Peter T. Chingos CPA
Mercer Human Resources Consulting
Walton T. Conn Jr., CPA
KPMG Peat Marwick LLP
John R. Deming CPA
KPMG Peat Marwick LLP
The nature and types of stock-based compensation plans and awards have constantly changed over the years. However, the two most significant problems in determining the appropriate accounting for such awards have remained the same:
Measurement of compensation cost (i.e., the determination of total compensation cost to be allocated to expense for financial reporting purposes)
Allocation of compensation cost (i.e., the determination of the period(s) over which total compensation cost should be allocated to expense and the method of allocation)
To be sure, employees are compensated by being awarded stock options when they contribute services. However, their employers do not incur any cost in compensating them that way, any more than they do in issuing previously unissued shares of their stock when they receive money from new stockholders. The preexisting stockholders are the ones who incur a cost when employees are awarded stock options, first a cost of contingent dilution of their ownership interest and later a cost of actual dilution of their ownership interest. A reporting entity should report the costs it incurs, not costs other entities incur. Ironically, after centering its consideration of reporting in connection with the awarding of employee stock options on the concept of compensation cost, the Financial Accounting Standards Board (FASB) implicitly agreed that the employers incur no cost when compensating the employees when awarding the options, though they do incur a cost in using up the services provided by the employees for which they are awarded options: ". . . issuances of equity instruments result in the receipt of . . . services, which give rise to expenses as they are used in an entity's operations."[33] Compensation cost is therefore a misnomer, and attempting to determine the amount and timing of such a nonexistent cost diverts attention away from determining the amount and timing of the cost of using up the services received from the employees. The American Institute of Certified Public Accountants (AICPA) Accounting Standards Division made that point to the FASB when the FASB was considering the issue. The FASB explicitly ignored that advice when it issued its Invitation to Comment: It stated that AcSEC's analysis is ". . . beyond the scope of this project."[34]
The authoritative accounting literature addresses the accounting for stock-based compensation in two pronouncements which are as follows:
APB Opinion No. 25, "Accounting for Stock Issued to Employees" (AICPA, 1972). Also see Interpretation of APB Opinion No. 25, "Accounting for Stock Issued to Employees" (AICPA, 1973).
Statement of Financial Accounting Standard No. 123, "Accounting for Stock-Based Compensation" (FASB, 1995).
The APB Opinion No. 25 is applicable "to all stock option, purchase, award, and bonus rights granted by an employer corporation to an individual employee . . . . "The Opinion contains substantial guidance in the application of its provisions to such plans.
Subsequent to the issuance of APB Opinion No. 25, the trend toward the adoption by enterprises of more complex plans and awards continued. Of particular significance was the increase in the number of combination plans—plans that provide for the granting of two or more types of awards to individual employees. In many combination plans, the employee, or the enterprise, must make an election from alternative awards as to the award to be exercised, thereby canceling the other awards granted under the plan.
Following the issuance of APB Opinion No. 25, there was also a significant increase in the number of plans that provided for the granting of variable awards to employees. A variable award is one that at the date the grant is awarded, either (1) the number of shares of stock (or the amount of cash) an employee is entitled to receive, (2) the amount an employee is required to pay to exercise his rights with respect to the award, or (3) both the number of shares an employee is entitled to receive and the amount an employee is required to pay, are unknown. One of the most popular variable awards is the stock appreciation right (SAR). The SARs are rights granted that entitle an employee to receive, at a specified future date(s), the excess of the market value of a specified number of shares of the granting employer's capital stock over a stated price. The form of payment for amounts earned under an award of SARs may be specified by the award (i.e., stock, cash, or a combination thereof), or the award may permit the employee or employer to elect the form of payment.
Notwithstanding the guidance provided in APB Opinion No. 25, considerable disagreement continued to exist as to the appropriate method of accounting for variable awards. As a result, significant differences arose in the methods used by employers to account for variable awards, which led to numerous requests of the FASB for clarification. In December 1978, the FASB provided this clarification through the issuance of FASB Interpretation No. 28, "Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans," an interpretation of APB Opinion No. 25. In paragraph No. 2 of the Interpretation, the FASB specifies that:
APB Opinion No. 25 applies to plans for which the employer's stock is issued as compensation or the amount of cash paid as compensation is determined by reference to the market price of the stock or to changes in its market price. Plans involving SARs and other variable plan awards are included in those plans dealt with by [APB] Opinion No. 25.
The Interpretation provides specific guidance in the application of APB Opinion No. 25 to variable awards, particularly in those more troublesome areas where the greatest divergence in accounting existed prior to its issuance.
However, APB Opinion No. 25, as interpreted, failed to incorporate criteria that can be consistently applied to all types of plans. As a result, as new types of plans have evolved and changes in the tax laws have occurred, new interpretations and guidance have been required, resulting in a steady stream of pronouncements by the FASB and the Emerging Issues Task Force (EITF) since 1978, as shown in Exhibit 39.1.
The nature and the frequency of these additional pronouncements underscore the difficulties in applying the primary pronouncements to the myriad of stock-based compensation awards that have arisen since their issuance.
To address this problem, the FASB undertook a major project in 1984 to reconsider the accounting for stock-based compensation, whether issued to employees or issued to vendors, suppliers, or other nonemployees. In October 1995, the FASB issued FASB Statement No. 123, "Accounting for Stock-Based Compensation." FASB Statement No. 123 allows companies to retain the current approach set forth in APB Opinion No. 25, as amended, interpreted, and clarified; however, companies are encouraged to adopt a new accounting method based on the estimated fair value of employee stock options. Companies that do not follow the fair value method are required to provide expanded disclosures in the footnotes. Thus, the FASB settled on a compromise solution to a complex issue that had become extremely politicized. The vast majority of entities have not elected the fair value method of accounting for stock options. Therefore, the financial statements of most companies include two presentations of a company's results of operations rather than the normal presentation of a single net income.
FASB Statement No. 123 was preceded by an exposure draft issued by the FASB that would have required a new accounting method that results in reporting expense in connection with virtually all stock options issued to employees. However, those who receive stock options believe a requirement to change to the new method could threaten their stock options: The Wall Street Journal reported that "FASB's chairman . . . Dennis Beresford . . . says he scoffed at the doomsday arguments during a heated discussion aboard one corporate jet. The executives he was debating invited him to exit the craft—at 20,000 feet."[35] And Beresford himself reported that ". . . the CEO of one of United States' most successful companies . . . said that if the FASB was allowed to finalize the draft as proposed 'it would end capitalism' "[36]
To prevent this "disaster," the U.S. Congress prepared a bill entitled the Accounting Standards Reform Act, which, if enacted, would have required the Securities and Exchange Commission (SEC) to pass on all new standards approved by the FASB. The bill stated, in part: ". . . any new accounting standard or principle, and any modification . . . shall become effective only following an affirmative vote of a majority of a quorum of the member of the [Securities and Exchange] Commission." The bill was proposed simply to pressure the SEC to prevent the FASB from making this particular exposure draft final.
When the FASB was considering accounting for stock-based compensation leading to the issuance of FASB Statement No. 123, it did not address practice issues related to Opinion No. 25, because the Board had planned to supersede Opinion No. 25. Because FASB Statement No. 123 did not supersede Opinion No. 25, the FASB issued its Interpretation No. 44 to address issues on the application of Opinion No. 25 in a number of circumstances. Interpretation No. 44 was developed within the framework of Opinion No. 25 and does not refer to the concepts in FASB Statement No. 123.
Interpretation No. 44 became effective July 1, 2000. Except as noted next, it was to be applied prospectively to new awards, exchanges of awards in business combinations, modifications to outstanding awards, and changes in grantee status that occurred on or after that date.
The guidance about modifications to fixed stock option awards that directly or indirectly reduce the exercise price of an award apply to modifications made after December 15, 1998. The guidance about the definition of an employee applies to new awards granted after December 15, 1998. The guidance about modifications to fixed stock option awards to add a reload feature applies to modifications made after January 12, 2000. To the extent that events covered by the Interpretation discussed in this paragraph occur after the applicable date but before July 1, 2000, the effects of applying the Interpretation are to be recognized only prospectively. Accordingly, no adjustments are to be made on initial application of the Interpretation to financial statements for periods before July 1, 2000. Additional compensation cost measured on initial application of the Interpretation attributable to periods before July 1, 2000, is not recognized.
The initial application of the guidance for awards to an entity's nonemployee board of directors, if previously accounted for as awards to nonemployees and now required by the Interpretation to be accounted for under Opinion No. 25, is to be reported as a cumulative effect of a change in accounting principle.
Since companies continue to use the intrinsic value approach prescribed by APB Opinion No. 25, the authors have separated the chapter into two distinct parts. The first part will cover the application of APB Opinion No. 25 and its related interpretations and EITF issues. The remainder of the chapter will address the application of FASB Statement No. 123.
