PORTFOLIO

Accounting for Share-Based Compensation (Portfolio 5109)

Portfolio 5109-2nd, Accounting for Share-Based Compensation (Accounting Policy and Practice Series), provides a detailed analysis of the rules on share-based compensation contained in FASB Accounting Standards Codification (“ASC”) Topic 718, (former Statement of Financial Accounting Standards 123(R), Share-Based Payment). 

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DESCRIPTION

Portfolio 5109-2nd, Accounting for Share-Based Compensation (Accounting Policy and Practice Series), provides a detailed analysis of the rules on share-based compensation contained in FASB Accounting Standards Codification (“ASC”) Topic 718, (former Statement of Financial Accounting Standards 123(R), Share-Based Payment). ASC 718 requires companies to recognize the compensation cost of options under the fair-value method. ASC 718 eliminates the use of the intrinsic value method under which the compensation cost for an employee stock option was determined as the difference between the firm's stock price on the option's grant date and the option's exercise price. FAS 123(R), codified in ASC 718 became effective for all annual periods beginning after June 15, 2005 for public firms and December 15, 2005 for non-public and small business issuers.
Under ASC 718, the cost of employee services (or compensation cost) that a granting firm initially must recognize is the fair value on the grant date of the share-based instruments the firm is required to issue to employees. Share-based instruments given to employees constitute either awards of equity (e.g., employee stock options) or liabilities incurred by the firm (e.g., stock appreciation rights that must be settled in cash). The cost of share-based instruments classified as equity is measured and fixed on the date on which the share-based instruments are granted. This cost is not re-measured in subsequent reporting periods. For share-based awards that are liabilities of the firm, the value of the award must be re-measured each reporting period until the liability is settled. Thus, recognized compensation costs tend to be more volatile for awards classified as liabilities. The authors distinguish awards classified as equity versus awards classified as liabilities.
The Portfolio also discusses valuation techniques for estimating the fair value of an employee stock option (e.g., the Black-Scholes-Merton (BSM) and lattice option pricing models), the special considerations for non-public companies, and recognizing employee compensation costs.
Section II of this Portfolio analyzes the detailed measurement and recognition requirements of ASC 718. Section III compares ASC 718 (former FAS 123(R)) with International Financial Reporting Standards 2 (IFRS 2), Share-Based Payment, issued by the International Accounting Standards Board. Section IV of this Portfolio primarily will interest readers wishing to learn more about the mathematical foundations and theory behind the BSM and lattice models.
This Portfolio may be cited as BNA Tax and Accounting Portfolio 5109-2nd, Mande & Chavis, Accounting for Share-Based Compensation (Accounting Policy and Practice Series).
A portion of FASB Statement No. 123 (revised 2004), Share-Based Payment, copyright by the Financial Accounting Standards Board, 401 Merritt 7, PO Box 5116, Norwalk, CT 06856-5116, U.S.A., is reprinted with permission. Complete copies of this document are available from the FASB.


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AUTHORS

VIVEK MANDE, PH.D
Vivek Mande, Ph.D, is a Professor of Accounting and the Director for the Center for Corporate Reporting and Governance at California State University, Fullerton. Dr. Mande teaches and researches in the areas of corporate governance, financial accounting, and auditing. He was the Academic Accounting Fellow at the Securities and Exchange Commission's Office of Economic Analysis in Washington, D.C. from 2001–2002. Professor Mande holds a Ph.D. in Accounting from the Anderson Graduate School of Management, U.C.L.A. Dr. Mande is an Associate Member of Institute of Chartered Accountants. His research findings have been published in Contemporary Accounting Research, Auditing: A Journal of Practice and Theory, Journal of Accounting and Public Policy, International Journal of Accounting, ABACUS, Accounting and Business Research, and a number of other journals.

BETTY CHAVIS, PH.D
Betty Chavis, Ph.D., is a Professor of Accounting and serves as the Chair of the Department of Accounting at California State University, Fullerton. Dr. Chavis teaches and conducts research in the areas of financial accounting and reporting, international accounting, and financial statement analysis. She was an Accounting Academic Fellow with the SEC in the Division of Corporation Finance in Washington, D.C. in 2001-2002. Professor Chavis received her Ph.D. in Accounting from the University of Southern California. In addition to the current Share-Based Compensation research, Dr. Chavis is actively researching convergence issues between US GAAP and IFRS. Her research has been published in several academic journals including the Journal of Accounting, Auditing and Finance. She has also presented seminars on US GAAP, Sarbanes-Oxley regulation, SEC reporting and International Financial Reporting in the United Kingdom, Germany and China.

