

Other instrument characteristics are reflected in recognized compensation cost but are not included in the measurement of the fair value, such as the following:

• Restrictions regarding vesting, such as service period or performance conditions.
• Restrictions related to forfeiting instruments that the employee has not earned, such as the inability to exercise a nonvested stock option or to sell nonvested shares.
• Reload or contingent features that require an employee to transfer equity shares earned or gains realized from the sale of equity instruments earned to the issuing entity for an amount less than the fair value on the date of transfer (including a zero amount). These features are accounted for if and when the contingent event occurs (see Sidebar 3).

Any valuation technique should include assumptions about the following variables:

• The exercise price of the option.
• The expected term of the option, reflecting both the contractual term and the employees’ expected exercise and employment behavior.
• The current price of the underlying share.
• The expected volatility of the underlying share for the expected term of the option.
• The expected dividends on the underlying share during the expected option term.
• The risk-free interest rate for the expected term of the option.

Valuation techniques meeting SFAS 123(R)’s criteria are closed-form models, such as the Black-Scholes-Merton formula, and binomial models, such as the lattice model. The Black-Scholes-Merton formula is generally applied the same way to awards accounted for under SFAS 123 and prior pronouncements, except for the use of expected (as opposed to historical) volatility. Under SFAS 123(R), it must be adjusted to reflect certain characteristics of employee stock options that are not consistent with the model’s assumptions, such as the ability to exercise the option prior to the end of its contractual term.

A lattice model produces an estimated fair value based on the assumed changes in prices of a financial instrument during each successive reporting period within the context of the option’s contractual term. Results will differ if the reporting entity uses the lattice model rather than the Black-Scholes-Merton formula. For example, determining the expected option term using the lattice model requires the consideration of vesting period, employees’ historical exercise and employment behavior for similar grants, expected share-price volatility, blackout periods, and employee demographic information such as age and length of service. Volatility affects the expected term because although option pricing theory contends that the optimal time to exercise an option is at the end of its term, the option holder may exercise the option early if the price of the stock reaches a certain level. Employee exercise behavior is described as the suboptimal exercise factor. For example, a determination that an appreciable number of individuals will exercise the option if the price of the stock is twice the exercise price will result in a suboptimal exercise factor of two.

Although in its exposure draft FASB expressed a preference for the lattice model, SFAS 123(R) does not require the use of a particular valuation technique. In any event, no acceptable lattice computer model is available as of this writing, although a number of binomial models are on the market. FASB has indicated it will not provide a list of vendors offering software that complies with SFAS 123(R)’s criteria.

In estimating the expected term of the option reflecting both the contractual term and the employees’ expected exercise and employment behavior, companies should identify separate homogenous employee groups with similar exercise and employment behavior. This procedure effectively results in different fair values for the options issued to each group. For example, a company may classify managers and hourly employees as separate groups and estimate the expected term of the award relative to each group, based on its historical experience of forfeitures (due to employees resigning before the vesting period is complete) and exercise behavior. The company can then estimate the fair value for the instruments issued to managers and hourly employees based on behavior unique to each group. In this scenario, the company, in effect, accounts for two awards with different values based on different expected terms.

SFAS 123(R) does not specify a method for estimating expected share price volatility, but it does require a process for making such estimates and for evaluating factors incorporated in that process. The factors for estimating expected volatility include historical volatility of the price of the underlying share, the implied volatility of other publicly traded instruments, the length of time the company’s shares have been traded, and the corporate and capital structure. In considering historical volatility, SFAS 123(R) permits disregarding an identifiable period in which the stock was extremely volatile because of a unique event, such as a failed merger bid, that is not expected to occur during the option term. SFAS 123(R) also allows volatility to be deemphasized during a period of general market decline. SFAS 123(R) gives no substantive guidance about entities without historical experience, such as entities that have only recently become a public company.

SAB 107 provides additional guidance on estimating expected volatility, including factors that would justify the use of either historical or implied volatility. Implied volatility is derived from the market prices of the reporting entity’s publicly traded options or other financial instruments with optionlike features.

