FASB Statement 123(R) Consulting Services

Under new rules issued by the Financial Accounting Standards Board, all companies must begin reporting the fair value of employee stock options, share appreciation rights, and similar instruments in their financial statements. The rules apply to both public  and nonpublic companies. Complex transition rules apply for instruments outstanding on the effective date of the new rules.

How we can help.

• We can value stock options and share appreciation rights for purposes of SFAS No. 123(R).
• We can determine the amount of compensation cost that a company must recognize in each period for financial reporting purposes and tax purposes.
• We can calculate the income tax effect, for financial reporting purposes, of the recognition of compensation cost.

Contact: David E. Hardesty, CPA, MBA    Wilson Markle Stuckey Hardesty &Bott  101 Larkspur Landing Circle, Suite 200 Larkspur, CA  94939, USA, 415-925-1120 ext 104 ~ FAX 414-925-1140

Qualifications

David Hardesty is the author of the book, Share-Based Payments: An Analysis of FASB Statement 123(R)

Primer on accounting for stock options and share appreciation rights

The essence of the fair-value-based method of accounting, required by SFAS No. 123(R), as it applies to equity instruments is as follows: An employer that issues to its employees equity instruments (share, share options, or similar instruments) recognizes compensation cost equal to the grant-date fair value of such instruments as they vest (i.e., as employees perform the services necessary to earn the instruments).  Fair value is generally equal to the observable price of such instruments, if there is one. If there is no observable price, which is often the case for share options awarded to employees, an employer determines fair value using an option pricing model, such as a lattice model. An employer recognizes compensation cost only for equity instruments that vest, and only over the vesting period.

Example: On January 1, 2006, Entity X issues 1,000 share options to each of its 1,000 employees. The options cannot be exercised when issued. Exercise is contingent upon performing three years of future service for the company. The company uses a lattice option-pricing model and calculates a grant-date option fair value of $4. The company estimates that only 800 of its employees will perform the services required to earn the options. Accordingly, the company estimates that the total value of the compensation associated with the award of options will be $3,200,000 (1,000 x 800 x $4). Entity X recognizes in its financial statements compensation cost of $1,066,667 ($3,200,000 / 3) in 2006 and 2007. In 2008, 825 employees actually complete the service requirement and vest in the options. Entity X must base the final amount of compensation recognized on the number of options that actually vest. Accordingly, the company recognizes compensation cost of $1,166,666 (($4 x 1,000 x 825) - $1,066,667 x 2) in 2008.

Fair value accounting for liabilities (such as share appreciation rights) arising from share-based payment transactions is similar to the method as it applies to equities, except for two important differences. First, whereas the fair value of equity instruments, such as options, is determined on the grant date, and never changes, the fair value of liability instruments, such as share appreciation rights, is remeasured each reporting period. Second, an employer continues to recognize compensation based on the changes in value of outstanding liability awards until the awards are settled or expire. 

Example: On January 1, 2006, Entity X issues 1,000 share appreciation rights (SAR) to each of its 1,000 employees. The rights cannot be exercised when issued. Exercise is contingent upon performing three years of future service for the company. The company uses a lattice option-pricing model and calculates a grant-date SAR fair value of $4. The company estimates that only 800 of its employees will perform the required services to earn the award. Accordingly, the company estimates that the total value of the compensation associated with the award of SARs will be $3,200,000 (1,000 x 800 x $4). Over the next three years Entity X remeasures the value of the SARs at the end of each reporting period, and recognizes compensation based on the remeasured value, and the portion of the award earned. For example, on December 31, 2006 the SARs have a fair value of $6 per share, and one-third of the award has been earned. The company still expects 800 employees to complete the required service, and records compensation of $1,600,000 (($6 x 1,000 x 800)/3) in 2006. In 2008, 825 employees vest in the SARs at a time when the SARs have a fair value of $2 per share. Entity X adjusts compensation cost recognized in 2008 so that the cumulative compensation recognized in connection with the SARs is $1,650,000 ($2 x 1,000 x 825). All of the SARs are settled for cash in 2009. The settlement price is equal to the excess of the Entity X stock value over a base price of $10. On the settlement date Entity X stock is trading at $16, so the total settlement amount is $4,950,000 (($16 - $10) x 1,000 x 825). Entity X previously recognized $1,650,000 in compensation in connection with the SARs. In 2009 the company recognizes an additional $3,300,000 in compensation cost when it settles the instruments.

Effective dates. For public companies other than small business issuers the new rules are effective as of the beginning of the first interim or annual reporting period beginning after June 15, 2005; and for small business issuers the rules are effective for the first interim or annual reporting period beginning after December 15, 2005. For nonpublic entities the effective date is as of the beginning of the first annual reporting period beginning after December 15, 2005.

Fair value versus intrinsic value. Under previous rules all companies could account for stock options using intrinsic value. Now these companies must switch to fair value. The following example illustrates the difference between the two methods.

Example: On January 1, 2006, Entity X issues to Jones, its president, 100,000 options to purchase Entity X stock, at a price of $25 per share, at a time when the stock is trading at $25. The options are fully vested, meaning Jones does not have to provide further services to retain these options. Assume Jones can exercise the options only on January 1, 2011. Also assume Entity X stock pays a 3% dividend, and that the risk-free interest rate is 2.5%. Finally, assume that the volatility of Entity X stock is 35% per year. The intrinsic value of these options (i.e., the excess of the stock price over the exercise price) is $0, and Entity X recognizes no compensation in connection with the issuance of these options under the intrinsic method. The fair value of these options, however, is $6.36 per share option, using the Black-Scholes-Merton option-pricing formula; and the value is $6.67 using a simple lattice option-pricing model.(1) Therefore, depending on the option pricing model used, compensation cost based on the fair value of the award is either $636,000 or $667,000.

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Copyright © David E. Hardesty, 2006. All rights reserved.