TABLE OF CONTENTS

Detailed Analysis

I. Historical Background and Overview

Introductory Material

A. Historical Background

B. Outline of Portfolio

II. Accounting for Share-Based Payments Under FAS 123(R)

Introductory Material

A. Overview and Summary of FAS 123(R)

1. Scope

2. Measurement of Share-Based Compensation Costs

a. Option Pricing Valuation Models

b. Measurement of Equity and Liability Awards

c. Special Considerations for Non-Public Companies

3. Recognition of Share-Based Compensation Costs

a. Explicit, Implicit, and Derived Service Periods

b. Accounting for Forfeitures

c. Recognition of Vesting

d. Modifications of the Terms of Share-Based Awards

e. Income Taxes

f. Liability Awards

g. Disclosures

4. Effective Dates and Transition Methods

5. Cross References

B. Measurement of Share-Based Compensation Costs

1. Measurement Objective

2. Estimating Fair Value

a. Fair Value Measurement of Awards of Shares

b. Fair Value Measurement of Awards of Stock Options

3. Creating New Markets for Employee Stock Options

4. Option Pricing Valuation Techniques

a. Cross Reference

b. BSM Model

c. Lattice Model

5. Valuation Inputs to Option Pricing Models

a. Minimum Requirements

b. General Guidelines

c. Obtaining the Inputs to an Option Pricing Model

(1) Expected Term

(2) Expected Volatility

(a) Historical Volatility

(b) Comparable Firm Volatility

(c) Implied Volatility

(d) Estimating Expected Share Price Volatility for Newly Public and Non-Public Firms

(3) Risk-free Rate

(4) Expected Dividends

6. Special Features of Employee Stock Options Affecting Option Value

a. Suboptimal Exercises

b. Blackout Dates

c. Forfeitures

d. Non-Transferability Discounts

(1) Effect of Pre-Vesting Restrictions on Estimated Fair Value

(2) Effect of Post-Vesting Restrictions on Estimated Fair Value

7. Options With Reload and Contingent Features

a. In General

b. Clawback Contingencies

8. Instruments for Which Fair Value Cannot Reasonably Be Estimated

9. Summary

10. Black-Scholes-Merton or the Lattice Model: What Does the FASB Recommend?

C. Recognition of Compensation Cost for Awards Classified as Equity

1. Key Concepts and Dates

a. Requisite Service Period

b. Explicit, Implicit, and Derived Service Periods

c. Service Inception Date

d. Grant Date

e. Examples

2. Service, Performance and Market Conditions

a. Service Conditions

b. Performance Conditions

c. Market Conditions

d. Two Categories of Conditions Based on Possible Affects

3. Service, Performance, and Market Conditions Affecting Exercisability or Vesting

a. Example of Share-Based Award With a Service Condition

b. Example: Share-Based Award With a Performance Condition

c. Example of Share-Based Award With a Market Condition

d. Fully Vested, Deep-out-of-the-Money Share Options

4. Multiple Service, Performance and Market Conditions Affecting Vesting or Exercisability

a. Example of Share-Based Awards With a Service and a Performance Condition

b. Example: Share-Based Awards With a Service and a Market Condition

c. Changes in Estimates of the Requisite Service Period

d. Comprehensive Example With Journal Entries: Awards With Performance and Service Conditions