FASB Interpretation No. 44 addresses questions that have been raised as to whether Opinion No. 25 applies to accounting by the grantor of stock compensation to independent contractors or other service providers not employees of the grantor. It states that Opinion No. 25 applies to grantor employers for only stock compensation to those who meet the definition of employee under Opinion No. 25 as amplified by Interpretation No. 44.
For purposes of applying Opinion No. 25, a person is an employee if the grantor consistently represents the person to be an employee under common law, as illustrated in case law and under U.S. Internal Revenue Service Revenue Ruling 87–14. For such a person to be a common law employee, the grantor must represent the person as an employee for payroll tax purposes. However, simply representing a person as an employee for payroll tax purposes is insufficient to indicate that the person is an employee for purposes of Opinion No. 25.
An exception to the guidance in the preceding paragraph involves a grantor of stock compensation to a person who provides services to the grantor under a lease or co-employment agreement between the grantor and another entity under which the grantor is not the employer of record for payroll tax purposes. Such a person is deemed to be an employee of the grantor under Opinion No. 25 if all of the following criteria are met:
The person is a common law employee of the grantor, and the other entity is contractually required to pay payroll taxes on the compensation paid to the person for services provided to the grantor.
The grantor and the other entity agree in writing to all of the following:
The grantor has the exclusive right to grant stock compensation to the person for the person's services to the grantor.
The grantor has a right to hire, fire, and control the activities of the person. (The other entity may have the same right.)
The grantor has the exclusive right to determine the economic value of the services performed by the person (including wages and the number of units and value of stock compensation granted).
The person can participate in the grantor's employee benefit plans, if any, on the same basis as comparable employees of the grantor.
The grantor agrees to and does remit funds to the other entity sufficient to cover the complete compensation of the person, including all payroll taxes, on or before a contractually agreed date or dates.
A nonemployee member of a grantor's board of directors ordinarily does not meet that definition of an employee. However, application of Opinion No. 25 is required to stock compensation granted to such a person for services provided as a director if the person (a) was elected by the grantor's shareholders or (b) was appointed to a board position to be filled by shareholder election when the existing term expires. Employee status is not involved for awards granted to people for advisory or consulting services in a nonelected capacity or to nonemployee directors for services outside their role as directors, such as legal or investment banking advice or for loan guarantees.
Except as indicated in the preceding paragraph, Opinion No. 25 does not apply to the accounting by a grantor for stock compensation granted to nonemployees. For example, it does not apply to the accounting by a corporate investor of an unconsolidated investee for stock options or awards granted by the investor to employees of the investee accounted for under the equity method.
Whether a person is an employee under Opinion No. 25 is evaluated for consolidated financial statements at the consolidated group level. Stock compensation based on the stock of any consolidated group member is accounted for under Opinion No. 25 if the person meets the definition of an employee for any entity in the consolidated group. For example, Opinion No. 25 applies to the accounting in the consolidated financial statements for awards based on parent stock granted to employees of a consolidated subsidiary, to awards in stock of a consolidated subsidiary granted to employees of the parent, and to awards based on a consolidated subsidiary's stock granted to the employees of another consolidated subsidiary.
Opinion No. 25 does not apply to accounting by an employer for stock compensation granted to its employees (a) by another entity, such as an investee, based on that entity's stock or (b) by the employer based on the stock of another entity. Though that would seem to apply to awards based on the stock of a subsidiary for purposes of reporting in the separate financial statements of the subsidiary, Opinion No. 25 does apply in such circumstances if the subsidiary is part of the consolidated group including the parent company for purposes of preparing its consolidated financial statements.
With a change in status of a grantee to or from that of an employee of the grantor while an outstanding stock option or award is retained by the grantee with no modification of any of its terms, compensation cost under Opinion No. 25 is measured as if the award were newly granted at the date of the change in status. Only the portion of the newly measured cost attributable to the remaining vesting (service) period is recognized as compensation cost prospectively from the date of the change in status. Further, no adjustment is made to compensation cost recognized by the grantor before the change in status unless the award is forfeited unvested because the grantee does not fulfill an obligation. A modification made to a vested award's terms as a result of a change in status has no effect. If the grantee terminates employment before vesting, the cumulative estimate of compensation cost recorded in previous periods is reduced to zero by decreasing compensation cost in the period of forfeiture.
If there is a change in status of a grantee to or from that of an employee of the grantor while an outstanding stock option or award is retained by the grantee with a modification to the award at the time the status is changed, the modified award is treated under Opinion No. 25 as a new award appropriate to the new status of the grantee. Compensation cost thus measured is recognized in full over the remaining vesting (service) period, if any. Compensation cost previously recognized for the forfeited award, if any, is adjusted to zero in the period of forfeiture. A modification is deemed made if its terms would have required it to be forfeited on the change in status and the terms are then modified to continue the award. The modification in effect reinstates or extends the life of the award as a new award to the grantee immediately after the change in status. Similarly, a modification and an effective reinstatement of an award is made if the terms of the award (or underlying plan) provide for the award to continue at the discretion of the grantor and the grantee retains the award after the change in status.
As an exception, a change in grantee status from an employee to a nonemployee as a direct result of a spin-off does not change the grantor's accounting under Opinion No. 25. This applies to only awards granted and outstanding, including adjustments to those awards, at the date of the spin-off. This exception does not apply to other kinds of transactions, such as sale by a parent company of a large enough percentage of the shares of a subsidiary requiring the parent company to deconsolidate the subsidiary.
The APB Opinion No. 25 provides that a plan must have the following four characteristics in order to be considered as noncompensatory:
Substantially all full-time employees meeting limited employment qualifications may participate (employees owning a specified percentage of the outstanding stock and executives may be excluded).
Stock is offered to eligible employees equally on the basis of a uniform percentage of salary or wages (the plan may limit the number of shares of stock that an employee may purchase through the plan).
The time permitted for exercise of an option or purchase right is limited to a reasonable period.
The discount from the market price of the stock is no greater than would be reasonable in an offer of stock to stockholders or others.
Because Opinion No. 25 refers to a plan that qualifies under Section 423 of the U.S. Internal Revenue Code as a noncompensatory plan, which permits discounts of up to 15 percent, such a plan has the characteristic required under item 4. Further, for a stock option with an exercise price fixed at the date of grant, a discount of the exercise price of no more than 15 percent from the stock price on that date is reasonable for application of item 4.
Section 423 of the U.S. Internal Revenue Code permits a qualified employee stock purchase plan to contain a look-back option. A look-back option, for example, is a provision in an employee stock purchase plan that establishes the purchase price as the lesser of the stock's market price at the grant date or its market price at the exercise (purchase) date. Because Opinion No. 25 states that a plan that qualifies under Section 423 is noncompensatory, a plan with a look-back option qualifies as noncompensatory under Opinion No. 25.
A compensatory plan is any plan that does not have all four characteristics of a noncompensatory plan. It should be recognized, however, that awards granted under compensatory plans do not necessarily result in recognition of compensation expense by the employer. An employer recognizes compensation expense with respect to awards granted pursuant to a compensatory plan only if the application of the measurement principle results in the determination of compensation cost.
Paragraph 10 of APB Opinion No. 25 sets forth the following "measurement principle" for the measurement of compensation cost related to stock option, purchase, and award plans:
Measurement Principle—Compensation for services that a corporation receives as consideration for stock issued through employee stock option, purchase, and award plans should be measured by the quoted market price of the stock at the measurement date less the amount, if any, that the employee is required to pay . . . . If a quoted market price is unavailable, the best estimate of the market value of the stock should be used to measure compensation . . . . The measurement date for determining compensation cost in stock option, purchase, and award plans is the first date on which are known both (1) the number of shares that an individual employee is entitled to receive, and (2) the option or purchase price, if any.
When both of the factors specified in paragraph 10 of APB Opinion No. 25 are known at the grant or award date (i.e., a fixed award), total compensation cost for an award is measured at the grant date. However, when either or both of these factors are not known at the grant or award date (i.e., a variable award), an employer should estimate total compensation cost each period from the date of grant or award to the measurement date based on the quoted market price of the employer's capital stock at the end of each period. This latter point is clarified in FASB Interpretation No. 28, which defines the compensation related to variable plan awards as:
The amount by which the quoted market value of the shares of the employer's stock covered by the grant exceeds the option price or value specified, by reference to a market price or otherwise, subject to any appreciation limitations under the plan. Changes, either increases or decreases, in the quoted market value of those shares between the date of grant and the measurement date [as defined in APB Opinion No. 25] result in a change in the measure of compensation for the right or award.
