Accounting for Equity Awards — A Non-Technical Overview of Selected Key Issues

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On June 8, 2015, the Financial Accounting Standards Board issued an exposure draft to make some helpful changes to the accounting for compensatory stock options.  The most significant would allow awards to continue classification as equity so long as net withholding is less than or equal to the applicable maximum withholding rates rather than minimum withholding rates. Also, equity repurchase rights triggered by a voluntary termination would not cause an award to be classified as liability awards. Other important changes include a change for the accounting for taxes.  To make it easier to put these changes in context, we include the accounting article to our executive compensation treatise (“Executive Compensation for Emerging Growth Companies, Thomson Reuters, 2015) with highlights in red below to indicate the changes (please excuse the occasional edit codes that Thomson Reuters embeds into the raw text).

 

6.1 Introduction.  Note:  FASB has changed the cataloging format for its standards.  What was previously known as FAS 123R is now Topic 718.  In general, the following chapter uses the original citations to FAS 123R.  Generally Accepted Accounting Principles (“GAAP”) in the United States are determined by the Financial Accounting Standards Board (“FASB”), a private professional organization dedicated to the establishment of standards for the fair presentation of financial results in an entity’s financial statements.1 In December 2004, FASB issued Financial Accounting Statement 123 (revised), Share Based Payment, (“FAS”) which requires companies to recognize compensation cost on their financial statements in connection with various compensatory equity awards. Awards covered by FAS 123R include options, direct shares (including fully vested stock, restricted stock and restricted stock units (“RSUs”) and stock appreciation rights (“SARs”).

It should be noted that it is likely at some point in the future much of GAAP will converge into standards promulgated by the International Accounting Standards Board (“IASB”).2 IASB has issued its own rule regarding share-based payments in International Financial Reporting Standard (“IFRS”) 2. While IFRS 2 and FAS 123R are substantially similar, there are differences that will likely apply to US companies once the convergence is complete.

6:2. FAS 123R applicability– General

►►FAS 123R establishes standards for accounting for the payment of share-based compensation in exchange for goods or services.1 FAS 123R does not apply to equity payments in exchange for cash or other financial instruments or payments under certain employee stock ownership plans.2 Share-based compensation is subject to FAS 123R if equity securities are issued or liabilities are incurred that either are settled, at least in part, based on the price of the company’s equity or may require payment in equity, such as paying the bill of a supplier with company stock.3

6:3. FAS 123R applicability– Applicability to employees/non-employees

►►FAS 123R applies to any share-based compensation payment though FAS 123R does not specify a measurement date for valuing awards to non-employees. Until such guidance is issued, previous guidance issued under the direct predecessor to FAS 123R (simply FAS 123) applies. Such guidance requires a treatment for non-employees similar to that applicable to employees under FAS 123R, except that the measurement date does not occur until the vesting date. Thus, until the vesting date, the expense is measured and re-measured as of the end of each reporting period–the same treatment applicable to liability awards as discussed below. As noted, liability treatment is often not desirable because of its unpredictable yet changing effect on the financial statements (somewhat similar to the dreaded variable accounting that existed prior to FAS 123R and which is discussed briefly later in this chapter).1

Generally, employee vs. non-employee status is determined under the IRS’ standard for making the same distinction.2 The IRS standard for determining whether a service provider is an employee is based on whether the employer exercises sufficient control for there to be an employer/employee relationship. While employees typically are subject to wage withholding, such treatment is not dispositive. Thus, an owner of a pass-through entity, such as a limited liability company (“LLC”), who receives equity in connection with employment services for the LLC, is treated as an employee by the LLC even if no wage withholding applies because of the individual’s status as a partner for income tax purposes.3

See §6:45 for a discussion of the rules regarding a change in status from employee to non-employee.

6:4. FAS 123R applicability– Applicability to employees/non-employees– Leased employees

Equity grants to leased employees are considered awards of the lessee if the employee would be considered to be a common law employee of the lessee and the lessee and lessor agree in writing to all of the following conditions related to the leased employee:

(i) the lessee has the exclusive right to grant stock for the employee’s service;

(ii) the lessee has a right to hire, fire and control the activities of the employee (the lessor may have these rights as well);

(iii) the lessee has the exclusive right to determine the economic value of the services provided by the employee;

(iv) the employee has the right to participate in the lessee’s employee benefit plans, if any, on the same basis as comparable employees of the lessee; and

(v) on or before an agreed date the lessee remits funds to the lessor to cover the complete compensation of the employee, including payroll taxes.1

6:5. FAS 123R applicability– Applicability to employees/non-employees– Non-employee directors

Non-employee directors are treated as employees for purposes for FAS 123R if they are either elected by the employer’s shareholders or appointed to a board seat that will be filled by shareholder election when the term expires. This exception does not apply to advisory board members (who typically are not elected by shareholders).1 Employee treatment for non-employee directors only applies with respect to compensation paid to that person for services rendered as a member of the board.2

Also, with respect to consolidated companies, only members of the parent company’s board are treated as employees for purposes of FAS 123R, except that a member of a consolidated subsidiary’s board is an employee if the members of the subsidiary board are appointed by the non-controlling shareholders of the parent company or by another member of the consolidated group,3 and further, the controlling shareholder must be precluded from voting for the director.4 This treatment applies only with respect to the consolidated financial statements. If the director is not treated as an employee for consolidated financial statement purposes, the consolidated financial statements will treat awards to that director as awards to a non-employee. However, if that director is elected by the subsidiary’s shareholders, the award will be accounted for as an employee award under FAS 123R in the separate statements of the subsidiary.

6:6. FAS 123R applicability– Applicability to employees/non-employees– Grants by related parties

►►FAS 123R also requires that equity awards from a related party or other economic interest holder (such as a shareholder) be accounted for as an award by the company unless it can be clearly demonstrated to be for something other than services for the company.1

6:7. FAS 123R applicability– Applicability to employees/non-employees– Grants to employees of related parties

For purposes of FAS 123R, employees of a consolidated subsidiary are considered employees of the parent company. However, FAS 123R does not govern parent company grants to employees of an unconsolidated entity (such as in the case of a joint venture).1

6:8. Overview of fair value recognition– General

►►FAS 123R requires companies to value equity-based awards and then “recognize” the cost, typically as an expense or offset to income, as the services are provided.1 As discussed below, the compensation cost typically is recognized as a debit to compensation expense and a corresponding credit to a liability account if the award is subject to liability award treatment (see §6:32) or as an addition to equity (typically addition to paid-in-capital) if equity treatment is available. Because liability treatment involves continuing re-measurement of the award and adjustment of the amount to be recognized, companies generally have a strong preference to avoid liability award treatment.

As a very simplistic opening example, assume a share of fully vested stock is issued to an employee pursuant to an award that qualifies for equity treatment, rather than liability treatment. Further assume that as of the “grant date,” the value of the fair value of the stock, as determined under FAS 123R, is $40. In this simple case the company would record total accounting entries as follows:

►► Compensation expense: $40
►► Additional paid in capital: $40

 

 

Assume instead the award was a fully vested option that also has a FAS 123R fair value of $40. The value of the underlying stock at grant, now assumed to be $100 is also the exercise price. The same entry as above would be recorded as of grant. If the optionee later exercises the option by paying the $100 exercise price, the following entries would be recorded:

►► Cash (debit): $100
►► Additional paid in capital (debit): $40
►► Common Stock/APIC (credit) $1402

 

 

6:9. Overview of fair value recognition– Measurement principle

The measurement of equity compensation awards subject to FAS 123R depends on the fair value of the equity instruments the employer is required to deliver once the employee has satisfied all conditions for the award.1 For awards that qualify for equity treatment (as opposed to liability treatment) the fair value is based on the underlying share price and other factors at the date of grant. For awards subject to liability treatment, the measurement date is the settlement date (the date of exercise, payment etc.).2 Prior to that time, the awards are measured and re-measured at the end of each reporting period.

For restricted stock, RSUs and similar awards, fair valuation is typically simply the fair value of the underlying stock. Valuation of options and similar rights, such as SARs, is much more complex however. Typically an option permits an employee to purchase the underlying stock at a fixed price equal to the fair value of the underlying stock at grant. Under Accounting Principles Board Opinion APB 25 (“APB 25”), one of the predecessors to FAS 123R, typically no compensation expense was incurred because at grant there was deemed to be no compensation element. This is because APB 25 relied on an “intrinsic value” concept rather than FAS 123R’s fair value concept–intrinsic value being the difference between the fair value of the stock at measurement (usually the grant date) over the exercise price. Thus under APB 25 and assuming all other conditions for fixed accounting under APB 25 were met, there was no compensation cost recognized if the award required an exercise price exactly equal to the grant date value of the stock to be received. However, FASB concluded there is tangible value to the practical right to purchase stock only when it increases in value with no corresponding obligation to purchase the stock if, for example, the fair value of the stock falls below the exercise price. The award of such a unique right has real and perceived value which is determined under FAS 123R and expensed over the vesting period.3 The fair valuation methodology for options is discussed starting at §6:18.

The fair value of an award is reduced for any consideration the employee must pay at grant to receive the award.4 Also, restricted stock, RSUs or similar awards are valued as if fully vested as of the date of grant.5 Only restrictions that continue past the date of vesting, such as prohibitions on sale, are taken into account in determining fair value.6

6:10. Overview of fair value recognition– Effect of vesting requirements

While generally vesting, or any restriction that does not last past the vesting period, is not taken into account in valuing awards, it does play a significant role in the recognition of compensation cost under FAS 123R. As discussed below, expense is recognized periodically for the fair value of awards that are expected to vest, and with certain exceptions principally due to vesting tied to market conditions and modifications, no expense is ultimately recorded for awards that do not vest. Thus, an award that does not ultimately vest but was expected to vest often will involve later reversal of any recognized cost.1 If an option vests but expires unexercised, the previously recorded compensation expense is not reversed.2

Also, vesting expectations can influence the pricing models used in valuing options and SARs. In closed-form models such as the Black-Scholes model, an expected term is developed based on assumptions about the option and exercise patterns. The expected term is influenced by the exercise period, and while it cannot be longer than the contractual term, it also cannot be shorter than the vesting term.3 Also, typical lattice models will reflect exercise behavior influenced by vesting.

In addition, compensation cost is actually recognized over the vesting period generally.4 If an employee terminates before a portion vests, any expense that was incurred with respect to the unvested portion is reversed. For example, if a restricted stock award is subject to a three year cliff vesting schedule, a substantial portion of the award will have been expensed by the end of year two. If the employee terminates at the end of year two the employer must reverse the amount previously expensed. For large grants, companies typically estimate the expected forfeiture rate by making assumptions regarding turnover. At the end of a vesting period the company does a “true up” adjustment to reflect actual forfeitures compared to those presumed in earlier years. If during the course of a three year grant the company assumes a 3% turnover rate but the actual turnover rate is 5% in year two, the company could adjust its forfeiture assumption unless it determines that the 3% rate will still apply as of the end of the vesting period.5

   It should be noted that on June 8, 2015 FASB issued an exposure draft that would permit the employer to forego the expense and uncertainty of estimating forfeitures by electing to account for forfeitures as they occur.[1]  The election must be made on a company basis as opposed to a grant by grant basis.  Once the rules become effective, the choice of the company—to elect the new permissible treatment or continue estimating—will establish the company’s policy.  Any later attempt to change to the other would be treated as a change in accounting principle which requires an assessment of preferability, and the change would have to be reflected retrospectively.