5. Service, Performance, and Market Conditions that Affect Factors Other Than Exercisability or Vesting

a. Changes in the Probable Outcomes of a Share-Based Award

b. Example of Awards with Multiple Performance Conditions-Variable Exercise Price

c. Example of Awards With Multiple Performance Conditions-Variable Quantity of Options

d. Example of Awards With Performance and Market Conditions

6. Accounting for Awards With Graded Vesting

a. Example of Accounting for Awards With Graded Vesting

7. Accounting for Forfeitures

a. Rules and Their Erudition

b. Example of Accounting for Forfeitures

8. Accounting for Income Taxes

a. Availability of Tax Deductions

b. Accounting for Differences in Timing Between Tax Returns and Financial Statements

c. Disclosures in the Cash Flow Statement

d. Example of Accounting for Excess Tax Benefits for Equity Awards

e. Example of Accounting for Tax Deficiencies for Equity Awards

f. Example of Alternative Accounting Method for Tax Effects Under FASB Staff Position No. FAS 123(R)-3

9. Summary on Recognition of Compensation Costs for Awards Classified as Equity

D. Recognition of Compensation Cost for Share-Based Payment Instruments That Are Liabilities

1. Classification of Awards as Liabilities or Equity

a. Cash Settlement Versus Share Settlement

b. Applying FAS 150

c. Analyzing the Substantive Terms of the Arrangement

d. Share Awards With Repurchase Features

e. Share Awards Containing Conditions Other Than Market, Service, or Performance

2. Measurement of Liability Awards

3. Recognition of Liability Awards

4. Accounting for the Tax Effects of Liability Awards

a. Rule

b. Example of Tax Effects of Liability Awards

5. Comprehensive Example of Accounting for Liability Awards

6. FAS 123(R) and Redeemable Financial Instruments

7. Reclassification and Remeasurement of Freestanding Financial Instruments Originally Issued to Employees Under FAS 123(R)

E. Changes in Share-Based Arrangements Subsequent to the Grant Date

1. Types of Modifications of Share-Based Arrangements

2. Modifications Involving Changes in Fair Value of Equity Awards

a. Modification of the Terms of Unvested Awards

b. Example: Modifications Involving Changes in Fair Value of Unvested Awards

c. Modifications of the Terms of Vested Awards

d. Example of Modifications Involving Changes in Fair Value of Vested Awards

3. Modifications Involving Changes in the Vesting Terms and Conditions

a. Discussion of Situation A

b. Discussion of Situation B

c. Example of Type I Modification-Probable Outcome to Probable Outcome Modification

d. Example of Type II Modification-Probable Outcome to Improbable Outcome Modification

e. Example of Type III Modification-Improbable Outcome to Probable Outcome Modification

f. Example: Type IV Modification-Improbable Outcome to Improbable Outcome Modification