A proper understanding of the measurement principle of APB Opinion No. 25 (including the clarification set forth in FASB Interpretation No. 28) is essential to determining the appropriate accounting, including the amount of compensation expense to be recognized. Paragraphs 11(a) through 11(h) of APB Opinion No. 25, as well as subsequent FASB and EITF pronouncements, contain guidance on the application of the measurement principle, as discussed in the following paragraphs.
Paragraph 11(a) states:
Measuring compensation by the cost to an employer corporation of reacquired (treasury) stock that is distributed through a stock option, purchase, or award plan is not acceptable practice. The only exception is that compensation cost under a plan with all the provisions described in paragraph 11(c) may be measured by the cost of stock that the corporation (1) reacquires during the fiscal period for which the stock is to be awarded and (2) awards shortly thereafter to employees for services during that period.
Thus compensation cost of an award of stock for current services may be measured by the cost of reacquired treasury stock only if the above conditions and those specified in paragraph 11(c) (see below) of the Opinion are met. Otherwise, compensation cost should be measured as of the measurement date otherwise determined in accordance with the criterion set forth in paragraph 10 of the Opinion.
Paragraph 11(b) states:
The measurement date is not changed from the grant or award date to a later date solely by provisions that termination of employment reduces the number of shares of stock that may be issued to an employee.
This paragraph makes it clear that a requirement that an employee remain employed by the granting enterprise for a specified period of time in order for his rights to become vested under a stock-based compensation award does not preclude a determination, as of the grant or award date, of the total compensation cost to be recognized as an expense by the granting employer.
Paragraph 11(c) states:
The measurement date of an award of stock for current service may be the end of the fiscal period, which is normally the effective date of the award, instead of the date that the award to an employee is determined if (1) the award is provided for by the terms of an established formal plan, (2) the plan designates the factors that determine the total dollar amount of awards to employees for the period (for example, a percent of income), although the total amount or the individual awards may not be known at the end of the period, and (3) the award pertains to current service of the employee for the period.
The effect of this paragraph is to allow the designation of the end of a fiscal period as the measurement date when all of the conditions specified in paragraph 11(c) are met, even though the actual awards to individual employees may not be determined until after the close of the fiscal period.
Paragraph 11(d) states:
Renewing a stock option or purchase right or extending its period establishes a new measurement date as if the right were newly granted.
This paragraph reflects a very important concept. Its application could result in measurement of compensation cost with respect to outstanding stock option or purchase rights upon their renewal or extension, even though no compensation cost was ascribable to the original award under the measurement principle of APB Opinion No. 25. For example, any excess of the quoted market price of an employer's capital stock over the exercise price of a stock option at the date of renewal or extension is compensation cost; this may require recognition of compensation cost in addition to any compensation cost associated with the original award.
Paragraph 11(d) addresses "renewals" and "extensions" of stock purchase rights. There are modifications other than renewals and extensions that could also have an impact on the accounting for previously granted awards.
The EITF Issue No. 87–33, "Stock Compensation Issues Related to Market Decline," addresses a series of issues related to modifications to stock option and award plans as a result of market decline. The EITF's consensus on these issues generally precludes reversals of previously recognized compensation expense when outstanding awards are modified because of market value declines and, in many instances, require measurement and recognition of compensation cost for both the original and the modified award.
FASB Interpretation No. 44 addresses several issues related to modifications to stock option and award plans that change the life of the award through an extension of the exercise period or a renewal, decreases the exercise or purchase price of the award, or increases the number of shares the grantee is entitled to receive, including the addition of a reload feature.
A modification that renews a fixed award or extends the award's period (life), including a modification contingent on a future separation from employment, results in a new measurement of compensation cost the same as a newly granted award. Any intrinsic value at the modification date in excess of the amount measured at the original measurement date is recognized as compensation cost over the remaining future service period if the award is unvested, or immediately if the award is vested, for any employee who could benefit from the modification.
A modification that increases the life of an option award on separation from employment, but not beyond the original maximum contractual life of the award, is an extension of the award at the date the separation occurs and the life of the award is extended. The intrinsic value of the award is measured at the date of the modification, and any intrinsic value in excess of the amount measured at the original measurement date is recognized as compensation cost if the separation occurs. If the award vests and is exercised before the separation, any incremental intrinsic value at the date of the modification is not recognized, because the life of the award has not been extended. Attribution of additional compensation cost may require estimates, and adjustment of the estimates may be necessary in later periods.
If the original terms of the award provide for vesting to be accelerated at the discretion of the grantor (or on some other discretionary basis), subsequent acceleration of vesting is a modification. In contrast, if vesting is accelerated based on the occurrence of a specific event or condition in accordance with the original terms of the award, for example, if the original terms of an award specify that vesting is accelerated on retirement, death, or disability, no modification has been made and no new measurement of compensation cost is required.
A fixed stock option award may be subject to a modification by having its exercise price reduced (commonly called repricing). The exercise price has been reduced if the fair value of the consideration required to be remitted by the grantee on exercise is less than or potentially less than the fair value of the consideration required of the grantee according to the original terms of the award. Such an award is accounted for as variable from the date of the modification to the date the award is exercised, forfeited, or expires unexercised.
An exercise price can be reduced indirectly. For example, the grantor can give the grantee a cash bonus arrangement that is paid only if and when the award is exercised. This is an example of a combined stock award and cash bonus arrangement, discussed below. Or the grantor can allow the grantee to exercise the award with a full-recourse note that does not bear the market interest rate. If the exercise price has been reduced indirectly, the guidance in the preceding paragraph applies.
A grantor can directly or indirectly modify an award by reducing the exercise price contingent on the occurrence of a specified future event or condition, for example, if a certain earnings target or stock price is achieved in the future. Such a modification causes the award to be variable for the remainder of its outstanding life regardless of whether the triggering event occurs or the contingency provisions expires without the contingency occurring. In contrast, the original terms of a stock option award may provide for a reduction to the award's exercise price if a specified future event or condition occurs. If so, variable accounting is applied from the date of grant. A measurement date would occur and variable accounting would stop when the contingency is resolved or the contingency provision expires.
A grantor can, in effect, cancel an option award, for example, by modifying its terms to reduce or eliminate the likelihood that the grantee will exercise the option, such as by increasing the exercise price or curtailing the remaining life of the award. Any such modification is a cancellation.
A grantor can indirectly reduce the exercise price of a fixed stock option award by canceling or effectively canceling it or settling it for cash or other consideration and granting a replacement award at a lower exercise price, either before or after the cancellation or effective cancellation. If a cancellation and an award are combined that way, the replacement award is given variable accounting until it is exercised, is forfeited, or expires unexercised.
An option award cancellation is combined with another option award with a lower exercise price and results in an indirect reduction to the exercise price of the combined award if the other award is granted to the grantee within one of the following periods:
The period before the date of the cancellation that is the shorter of six months or the period from the date of the grant of the canceled option
The period ending six months after the date of the cancellation
To identify the replacement award that becomes subject to variable accounting on the cancellation of an award, the grantor first looks back in the period before the cancellation described in (a) above. If the award was granted during that period with an exercise price below that of the canceled award, the award and the canceled award are combined. If canceled options remain that were not combined with a replacement award in the look-back period, the grantor then looks forward to the period described in (b) above. If an award is granted during that period at an exercise price below that of the canceled award, the award and the canceled award are combined. When looking backward and then forward, options granted at dates closest to the date of cancellation are first identified as the replacement award. If the replacement award is identified in the look-back period, variable accounting for the award begins at the cancellation date. Prior-period financial statements are not restated if the award was accounted for as a fixed award in those statements.
Nevertheless, an oral or written agreement or implied promise by the grantor to compensate the grantee for any increase in the market price of the stock after a cancellation but before grant of a replacement award requires variable accounting for the replacement award regardless of the amount of time between the cancellation and the replacement grant. Any agreement between the grantor and the grantee when an option award is granted to cancel at a future date another outstanding option award requires variable accounting for the newly granted award from the date of grant.
The preceding also applies to the cancellation of an option award that has been accounted for as variable because of a reduction to that award's exercise price through a prior modification. But any option award granted during the look-back and look-forward periods, regardless of the exercise price of the replacement award, is eligible to be the replacement award. Thus, any replacement or modified award that has been accounted for as a variable award retains that status.
A cancellation of a fixed stock option award and the grant of stock results in a new measurement of compensation cost for the stock grant. The exercise price has been effectively reduced to zero. Variable accounting does not therefore apply to the replacement award. Any excess of the number of shares underlying the canceled fixed stock option award over the number of shares of the replacement stock award is subject to the guidance in the immediately preceding paragraphs.