As noted, there is a very significant exception to the principle that unvested awards are not ultimately expensed. Awards can vest based upon service conditions (typically time based), performance conditions or market conditions. A market condition relates to achievement of a specified price of the company’s shares, including a share determined by an index of similar securities.6 Market based awards are expensed even if the market condition is not met unless another service or performance condition is also required but not satisfied.7

6:11. Overview of fair value recognition– Exclusions from value

Certain elements in addition to vesting are not taken into account in determining fair value: reload options and contingent features.1 Reload options typically provide that as an option is exercised, an additional option grant will be made based upon the number of shares exercised. The reload feature does not affect the fair value determination of the original option. Rather, when the reload grant occurs, its value will be determined under FAS 123R valuation principles at that time. Also, contingent features that require the return of the equity for less than fair value are not taken into account in determining the grant date fair value. Instead, the contingent feature shall be taken into account when the contingency occurs. Typically such contingencies are referred to as clawbacks, pursuant to which the equity must be returned for cost if, for example, an employee violates a non-compete, or it is later determined that the award was based on accounting results that are subsequently restated.

6:12. Overview of fair value recognition– Exceptions from fair value requirements

Certain exceptions apply, especially for private companies. Private companies generally are companies other than those that have or are controlled by companies that have publicly traded equity securities or have filed a registration statement to publicly trade equity securities.1 Companies that only have publicly traded debt are private companies for purposes of FAS 123R.

6:13. Overview of fair value recognition– Exceptions from fair value requirements– Private company volatility

There are several other limited instances in which the general fair value rules do not apply or are altered. As noted in §6:19, an important component in the valuation of options is the volatility of an entity’s shares. Even for private companies, volatility can be based on the volatilities of similar public companies. However, if it is not practicable to derive specific volatility, private companies may use an historical volatility index of an appropriate industry sector.1

6:14. Overview of fair value recognition– Exceptions from fair value requirements– Fair valuation not possible

FASB believes it is possible to derive a fair value of an option in nearly all circumstances but in those “rare circumstances,” for example, if an option contains such extra-ordinary complexity that such is not the case, any company (including a public company) may use a modified form of the APB 25 rules that preceded FAS 123R.1 That is, rather than measuring compensation by reference to a grant date fair value, compensation can be recognized by reference to its intrinsic value, which, as noted above, is the difference between the value of the underlying stock and the option exercise price. This intrinsic value is re-measured every period and compensation is adjusted based on the re-measured amount. Thus, this alternative is comparable to variable accounting under APB 25–a rule that was much detested because of its unpredictable effect on the income statement.

6:15. Overview of fair value recognition– Liability awards of private companies

Also, private companies with liability awards (awards that do not qualify for equity treatment–see §§6:32 et seq.) may choose to have those awards valued on an intrinsic basis rather than the FAS 123R fair value basis.1 This choice might make sense in a variety of circumstances, including that, while companies are private there typically is little importance attached to GAAP accounting financial statements–other measures are typically more important such as cash flow, revenue growth etc. Given the complexity of option calculation, under circumstances such as this, the intrinsic value alternative may make sense.

6:16. Overview of fair value recognition– ESPPs

►►FAS 123R generally covers all types of share based awards including employee stock purchase plans (“ESPPs”) subject to I.R.C. §423. See Chapter 2.

►►FAS 123 provides limited guidance on the accounting for ESPPs.1 For a standard plan with a discount equal to 15% of the lower of the fair market value of the stock at the beginning or end of the purchase period, FAS 123R basically concludes there are two components of value: 15% of the beginning purchase period price and an option fair value (see §§6:18 et seq.) equal to 85% of the value of an option to purchase the stock at the end of a purchase period. These two values combined constitute the fair value of the ESPP.

For more complicated valuations reference must be made to earlier guidance under the previous rule, FAS 123.2 Most specifically, many ESPPs that pre-date FAS 123R provided for as many as four purchase periods within a 24 month offering period. If the stock price continues to increase, participants in the second, third and fourth purchase periods can still take advantage of the opening price in the first period. This ongoing complexity adds a third element of value to be considered.

Certain ESPPs are deemed non-compensatory and thus do not require expense recognition, though most companies have assessed that the limited nature of such ESPPs make them too unattractive to warrant the effort and expense to maintain.3 The most important limit is that the discount at which the employees may purchase the shares generally cannot exceed 5% of the actual purchase price (larger discounts need to be justified as genuine costs of raising significant amounts of capital in a public offering if they are to avoid FAS 123R recognition). This limitation is not only small in comparison to the maximum 15% allowable under I.R.C. §423 but it does not permit the discount to be based on the fair market value at the start or end of the purchase period, whichever is lower, as permitted by I.R.C. &s;§423. A discount greater than 5% is permissible if available to all holders of the same equity class regardless whether such higher costs are consistent with the per sharing costs of raising capital. This alternative is rarely attractive.

Other requirements regarding non-compensatory ESPPs are that all employees be eligible after meeting limited employment qualifications and that employees must enroll no later than 31 days after the price has been fixed.

In an interesting though not particularly significant wrinkle, if an ESPP provides for a fixed discount (for example, 10%) from the purchase date price only, the award is classified as a liability under FAS 150.4 Thus, from the date of grant until purchase the discount and any withholdings show as liabilities on the balance sheet and not as credits to equity. This is because the award will result in a fixed monetary value known at grant with a variable number of shares. See §§6:32 and 6:43 with regard to liability awards. For example, assume an employee elects to have $1,000 withheld for six months with a 10% discount based on the purchase price. Regardless of what happens to the stock price, the employee will purchase $1,111 in value of the stock. Thus, if the stock price is $10 per share, the purchase price will be $9, with a total purchase of $111.11 shares (a value of $1,111). If the stock price is $20, the purchase price will be $18, with a total purchase of $55.55 shares (also a $1,111 value). At purchase a total of $111 must be expensed.

6:17. Mechanics of fair valuation measurement

As noted, share-based awards are generally valued by a fair value method and that value is generally expensed over the vesting period. See §6:25 for rules for determining the date as of when the fair value is determined, and §6:26 for determining the period over which the fair value is expensed.

It should be noted that while the total compensation cost is generally determined by reference to the value of the equity awarded to the service provider, FAS 123R does provide that the value of the goods and services received by the company can be used to determine compensation cost if such measure is more reliably determinable on the basis of such values in share based transactions with non-employees.1 Thus, for example, if a company pays an outside vender X number of shares for services that the vendor provides for a determinable amount of cash to other customers, this value might be a better measurement if those exact same services can be specifically associated with shares provided to an employee. This circumstance would seem exceedingly rare however, and accordingly, the vast majority of FAS 123R cost calculations focus on the value of equity paid to employees.

Observable market prices of identical or similar instruments “in active markets” should be used if available. Thus, awards of stock subject only to vesting should be based on the market price as of the measurement date.

If observable prices are not available, fair value should be determined (a) based on the exchange value between willing buyers and sellers;2(b) based on established economic principles of modern corporate finance;3 and (c) taking into all substantive characteristics of the instrument4 except those specifically excluded and discussed in §6:8, such as vesting conditions and reload features.

6:18. Mechanics of fair valuation measurement– Option valuation

Determining the fair value of options and similar awards is particularly challenging. As noted, the fair value of share awards such as fully vested stock, stock subject to vesting (commonly referred to as restricted stock) or stock deliverable in the future, typically reflects the value of the underlying stock, either by reference to observable prices in active <?I01AR61 ?>markets or acceptable fair market valuation standards. Option fair value determination is more complex. While the value of the underlying stock is certainly an important component of option fair value, what in fact is being measured is the value of owning a right, not an obligation: (1) to purchase for a price which is typically, though not always, both fixed and known; (2) shares of stock whose number potentially may increase or decrease based on events that are unknown at the time of grant (such as length of employment, satisfaction or non-satisfaction of performance conditions, market performance of the stock); (3) over a period of time that is typically limited, but that also may decreased based on such factors as (again) length of employment.

To the extent there are observable market prices for options with same or similar terms, such prices should be used. It is exceedingly rare however to find such similar instruments. While vesting is disregarded in valuing underlying stock, vesting is important in determining the expected term of or exercise patterns of an option. Thus, the price an investor might pay for a tradeable option in a company’s stock is not particularly relevant in pricing an employee option in that company’s stock because many terms, including the expected term influenced by vesting, are dissimilar.

Absent observable market prices for options with the same or similar terms, option fair value must be “estimated using a valuation technique such as an option pricing model.”1

As noted, valuing an option requires that a variety of unknown factors be taken into account. This is not a novel concept–any valuation of an asset to be held over time takes into account assumptions regarding unknown events. Both the purchaser and seller of stock traded on a public market take into account both objective and subjective assessments of future events such as product value in a changing market, barriers to competition, assessment of management effectiveness, ability to deal with debt obligations to identify just a few. The same is true of private company stock valuations that not only take into account the past (revenues and earnings) and the present (current assets) but also the future (what is the rate at which earnings should be capitalized; what is the future value of company intellectual property and goodwill; what is the value of comparable companies–a value influenced as well by future expectations).

In theory, an option valuation isolates certain aspects of future behavior, though the means of isolating such value can differ. The value of the underlying stock is essentially a given input. Option valuation is an attempt to value certain other elements in reference to that input, such as, how long the right will last, what can be expected to happen to the value of the stock over that period of time, when the exercise price is tendered, and today’s present value of that exercise price. FAS 123R generally requires that at the time of valuation (which as discussed in this chapter) can vary depending on whether the award is an equity or liability award, when the award is granted, when it is modified, etc., the fair value assumptions be based on expectations at that time based on information available at that time.2 Changes in information and expectations generally do not affect the original valuation, though if a later valuation is required because for example, certain modifications occur or because the award is a liability award, updated information and expectations as of the time of the revaluation must be taken into account.

6:19. Mechanics of fair valuation measurement– Option valuation models

►►FAS 123R specifically mentions two principal acceptable option valuation models: closed-form models (most prominently, the Black-Scholes-Merton Model, more commonly referred to as simply, “Black-Scholes”) and lattice models.1 The Black-Scholes model continues to be the most commonly used valuation method under FAS 123R, and for that reason is more widely understood, though lattice models are more typically favored by investment financial analysts and major shareholder advisory services. Observers generally believe the two methods yield similar results except in those cases where companies use Black-Scholes inputs that are either at the high or low end of acceptable ranges.2 While FASB indicates that lattice models reflect more fully the substantive characteristics of a particular option (an about face from the position taken by FASB in the FAS 123R Exposure Draft), both models are acceptable.3

6:20. Mechanics of fair valuation measurement– Black-Scholes

The Black-Scholes formula itself is extremely complex,1 though it is commonly available in certain hand-held calculators and via various internet sites. The Black-Scholes method typically requires six variables:

1. underlying stock price;

2. option exercise price;

3. option expected term;

4. risk-free interest rate over the expected term;

5. expected annual dividend note of the underlying stock over the expected term; and

6. volatility of the underlying stock over the expected term.

The first two variables should be readily determinable (even though a valuation might be required to determine the value of the underlying stock for a private company).