Nonpublic companies are encouraged to estimate expected volatility based on those reported by similar-sized publicly traded entities in the same industry. At least some of these companies will find it is not practicable to estimate the expected volatility of the entity’s share price. Nonpublic companies are explicitly prohibited from using a broad-based market index, such as the S&P 500, that is not representative of the industry sector in which the nonpublic entity operates.

The risk-free interest rate should be based on the implied yields currently available on U.S. Treasury zero-coupon issues with a remaining term used in the model.

Share-Based Transactions Classified as Liabilities

Share options are classified as liabilities if the underlying securities are classified as liabilities, or if the company can be required, under any circumstances, to settle the option or similar instrument by transferring cash or other assets. For example, SFAS 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity, classifies certain equity instruments as liabilities. Public companies classify options to purchase mandatory redeemable preferred stock as liabilities, because the underlying security is classified as a liability. In contrast, FASB Staff Position (FSP) FAS 150-3 permits nonpublic entities to classify mandatory redeemable stock as equity. Because the underlying security is considered equity, the option to buy that equity is also classified as equity.

An option may be puttable if the reporting entity is required to repurchase the shares issued when the option is exercised. A puttable or callable share option awarded to an employee may be classified as a liability if either 1) the repurchase feature permits the employee to avoid bearing the risks and rewards normally associated with share ownership for a reasonable period of time from the date the requisite service is rendered and the share is issued, or 2) it is probable that the employer would prevent the employee from bearing those risks and rewards for a reasonable period of time after the share is issued. An example of an employee avoiding the risks and rewards associated with ownership would be a plan that permitted an employee to sell stock, acquired through the exercise of a stock option, back to the employer at the exercise price. A reasonable period of time is a period of at least six months.

An award indexed to a factor, such as a commodity price, in addition to the entity’s share price is classified as a liability if that additional factor is not a market, performance, or service condition.

A public company measures a liability related to a share-based payment arrangement based on the award’s fair value, which is determined using a methodology similar to that used in determining the fair value of equity instruments. At the service inception date, the company estimates the comprehensive fair value of the liability and allocates that value over the requisite service period. During each reporting period until settlement, the company remeasures the fair value of the liability and recognizes the cumulative effect of the change in estimate.

Nonpublic entities have the option to measure liabilities arising from share-based payment arrangements at either the fair value or the intrinsic value. Regardless of the measurement method applied, nonpublic entities must remeasure the liabilities at each reporting date until settlement.

Modification of Awards of Equity Instruments

A modification of the terms or conditions of an equity award is considered an exchange of the original award for a new award.

If the original options are expected to vest, the entity should recognize the total compensation cost of the original award plus any incremental costs derived from the modification. The incremental costs are the excess of the fair value of the modified awards over the fair value of the original awards just prior to the effective modification date. A company modifying an existing award must determine the fair value of the original award just prior to the effective modification date and then after the modification date. If the fair value of the modified award is less than the fair value of the original award, the company would recognize the fair value of the original award as compensation cost. Sidebar 4 presents an example of accounting for a modification of nonvested share options.

If the original options are not expected to vest, the company should recognize the total compensation cost based on the fair value of the modified award. This is consistent with the idea that no compensation cost is recognized when no instruments vest and that a modified award is considered a new award.

The following transactions are considered modifications to awards:

• A short-term inducement available for a limited period of time.
• Exchanges of awards or modifications of the terms resulting from equity restructurings.
• Immediate replacements for a cancelled award.
• Repurchases or cancellations.

A company that repurchases an award for which the requisite service or performance has not yet been rendered has effectively modified the requisite service period and must recognize any previously unrecognized compensation cost (as calculated at the grant date) at the repurchase date. The amount of cash or other assets transferred (or liabilities incurred) to repurchase an award is charged to equity, up to the fair value of the equity instruments repurchased. Any excess of the repurchase price over the fair value of the instruments repurchased is charged as an additional compensation cost.

Cancellation of an award that is not accompanied with a replacement award, cash, or other consideration is deemed to be a repurchase for no consideration. Consequently, the company should recognize any previously unrecognized compensation cost at the cancellation date. The replacement award must be issued concurrently in order to avoid recognizing this additional compensation cost. After the effective date of SFAS 123(R), companies no longer have six months to issue replacement awards.