An equity restructuring is a nonreciprocal transaction between an entity and its shareholders, such as a stock dividend, spin-off, stock split, rights offering, or recapitalization through a special, large, nonrecurring dividend that causes the market value per share of the stock underlying the option award to decrease. Such a restructuring may adjust the exercise price, the number of shares, or both of outstanding stock options or awards. (Ordinary cash dividends or distributions are not equity restructurings for this purpose.) The grantor may reduce the exercise price, increase the numbers of shares under the award, or both, to offset the decrease in the per share price of the stock underlying the award. No accounting consequence results from such an equity restructuring if both of the following are met:
The aggregate intrinsic value of the award immediately after the change is not greater than the aggregate intrinsic award immediately before the change.
The ratio of the exercise price per share to the market value per share is not reduced.
If those criteria are not met, the modified award is accounted for under Opinion No. 25 as variable from the date of the modification to the date the award is exercised, is forfeited, or expires unexercised. If they are met but the terms of the original award have also been modified to either accelerate the vesting or extend the life of the award, a new measurement of compensation cost is made at the date of the modification as if the award were newly granted. Cash or other consideration provided to restore the economic position of the grantee as a result of an equity restructuring transaction is recognized as compensation cost. The guidance concerning restructuring is applied without regard to whether the provisions of the stock option or award provide for adjustments to the terms in the event of an equity restructuring.
A modification that increases the number of shares to be issued under a fixed stock option award requires the award to be accounted for as variable from the date of the modification to the date the award is exercised, is forfeited, or expires unexercised.
A grantor that modifies a fixed stock option award to add a reload feature, which provides for the grant of a new option award on the exercise of an existing award if specified conditions are met, applies variable accounting for the modified award from the date of the modification to the date the award is exercised, is forfeited, or expires unexercised. The methods used to determine the exercise price, the number of shares, and the life of the reload grant are irrelevant. Variable accounting is required for each additional grant that includes a reload feature under a reload feature that provides for multiple subsequent grants through further reloads.
Total compensation cost is measured as the sum of the following if a fixed stock option or award is canceled or modified and a new measurement of compensation cost or variable accounting is required as a result of the modification:
The intrinsic value of the award (if any) at the original measurement date
The intrinsic value of the modified (or variable) award that exceeds the lesser of the intrinsic value of the original award (1) at the original measurement date or (2) immediately before the modification
When a stock option or award is modified and a new measurement of compensation cost or variable accounting is required, the remaining unrecognized original intrinsic value, if any, plus any additional compensation cost measured under (b) above is recognized over the remaining vesting (service) period, if any. If the modified award is fully vested at the date of the modification, any additional compensation cost to be recognized is recognized immediately. Recognized compensation cost for an award forfeited because an employee does not fulfill an obligation is reduced to zero by decreasing compensation cost in the period of the forfeiture.
Additional compensation cost measured as of the modification date for modifications to accelerate vesting or to extend the life of an award on a specified future separation from employment (but not beyond the award's original maximum contractual life) for all awards for which the modification results in an effective term extension or an effective renewal. Attribution of additional compensation cost may require estimates and adjustments of the estimates in later periods.
Compensation cost is adjusted for increases or decreases in the intrinsic value of a modified award that requires variable accounting in subsequent periods until the award is exercised, is forfeited, or expires unexercised. Compensation cost is not, however, adjusted below the intrinsic value (if any) of the modified stock option or award at the original measurement date unless the award is forfeited because the employee does not fulfill an obligation.
If cash is paid to an employee to settle an outstanding stock option, to settle an earlier grant of a stock award within six months after vesting, or to repurchase shares within six months after exercise of an option or issuance, total compensation cost is measured as the sum of the following:
The intrinsic value of the stock option or award (if any) at the original measurement date
The amount of cash paid to the employee (reduced by any amount of cash paid by the employee to acquire the shares) that exceeds the lesser of the intrinsic value (if any) of the award (1) at the original measurement date or (2) immediately before the cash settlement
The following guidance differs on whether the entity is a public entity or a private entity for this purpose. For this purpose, a public entity is any entity (a) whose securities trade in a public market either on a stock exchange (domestic or foreign) or in an over-the-counter market, including securities quoted only locally or regionally, (b) that makes a filing with a regulatory agency in preparation for the sale of any class of equity securities in a public market, or (c) that is controlled by an entity that meets criterion (a) or (b). A subsidiary of a public entity or a public entity with thinly traded stock follows the accounting for the public entity. But an entity with publicly traded debt but no publicly traded equity securities follows the accounting for a nonpublic entity.
For public reporting entities other than for shares expected to be repurchased at fair value for required tax withholding, variable accounting is required for a stock option or award with a share repurchase feature if the shares are expected to be repurchased within six months after option exercise or issuance of the shares. For a repurchase feature that is a right held by the employee to sell the shares back to the entity, variable accounting is required for the award if the right can be exercised within six months of issuance of the shares. After an option is exercised, the employee bears the risks and rewards of ownership with respect to those shares (except that if the consideration for exercise is a nonrecourse note, the substance is the same as a stock option and the employee bears no risks or rewards of ownership in the shares received). A subsequent repurchase of the shares by the entity (except within six months after option exercise or share issuance) thus represents a separate transaction to acquire treasury stock that is accounted for apart from the original stock option or award.
If the grantor repurchases shares within six months of issuance or option exercise and the repurchase was not expected by the grantor before the date of the repurchase, the grantor follows the preceding guidance for cash settlement of an earlier award.
If a share repurchase feature gives the employee the right to sell the shares back to the grantor after option exercise or share issuance for a premium that is not fixed or determinable over the then-current stock price, that feature creates an arrangement that requires variable accounting, even if the share cannot be sold back to the entity within six months after option exercise or issuance. If such a feature gives the employee the right to sell shares back to the entity for a fixed dollar amount over the stock price but not within six months of issuance of the shares, the fixed premium is recognized as additional compensation cost over the vesting (service) period.
For nonpublic reporting entities, variable accounting is not required for a stock option or award with one of these share repurchase features:
The stated share repurchase price is equal to the fair value of the shares at the date of repurchase, the employee cannot require the entity to repurchase the shares within six months of option exercise or share issuance, and the shares are not expected to be repurchased within six months after exercise or share issuance.
The stated share repurchase price is not the fair value of the shares at the date of repurchase, but the employee has made a substantial investment and must bear risks and rewards normally associated with share ownership for at least six months.
Shares are repurchased for tax-withholding purposes at the grantor's minimum statutory withholding rates, including payroll taxes, applicable to supplemental taxable income.
A substantial investment has been made for purposes of an award that contains a repurchase feature at other than fair value when the employee invests in a form other than services rendered to the entity an amount equal to 100 percent of the stated share repurchase price calculated at the date of grant. If the award is an option, a substantial investment therefore cannot be made before exercise of the option. Because the award is variable, compensation cost is recognized for any intrinsic value of the option from the date of grant to the date a substantial investment has been made.
For purposes of paragraph 11(g) of Opinion No. 25 for both public and nonpublic entities, to determine the variable amount not required, required tax withholding is defined as the employer's minimum statutory withholding rates for federal and state tax purposes, including payroll taxes applicable to such supplemental taxable income. Withheld amounts in excess of that rate do not represent the employer's required tax withholding for this purpose.
If an election to repurchase shares on exercise in excess of the number necessary to satisfy the employer's required tax withholding is at the discretion of the employee, variable accounting is required from the date the award is granted to the date the award is exercised, is forfeited, or expires unexercised. If the terms of an award are silent on tax withholding, or if the repurchase of shares for tax withholding in excess of the number necessary to satisfy the employer's required tax withholding is at the discretion of the employer, variable accounting is not required. However, in either circumstance, if the employer exhibits a pattern of consistently approving repurchases of excess shares, variable accounting is required from the date of grant for all awards under the plan.
If shares are repurchased on exercise of a fixed option award in excess of the number necessary to satisfy the employer's required tax withholding, a new measurement of compensation cost is required for the entire award.
Changes to the exercise price or the number of share of a fixed stock option award as a result of an exchange of fixed stock option awards in a business combination accounted for by the pooling of interests method have no accounting consequence if both of the following are met at the date of exchange:
The aggregate intrinsic value of the options immediately after the exchange is no greater than the aggregate intrinsic value of the options immediately before the exchange.
The ratio of the exercise price per option to the market value per share is not reduced.
If those criteria are not met, a new measurement of compensation cost is required.
Vested stock options or awards issued by an acquirer in a business combination accounted for by the purchase method in exchange for outstanding awards held by employees of the acquiree are considered to be part of the purchase price paid by the acquirer for the acquiree and accounted for under FASB Statement No. 141. The fair value of the new (acquirer) awards are included as part of the purchase price.