The expected term lies somewhere between the vesting date and the contractual expiration of the option. It is influenced by items such as the vesting schedule, employee exercise behavior and post-termination exercise periods. The judgment is likely subjective. Companies with greater stock volatility will experience greater change in its Black-Scholes valuation as a result of changes in expected term simply because high volatility stocks have more likelihood of a dramatic positive increase in price over a longer expected term of the option.2

Note that while the SEC permits safe harbor type expected terms for plain vanilla options of reporting companies, such relief is unavailable for options granted after December 31, 2007, unless the reporting company has insufficient historical data to reasonably estimate the expected term.3 The expiration of the safe harbor for most companies is based on the thought that over time legitimate expectations about behavior patterns could emerge, of course solving one of the more complex elements of the Black Scholes model, an observation that seems to have come to fruition.

It should be noted that on June 8, 2015 FASB issued an exposure draft that would permit private employers (not otherwise subject to SAB 107) to use the plain vanilla safe harbor for determining expected term.[2] 

Stock volatility also has a significant effect on valuation. Stock volatility is basically a measure of the amount a stock price can be expected to fluctuate over the expected term.4 Growth oriented companies typically have significantly more volatility than mature companies principally because there is more perceived data about where a mature company can go in the future as predicted by where it has been over long periods of time. The Black-Scholes value of a stock with greater volatility over the expected term will often be more affected by that volatility because at some time during the expected term a substantial spike in the value of the stock can be expected to occur, increasing the likelihood of exercise during that spike.

6:21. Mechanics of fair valuation measurement– Risk-free interest rate

►►FAS 123R requires that option pricing models use a time value of money rate equal to the implied yield available at the date of valuation from the United States Treasury zero-coupon yield.1 The implied yield must be computed over the expected term if a Black-Scholes type model is used (if a lattice model is used the term is the option contractual term). The higher the interest rate assumption, the higher the option value due in part to the shrinking true value of the exercise price over the expected term but also due to assumed equity premiums of the stock above the risk free rate.

6:22. Mechanics of fair valuation measurement– Dividend yield

Implicit in the value of a share of stock is an allocation of that value to expected dividends. Option holders do not receive dividends and therefore, expected dividend value over the expected term should decrease the fair value of the option itself. The higher the expected dividend, the lower the option value under an option pricing model. Thus, for the typical emerging company, the dividend adjustment is likely to be small because typically dividends are not expected.

In computing expected dividends, management should consider historical dividend practice. If, for example, the company has historically increased dividends at a certain percentage, it would not be appropriate to use a static assumption. Also, the company must take into account dividend preferences, rights and features. If the company permits dividends accumulated on the underlying stock prior to exercise to reduce the exercise price, that feature should be taken into account.1

As noted, the Black-Scholes pricing model is very complex in detail but is straight-forward in concept. As explained by one major accounting firm, this type of model has two components typically: a minimum value and a volatility value.2 Minimum value is the underlying fair value of the stock minus the present value of the exercise price (at the risk free return described above) over the expected term and minus the present value of expected dividends over the expected term. PwC offers the following example:

►►Expected term: 6 years          
►►&emsp;          
►►Exercise price: $50          
►►&emsp;          
►►Fair value of stock at grant: $50          
►►&emsp;          
►►Expected dividend yield: 1% (compounded annually)          
►►&emsp;          
►►Risk free rate: 3% (continuously compounded)          
►►&emsp;          
►►Minimum value computation:          
►►&emsp;          
►► Current stock price: $50.00    
►►Less:          
►► &b;• Present value of exercise price  
►► ($50 discounted at 3% over 6 years) $41.76
►► &b;• Present value of expected dividends  
►► (at 1% over 6 years) $ 2.90
►► Minimum Value: $ 5.34    

 

 

The volatility value, itself a complex determination, is zero for zero volatility and rises with increases in assumed volatility. PwC indicates that the typical formula, when applied to the example above, would yield increases in the option value of $11.52, $23.17 and $32.59 for assumed volatilities of 20%, 50% and 80% respectively. Thus for a company with 50% volatility, the option value is about 46% of the underlying value of the stock at grant.

Finally, if the option is in the money at that time of grant, the in the money value–intrinsic value–is a third theoretical component of the value of the option as measured by the Black-Scholes model. While in the money option grants are particularly rare under I.R.C. &s;§409 (See Chapter 2), this component affects an option’s value, for example, when an option is modified or when it is revalued because it is liability award.

6:23. Mechanics of fair valuation measurement– Lattice models

As noted, FAS 123R indicates that lattice models are preferable, though, closed-form models such as the Black-Scholes model are acceptable. Lattice models start with inputs similar to those used in a Black-Scholes model: underlying stock value, exercise price, volatility, interest rate and dividend yield. The significant difference is the term–lattice models utilize the entire contractual term.1 While a great deal of individual mathematical calculations must be made to price an option with a lattice model, the model is not a formula but an averaging the present value of a reasonably expected range of cash flows influenced by exercise behavior and contractual terms. The theoretical benefit of a lattice model is that it can be expanded to include virtually all outcomes for such behavior and contractual terms. The basic lattice model starts with the original stock price and then assumes formula increases and decreases over set intervals during the contractual term until a stock value tree is built out at the end of the contractual term.

PwC provides the following example, though for ease of illustration here (and at the risk of altering the true numbers because of a change in the contractual term), the presentation here goes out for only six rather than 10 years.2 The assumptions are as follows:

►► Grant date stock fair value: $100  
►► Exercise price: $100  
►► Vesting period (cliff) 3 years  
►► Expected (and assumed for this purpose) 6 years  
►►Contractual Term      
►► Expected volatility 30%  
►► Expected dividend yield 0%  
►► Risk-free rate 3%  

 

 

The first step is to build a mathematically derived outcome tree of potential values through the contractual term starting with the value of the underlying stock at the date of grant (far left — $100). The tree then builds to the right for Time 1 (for ease of reference this is the first anniversary of grant–more typically the time intervals would be small to the point of almost being continuous–at such a point the movement becomes curved and ceases to be in a straight line, though the aggregate change resulting from such increased precision is small). This is done by using mathematical formulas to derive both an upward price and a downward price at Time 1 starting from the original grant date value.3

Tree to Build Hypothetical Stock Values

►►

Then, having arrived at Time 1, the first anniversary of the grant, the tree moves to Time 2, the second anniversary, assuming upward or downward movements from each of the previous two Time 1 outcomes. This process is repeated until Time 6, the six-year anniversary of the grant. Time 6 thus represents different possible and reasonable outcomes of the value of the stock price at the expiration of the option (obviously the stock value could fall to zero or rise to any number above $724, but under the circumstances and the formula applied, the range derived by the formulas should be a reasonably acceptable range projecting forward from the grant date). The outcomes at the far right are significant numbers–they represent reasonable outcomes of the value of the stock, and when reduced by the exercise price of $100, equal various potential values of the option at its expiration. This is because the day an option expires it is exactly worth the intrinsic value (the excess, if any, of the stock’s fair value over the exercise price), at that time.

Getting to the year six numbers is the entire point of the first tree and is the starting place for a second tree which, taking the Time 6 value minus the option exercise price, works backward in time to derive the option value at the date of grant. So, notice the far right numbers in the following tree are just the far right number in the preceding tree minus the $100 exercise price, but not below zero.

Tree to Deduce Option Value Working Back in Time from the Right

►►

Having derived the starting point at the far right as described above, the next step is to derive the value, working back in time, for the boxes in Time 5 based on the Time 6 boxes. The obvious first adjustment is that the Time 5 boxes must be adjusted down for the time value of money–the value today of a dollar received next year is less than a dollar.4

Note that the bottom three boxes to the right are zeroes because the fair value of the stock at those boxes is less than the option exercise price.

However, there is more to it. For example, taking the top two values, they are theoretically the result of either an increase or a decrease from the derived value in Time 5, less the exercise price and adjusted for present value. If one simply averages the $624 and $297, the result is $460. The discounted value of that amount at Time 5, assuming a 3% discount rate is approximately $447, a number somewhat higher than $424 value in the top box of Time 5. This skew looks like a probability skew. For example, if the top box at Time 6 had only a one in three chance of occurring and the second box had a two in three chance of occurring, the value of the box in Time 5 would be approximately $624 + 297 + 297/3, or $406.

Actually, the reason for the skew occurs for mathematical reasons associated with the risk free interest assumption and volatility. In building the first tree for stock value, it is assumed that on average, owing to equity premiums and the fact that over time they exceed the 3% risk free return, if one were to assume an exercise in year 5, to compare that potential value to that available as a result of an exercise in year 6, one would have to back out such probability like increases, thus seeming to skew the probability toward the lower number.5

This process is computed for each box in the preceding time node until an option value of $36 is derived as of the date of grant. That is the FAS 123R value upon which cost recognition is based.

6:24. Mechanics of fair valuation measurement– Other factors

Regardless of the method, in certain limited instances, the effect on value of share dilution and the credit risk associated with the cash settlement of liability awards may have to be considered.1

6:25. When is fair value determined?

The determination of the valuation of a share-based award that is an equity award is determined on the award’s grant date. The grant date is the date on which the employee and employer “reach a mutual understanding of the key terms and conditions” of the award.1 Notwithstanding the foregoing, the grant date does not occur until all approvals are obtained (including necessary shareholder approval unless such approval is perfunctory, such as when the board approving the change constitutes a majority of the shareholders). Also, the grant date generally does not occur until the company is obligated to issue the award and the employee actually begins to be affected by changes in the stock price.

Awards subject to liability treatment are measured and then re-measured at the end of each reporting period until the award is settled.2 Generally, the re-measured cost is recognized proportionately over the vesting period and after the vesting period the changes in fair value are recognized in the period in which they occur. See §6:43.

6:26. Once measured, how is compensation cost actually recognized?– General

Compensation cost determined pursuant to FAS 123R typically is not recognized all at once but is generally recognized over the requisite service period as discussed below. However, while recognition of compensation cost leads to an increase in compensation expense on the income statement (with a corresponding reduction in net income), this is not always immediately the case. For example, if the employee services are part of the cost of another asset, such as software development costs, property, inventory or equipment, etc., the FAS 123R costs recognized for the period might instead be capitalized as part of the cost of that asset and then expensed as the asset is consumed.1

6:27. Once measured, how is compensation cost actually recognized?– Requisite service period

The requisite service period is generally the vesting period. Vesting is typically determined on a time, performance or market basis. While it would be rare for an award to vest on some other basis–for example by reference to a country’s gross national product (GNP), if such is the case the award will be subject to liability treatment. See §6:35 below. The requisite service period starts on the service inception date, which is the date the service required with respect to the award begins.1 In the rare instances in which the service inception date begins prior to the grant date, the accrual of the compensation cost prior to the grant date is based on the value of the award on the reporting date, not the earlier service inception date or the later grant date.2

[An important distinction is necessary here. It is often the case that a grant is made on one date, for example November 1, 2009, but that the vesting period, assume monthly vesting over 48 months, begins as of an earlier date, which is as<?I04AEBM ?>sumed to be August 1, 2009. This might occur when an employee is hired on August 1, 2009 but the compensation committee does not meet until just prior to November 1, 2009.

In this common circumstance, the service inception date is the November 1, 2009 grant date even though under the terms of the award, service prior to November 1, 2009 counts for vesting purposes. FAS 123R indicates the service inception date begins prior to the grant date only when each of the following is satisfied: (a) an award is authorized; (b) service begins before there is a mutual understanding of the key terms (including the exercise price); and (c) either (1) the award’s terms do not include a substantive future requisite service condition that exists at the grant date or (2) the award contains a market or performance condition that if not satisfied during the service period preceding the grant date and following the inception results in forfeiture of the award.3 Typically (a) is not met because there is not an award authorized prior to the November 1, 2009 grant date, but even in instances where an award has been authorized, neither (c)(1) nor (2) typically applies because the grant would have to be totally vested as of November 1, 2009.]