SFAS 123(R) has complex procedures for accounting for an award whose modification in terms results in a change in classification from equity to a liability.

Disclosures

A company with one or more share-based payment arrangements must disclose information that enables financial statement users to understand the following:

• The nature and terms of such arrangements that existed during the period, and the potential effects of those arrangements on shareholders.
• The effect of compensation costs arising from share-based payment arrangements on the income statement.
• The method of estimating fair value of the goods or services received, or the fair value of the equity instruments granted.
• The cash flow effects resulting from share-based payment arrangements.

SFAS 123(R) provides a sample disclosure of an ongoing plan.

Effective Date and Transition

According to the SEC, SFAS 123(R) applies to all awards with service inception dates occurring as follows:

• Public companies that do not file as small business issuers, such as accelerated filers, should apply SFAS 123(R) to the first interim or annual reporting period of the first fiscal year beginning after June 15, 2005.
• Public companies that file as small business issuers (pursuant to Regulation S-B) should apply SFAS 123(R) to the first interim or annual reporting period of the first fiscal year beginning after December 15, 2005.
• Nonpublic companies should apply SFAS 123(R) to the first annual reporting period that begins after December 15, 2005.

The SEC’s revision affects non–small business public companies with different fiscal years in different ways. Companies with a calendar fiscal year must apply SFAS 123(R) on January 1, 2006, six months later than the original requirement. Companies with a fiscal year beginning on November 1, 2005, must apply SFAS 123(R) on that date, rather than the quarter beginning August 1, 2005. Companies with a fiscal year beginning on July 1, 2005, must apply SFAS 123(R) on the original implementation date, with no delay permitted.

As of the required effective date, all public and nonpublic companies that previously used the fair value method for either recognition or disclosure must use a modified prospective method. This method requires that SFAS 123(R) be applied to all awards whose service inception date follows the applicable effective date and all existing awards modified, repurchased, or cancelled after that effective date. For awards for which the requisite conditions have not been fully satisfied and are outstanding as of the applicable effective date, the modified prospective method requires the recognition of the portion of the requisite service period not yet rendered as compensation cost using the valuation methodology required under the old SFAS 123. Companies should apply the guidance in SFAS 123(R) in measuring new awards or existing awards that were modified, repurchased, or cancelled after the required effective date. Sidebar 5 presents an example of applying the modified prospective method.

All public entities and those nonpublic entities that used the fair value method for either recognition or disclosure have the option of applying the modified retrospective application. The modified retrospective application requires entities to recognize, as compensation cost, the pro forma disclosures made under the old SFAS 123 (see Sidebar 6) to prior financial periods. The modified retrospective application requires the restatement of prior annual and interim financial statements presented in the filing to recognize compensation cost and an adjustment to beginning capital accounts of the earliest period shown.

SFAS 123(R) provides additional transition guidance pertaining to instruments classified as liabilities under the new rules and certain forfeitures, deferred tax assets, and valuation issues.

SFAS 123(R) requires entities to disclose, in the period of adoption, the effect of the change from applying the original provisions of SFAS 123 on income from continuing operations, income before income taxes, net income, cash flows from operations, cash flows from financing activities, and basic and diluted earnings per share. In addition, public entities that accounted for share-based payment arrangements with employees using the intrinsic method under APB Opinion 25 shall continue to provide the following information (in tabular form), as required by SFAS 123, for all periods:

• Net income and basic and diluted earnings per share, as reported.
• The share-based employee compensation cost, net of related tax effects, that would have been included in net income, as reported.
• The share-based employee compensation cost, net of related tax effects, that would have been included in net income if the fair value–based method had been applied to all awards.
• Pro forma net income, as if the fair value–based method had been applied in all awards.
• Pro forma basic and diluted earnings per share as if the fair value–based method had been applied in all awards.

FASB encourages, but does not require, early adoption of SFAS 123(R) for interim or annual periods for which financial statements or interims have not been issued.