Unvested stock options or awards granted by an acquirer in a business combination accounted for by the purchase method in exchange for stock options or awards held by employees of the acquiree are considered to be part of the purchase price for the acquiree, and the fair value of the new (acquirer) awards are included in the purchase price. However, to the extent that service is required after the consummation date of the acquisition in order to vest in the replacement awards, a portion of the intrinsic value (if any) of the unvested awards is allocated to unearned compensation and recognized as compensation cost over the remaining future vesting (service) period. The amount allocated is based on the portion of the intrinsic value at the consummation date related to the future vesting (service) period. The amount is calculated as the intrinsic value of the replacement awards at the consummation date multiplied by the fraction that is the remaining future vesting (service) period divided by the total vesting (service) period, which is the vesting period before the consummation date plus the remaining future period required to vest in the replacement award. Any intrinsic value of the replacement awards allocated to unearned compensation cost is deducted from the fair value of the awards for purposes of the allocation of the purchase price to the other assets acquired.
Awards granted under a plan subject to shareholder approval generally are not deemed granted until approval is obtained, and, therefore, no measurement date can occur before then. However, if management and the members of the board of directors control sufficient votes to approve the plan, a grant date and therefore a measurement date may be deemed to have occurred before shareholder approval, because approval then is merely a formality.
Deferred tax assets recognized for temporary differences related to stock options or awards under Opinion No. 25 should not be adjusted for subsequent declines in the stock price. Such assets are determined by the compensation expense recognized for financial reporting rather than by reference to the expected future tax deduction, which would be estimated using the current intrinsic value of the award. A valuation allowance to reduce the carrying amount of the assets is established only if the grantor expects future taxable income to be insufficient to recover the assets in the periods in which the deduction would otherwise be recognized for tax purposes.
A cash bonus and a stock option award are accounted for as a combined award if payment by the grantor or refund by the employee of the cash bonus is contingent on exercise of the option award. A cash bonus that is not fixed and that is contingent on exercise of an option award is accounted for as a variable award. A fixed cash bonus that is contingent on exercise of a fixed option award is accounted for as a combined fixed award with the cash bonus reducing the stated exercise price of the option award. A cash bonus, regardless of whether it is fixed or variable, that is contingent on vesting of a stock option or award is accounted for as compensation cost separate from the stock option or award.
Paragraph 11(e) states:
Transferring stock or assets to a trustee, agent, or other third party for distribution of stock to employees under the terms of an option, purchase, or award plan does not change the measurement date from a later date to the date of transfer unless the terms of the transfer provide that the stock (1) will not revert to the corporation, (2) will not be granted or awarded later to the same employee on terms different from or for services other than those specified in the original grant or award, and (3) will not be granted or awarded later to another employee.
This paragraph reinforces the principle that the measurement date is the first date on which are known both (1) the number of shares that an individual employee is entitled to receive and (2) the option or purchase price, if any. The authors are not aware of any awards that have been structured in a manner that has resulted in an acceleration of the otherwise determined measurement date as a result of the application of paragraph 11(e).
Paragraph 11(f) states:
The measurement date for a grant or award of convertible stock (or stock that is otherwise exchangeable for other securities of the corporation) is the date in which the ratio of conversion (or exchange) is known unless other terms are variable at that date (paragraph 10b). The higher of the quoted market price at the measurement date of (1) the convertible stock granted or awarded or (2) the securities into which the original grant or award is convertible should be used to measure compensation.
Awards to employees of convertible stock or rights to purchase convertible stock are not common. Nevertheless, this paragraph provides guidance in measuring the compensation cost of such awards. Further guidance can be found in FASB Interpretation No. 38, "Determining the Measurement Date for Stock Option, Purchase, and Award Plans Involving Junior Stock," an interpretation of APB Opinion No. 25.
Paragraph 11(g) states:
Cash paid to an employee to settle an earlier award of stock or to settle a grant of option to the employee should measure compensation cost. If the cash payment differs from the earlier measure of the award of stock or grant of option, compensation cost should be adjusted (par. 15). The amount that a corporation pays to an employee through a compensation plan is "cash paid to an employee to settle an earlier award of stock or to settle a grant of option" if stock is reacquired shortly after issuance. Cash proceeds that a corporation receives from sale of awarded stock or stock issued on exercise of an option and remits to the taxing authorities to cover required withholding of income taxes on an award is not "cash paid to an employee to settle an earlier award of stock or to settle a grant of option" in measuring compensation cost.
The intent of this paragraph seems quite clear. If an earlier award of stock or stock options is ultimately settled by cash payment to the employee, the amount actually paid is the final measure of compensation cost to be recognized by the employer, regardless of the amount of compensation cost previously determined. However, in practice, application of this paragraph has often proved difficult and, as a result, a number of EITF Issues have dealt with cash settlements of awards, as discussed in the following paragraph.
This pronouncement sets forth the EITF's consensus that the "target company" in a leveraged buyout should recognize compensation expense in the amount of cash paid by the target company to acquire outstanding stock options and SARs.
Similar to the consensus in EITF Issue No. 84–13, this consensus indicates that when a target company settles outstanding stock options or awards "voluntarily, at the direction of the acquiring company, or as part of the plan of acquisition, APB Opinion No. 25 requires that the settlement be accounted for as compensation expense in the separate financial statements of the target company."
This consensus addresses stock option plans that contain a cash bonus feature that provides for a reimbursement to employees of the taxes payable as a result of the exercise of a nonqualified stock option (a "tax-offset bonus"). The consensus indicates that awards under such plans are variable awards. Thus, the existence of a tax-offset bonus related to a stock option award requires that the entire award (the stock option plus the cash bonus feature) be accounted for as a variable award, as the option and the tax-offset bonus are viewed as a single variable award. This consensus is consistent with footnote 1 to FASB Interpretation No. 28, "Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans" which states, in part, "Plans under which an employee may receive cash in lieu of stock or additional cash upon the exercise of a stock option are variable plans for purposes of the Interpretation as the amount is contingent upon the occurrence of future events." The significant point here is that two different awards, one being a fixed award and the other a variable award, should be accounted for as a single, variable award.
This consensus provides much-needed guidance in accounting for formula-based plans, under which employees purchase shares, or are granted options to acquire shares, of the employer's common stock at a formula price. The formula price is usually based on book value, a multiple of book value, or earnings. Additionally, the employee must sell the acquired shares back to the employer upon retirement or other termination of employment, at a selling price determined in the same manner as the original purchase price.
Privately held companies only:
No compensation expense should be recognized for changes in the formula price during the employment period "if the employee makes a substantive investment that will be at risk for a reasonable period of time." This consensus applies to plans where the employee is allowed to resell all or a portion of the acquired shares to the company at fixed or determinable dates, as well as plans where the shares are resold to the company only upon retirement or other termination of employment.
Privately held and publicly held companies:
If options are granted to employees to purchase shares at the formula price and the employees can resell the options, or the shares acquired upon exercise of the options, to the company upon retirement or other termination of employment, or at fixed or determinable dates, the consensus of the EITF is the same for both privately held and publicly held companies. The consensus indicates that compensation expense should be recognized for increases in the formula price from the grant date to the exercise date (i.e., the award should be accounted for as a variable award). The consensus further indicates that the expense previously recognized should not be reversed upon exercise of the option, and that "additional expense would be recognized if the shares are sold back to the company shortly after exercise, as required by paragraph 11(g) of APB Opinion No. 25."
The SEC observer at the EITF provided the following clarification of the SEC staff's views of book value plans for publicly held companies:
The SEC Observer indicated that the SEC staff views a book value plan for a publicly held company as a performance plan and noted that it should be accounted for like an SAR.
As previously noted, a difference exists between accounting for book value purchase (and other formula-based) awards by privately held and publicly held companies. This difference, of course, raised questions as to the accounting to be applied to these types of awards when a privately held company becomes publicly held. This issue was subsequently addressed in EITF Issue No. 88–6, "Book Value Stock Plans in an Initial Public Offering."
This consensus addresses a number of issues related to the October 1987 stock market decline, including "How to account for the repurchase of an outstanding option and the issuance of a 'new' option." The Task Force consensus on this issue was that "paragraph 11(g) of APB Opinion No. 25 does not apply if an existing option is repurchased in contemplation of the issuance of a new option that contains terms identical to the remaining terms of the original option except that the exercise price is reduced . . . ." The consensus also indicates that "the cash paid to repurchase the original option represents additional compensation that should be charged to expense in the current period."
The effect of this consensus is to preclude an employer from decreasing compensation cost associated with a stock option award, by "settling" the award through a cash payment that is less than the amount of compensation cost previously determined, and then granting a "new" option to the same employee that contains terms identical to the remaining terms of the original option except that the exercise price is reduced. In the event such an arrangement were entered into, application of the consensus would (1) require the employer to charge the amount of the cash payment to expense in the current period, (2) prohibit the reversal of previously recognized expense associated with the original option, and (3) require continued amortization of any compensation measured at the original measurement date that had not been amortized and, additionally, could result in the measurement of additional compensation expense associated with the "new" award.