The requisite service period may be explicit, implicit or derived.4 While an award may have one or more of the foregoing, only one type of service period may apply for purposes of FAS 123R. An explicit service period is one expressly stated in the terms of the award, such as four year monthly vesting.5 An implicit service period is not expressly stated but may be inferred from the terms of the award and other facts and circumstances.6 Thus, if an award is based on completion of a product and it is probable the product will be completed in 18 months, the requisite service period is the implied service period of 18 months. A performance award will typically have an implied service period but recognition will not begin until it becomes probable the vesting requirements will eventually be met, as discussed below.

A derived service period is inferred from the application of valuation techniques7 and this approach is only appropriate for market vesting conditions. For example, if an award provides for vesting only if the value of the underlying stock price increases to a certain multiple of its current value, a derived service period would be required. Models such as the lattice model briefly described above may be used.8

6:28. Once measured, how is compensation cost actually recognized?– Vesting must be probable

As noted, compensation cost is recognized only for awards that are expected to vest. Thus, when the value is measured, the company must estimate the portion of the award that will vest, including with respect to time-based vesting awards. Typically, the company will make certain assumptions regarding turnover in relationship to when the awards will vest. If the assumptions regarding awards that are expected to vest change, an adjustment must be made to pick up the cumulative effect in the year the change is made.1 Thus, a sort of true-up is required to account for changes in vesting. Also, compensation for awards subject to performance vesting is not recognized until the period determines that performance (includng performance in later periods) is probable.2 However, an expense that has been incurred and not subject to further adjustment of vesting assumptions is not reversed simply because the award expires unexercised.3

6:29. Once measured, how is compensation cost actually recognized?– Time based vesting

►►FAS 123R requires that the value of an award be recognized over the requisite service period.1 For an award subject to cliff vesting (all or nothing depending on length of employment), the portion of the grant date fair value that vests on the cliff date must be fully recognized by the reporting date that includes the cliff vesting date. For any reporting dates prior to the cliff vesting date a portion of that value must be recognized on a straight line, or strictly pro rata, basis.2 For example, as of the January 1, 2009 date of grant, assume 1,000 shares are expected to vest on the December 31, 2011 cliff vesting date. Assume the award qualifies for equity (as opposed to liability) award treatment and that the grant date fair value is $10 per share, or $10,000 total value. Assuming the expected vesting assumption remains unchanged as of December 31, 2011, the entire $10,000 must be recognized as of the reporting period ending December 31, 2011. This is accomplished by recognizing $3,333 (one third) in each of the reporting years ending December 31, 2009, 2010 and 2011.

For awards subject to graded time based vesting only (portions vest prior to the last vesting date depending on length of service), the company must make a policy choice between applying a straight line method above, or assuming the award constitutes separate grants–each beginning with the same service inception date but with requisite service periods ending in the subsequent reporting periods.3

Consider the same example discussed above except that the option vests in three equal annual installments. If the company elects, it may recognize the $10,000 total cost exactly as it does for cliff vesting: $3,333 recognized each year under the assumption there is one award which vests in full on December 31, 2011. (However, the expense recognized as of each period must be at least equal to the portion that has already vested–thus, if 50% vests in year one and 25% vests in each of years 2 and 3, 50% of the award must be recognized at the end of year 1 and 25% by the end of year 2).

Alternatively, the company could elect to expense the award as if it were three separate awards, each with requisite service periods beginning January 1, 2009. However, the three awards would have requisite service periods ending December 31, 2009, 2010 and 2011 respectively. The total expense would be calculated as follows:

 

►►►End of Requisite Service Period Grant Date Value 2009 Expense 2010 Expense 2011 Expense                    

 

►► Award 1 2009 $3,334 $3,334                    
►► Award 2 2010 $3,333 $1,667 $1,666                  
►► Award 3 2011 $3,333 $1,111 $1,111 $1,111                
►►$10,000 $6,112 $2,777 $1,111                      

 

 

This method results in a front loaded expensing of options. It was essentially required by the FASB in FAS 123R Exposure draft, though the final version of FAS 123R also permits the use of the single award straightline concept above.

6:30. Once measured, how is compensation cost actually recognized?– Performance vesting

As noted, an award subject to performance vesting is not recognized until the performance criteria are “probable” which means likely to occur pursuant to FAS 5, Accounting for Contingencies.1 Often, probability is not achieved until the event has occurred, such as when a required IPO or liquidity event occurs. Also, if the event requires a specified return to investors, the award is not a performance based <?I01K4J7 ?>award but is a market based award.2 This distinction can be very significant because cost will be recognized by the end of a time-based vesting period (if any) even if the investor return is never achieved and thus the award never vests.

Performance vesting is recognized ratably over the requisite service period.3 For example, re-consider the example above regarding time-based cliff vesting except that the award vests only if the participant is still employed as of December 31, 2011 and the market share of the company has increased by 5%. If it is probable as of the date of grant that the 5% hurdle will be met, the recognition of the $10,000 grant date value will be essentially the same as applicable in the case of cliff vesting. However, if it is not probable that the 5% hurdle will be met until 2010, and if satisfaction of the 5% hurdle remains probable through 2011 and is met on or before the end of 2011, then no amount will be recognized in 2009, but $6,667 will be recognized in 2010 and $3,333 will be recognized in 2011.4

Assume that an employer grants options with an exercise price equal to the fair value of the stock on January 1, 2009. Further assume there are 1,000 employees and that all grants will vest at the rate of 100 shares for each 5% increase in market share. Also, the company estimates a 3% forfeiture rate and as of the date of grant the company believes it is probable that a 5% increase in market share is probable but does not believe any greater increase is probable. The fair value of the options is $20 per share at grant.

For 2009, the compensation cost to be recognized is determined as follows:

►►(100 shares &times;× $20 &times;× 1,000 employees &times;×.973)    
►►&times;× 1/3    
►►= (100 &times;× 20 &times;× 1000 &times;× .913) &times;× 1/3    
►►=$608,4495    

 

 

Assume in 2010, the company changes its forfeiture estimate to 6%. The probable increase in market share remains the same. In 2010, the compensation cost to be recognized is determined as follows:

►►[(100 &times;× $20 &times;× 1000 &times;× .943) &times;× 2/3] — $608,449  
►►=$498,996  

 

 

Assume at the end of 2011 market share has increased by 10% since grant and that the 6% forfeiture estimate has proven accurate. Compensation cost recognized for 2010 is determined as follows:

►►(200 &times;× $20 &times;× 1000 &times;× .943) — $608,449 — $498,996  
►►=$2,214,891  

 

 

Performance awards can come in many different arrangements and must be carefully examined. In the preceding example, the required targets are known as of the date of grant and they may be met at any time during the period. For accounting purposes this award constitutes three separate grants that can be valued as of the date of grant because all material terms are known, though in this case, until the third year, only one of the awards is probable of being earned. Thus expense for 2009 and 2010 is based only on the one award probable of being earned (the 5% market share increase award on the first 100 shares per employee). If at the end of 2011 the market share in fact only increases by 4%, so that none of the awards actually vests, the second 100 shares is not recognized and the cost recognized in 2009 and 2010 for the first 100 shares must be reversed.6

As a variation of the previous example, the award provides <?I008YKT ?>that 100 shares per employee vest if certain sales targets are met in each year. Unearned awards do not carry over from year to year and as of the date of grant, management believes it probable that all awards will be earned. In this instance, there will again be three separate awards. Each will be valued at the $20 grant fair value because at the grant date all material terms are known, and each has its own distinct service inception date and requisite service period over which the cost will be recognized because only service and performance during that period will be counted for purposes of that portion of the total award.7 Ignoring the effect of forfeitures, the compensation cost recognized in each year is $2,000,000–the value of 100 option shares in each year for the 1,000 employees.

Assume the preceding example is modified so that each 100 share tranche is earned if a certain sales target is achieved in each of the three years but that target is not determined until the beginning of each year. In this case, the grant is treated as three separate awards but the grant date for each separate award does not occur until the beginning of each year because the material terms of each separate grant are not known until then. Thus the value of each award is determined as of the beginning of each service period.8 Assume that the value of the options is $20, $25 and $30 as of the beginning of 2009, 2010 and 2011 respectively and that as of the beginning of each year it is probable that award for that year will vest. Again, ignoring the effect of forfeitures, the cost of the awards is recognized as follows:

►►2009    
►►$20 &times;× 100 &times;×1,000 = $2,000,000    
►►2010    
►►$25 &times;× 10 &times;×1,000 = $2,500,000    
►►2011    
►►$30 &times;× 100 &times;× 1,000 = $3,000,000    

 

 

In yet another variation, assume the sales targets for each year are known at the grant date, that the first 100 share tranche applies for 2009, the second for 2010, the third for 2011, and that a shortfall in one year can be made up in a subsequent year so that earlier awards may be earned in a later year. Also assume that as of grant it is probable that all targets will be met as of the end of 2011. In this case the original grant date value is used for each portion of the total award because all material terms are known at that time. While each award has its own service inception date at the beginning of each year, the requisite service period is the entire three years for the first 100 shares and the last two years for the second 100 shares because those awards can be earned in the later year(s). Again, ignoring the effect of forfeitures, the compensation cost is recognized as follows:

►► 2009  
►► Tranche 1: ($20 &times;× 100 &times;× 1,000) &times;× 1/3 = $666,667  
►►&emsp;  
►► 2010  
►► Tranche 1: ($20 &times;× 100 &times;× 1,000) &times;× 1/3 = $666,667  
►► Tranche 2: ($20 &times;× 100 &times;× 1,000) &times;× 1/2 = $1,000,000  
►►$1,666,667          
►► 2011  
►► Tranche 1: ($20 &times;× 100 &times;× 1,000) &times;× 1/3 = $666,667  
►► Tranche 2: ($20 &times;× 100 &times;× 1,000) &times;× 1/2 = $1,000,000  
►► Tranche 3: $20 &times;× 100 &times;× 1,000 = $2,000,000  
►►$3,666,667          

 

 

Assume a drug development company awards an option for 20,000 shares. The fair value of the award is $40,000. One-fourth of the award vests upon clinical trial approval, which at grant is deemed probable of achievement within 2 years and the remaining three-fourths vests when the product is taken to market, which, at the date of grant, is deemed probable of achievement within 5 years. The second award is obviously contingent on achievement of the first. The grant date value of $40,000 is used because all material terms are known at that date. Also, the service inception date is the same for both grants because services starting immediately after the grant date are considered for each award. However, the requisite service period for the first tranche is two years <?I0221OT ?>while it is five years for the second tranche. Ignoring the effect of forfeitures, the compensation cost is recognized as follows:

►► 2009 and 2010 each    
►► Tranche 1: $10,000 &divide; 2 = $5,000  
►► Tranche 2: $30,000 &divide; 5 = $6,000  
►►$11,000          
►►&emsp;  
►► 2011 through 2013 each      
►► Tranche 2: $30,000 &divide; 5 = $6,000  

 

 

Note that if an award previously determined to be probable subsequently is determined to be not probable, previously recorded cost is reversed.9

6:31. Once measured, how is compensation cost actually recognized?– Market-based vesting

As noted, it is extremely important to recognize when a vesting condition is market based. The effect of the market condition must be taken into account in determining the grant date fair value of the award,1 the cost must be recognized regardless of whether the market condition is achieved unless another service or performance condition is also not met,2 and typically a requisite service period will have to be “derived.”

