Accounting for Share-Based Compensation (Portfolio 341)

Tax Management Portfolio, Accounting for Share-Based Compensation, No. 341-3rd, 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). To view this Portfolio, visit Bloomberg Tax for a free trial.

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Description

Tax Management Portfolio, Accounting for Share-Based Compensation, No. 341-3rd, 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 Mande & Chavis, 341-3rd T.M., Accounting for Share-Based Compensation.

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.

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.

Mark L. Zyla, CPA/ABV, CFA, ASA

Mark L. Zyla, CPA/ABV, CFA, ASA, provides valuation consulting for various types of entities for the purposes of mergers and acquisitions, financial reporting, tax planning, and corporate recapitalizations, as well as valuing various types of intellectual property and other intangible assets. Mr. Zyla is a member of the American Society of Appraisers (“ASA”), the American Institute of Certified Public Accountants (“AICPA”), the CFA Institute, and the Atlanta Society of Financial Analysts. He is a former member of the Business Valuations Committee of the AICPA and a current Chairman of the ABV Examination Committee of the AICPA. He is also a current member of the Business Valuation Standards Subcommittee of the ASA. He is also a member of the Atlanta Venture Forum, a professional organization of the venture capital community. He is one of the authors of the International Glossary of Business Valuation Terms which has been adopted by the major valuation organizations. Mr. Zyla co-authored Valuation for Financial Reporting: Intangible Assets, Goodwill and Impairment Analysis, SFAS 141 and 142, published by John Wiley & Sons, Inc. He also co-authored the course, “Valuing Goodwill and Other Intangible Assets”, published by the AICPA.

Table of Contents

Detailed Analysis
I. Background and Overview
Introductory Material
A. Background
B. Outline of Portfolio
II. Accounting for Share-Based Payments
Introductory Material
A. Overview and Summary of ASC 718
1. Scope
2. Distinguishing Between Employees and Non-Employees
3. 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
4. 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
5. Effective Dates and Transition Methods
6. 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
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 (not codified)
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 ASC 480-10
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. ASC 718 and Redeemable Financial Instruments
7. Reclassification and Remeasurement of Freestanding Financial Instruments Originally Issued to Employees Under ASC 718
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) (ASC 718)
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)
J. Effective Dates and Transition Methods
1. SEC Adjustment of Effective Dates of FAS 123(R) (now ASC 718)
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 ASC 718 and Former Guidance (FAS 123 and APB 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) (Now ASC 718)
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
C. Comparison of IFRS 2 and ASC 718
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
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
V. Valuation Guidance for Measuring the Value of Share-Based Awards for Non-Public Firms
Introductory Material
A. Fair Value Defined
B. Determining the Fair value of Equity Securities in a Non-Public Company
1. Valuation Methods
a. The Market Approach
i. The Backsolve Method
b. The Cost Approach
c. The Income Approach
i. Appropriate Discount Rate for Income Approach Methods
ii. Weighted Average Cost of Capital
iii. Capital Asset Pricing Model: Estimating Cost of Equity
iv. Deterimining Cost of Capital and Discount Rates in Private Markets
2. Stages of Development
3. Fair Value of Debt
4. Capital Structure
a. Rights Associated with Preferred Stock
b. Methods for Allocating Value to Individual Equity Securities
i. Current Valuation Method (“CVM”)
ii. Option Pricing Model (“OPM”)
iii. Probability-Weighted Expected Return Model (“PWERM”)
iv. The Hybrid Method
5. Control
6. Marketability
7. Conclusion

Working Papers

TABLE OF WORKSHEETS
Worksheet 1 Comparing the BSM and Lattice Models
Worksheet 2 Definitions of Grant Date, Service Inception Date, Requisite Service Period and Service, Performance and Market Conditions Grant Date
Worksheet 3 Accounting for Stock Options and Restricted Stocks: Sample Disclosures
Worksheet 4 Sample Disclosures for Accelerated Vesting of Stock Options
Worksheet 5 Computing Earnings per Share (EPS)
Worksheet 6 A Tabular Comparison of ASC 718 and IFRS 2
Worksheet 7 SEC Letter to Zions Bancorporation Approving ESOARS Market-Based Valuation Approach