The consensus also requires similar accounting when an option is "repriced," as opposed to the situation described above where an option is canceled and reissued.
As previously noted, EITF Issue No. 87–23 addresses certain issues related to the accounting for stock purchase awards to employees, where the purchase price is a formula price based on book value or earnings, and where the shares must ultimately be sold back to the company by the employee at a price determined in the same manner as the original purchase price. The consensus set forth in EITF Issue No. 87–23 makes certain distinctions between privately and publicly held companies with respect to the accounting for these types of awards.
In EITF Issue No. 88–6, the Task Force reached a consensus that a book value stock purchase plan of a publicly held company should be viewed as a performance plan and should be accounted for like an SAR (this is consistent with the SEC observer's comment noted under the discussion of EITF Issue No. 87–23 above). Thus, for a publicly held company, compensation expense should be recognized for increases in book value (or other formula price based on earnings) on awards outstanding under such a plan. For a privately held company, however, under the consensus reached in EITF Issue No. 87–23, no compensation expense would be recognized for such increases in the book value or other formula price, regardless of when the awards were granted.
The Task Force also reached consensuses in EITF Issue No. 88–6 related to the recognition and measurement of compensation expense by a privately held company for such awards in the event of a subsequent IPO (i.e., when a privately held company becomes a publicly held company). These consensuses are set forth in Exhibit 39.2.
EITF Issue No. 88–6 also contains certain guidance regarding pro forma disclosures for these types of plans in the event of an IPO, as well as an exhibit that contains "Examples of the Application of APB Opinion No. 25 and the EITF Consensus from Issue Nos. 87–23 and 88–6 in an IPO."
EITF Issue No. 87–33 addressed the settling of options and the issuance of new options. In this issue, the Task Force was asked to address the buyout, or settling, of options without an issuance of new options. In the consensus, the Task Force imposes a rebuttable presumption that options granted within six months of the buyout of the outstanding options would be considered replacement options. In such a case, the issuer would have to consider the implications of EITF Issue No. 87–33.
The Task Force reached a consensus that the total amount of compensation cost to be recognized is the sum of: (1) the compensation cost amortized to the buyout date; (2) the options' intrinsic value, if any, at the buyout date in excess of the compensation cost recognized as expense to the buyout date; and (3) the amount, if any, paid for the options in excess of their intrinsic value at the buyout date. In addition, any remaining unamortized compensation cost related to the original options would not be included in income for any period. Exhibit 94–6A of the EITF Issue No. 94–6 provides examples.
Paragraph 11(h) states:
Some plans are a combination of two or more types of plans. An employer corporation may need to measure compensation for the separate parts. Compensation cost for a combination plan permitting an employee to elect one part should be measured according to the terms that an employee is most likely to elect based on the facts available each period.
If more than one type of award is granted to an employee under a plan, the measurement principle must be applied to each award for purposes of measuring compensation cost to an employer. Furthermore, if a combination plan permits an employee to elect one award from a number of alternative awards, compensation cost should be measured in terms of the award the employee is considered most likely to elect in view of the facts available each period. In many combination plans involving alternative awards, an employer retains the right to approve or reject an employee's election under certain circumstances, giving the employer significant control over the determination of the award under which compensation cost will be measured.
FASB Interpretation No. 28 provides additional guidance with respect to combination plans. In that Interpretation, the FASB specifies that in combination plans involving both an SAR or other variable award and a fixed award (e.g., a stock option), compensation cost should normally be measured and allocated to expense under the presumption that the variable award will be elected by the employee. However, this presumption may be overcome if experience or other factors, such as ceilings on the appreciation available to the employee under the variable feature, provide evidence that the employee will elect to exercise the fixed award.
Stock option pyramiding is a stock option exercise approach that developed subsequent to the issuance of APB Opinion No. 25. This approach involves the payment by the employee of the option exercise price by transferring to the employer previously owned shares with a current fair value equal to the exercise price. In EITF Issue No. 84–18, "Stock Option Pyramiding," the Task Force reached a consensus that "some holding period" for the exchanged shares is necessary to "avoid the conclusion that the award of the option is, in substance, a variable plan (or a SAR), thereby requiring compensation charges." A majority of the Task Force members indicated that a six-month period would satisfy the holding period requirement.
In a subsequent consensus set forth in EITF Issue No. 87–6, "Adjustments Relating to Stock Compensation Plans," the Task Force addressed a "phantom" stock-for-stock exercise arrangement, under which an employee holds "mature" shares meeting the holding period requirement discussed in EITF Issue No. 84–18. In this consensus, the Task Force indicated that if the exercise is accomplished by the enterprise issuing a certificate for the "net" shares (i.e., the shares issuable upon exercise of the option less the number of shares required to be relinquished to pay the exercise price), as opposed to the enterprise accepting the mature shares in payment of the exercise price and then issuing a new certificate for the total number of shares covered by the exercised option, the plan remains a fixed plan.
Thus, even though the "net" number of shares to be issued under either of the arrangements described above is not known at the date of grant, the use of qualifying mature shares to pay the option exercise price does not, under these two consensuses, change a plan that otherwise qualifies as a fixed plan to a variable plan. As a result, the enterprise is not required to recognize compensation expense for appreciation in shares under option subsequent to the date of grant solely because the award allows for payment of the exercise price of an option by surrendering mature shares owned by the employee or through a phantom stock-for-stock exercise involving mature shares owned by the employee.
Compensation consultants have developed a transaction that they believe enables employees to defer the taxable income derived from the exercise of stock options (and that also delays the employer's tax deduction) by deferring the employees' receipt of the shares of the stock. The transaction, typically referred to as a stock option gain deferral transaction, is accomplished by a stock-for-stock exercise. An employee receives new shares equal to the value of the shares tendered, and the remaining shares under option are credited to the employee's deferred compensation account. The employee then receives the shares from the deferred compensation account at retirement or some other future date.
In EITF Issue No. 97–5, "Accounting for the Delayed Receipt of Option Shares upon Exercise under APB Opinion No. 25," the Task Force addressed whether certain characteristics of stock option gain deferral arrangements would cause a new measurement date (or variable plan accounting) for financial reporting purposes under APB Opinion No. 25. An FASB staff announcement resolved the issue prior to the EITF's reaching a consensus. The announcement provides that variable plan accounting would be required if the employee does not meet the necessary six-month holding period set forth in EITF Issue 84–18, "Stock Option Pyramiding," which is discussed above. In addition, the announcement provides that an award that permits diversification into alternative types of investments makes the award subject to variable accounting. Accordingly, if an employee uses "mature" shares in the stock-for-stock exercise and if an award does not permit diversification, the delayed delivery of shares generally would not create a new measurement date or variable plan accounting.
EITF Issue No. 87–6, "Adjustments Relating to Stock Compensation Plans," addresses an issue that is similar to the stock option pyramiding issue discussed under (ix) above. The Task Force reached a consensus that "an option that allows the use of option shares to meet tax withholding requirements may be considered a fixed plan if it meets all the other requirements of APB Opinion No. 25. No compensation needs to be recorded for the shares used to meet the tax withholding requirements. The Task Force noted that this treatment would be limited to the number of shares with a fair value equal to the dollar amount of only the required tax withholding." Therefore, even though the net number of shares to be issued would not be known at the date of grant under these circumstances (since the shares to be withheld to cover the required tax withholding will not be known until the exercise date), plans with tax withholding features may be accounted for as fixed plans as long as they meet the other requirements for a fixed plan under APB Opinion No. 25.
APB Opinion No. 25 requires that compensation cost related to "stock option, purchase, and award plans should be recognized as an expense of one or more periods in which an employee performs services . . . . The grant or award may specify the period or periods during which the employee performs services or the periods may be inferred from the terms or from the past pattern of grants or awards."
FASB Interpretation No. 28 also indicates that compensation cost with respect to variable awards should be allocated to expense over the period(s) in which the employee performs the related services. However, the FASB went a step further in this interpretation by specifying that the service period is presumed to be the vesting period. The vesting period is normally the period from the date of the grant of the rights or awards to the date(s) they become exercisable. These criteria for determining the service period are considerably more definitive than the guidance provided in APB Opinion No. 25 and, in the authors' view, should be used for determining the service period for awards made pursuant to all stock-based compensation awards (i.e., both fixed and variable awards).
Compensation cost related to fixed awards should normally be allocated to expense over the service period on a straight-line basis. On rare occasions, however, circumstances may arise that would justify allocation on another basis. In any event, the method used should be systematic, reasonable, and consistently applied.