A market condition is a condition affecting a material term in determining the fair value of the award (typically exercisability) that relates to the achievement of a specified price of the company’s stock or index of similar securities.3

►►FAS 123R provides an example similar to the following.4 On January 1, 2009 the company grants an option for 200,000 shares to an executive. The option vests if either the price of the company’s stock reaches a certain level for at least 30 consecutive days or the executive remains employed for five years. The company must derive a service period for the market condition and use that or five years, whichever is shorter.5 Thus, if the derived market service period is three years, the grant date option value must be spread over the first three years. If the market condition is satisfied before three years have elapsed, all unrecognized cost must be immediately recognized. If the executive terminates employment before the market condition is met, but after the three-year derived service period, the previously recognized expense is not reversed under any circumstance, even if the executive terminates prior to the five year service requirement and thus never vests.

If, however, the executive must meet both the market condition and the five year service condition, the requisite service period is the longer of the five year explicit period and the three year derived period and recognition will not commence until it is probable both conditions will be satisfied. If the executive terminates prior to the end of five years without meeting the market condition, any previously recognized cost will be reversed. If the executive is still employed at the end of five years, no cost previously recognized is reversed.

6:32. Liability awards

Share-based awards subject to FAS 123R are either subject to equity or liability award treatment. Although most of FAS 123R applies to both, there is one significant difference–equity awards are valued as of the grant date and that value does not change, unless there is a modification, while li<?I05YSR1 ?>ability awards are measured and re-measured as of each reporting date until the award is actually settled.1 This is one of the most important distinctions to be made in designing an equity compensation award. The result of ending up with liability treatment is similar to the undesirable variable accounting treatment under previous APB 25, in that it involves unpredictable changes to the amount of compensation recognized while the award is outstanding.

6:33. Liability awards– General

Options or similar instruments such as SARs are expressly subject to liability treatment if the underlying shares are classified as liabilities, as briefly discussed below (for example a mandatorily redeemable share or certain repurchase rights) or the company can be required to settle the award in either cash or other assets.1 The substance of the award is determinative (including the use of a tandem award which cancels the equity award and settles in cash). Also, despite the terms, if the company demonstrates a pattern of agreeing to requests for cash settlement the award may be classified as a liability.2

6:34. Liability awards– Repurchase rights

An employee’s right to put shares to the company or an employer’s right to call shares is classified as a liability award if the feature permits the employee to avoid bearing the risks and rewards of stock ownership for at least six months from the date the shares are issued and the award is vested. The same is true if it is probable the company will prevent the employee from bearing those risks and rewards for at least six months from the date the shares are issued.1 If the repurchase is conditioned on an event outside the employee’s control, such as a change of control of the company, the award would not be subject to liability treatment unless such event becomes probable within that six month period.2 Liability treatment is also required if the shares must be held for six months but the risks and rewards are not borne by the employee because the repurchase price is fixed.3

It should be noted that on June 8, 2015 FASB issued an exposure draft that would base the classification of an award with repurchase features as equity of liability on the basis of probability, not whether or not the employee or the employer can control the event.  The most obvious example is a repurchase right on voluntary termination.  Under the current rules, such a repurchase right would trigger liability treatment.  Under the current rules, such a provision would permit the award to be classified as equity unless the voluntary termination were deemed probable by the company.[3] 

6:35. Liability awards– External measures

An award that is based on a factor, in addition to the company’s stock price, that is not a service, performance or market condition is subject to liability treatment. For example, an award that vests based on a country GNP or who wins the Super Bowl is subject to liability treatment. However, awards that otherwise qualify as equity awards are not liability awards simply because those awards have a fixed exercise price denominated in the currency of a foreign operation or in which the employee’s pay is denominated.

6:36. Liability awards– Mandatorily redeemable shares

An important liability award category is the mandatorily redeemable share. While FAS 123R awards are specifically excluded from the application of FAS 150,1 FAS 123R specifically adopts paragraphs 8&ndash;-14 of FAS 150, with exceptions set forth in FAS 123R, in determining whether employee <?I08AS60 ?>share-based awards are subject to liability award treatment.2 Pursuant to paragraph 9 of FAS 150, a mandatorily redeemable share exists when the company and employee are unconditionally obligated to redeem a share at a determinable date or an event certain to occur, such as a death or termination of employment. However, application of the mandatorily redeemable share requirement is indefinitely deferred for private companies that are not required to file financial statements with the SEC unless the redemption is on a fixed date at a price which is either fixed or determinable from an external index.3

6:37. Liability awards– Variable settlement

►►FAS 150 also includes certain obligations to issue a variable number of shares, for example, (i) a fixed dollar obligation settled in the number shares equal to that value at settlement, (ii) variations based on something other than the value of the Company’s stock such as a precious metals index, or (iii) variations inversely related to changes in the fair value of the company’s stock, such as a written put option settled net in shares.1

6:38. Liability awards– Freestanding puts and calls

An instrument which is not a share but which obligates the company to repurchase its shares is also subject to liability treatment. This includes a put not tied to the award of shares–a freestanding put.1 This also includes a compound instrument other than outstanding shares, such as collars with written puts.2

6:39. Liability awards– Book value redemption

Mandatory redemption of book value shares (where value is based on a formula price) require liability award treatment unless the private company deferral of FSP FAS 150-3 applies.1 Even if the deferral applies, liability award treatment could apply as provided above with respect to repurchase rights if the employee could put the shares to the company within the six months following vesting.2

6:40. Liability awards– Cashless exercise

As under APB 25 it is important to comply with the rules of FAS 123R with respect to broker-assisted cashless exercises and tax withholding.1 As noted below, under FAS 123R it should be perfectly acceptable for an award to qualify for equity treatment if it permits the exercise of an option by the delivery of net shares–a practice that was problematic under APB 25. Under APB 25, the typical way to accomplish net exercise (i.e., payment of the exercise price using shares subject to the option rather than payment with cash or other assets) and avoid variable accounting was the use of a broker-assisted sale of option shares on the market. Such a technique remains popular for public companies though to avoid liability treatment, FAS 123R expressly requires that a valid exercise of the option must occur and the employee must be the legal owner of the option shares even though no exercise price is paid before the sale of the shares on the market.<?I0049W8 ?>

Prior to the adoption of FAS 123R, APB 25 provided that variable accounting applied to any settlement in net shares (receiving the intrinsic value, or spread between the stock’s value and exercise price in shares without paying a cash exercise price) unless the option was either exercised with mature shares (shares already owned for six months) or pursuant to a transaction with a third party (such as a broker-assisted cashless exercise on the market described above). Since the adoption of FAS 123R it has been asserted occasionally that a net settlement in shares should be subject to liability treatment, just as is definitely the case with net settlement in cash. However, most accounting firms seem to be going out of their way to be clear that net settlement in shares is subject to equity treatment and not liability treatment.2

6:41. Liability awards– Withholding taxes

As for withholding taxes, to continue as an equity award and avoid liability treatment for shares subject to net settlement, the award’s terms must limit the withholding settlement to no more than the minimum state and federal withholding taxes (including FICA and other employment taxes1) and the company does not, as a matter of practice, withhold amounts in excess of the statutory minimums.

  However, it should be noted that on June 8, 2015, the FASB issued an exposure draft that would liberalize the current withholding rules to permit equity treatment so long as the withholding settlement does not exceed the maximum rate in a particular jurisdiction.[4]  The proposed rule would also require that any cash paid by the employer to the taxing authorities to pay the withholding obligation on a net settlement should be reflected in the cash flow statement as a financing activity.

6:42. Liability awards– Rewards of LLC, subsidiary-based interests, etc.

Grant Thornton describes a discussion by the SEC Staff regarding the equity/liability award treatment of certain instruments, specifically instruments with a value based on a subset of the parent’s assets, such as a subsidiary or the grant of a special class of stock to participate in a liquidity event.1 The issues are similar to the grant of an LLC profits interest addressed in Issue 40 of EITF 00-23.2

The critical analysis focuses on whether the awards in substance are equity awards accounted for as such under FAS 123R or more similar to performance or profit sharing arrangements subject to liability treatment. Characteristics indicative of equity treatment are voting and dividend rights similar to those enjoyed by other shareholders. The interest should also constitute equity for corporate law purposes and retain a residual interest in net assets. On the other hand, liability treatment would be indicated by few if any assets underlying the interests, significant subordination of the interests and liquidation or repayment provisions that limit downside or provide for cash payment. If equity is indicated the SEC rejects valuation based strictly on liquidation that ignores the upside potential.

Even if an award is not accounted for as a liability, applicable SEC guidance may require public reporting companies to include it on the balance sheet as “temporary” (as opposed to permanent) equity for options and shares with a repurchase feature exercisable by the employee after the shares have been vested six months, shares with a less than probable contingent repurchase feature outside the control of the employee and the company, and options with a less than probable cash settlement feature outside the control of the employee and the company.3

6:43. Accounting for liability awards

As noted, FAS 123R requires the re-measurement of compensation expense for a liability at each reporting date. Assume a cash-settled SAR is granted on January 1, 2009 and has a six year contractual term but vests on a 100% cliff basis three years after grant. The option has a $100 strike <?I01XD08 ?>price, which is the fair value of the underlying stock at the date of grant. Assume that the grant date fair value of the option, as determined under an appropriate pricing model under FAS 123R is $36. Assume that as of December 31, 2009 the fair value of the option is $33.1 In this instance, disregarding the effect of a forfeiture, the cost recognized for 2009 is $11–one third of the reporting date value as opposed to the grant date value.

Assume that the value of the option at December 31, 2010 has increased to $45.2 For 2006, the cumulative cost to be recognized through the end of the second year is two thirds of the $45. This means $45 minus the expense recognized in 2009 is recognized in 2010: $30-11=$19. Assume at the end of year 2011, the value of the option is $40. The cost recognized in 2011 is the full $40 minus the $30 expensed in 2009 and 2010, or $10.

At this point, the difference between equity and liability award treatment is that $40 has been recognized as a liability award over the three years of the requisite service period and the amount has varied as follows, based on a number of factors, most significantly a change in the value of the underlying stock: $11 in 2009, $19 in 2010 and $10 in 2001. Also, the grant date fair value is not particularly relevant–value is computed on the reporting date. If the SAR were instead settleable in stock and otherwise eligible for equity treatment, the total expense in this instance would have been $36 and the annual expense would have been $12 based on the grant date fair value. Also, this cost would not have changed regardless of the change in the underlying value of the stock.