4. Summary of Accounting for Modifications

5. Cancellations and Replacements of Share-Based Awards

6. Modifications Involving Reclassifications of Stock Awards

a. Example of Reclassification of Stock Awards from Equity to Liability

b. Example of Reclassification of Stock Awards From Liability to Equity

F. Share-Based Awards of Non-Public Firms

1. Measurement of Equity Awards

2. Measurement of Liability Awards

3. Disclosures

4. Transition to FAS 123(R)

5. Effective Dates

6. Non-Public Firms Transitioning to Public Firm Status

7. Public Firms Transitioning to Non-Public Firm Status

G. Required Disclosures

H. Employee Share Purchase Plans (ESPPs)

I. Other Accounting Issues

1. Classification of Compensation Cost on an Income Statement

2. Internal Controls Over Capitalization of Share-Based Compensation

3. Non-GAAP Measures of Income That Exclude Share-Based Compensation Costs

4. Disclosures in MD& A After Adoption of FAS 123(R)

5. Foreign Filers

J. Effective Dates and Transition Methods

1. SEC Adjustment of Effective Dates of FAS 123(R)

2. Modified Prospective Method

3. Modified Retrospective Method

4. Prospective Method

5. Example of Using the Modified Prospective Transition Method-I

6. Example of Using the Modified Prospective Transition Method-II

7. Example of Using the Modified Retrospective Transition Method

8. Transition Methods for Newly Public Firms

9. Accelerated Vesting of Stock Options Prior to Effective Dates of FAS 123(R)

10. Transition Provisions for Liability Awards

11. Transition Provisions for Changes in Classification From Equity to Liability

12. Equity Awards for Which Fair Value Was Not Determinable Under FAS 123

13. Disclosures

K. A Comparison of FAS 123(R) and FAS 123 (Including APB Opinion 25)

1. Measurement of Compensation Cost

a. Fair Value Measurement

b. Option Pricing Models

c. Liability Awards

d. Special Considerations for Non-Public Companies

2. Recognition of Compensation Cost

a. Requisite Service Period

b. Grant Date

c. Service Inception Date

d. Service, Performance, and Market Conditions

e. Fixed Accounting for Certain Plans With Performance Conditions

f. Awards With Graded Vesting

g. Forfeitures

h. Income Taxes

i. Cash Flow Statement Disclosures

3. Other Issues

a. Modifications of the Terms of an Award

b. Disclosures

c. Employee Stock Purchase Plans

III. Accounting for Share-Based Payments Under International Financial Reporting Standard 2 (IFRS 2)

Introductory Material

A. Perspectives

B. Convergence of IFRS 2 and FAS 123(R)

1. Historical Overview

2. Chronology of Convergence of Accounting Standards on Share-Based Payments

a. Classification of Share-Based Arrangements as Debt or Equity

b. Share-Based Arrangements With Non-Employees

c. Reload Features

d. Tax Effects on Exercise of Share-Based Instruments

3. Convergence From Changes Made to ED2 by the IASB

a. Reload Features

b. Tax Effects on Exercise of Share-Based Instruments

c. Use of Intrinsic Value in Certain Cases

d. Elimination of Units of Service Method

4. Convergence From Changes Made to FAS 123 by the FASB

a. Option Pricing Models

b. Graded Vesting

c. Awards With Performance and Market Conditions

d. Employee Stock Purchase Plans (ESPPs)

e. Option Valuation for Non-Public Entities

f. Income Taxes

g. Accounting for Stock Appreciation Rights

5. Convergence From Changes Made to Exposure Draft (ED) by the FASB

a. Differences Arising From the Level of Guidance Provided in the Standards

b. Differences Arising Due to Inconsistency in Other Standards

c. Differences Arising Due to Inconsistencies in the Decisions of the Boards

(1) Accounting for Income Tax Effects

(2) Graded Vesting

(3) Employee Stock Purchase Plans

6. Convergence: What Lies Ahead?

C. Comparison of IFRS 2 and FAS 123(R)

1. Scope

2. Measurement of Share-Based Compensation Costs

a. Fair Value Measurement

b. Option Pricing Models

c. Awards With Graded Vesting

d. Options With Reload Features

e. Accounting for Modifications in the Terms and Conditions of an Award

f. Cash-Settled Share-Based Transactions (Liability Awards)

g. Employee Share Purchase Plans (ESPP)

h. Share-Based Payments of Non-Public Firms

3. Recognition of Share-Based Compensation Cost

a. Modified Grant Date Method

b. Grant Date

c. Requisite Service Period

d. Service Inception Date

e. Service, Performance and Market Conditions

f. Forfeitures

g. Accounting for Income Taxes

(1) Example

(a) Assumptions

(b) IFRS 2 Deferred Tax Worksheet

(c) Journal Entries

(d) Journal Entries

4. Disclosures

5. Transition Methods

6. Effective Dates

IV. Option Pricing Valuation Models

Introductory Material

A. Black-Scholes-Merton Model of Option Pricing

1. Black-Scholes Option Pricing Formula for a Non-Dividend Paying Stock

2. Assumptions Made by the Black-Scholes Model

3. Normal Probability Distribution

a. Computing Cumulative Standard Normal Probabilities (i.e., N(d1) and N(d2))

b. Computing the Black-Scholes Value of an Option for a Non-Dividend Paying Stock

4. Computing the Black-Scholes Value of a Stock Option Using an Options Calculator

5. Black-Scholes-Merton Formula for Dividend Paying Stocks

a. Continuous Dividends

(1) Black-Scholes-Merton Option Pricing Formula for a Dividend Paying Stock

(2) Example: Using the Black-Scholes-Merton Formula for a Stock Paying a Continuous Dividend