Allocating compensation cost related to variable awards to expense is more complex, because the measurement date and, thus, the final determination of compensation cost, occur subsequent to the date of grant. Total compensation cost with respect to a variable award must be estimated from the date of grant to the measurement date, based on the quoted market price of the employer's stock at the end of each interim period. Compensation cost so determined should be allocated to expense in the following manner:
If a variable award is granted for current and/or future services, estimated total compensation cost determined at the end of each period prior to the expiration of the service period should be allocated to expense over the service period. Changes in the estimated total compensation cost attributable to increases or decreases in the quoted market price of the employer's capital stock subsequent to the expiration of the service period (but prior to the measurement date) should be charged or credited to expense each period as the changes occur.
If a variable award is granted for past services, estimated total compensation cost determined at the date of grant is charged to expense of the period in which the award is granted. Changes in the estimated total compensation cost attributable to increases or decreases in the quoted market price of the employer's capital stock subsequent to the date of grant (but prior to the measurement date) should be charged or credited to expense each period as the changes occur.
APB Opinion No. 25 states in paragraph 15: "If a stock option is not exercised (or awarded stock is returned to the corporation) because an employee fails to fulfill an obligation, the estimate of compensation expense recorded in previous periods should be adjusted by decreasing compensation expense in the period of forfeiture." Application of this paragraph to a situation where an award is canceled or forfeited because employment is terminated prior to vesting of the award is straightforward; the previously accrued compensation should be eliminated by decreasing compensation expense in the period of cancellation or forfeiture.
However, prior to the issuance of FASB Interpretation No. 28, the application of this paragraph to combination plans was unclear. In a combination plan that permits an employee to elect either a fixed award (e.g., a stock option) or a variable award (e.g., an SAR), FASB Interpretation No. 28 specifies that compensation cost should be accrued based on the presumption that the employee will elect the variable award, unless there is evidence to the contrary. In cases involving combination plans where the employer has accrued compensation based on the presumption that the employee will elect to exercise the variable award and, due to a change in circumstances, it becomes more likely that settlement will be based on the fixed award (e.g., when appreciation in the quoted market price of the employer's capital stock exceeds the maximum appreciation an employee is entitled to receive upon exercise of an SAR), FASB Interpretation No. 28 specifies that the compensation accrued with respect to the variable award should not be adjusted by decreasing compensation expense, but should be recognized as consideration for the stock issued upon settlement of the fixed award. However, FASB Interpretation No. 28 further specifies that, if both the fixed award and the variable award are forfeited or canceled, accrued compensation should be eliminated by decreasing compensation expense during the period of forfeiture or cancellation.
EITF Issue No. 87–33, "Stock Compensation Issues Related to Market Decline," provides further clarification of APB Opinion No. 25, paragraph 15. In this pronouncement, "Task Force members agreed that the reversal of previously measured compensation would be appropriate only if the forfeiture or cancellation of an option or award results from the employee's termination or nonperformance."
Compensation expense associated with stock-based compensation awards is often deductible by the employer for income tax purposes in a different period from when such expense is recognized for financial reporting purposes. Such differences are temporary differences and should be accounted for as specified in FASB Statement No. 109, "Accounting for Income Taxes."
In many instances, however, there is a permanent difference between the amount of compensation expense recognized for financial reporting purposes and compensation expense deductible for income tax purposes. These differences generally arise because an employer is normally entitled to an income tax deduction for such awards equal to the amount of compensation reportable as income by the employee, and this amount is often different from the amount of compensation expense recognized by an employer for financial reporting purposes. In addressing this situation, APB Opinion No. 25 specifies that the reduction in income tax expense recorded by an employer with respect to a stock option, purchase, or award plan should not exceed the proportion of the tax reduction related to the compensation expense recognized by the employer for financial reporting purposes. Any additional tax reduction should not be accounted for as a reduction of income tax expense but, rather, should be credited directly to paid-in capital in the period that the additional tax benefit is realized through a reduction of current income taxes payable.
Occasionally, the amount of compensation expense for financial reporting purposes exceeds the amount of compensation deductible for income tax purposes. In these situations, an employer may, in the period of the tax reduction, deduct from paid-in capital and credit to income tax expense or previously recognized deferred taxes the amount of the additional tax reduction that would have resulted had the compensation expense recognized for financial reporting purposes been deductible for income tax purposes. However, this reduction is limited to the amount of tax reductions attributable to awards made under the same or similar plans that have been previously credited to paid-in capital.
One type of plan that possesses certain aspects of a variable award while providing for fixed award accounting is the "TARSAP." Under a TARSAP, restricted stock is awarded to the participant. The plans generally provide for a lifting of the restrictions based on the passage of time (e.g., 20 percent per year for five years, 10 percent per year for 10 years). The restrictions may be lifted quicker based on certain performance criteria; however, they can never be lifted later than the original schedule. The lifting of the restrictions only affects the timing of the recognition of the compensation expense, not the amount of the compensation expense. The earnings per share and balance sheet classification of a TARSAP follow the same rules as any restricted stock plan.
Another form of a TARSAP involves stock options. For example, a company grants stock options, at the market price, with cliff vesting after seven years. The plan provides for accelerated vesting if certain performance criteria are met.
It is important for companies to establish realistic vesting schedules in order to follow fixed plan accounting. If the employee cannot realistically expect to vest in the award, absent the achievement of the performance criteria, then fixed plan accounting would not be appropriate. An example of such a situation would be a stock option that, absent the achievement of performance criteria, does not vest until after the retirement date of the employee or after the expiration of an employment contract.
Generally accepted accounting principles require that the issuance of stock-based awards issued to nonemployees be recorded at fair value. Given this, one might wonder how a company should account for stock-based awards issued to directors or consultants. While directors are not legally employees, they perform services very similar to employees, and, accordingly, practice has extended the application of APB Opinion No. 25 to directors' stock based plans. The accounting for awards granted to consultants is not so clear. Some believe that if the consultant is working essentially as an employee (i.e., on a full-time basis), then APB Opinion No. 25 should be applied. However, if the consultant is truly consulting on a temporary basis, then the award should be recorded at its fair value. Because diversity has developed in practice, the FASB has added to its agenda a project to address the scope of APB Opinion No. 25, including the definition of an employee.
If a company issues stock or stock options shortly before an IPO, the SEC staff generally will presume that fair value of the (underlying) stock at the date of issuance for APB Opinion No. 25 purposes is the initial public offering price. This presumption is rebuttable by the company if objective evidence exists to validate the fair value to be something different than the initial public offering price. One other point of interest is that these shares, in certain circumstances, may be considered outstanding for diluted earnings per share computations for all periods presented in a registration statement filed in connection with an IPO. During the periods covered by income statements that are included in such a registration statement or in the subsequent period prior to the effective date of the IPO, a company may issue, for "nominal consideration," common stock, options, or other equity instruments (collectively, "nominal issuances"). The SEC staff has indicated that the determination of whether an equity instrument has been issued for nominal consideration is based on facts and circumstances; however, these situations should be rare. In computing diluted earnings per share for such periods, nominal issuances of common stock and potential common stock should be reflected in a manner similar to a stock split or stock dividend.
Computation of the effect of stock-based compensation awards on earnings per share is addressed in FASB Statement No. 128, "Earnings Per Share." FASB Statement No. 128, issued by the FASB in February 1997, superseded APB Opinion No. 15, "Earnings Per Share," and FASB Interpretation No. 31, "Treatment of Stock Compensation Plans in EPS Computations." It replaces the primary and fully diluted earnings per share computations set forth in APB Opinion No. 15 with basic and diluted earnings per share, respectively. Basic earnings per share, unlike primary earnings per share, excludes all dilution, while diluted earnings per share, like fully diluted earnings per share, reflects the potential dilution that could occur if stock options or other contracts to issue common stock were exercised or resulted in the issuance of common stock.
Specifically, basic earnings per share is computed by dividing net income available to common stockholders (the numerator) by the weighted-average number of common shares outstanding (the denominator) during the period. The computation of diluted earnings per share is similar to the computation of basic earnings per share except that the denominator is increased, by application of the Treasury stock method, to include the number of additional common shares that would have been outstanding if the dilutive potential common shares had been issued. In addition, the numerator in the diluted earnings per share computation is adjusted for any impact of assuming the potential common shares were issued, but such adjustments generally do not relate to stock-based compensation.
Stock-based compensation awards impact basic and diluted earnings per share to the extent of compensation expense or credits to compensation expense, net of income tax effects, recognized by the employer for financial reporting purposes. For awards that will be settled by payment of cash to the employee, there is no additional impact on earnings per share, because settlement of the award will not result in the issuance of shares of an employer's common stock. However, when awards will be settled through issuance of shares of common stock, diluted earnings per share may reflect further dilution because of the incremental number of shares of the employer's common stock deemed to be outstanding. Stock-based compensation arrangements that may be settled in either common stock or cash at the election of either the entity or the employee are presumed to be settled in common stock (absent compelling evidence to the contrary), and the resulting potential common shares are included in the computation of diluted earnings per share if the effect is dilutive.