There are numerous other consequences of variable treatment (for example, the actual payment of cash dividends increases the fair value by that amount in the year of payment).3 Another significant consequence, as compared to equity awards, is that re-measurement continues for awards still outstanding after the requisite service period has been met. For example, assume that as of December 31, 2012 the fair value of this cash-settled SAR is $41. In that instance, compensation cost in the amount of $1 is recognized for 2012. Assume further that $2 is recognized for 2013. However, assume the SAR is exercised on its last day, December 31, 2014, when the stock value is only $104 (presumably a precipitous drop in stock value occurs in 2014). In this instance, the value of the SAR on December 31, 2014 is necessarily $4, the difference between the $104 stock fair value and the $100 exercise price.4 In 2014, all but $4 of the previous recognized $43 is reversed.5

6:44. Modifications

Often, the terms of equity awards are modified. Common and expected examples occur if the employee terminates employment and both parties want to extend the post-termination exercise period, the vesting dates are amended to provide for acceleration in the event of a change of control, or the stock price plummets to such an extent that previously granted options fail to have retentive value so the options are either modified to provide for or are substituted with new options which provide for a lower exercise price.<?I03QG48 ?>

An unexpected and unwelcome example can occur in the event of an equity restructuring such as a stock split or a stock dividend. In the event of such a transaction it is often necessary to adjust the number of shares and/or the exercise price to retain the economic value of an option. However, if such equitable adjustment for anti-dilution is not expressly required by the terms of the option, the accounting firms have taken the position that under FAS 123R any such adjustment is a modification of the award. FAS 123R permits the amendment of a plan or award to add antidilution features without causing the amendment to be a modification only if the amendment is made before actual restructuring is contemplated. This is a point shat should be reviewed carefully in every plan.

The principal requirement of FAS 123R is simple: as of the date of the modification, the original option is revalued, taking into accounting all relevant terms for purposes of valuation: the stock and exercise prices at the time immediately before the modification, the remaining term (expected or contractual depending on the valuation method and the number of original options expected to vest under the original award), the risk free interest rate and volatility. This value is then compared to the value of the modified option as of the modification date taking into account all the same factors with respect to the modified award and the excess, if any, of the latter over the former is added to the value of the original option and the total, less the amount of the original award previously recognized, is recognized over the remaining vesting period.1

The only circumstance in which the modified award may be less than the original award is if, at the time of modification, satisfaction of performance (or where appropriate, service) vesting requirements of the original award is not probable. In that instance, going forward the original award is irrelevant for purposes of determining the amount of compensation recognized and whether it is recognized–that is, if the original performance requirements (or service requirements, if applicable) are met but the modified requirements are not (and thus the award ultimately does not vest), no compensation cost is recognized.2

Also, if it is probable at the time of modification that the original performance requirements (or service requirements, if applicable) will be met, the compensation cost will be recognized if either is met.3

If an option is repriced to a lower exercise price, for example, after a stock price drops sharply, it is often the case that for fiduciary reasons the vesting period of the modified option is extended past the original term of the original option. See Chapter 2. In that instance the company may do one of the following: (1) spread the remaining value of the original option over the remaining term of the original option and spread the incremental value attributable to the modification of the option over the remaining extended vesting term or (2) spread the total of the remaining value of the original option and the incremental value of the modified option over the extended vesting period.4

For example, assume 1,000 options are granted on January 1, 2009 with a fair value at that time of $6. The options have a cliff vesting period of 3 years. On January 1, 2011, the company reprices its options by lowering their exercise prices and by extending the vesting date two additional years. As a result there is an incremental value equal to $3 for the modified options at the modification date over the value of the original options. At that time, $4,000 of the original $6,000 value will have been recognized. The company could choose to recognize the remaining $2,000 of the original option in 2011 and then recognize the new incremental cost of $3,000 over 2011, 2012 and 2013. This would result in $3000 being recognized in 2011 and $1000 in each of 2012 and 2013. Employees who terminate after 2011 but before the end of 2013 will not vest in the awards but only any previously recognized portion of the $3,000 incremental cost is reversed.<?I02CE7C ?>

Alternatively, the company could spread the entire remaining $5,000 over each of the three remaining years ($1,667 each year). If employees quit in 2012 or 2013, compensation cost is adjusted so that only the original grant date value is expensed.

6:45. Change in status

Often an employee quits working as an employee but continues in non-employee service that counts for vesting purposes. As noted, awards for non-employees are not measured until the vesting date and accordingly, the award is re-measured and expensed similar to a liability award until then.1 If an employee ceases employment, continues in non-employee service and the original terms of the award permit such service to count for vesting purposes, at that point the option’s value is re-measured. The percent of that value represented by the remaining term of the service period is recognized over the remaining term.2 For example, assume an option is granted and that its FAS 123R grant date fair value is $100. The option vests on a cliff basis after four years. The option holder quits employment after year three but agrees to continue as a consultant. The option’s original terms permit consulting service to count for vesting purposes. The FAS 123R re-measured fair value of the award at termination is $300 (given the option itself has only one year to run, this suggests a dramatic increase in the value of the underlying stock). Assume the amount of cost recognized in the three years before termination is $75. Assuming the option holder continues in consulting service through year four, the amount of cost recognized in year four is the one-quarter of the remaining service period multiplied by $300, or $75. Thus, the total recognized cost of the award is $150.

If, however, the original award does not permit such service to count for vesting purposes, and is in effect modified to permit consulting service to count for vesting purposes, the award is treated as modified and thus the total value of the re-valued award, minus previously recognized cost, is recognized over the remaining service period. In this case, the amount to be recognized in the one vesting year remaining is $225 ($300 minus the $75 previously recognized). The total amount recognized is thus $300.

6:46. Business combinations

►►FAS 141R governs the accounting for share based awards issued by an acquirer to replace such awards of the target for acquisitions occurring in annual reporting periods beginning on or after December 15, 2008.1 Acquisitions prior to such date are accounted for under similar rules, with important differences noted below.2

6:47. Business combinations– Acquisitions in reporting periods beginning on or after December 15, 2008

If the acquirer is required to replace target shares, either because of the terms of the acquisition agreement or the target awards themselves, or because of state law, then all or part of the fair value of the replacement award is accounted for as payment of the purchase price to acquire the target. If the acquirer is not required to replace the awards, the entire fair value of the replacement awards is accounted for as FAS 123R compensation cost on the acquirer’s post-acquisition financial statements.

If replacement is required, both the target company awards and the replacement awards are valued as of the acquisition date under FAS 123R (including pursuant to any alternative valuation rules permitted for private companies under FAS 123R). Any replacement awards requiring post-acquisition service should be adjusted for awards expected to vest.<?I000ESD ?>

From the amount determined above, an amount is allocated to the purchase price by multiplying the FAS 123R value of the awards expected to vest by the requisite service completed before the acquisition divided by the greater of the total service period and the target company requisite service period. The total service period is the pre-acquisition completed service and the post-acquisition requisite service period under FAS 123R.

The remaining amount is recognized as post-acquisition compensation cost.

6:48. Business combinations– Acquisitions in reporting years before the year beginning on or after December 15, 2008

For transactions occurring prior to the FAS 141R effective date (transactions occurring in years prior to the annual reporting period beginning on or after December 15, 2008), the mechanics are a little different. First the fair value of the acquirer’s shares issued in exchange for target awards and expected to vest is estimated based on the acquirer’s price and other factors over a several day period around the agreement and announcement of the award.1 Then if the consummation date fair value of awards vested and expected to vest exceeds the fair value of target awards vested expected to vest, that excess, if any, is deducted from the purchase price and recognized as of the consummation date for vested awards and over the remaining service period for unvested awards.2

More significantly, the purchase price is reduced by the value of the unvested awards as of the consummation date that are expected to vest. To compute the fair value as of the consummation date, the fair value of unvested awards which are expected to vest is multiplied by the remaining service divided by the total service period. This amount is recognized over the remaining vesting period.3

6:49. Other topics

There are many other important topics addressed by FAS 123R though they are generally more technical matters that go beyond the concerns typically involved in designing executive compensation arrangements.

6:50. Other topics– Tax effects

Most compensation awards are deductible by the employer for tax purposes, and those effects generally increase net income (and often by a substantial amount) and accordingly the tax effects often are booked as contra-expense entries. However, the time and often the amount deductible bears little relationship to compensation cost recognized under FAS 123R. For example, ISOs (see Chapter 2) are not deductible at all if the ISO rules are met–but they certainly are subject to recognition under FAS 123R. Also, tax deductions are typically based on intrinsic value and ignore time value measurement, while FAS 123R relies on fair value which often relies on time value concepts. Also tax deductibility often is not allowed until exercise of an option or vesting of restricted stock while FAS 123R recognition can occur over the vesting dates in amounts that do not resemble amounts deductible for tax purposes. FAS 123R provides guidance as to the complicated and nuanced treatment for expenses.1

In general, the current rules require the computation of a “windfall” which is the excess of tax benefits over compensation costs. The windfall is then added as an equity item under additional paid-in capital. In addition, the windfall is classified as a financing activity on the cash flow statement.

 However, on June 8, 2015, FASB issued an exposure draft to eliminate the windfall pool and require the windfall to be reflected on the income statement without having to delay recognition until it actually reduces taxes.[5]  The cash flow statement treatment would be changed to reflect the windfall as an operating activity.  The change would be prospective with respect to the new income treatment, retrospective with respect to the cash flow statement change and require a cumulative change adjustment to opening retained earnings in the year of adoption with respect to the elimination of the delay in recognition treatment. Of course, these rules are subject to change pending the adoption of a final rule.  The changes, if adopted would likely increase income statement variability from year to year and because of the manner in which the treasury stock method address earnings per share calculations, will provide additional dilution of the EPS result.

6:51. Other topics– Disclosure

►►FAS 123R requires detailed footnote disclosure of the basis upon which the FAS 123R determinations are made.1 The following guidance appears in Appendix A, paragraph 240 of Appendix A regarding required disclosure and a sample appears in paragraph 241:

The minimum information needed to achieve the disclosure objectives in paragraph 64 of [FAS 123R] is set forth below. To achieve those objectives, an entity should disclose the following information:2

►►(a) A description of the share-based payment arrangement(s), including the general terms of awards under the arrangement(s), such as the requisite service period(s) and any other substantive conditions (including those related to vesting), the maximum contractual term of equity (or liability) share options or similar instruments, and the number of shares authorized for awards of equity share options or other equity instruments. An entity shall disclose the method it uses for measuring compensation cost from share-based payment arrangements with employees.

(b) For the most recent year for which an income statement is provided:

The number and weighted-average exercise prices (or conversion ratios) for each of the following groups of share options (or share units): (a) those outstanding at the beginning of the year, (b) those outstanding at the end of the year, (c) those exercisable or convertible at the end of the year, and those granted, (e) exercised or converted, (f) forfeited, or (g) expired during the year.

(c) The number and weighted-average grant-date fair value (or calculated value for a nonpublic entity that uses that method or intrinsic value for awards measured pursuant to paragraphs 24 and 25 of [FAS 123R]) of equity instruments not specified in paragraph A240(b)(1) (for example, shares of nonvested stock), for each of the following groups of equity instruments: (a) those nonvested at the beginning of the year, (b) those nonvested at the end of the year, and those (c) granted, (d) vested, or (e) forfeited during the year.

(d) For each year for which an income statement is provided:

(i) The weighted-average grant-date fair value (or calculated value for a nonpublic entity that uses that method or intrinsic value for awards measured at that value pursuant to paragraphs 24 and 25 of [FAS 123R]) of equity options or other equity instruments granted during the year.

(ii) The total intrinsic value of options exercised (or share units converted), share-based liabilities paid, and the total fair value of shares vested during the year.

(e) For fully vested share options (or share units) and share options expected to vest at the date of the latest statement of financial position:

(i) The number, weighted-average exercise price (or conversion ratio), aggregate intrinsic value, and weighted-average remaining contractual term of options (or share units) outstanding.

(ii) The number, weighted-average exercise price (or conversion ratio), aggregate intrinsic value (except for nonpublic entities), and weighted-average remaining contractual term of options (or share units) currently exercisable (or convertible).