(a) Assumptions

(b) Computation Steps

(c) Using Microsoft® Excel

(d) Using an Options Calculator

b. Lumpy Dividends

6. Computing the Inputs Used in the BSM Model

a. Computing the Risk-Free Rate for Use in the BSM Model

b. Computing Stock Price Volatility for Use in the BSM Model

(1) Historical Stock Price Volatility

(2) Implied Stock Price Volatility

(3) Computing Volatility of Stock Returns Using an Options Calculator

(4) Volatility Smile

7. Understanding How the BSM Model Works

a. Introduction to Geometric Brownian Motion

b. Ito's Lemma

c. Computing the Probability of a European Call Option Expiring in-the-Money

d. Black-Scholes Option Pricing Formula

8. Shortcomings of the Black-Scholes Model

B. Lattice Option Pricing Models

1. Binomial Lattice Model Summarized

2. Introduction to Binomial Trees

3. Standard and Flexible Trees

4. Building a Standard Binomial Tree

5. Convergence of Binomial Option Values With BSM Option Values

6. The Role of Risk-Neutrality in Option Pricing

7. Cox-Ross-Rubinstein and Equal Probability Approaches

8. Examples of Standard Binomial Trees

9. Binomial Trees for Dividend Paying Stocks

a. Dividends Expressed as a Yield

b. Dividends Expressed as Dollar Amounts

10. Pricing European Call Options

a. Option Payoff Tree

b. Formula to Price a European Call Option Over a Single Period

c. Example of a Single-Period Option Payoff Tree

d. Pricing Multi-Period European Call Options Using the Backward Induction Method

e. Example of Multi-Period Option Payoff Tree

11. How Many Time-steps Should Be Used in a Binomial Model?

12. Example of Pricing of Options That Allow Early Exercise (American Options)

13. Flexible Stock Price Trees: Lattice Models That Accommodate Changes in Risk Free Rates Over the Term of the Option

14. Lattice Models That Accommodate Changes in Stock Price Volatility Over the Term of the Option

a. Mean Reversion in Stock Price Volatilities

b. Example of Option Pricing Using a Flexible Stock Price Tree With Changing Volatilities Over the Term of the Option

15. Lattice Models That Accommodate Special Features Included in Employee Stock Options

a. Lattice Model That Accommodates Post-Vesting Terminations

b. Example of Lattice Model That Accommodates Suboptimal Exercises

c. Example of Lattice Model that Includes a Market Condition

16. Limitations of Lattice Models

C. Advanced Option Pricing Topics

1. Option Pricing Methods for Pricing Path-Dependent Options

2. Monte-Carlo Method for Pricing Path Dependent Options

3. Implied Volatility Trees

4. Implied Binomial Trees

Working Papers


WORKING PAPERS

TABLE OF WORKSHEETS

Worksheet 1 Professional Authoritative Standards Related to FAS 123R

Worksheet 2 Comparing the BSM and Lattice Models

Worksheet 3 FAS 123(R) Definitions of Grant Date, Service Inception Date, Requisite Service Period and Service, Performance and Market Conditions Grant Date

Worksheet 4 Minimum Disclosure Requirements and Illustrative Disclosures Under FAS 123(R)

Worksheet 5 Accounting for Stock Options and Restricted Stocks: Sample Disclosures

Worksheet 6 Sample Disclosures for Accelerated Vesting of Stock Options

Worksheet 7 Computing Earnings per Share (EPS)

Worksheet 8 A Tabular Comparison of FAS 123(R) and IFRS 2

Worksheet 9 Executive Compensation and Related Person Disclosure Transition Questions and Answers

Worksheet 10 PCAOB Staff Questions and Answers Auditing the Fair Value of Share Options Granted to Employees

Worksheet 11 FSP FAS 123(R)-5 FASB STAFF POSITION

Worksheet 12 List of Significant Accounting Pronouncements Principally Discussed

Worksheet 13 SEC Letter to Zions Bancorporation Approving ESOARS Market-Based Valuation Approach

Bibliography

OFFICIAL AUTHORITIES

Caselaw

AICPA

FASB

FASB Financial Accounting Standards

1975

1987

1992

1995

1997

1998

2002

2003

2004

2008

FASB Financial Interpretations

1978

2004

FASB Financial Statements of Positions

2005

2006

FASB EITF Issues

1996

2000

IASB

2004

PCAOB

2006

SEC

1979

2001

2003

2006

TAX STATUTES AND REGULATIONS

UNOFFICIAL AUTHORITIES