(f) For each year for which an income statement is presented:3

(i) A description of the method used during the year to estimate the fair value (or calculated value) of awards under share-based payment arrangements.

(ii) A description of the significant assumptions used during the year to estimate the fair value (or calculated value) of share-based compensation awards, including (if applicable): (a) Expected term of share options and similar instruments, including a discussion of the method used to incorporate the contractual term of the instruments and employees’ expected exercise and post-vesting employment termination behavior into the fair value (or calculated value) of the instrument. (b) Expected volatility of the entity’s shares and the method used to estimate it. An entity that uses a method that employs different volatilities during the contractual term shall disclose the range of expected volatilities used and the weighted- expected volatility. A nonpublic entity that uses the calculated value method should disclose the reasons why it is not practicable for it to estimate the expected volatility of its share price, the appropriate industry sector index that it has selected, the reasons for selecting that particular index, and how it has calculated historical volatility using that index. (c) Expected dividends. An entity that uses a method that <?I09S48Z ?>employs different dividend rates during the contractual term shall disclose the range of expected dividends used and the weighted-average expected dividends. (d) Risk-free rate(s). An entity that uses a method that employs different risk-free rates shall disclose the range of risk-free rates used.

(g) Discount for post-vesting restrictions and the method for estimating it.

(h) An entity that grants equity or liability instruments under multiple share-based payment arrangements with employees shall provide the information specified in paragraphs A240(a)-(e) separately for different types of awards to the extent that the differences in the characteristics of the awards make separate disclosure important to an understanding of the entity’s use of share-based compensation. For example, separate disclosure of weighted-average exercise prices (or conversion ratios) at the end of the year for options (or share units) with a fixed exercise price (or conversion ratio) and those with an indexed exercise price (or conversion ratio) could be important. It also could be important to segregate the number of options (or share units) not yet exercisable into those that will become exercisable (or convertible) based solely on fulfilling a service condition and those for which a performance condition must be met for the options (share units) to become exercisable (convertible). It could be equally important to provide separate disclosures for awards that are classified as equity and those classified as liabilities.

(i) For each year for which an income statement is presented:

(i) Total compensation cost for share-based payment arrangements (a) recognized in income as well as the total recognized tax benefit related thereto and (b) the total compensation cost capitalized as part of the cost of an asset.

(ii) A description of significant modifications, including the terms of the modifications, the number of employees affected, and the total incremental compensation cost resulting from the modifications.

(j) As of the latest balance sheet date presented, the total compensation cost related to nonvested awards not yet recognized and the weighted-average period over which it is expected to be recognized.

(k) If not separately disclosed elsewhere, the amount of cash received from exercise of share options and similar instruments granted under share-based payment arrangements and the tax benefit realized from stock options exercised during the annual period.

(l) If not separately disclosed elsewhere, the amount of cash used to settle equity instruments granted under share-based payment arrangements.

(m) A description of the entity’s policy, if any, for issuing shares upon share option exercise (or share unit conversion), including the source of those shares (that is, new shares or treasury shares). If as a result of its policy, an entity expects to repurchase shares in the following annual period, the entity shall disclose an estimate of the amount (or a range, if more appropriate) of shares to be repurchased during that period.

6:52. Other topics– Earnings per share

►►FAS 128 governs the reporting of earnings per share.1 Unexercised option shares, unvested shares and similar securities are reported as shares for purposes of computing fully diluted shares unless the effect would be antidilutive. If the exercise or vesting is contingent on a market or performance condition, the shares are treated as contingently issuable. If options or other award shares are outstanding for only part of the year, the portion added to the fully diluted calculation is weighted. Also, under FAS 128′s treasury method, the effect of any exercise

 

1►

FASB’s website is fasb.org.

 

2►

See SEC “Concept Release on Allowing U.S. Issuers to Prepare Financial Statements in Accordance with International Financial Reporting Standards” (available at sec.gov) (8/13/2007; corrected 9/13/2007).

 

1►

Financial Accounting Standards Board Statement 123R, Share-based Payment, paragraph 1 (Dec. 2004) [hereinafter FAS 123R].

 

2►

FAS 123R, paragraph 4. Employee stock ownership plans are commonly known as ESOPs, which are generally a unique type of tax-qualified retirement plan subject to I.R.C. &ss;§§401 et seq. While stock options are sometimes referred to as ESOPs because of the acronym for employee stock option plans, such option plans are covered by FAS 123R, whereas ESOPs are not. ESOPS are accounted for under American Institute of Certified Public Accounting (“AICPA”) Statement of Position (“SOP”) 93-6, Employers’ Accounting for Employee Stock Ownership Plans. SOP 93-6 is beyond the scope of this volume and is not discussed herein.

 

3►

FAS 123R, paragraph 4.

 

1►

FAS 123R, supra at §6:2, note 1, Emerging Issues Task Force (EITF) Issue 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees, or in Conjunction with Selling, Goods or Services.”

 

2►

FAS 123R, supra at §6:2, note 1, Appendix E, Glossary, definition of Employee. Appendix E, specifically cites the principles of I.R.S. Rev. Rul. 87-41, 1987-1 C. B. 296.

 

3►

Financial Accounting Standards Board Emerging Issues Task Force Issue 00-23, “Issues Related to Accounting For Stock Compensation Under APB 25 and FASB Interpretation 44,” Issue 40(a) [hereinafater EITF 00-23].

 

1►

FAS 123R, supra at §6:2, note 1, Appendix E, definition of Employee.

 

1►

►►Grant Thornton, Share-based Payment, FASB Statement 123R and Related Guidance, p. 5 (2008) [hereinafter Grant Thornton].

 

2►

Ernst & Young, Financial Reporting Developments, Share Based Payment–FASB Statement No. 123 (revised 2004), p. 52-7 (2005) [hereinafter Ernst & Young].

 

3►

FAS 123R, supra at §6:2, note 1, Appendix A, paragraph A-76; PricewaterhouseCoopers, Guide to Accounting for Stock Based Compensation, p. 6 (2007) [hereinafter PwC].

 

4►

Ernst & Young, supra at note 2.

 

1►

FAS 123R, supra at §6:2, note 1, paragraph 11.

 

1►

FAS 123R, supra at §6:2, note 1, paragraph 11. The awards in the case should be accounted for as derivatives pursuant to the guidance in FASB EITF 02-8.

 

1►

FAS 123R, supra at §6:2, note 1, paragraph 5.

 

2►

FAS 123R, supra at §6:2, note 1, Appendix A, Illustration 4(a), paragraphs 86&ndash;-93.

 

1►

FAS 123R, supra at §6:2, note 1, paragraph 16.

 

2►

FAS 123R, supra at §6:2, note 1, paragraph 36.

 

3►

FAS 123R, supra at §6:2, note 1, paragraph 22.

 

4►

FAS 123R, supra at §6:2, note 1, paragraph 15.

 

5►

FAS 123R, supra at §6:2, note 1, paragraph 21.

 

6►

FAS 123R, supra at §6:2, note 1, paragraph 17, 21. Note that FAS 123R provides yet a different meaning to the term restricted stock. As discussed in Chapter 2 from a tax perspective, restricted stock generally refers to stock which is issued subject to the issuer’s right to repurchase the stock at cost if certain performances conditions are not met. Also, as discussed in Chapter 3 with respect to SEC Rule 144, restricted stock refers to stock which is issued, but not pursuant to a registration statement. FAS 123R provides its own definition as it provides in footnote <?I04FIQ6 ?>11 that notwithstanding the tax definition, the term “restricted share” in FAS 123R refers to a fully vested outstanding share whose sale is contractually or governmentally prohibited for a specified period of time. For purposes of this text, restricted share or restricted stock is intended to be consistent with the tax usage of the term unless otherwise indicated.

 

1►

FAS 123R, supra at §6:2, note 1, paragraph 43.

 

2►

FAS 123R, supra at §6:2, note 1, paragraph 45.

 

3►

SEC Staff Accounting Bulletin 107, 17 C.F.R. &s;§211, subpart B Topic 14, D.2., Question 3 (March 29, 2005) [hereinafter SAB 107].

 

4►

FAS 123R, supra at §6:2, note 1, paragraphs 39, 47.

 

5►

FAS 123R, supra at §6:2, note 1, Appendix A, Illustration 4(a), paragraphs 86&ndash;-93.

 

[1] http://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176166112176&acceptedDisclaimer=true

6►

FAS 123R, supra at §6:2, note 1, Appendix E, Glossary, definition of market condition.

 

7►

FAS 123R, supra at §6:2, note 1, paragraph 19.

 

1►

FAS 123R, supra at §6:2, note 1, paragraphs 26 and 27.

 

1►

FAS 123R, supra at §6:2, note 1, Appendix E, Glossary, definition of nonpublic entity.

 

1►

FAS 123R, supra at §6:2, note 1, paragraph 23. Private companies may also use the simplified safe harbor in SAB 107 to determine expected term, §6:20, note 3.

 

1►

FAS 123R, supra at §6:2, note 1, paragraph 24.

 

1►

FAS 123R, supra at §6:2, note 1, paragraph 38.

 

1►

FAS 123R, supra at §6:2, note 1, Appendix A, paragraphs A211&ndash;-219.

 

2►

FASB Technical Bulletin, 97-1, Accounting under Statement 123 for Certain Employee Stock Purchase Plans with a Look-Back Option (December 1997).

 

3►

FAS 123R, supra at §6:2, note 1, paragraph 12.

 

4►

See infra §6:36, note 1; also see Grant Thornton, supra at §6:5, note 1, p. 25.

 

1►

FAS 123R, supra at §6:2, note 1, paragraph 7.

 

2►

FAS 123R, supra at §6:2, note 1, Appendix A.

 

3►

FAS 123R, supra at §6:2, note 1, Appendix A, paragraph A8.

 

4►

For example, FAS 123R, supra at §6:2, note 1, paragraph 6, indicates that the transfer of shares in exchange for a non-recourse note will be accounted for consistent with the substance of the transaction. Thus, although the transaction is structured as a purchase with apparent little compensation value because the payment is made with a note in which there is no personal recourse against the employee, it will be accounted for and valued according to its substance–i.e., as an option.

 

1►

FAS 123R, supra at §6:2, note 1, paragraph 22.

 

2►

FAS 123R, supra at §6:2, note 1, Appendix A, paragraph A.

 

1►

►►FAS 123R, supra at §6:2, note 1, Appendix A, paragraph A13. Appendix A also refers to a Monte Carlo simulation technique, which could also be described as a variation of a lattice model.

 

2►

See e.g., PwC, supra at §6:5, note 3, p. 215.

 

3►

►►FAS 123R, supra at §6:2, note 1, Appendix A, paragraph A16.

 

1►

See Ernst & Young, supra at §6:5, note 2, p. 57-7.

 

2►

PwC, supra at §6:5, note 3, p. 210.

 

3►

SAB 107, supra at §6:10, as amended by SEC Staff Accounting Bulletin 110 (December 21, 2007). FASB permits private companies to use the expected term for safe harbor. Grant Thornton, supra at §6:5, note 1.

 

[2] http://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176166112176&acceptedDisclaimer=true

4►

FAS 123R, supra at §6:2, note 1, Appendix E, definition of volatility.

 

1►

FAS 123R, supra at §6:2, note 1, Appendix A, paragraph A25.

 

1►

FAS 123R, supra at §6:2, note 1, Appendix A, paragraph 36. Such an exercise reduction provision could cause an option to fail to satisfy the option exception for I.R.C. &s;§409A because of a below market exercise price. See Chapter 2.

 

2►

PwC, supra at §6:5, note 3, p. 212 and 213.

 

1►

Ernst & Young, supra at &s;§6:5, note 2, Appendix E.

 

2►

PwC, supra at &s;§6:5, note 3, p. 215 (2007).

 

3►

Ernst & Young, supra at &s;§6:5, note 2, p. E-1 provides a formula, though not necessarily the formula used in the PwC formula. The Ernst & Young formula provides upward movements at each time node derived by the following formula, u=esvt where s is annualized volatility and t is the time period between nodes (expressed as one year = 1.0). For downward movements at each time node the formula is d=1/u.

 

4►

This might suggest that, contrary to the statement in §6:21 above that an increase in the risk tree rate increases the option value, a higher risk free rate decreases the option value of the option as the tree moves to the left (for example, PV = future value/1 x interest rate). However, either through probabilities below or the use of the risk-free rate in building the stock value of the first tree, the overall effect of an increase in the interest rate is to increase the option value.

 

5►

As noted supra in note 3, the Ernst & Young formula referenced above (which is not the formula PwC has used in building the tree which actually appears above) does not build into its formula for the first tree <?I03Y7BI ?>(building the stock value) an increase in the stock price based on rising interest rates. Thus, Ernst & Young provides a formula in working back through the second tree that weighs the probability in favor of the higher number, thus accomplishing a similar result.

 

1►

FAS 123R, supra at §6:2, note 1, Appendix A, paragraph A41.

 

1►

FAS 123R, supra at §6:2, note 1, Appendix E, definition of grant date.

 

2►

FAS 123R, supra at §6:2, note 1, paragraph 36.

 

1►

Grant Thornton, supra at §6:5, note 1, p. 59.

 

1►

FAS 123R, supra at §6:2, note 1, Appendix E, definition of service inception date.

 

2►

FAS 123R, supra at §6:2, note 1, paragraph 41.

 

3►

FAS 123R, supra at §6:2, note 1, Appendix A, paragraph A79.

 

4►

FAS 123R, supra at §6:2, note 1, paragraph 41.

 

5►

FAS 123R, supra at §6:2, note 1, Appendix E, Glossary, definition of explicit service period.

 

6►

FAS 123R, supra at §6:2, note 1, Appendix E, Glossary, definition of implicit service period.

 

7►

FAS 123R, supra at §6:2, note 1, Appendix E, Glossary, definition of derived service period.

 

8►

FAS 123R, supra at §6:2, note 1, Appendix A, paragraph A60.

 

1►

FAS 123R, supra at §6:2, note 1, paragraph 43.

 

2►

FAS 123R, supra at §6:2, note 1, paragraph 44.

 

3►

FAS 123R, supra at §6:2, note 1, paragraph 45.

 

1►

FAS 123R, supra at §6:2, note 1, paragraph 39.

 

2►

FAS 123R, supra at §6:2, note 1, paragraph 39. See also Grant Thornton, FAS 123R, supra at §6:5, note 1, p. 67.

 

3►

FAS 123R, supra at §6:2, note 1, Appendix A, Illustration 4(a), paragraph 86.

 

1►

FAS 123R, supra at §6:2, note 1, paragraph 44.

 

2►

Grant Thornton, supra at §6:5, note 1, p. 69.

 

3►

Ernst & Young, supra at §6:5, note 2, p. 34&ndash;-35.

 

4►

FAS 123R, supra at §6:2, note 1, Appendix A, Illustration 5(a), paragraph 105. See also Grant Thornton, Share-based Payment, FASB Statement 123R and Related Guidance, p. 69 (2008).

 

5►

FAS 123R, supra at §6:2, note 1, Appendix A, Illustration 5(a), paragraphs A105&ndash;-108.

 

6►

FAS 123R, supra at §6:2, note 1, Appendix A, paragraph A69, Illustration 6, paragraph A113.

 

7►

FAS 123R, supra at §6:2, note 1, Appendix A, paragraph A67.

 

8►

FAS 123R, supra at §6:2, note 1, paragraph A68.

 

9►

FASB Staff Position (FSP) FAS 123R-6 “Techical Corrections of FASB Statement No. 123(R)” (10/20/2007), paragraphs 8&ndash;-10.

 

1►

FAS 123R, supra at §6:2, note 1, Appendix A, paragraph 19.

 

2►

FAS 123R, supra at §6:2, note 1, Appendix A, paragraph 19. This is because the value of the market condition is already taken into account in determining the reduced fair value of the award.

 

3►

FAS 123R, supra at §6:2, note 1, Appendix E, Glossary, definition of market condition.

 

4►

FAS 123R supra at §6:2, note 1, Appendix A, paragraph 72.

 

5►

FAS 123R, supra at §6:2, note 1, Appendix A, paragraphs A61 and A74.

 

1►

Compare FAS 123R Financial Accounting Standards Board Statement 123R, paragraph 16 with paragraph 36.

 

1►

FAS 123R, supra at §6:2, note 1, paragraph 32.

 

2►

FAS 123R, supra at §6:2, note 1, paragraph 34.

 

1►

FAS 123R, supra at §6:2, note 1, paragraph 31. Liability treatment typically is not required if the repurchase is simply to accomplish a forfeiture on an early exercised option in the event of failure to meet the vesting event. See PricewaterhouseCoopers (“PwC”), Guide to Accounting for Stock Based Compensation, p. 49 (2007).

 

2►

FAS 123R, supra at §6:2, note 1, footnote 16.

 

3►

Grant Thornton, supra at §6:5, note 1, p. 13 (2008).

 

[3] http://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176166112176&acceptedDisclaimer=true

1►

FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both liabilities and Equity (5/15/2003) [herinafter FAS 150].

 

2►

FAS 123R, supra at §6:2, note 1, paragraph 29.

 

3►

FASB Staff Position (FSP) FAS 150-3, Effective Date, Disclosures and Transition for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests under FASB Statements No. 150Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (11/7/2003).

 

1►

FAS 150, supra at §6:36, note 1, paragraph 12. See also Grant Thornton, supra at §6:5, note 1, p. 10 (2008). The last example is interesting. Typically a put is the holder’s right to redeem shares thus creating a potential company obligation. A liability award can be created in this instance if the obligation can be settled by a number of shares that changes inversely with the change in value of the shares–if the stock price increases, the number of share required decreases and vice versa.

 

1►

FAS 150, supra at §6:36, note 1, paragraph 11.

 

2►

FAS 123R, supra at §6:2, note 1; PwC, supra at §6:5, note 3, p. 44.

 

1►

Grant Thornton, supra at §6:5, note 1, p. 10.

 

2►

Grant Thornton, supra at §6:5, note 1, p. 11.

 

1►

FAS 123R, supra at §6:2, note 1, paragraph 35; PwC, supra at §6:5, note 3, p. 48.

 

2►

See Grant Thornton, supra at §6:5, note 1, p. 12; PwC, supra at §6:5, note 3, p. 47 (2007).

 

1►

Grant Thornton, supra at §6:5, note 1, p. 17.

 

[4] http://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176166112176&acceptedDisclaimer=true

1►

Grant Thornton, supra at §6:5, note 1, p. 17, describing 2006 AICPA National Conference on SEC & PCAOB Development.

 

2►

EITF 00&ndash;-23, supra at §6:13, note 3, Issue 40(a).

 

3►

ASR 268, EITF Topic D-98, “Classification and Measurement of Redeemable Securities,” and SEC Staff Accounting Bulletin Topic 14.E. See Grant Thornton, supra at §6:5, note 1, p. 17 (2008). PwC, supra at §6:5, note 3, p. 50 and Ernst & Young, supra at §6:5, note 2, pp. 55&ndash;-14.

 

1►

The $33 is selected to make a point that can become important in many aspects of option valuation under FAS 123R. Refer back to the discussion at §6:22 regarding the three theoretical components of option value. Two are time-based–minimum value and volatility value, The third is intrinsic value. Consider that nothing has changed with respect to the option except that its contractual term has decreased. The exercise price remains the same of course and the underlying stock price is assumed to be the same. Under the Black-Scholes model there is likely to be little or no change to the expected term when preparing a December 31, 2009 FAS 123R valuation as compared to the January 1, 2009 grant date valuation. However, as the date gets closer to the ultimate option expiration date, the value of the option approaches the intrinsic value of the option and essentially the value of the option attributable to time based assumptions wears away. Of course, if the underlying stock price increases, the option value will increase, but that is a function of the increase in the intrinsic value even if it offsets the wearing away of the time based value as time goes on.

 

2►

Again, consistent with the note above, this dramatic increase is likely attributable to an increase in the underlying share value, absent a change in assumptions. The closer the date gets to the option expiration date, the less the value is influenced by time value assumptions.

 

3►

Grant Thornton, supra at §6:5, note 1, p. 19.

 

4►

As suggested above, the value of an option or SAR is less affected by time assumptions the closer the valuation date is to the option expiration date. At expiration the option or SAR is exactly equal to its intrinsic value.

 

5►

FAS 123R, supra at §6:2, note 1, Appendix A, paragraph 133.

 

1►

FAS 123R, supra at §6:2, note 1, paragraph 51.

 

2►

FAS 123R, supra at §6:2, note 1, Appendix A, Illustrations 13(c) and (d), paragraphs 166&ndash;-169.

 

3►

FAS 123R, supra at §6:2, note 1, Appendix A, Illustrations 13(a) and (b), paragraphs 162&ndash;-165.

 

4►

See Grant Thornton, supra at §6:5, note 1, p. 77, for a discussion of the deliberations of the FASB Statement 123R Resource Group at its May 26, 2005 meeting.

 

1►

Emerging Issues Task Force (EITF) Issue 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees, or in Conjunction with Selling, Goods or Services.”

 

2►

See FAS 123R, supra at §6:2, note 1, p. 5.

 

1►

FASB Statement No. 141R, Business Combinations (December, 2007).

 

2►

Id.; FASB Interpretation 44 “Accounting for Certain Transactions involvong Stock Compensation–an Interpretation of APB Opinion No. 25” (March, 2000); EITF Issue 00-23, and EITF Issue 99-12, Determination of Measurement Date for the Market Price of Acquirer Securities Issued in a Purchase Business Combination.

 

1►

FASB Emerging Issues Task Force, Issue 99&ndash;-12, last discussed January 19&ndash;-20, 2000.

 

2►

Grant Thornton, supra at §6:5, note 1, p. 82.

 

3►

FASB Interpretation 44, paragraph 85 (March, 2000).

 

1►

FAS 123R, supra at §6:2, note 1, paragraphs 58&ndash;-63. See Grant Thornton, supra at §6:5, note 1, p. 5; Ernst & Young, supra at §6:5, note 2, p. 52&ndash;-7; and PwC. supra §6:5, note 3, p. 6 for guidance regarding tax treatment of awards.

 

[5] http://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176166112176&acceptedDisclaimer=true

1►

FAS 123R, supra at §6:2, note 1, paragraphs 64 and 65.

 

2►

In some circumstances, an entity may need to disclose information beyond that listed in this paragraph to achieve the disclosure objectives.

 

3►

An entity that uses the intrinsic value method pursuant to paragraphs 24 and 25 of [FAS 123R] is not required to disclose the following information for awards accounted for under that method.

 

1►

FASB Statement 128, Earnings per Share (February, 1997). See FAS 123R, supra at §6:2, note 1, paragraph 66.

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