A discussion of basic earnings per share and diluted earnings per share involving various types of stock-based compensation plans follows.
Basic earnings per share does not include consideration of common stock equivalents. Thus, unexercised stock options do not affect the denominator, but the shares issued upon exercise of stock options are included in the denominator for the portion of the period they are outstanding. Similarly, nonvested stock does not affect the denominator until the awards become vested. Contingently issuable shares (shares issuable for little or no cash consideration upon the satisfaction of certain conditions) are considered outstanding common shares and included in the computation of basic earnings per share only beginning with the date that all necessary conditions have been satisfied. Outstanding common shares that are contingently returnable are treated in the same manner as contingently issuable shares. For example, shares that have been issued but that the holder must return if certain performance conditions are not achieved, are treated as contingently issuable shares.
As previously indicated, the denominator in the diluted earnings per share computation is increased to include the number of additional common shares that would have been outstanding if the dilutive potential common shares had been issued. Accordingly, the dilutive effect of all outstanding options (and their equivalents such as nonvested stock) that are subject only to time-based vesting are reflected in diluted earnings per share by application of the treasury stock method. As discussed in further detail below, stock-based compensation awards that are subject to performance-based vesting are treated as contingently issuable shares.
Dilutive options that are issued during a period or that expire or are canceled during a period are included in the denominator of diluted earnings per share for the period they are outstanding. Similarly, dilutive options exercised during the period are included in the denominator for the period prior to actual exercise. The common shares issued upon exercise of the options or warrants are included in the denominator for the period after the exercise date as part of the weighted-average number of common shares outstanding.
Contingently issuable shares are included in the computation of diluted earnings per share as of the beginning of the period in which the conditions are satisfied (or as of the date of the agreement providing for contingently issuable shares, if later). If all necessary conditions have not been satisfied by the end of the period, the number of contingently issuable shares included in diluted earnings per share is based on the number of shares, if any, that would be issuable if the end of the reporting period were the end of the contingency period. As noted above, stock-based compensation awards that are subject to performance-based vesting are treated as contingently issuable shares. Performance-based vesting describes vesting that depends on both (a) an employee rendering service to the employer for a specified period of time and (b) the achievement of a specified performance target.
In applying the Treasury stock method to stock-based awards, the assumed proceeds is the sum of (a) the amount, if any, the employee must pay upon exercise, (b) the amount of compensation cost attributed to future services and not yet recognized (assumed proceeds does not include compensation ascribed to past services), and (c) the amount of tax benefits (both deferred and current), if any, that would be credited to stockholders' equity assuming exercise of the options. The tax benefit is the amount resulting from a tax deduction for compensation in excess of compensation expense recognized for financial reporting purposes. If the resulting difference in income tax will be deducted from stockholders' equity, such taxes to be deducted are treated as a reduction of assumed proceeds.
Computations of the impact of fixed awards on diluted earnings per share are relatively straightforward. At the date an award is granted, both the number of shares that an individual employee is entitled to receive (i.e., the shares issuable pursuant to the award) and the option or purchase price, if any, are known. Thus the number of shares issuable pursuant to the award remains constant until the award is settled by issuance of shares. However, the reduction in the number of incremental shares for common shares deemed to be acquired by an employer with the assumed exercise proceeds might vary each period because of changes in (a) the quoted market price of the employer's common stock and (b) the amount of measurable compensation ascribed to future services and not yet charged.
It should be noted that though the issuance of shares pursuant to fixed awards may be contingent on time-based vesting, such shares are not considered to be contingently issuable shares.
Computations of the impact of variable awards on diluted earnings per share are considerably more complex than computations involving fixed awards. In the case of variable awards, either (1) the number of shares issuable pursuant to the award, (2) the option or purchase price, if any, or (3) both the number of shares issuable and the option or purchase price are not known at the date the award is granted. For example, in the case of SARs to be settled by issuance of shares of an employer's common stock, there is no option or purchase price. However, the estimated number of shares issuable will vary each period in which an award is outstanding, based on changes in the quoted market price of the employer's common stock. Furthermore, the number of shares deemed to be acquired by the employer from the assumed exercise proceeds will also vary each period in which an award is outstanding, due to changes in (a) the quoted market price of the employer's common stock and (b) the amount of measurable compensation ascribed to future services and not yet charged to expense.
As with fixed awards, shares to be issued pursuant to variable awards subject only to time-based vesting are not considered to be contingently issuable shares.
For stock-based compensation awards subject to performance-based vesting, as with variable awards subject only to time-based vesting, either (1) the number of shares issuable pursuant to the award; (2) the option or purchase price, if any; or (3) both the number of shares issuable and the option or purchase price are not known at the date the award is granted. However, because issuance of performance-based awards is contingent on satisfying conditions in addition to the mere passage of time, these awards are considered to be contingently issuable shares in the computation of diluted earnings per share.
If all necessary conditions have been satisfied by the end of the reporting period (i.e., the performance conditions have been achieved), those shares are included as of the beginning of the reporting period in which the conditions were achieved (or as of the date of the agreement providing for contingently issuable shares, if later).
If all necessary conditions have not been satisfied by the end of the reporting period, the number of contingently issuable shares included in diluted earnings per share is based on the number of shares, if any, that would be issuable if the end of the reporting period were the end of the contingency period and if the result would be dilutive. Those contingently issuable shares are included in the denominator of diluted earnings per share as of the beginning of the reporting period (or as of the date of the agreement providing for contingently issuable shares, if later).
In addition to the foregoing complexities, the estimated number of shares issuable may vary each period in which an award is outstanding, based on changes in the quoted market price of the employer's common stock. Furthermore, the number of shares deemed to be acquired by the employer from the assumed exercise proceeds will also vary each period in which an award is outstanding, due to changes in (a) the quoted market price of the employer's common stock and (b) the amount of measurable compensation ascribed to future services and not yet charged to expense.
This section includes: (a) definitions of certain stock-based compensation awards; (b) a summary of the accounting consequences of the awards, including the impact on compensation expense and federal income tax expense to be recognized for financial reporting purposes, and the impact on earnings per share; (c) a summary of the federal income tax consequences of the awards to both the employer and the employee; and (d) exhibits illustrating the accounting and federal income tax consequences of hypothetical awards.
The discussion and exhibits demonstrate the application of the principles and concepts discussed in this chapter. Stock-based compensation plans and awards, however, tend to be unique; accordingly, the income tax and accounting consequences of any stock-based compensation award should be determined based on the specific terms of the award and the authoritative accounting literature and the tax laws and rulings in effect at the time of the award. State and local income tax consequences of stock-based compensation awards are not addressed in this section; such consequences should be determined pursuant to the tax laws of the applicable state and local governments. Finally, the exhibits ignore any employer withholding tax requirements; however, an employer should institute measures to ensure compliance with any requirements to withhold income taxes from recipients of awards. Failure to comply with applicable withholding requirements could jeopardize the employer's right to a tax deduction with respect to an award.
The discussion and exhibits address the accounting and income tax consequences of a fixed award, a variable award, and a formula award, as follows:
Fixed Award. Nonstatutory stock option (nondiscounted).
Variable Award. SAR.
Variable Award. Performance stock option.
Book Value or Formula Award. Book value share.
A nonstatutory stock option is an employee stock option that does not qualify for the special tax treatment afforded incentive stock options under Internal Revenue Code (IRC) Section 422A, or the special tax treatment afforded stock options issued under employee stock purchase plans under IRC Section 423.
A nonstatutory stock option (nondiscounted) entitles an employee to purchase shares of the employer's capital stock for an amount equal to the fair market value of the shares as of the grant date. The employee's right is nontransferable and normally vests over a specified period (e.g., three to five years) although, in some instances, the right is vested at the date of grant. The right to exercise the option expires after a specified period of time (e.g., 10 years).
A nonstatutory stock option (nondiscounted) is a fixed award (i.e., both the number of shares the employee is entitled to receive and the option price are known at the date of grant). However, for financial reporting purposes, there is no compensation expense associated with such an award, since the option exercise price is equal to the fair market value of the employer's capital stock at the date of grant.
Upon exercise by an employee of a nonstatutory stock option, the employer is entitled to an income tax deduction for compensation expense, based on the difference between the option exercise price and the fair market value of the shares acquired through exercise, determined as of the exercise date. (Note: If the employee qualifies as an "insider" pursuant to the Securities Exchange Act of 1934, the computation of the tax deduction may differ.)
Thus, a difference usually arises between the amount of compensation expense recognized for financial reporting purposes and the amount of compensation expense that is deductible for income tax purposes. Any reduction of income taxes payable resulting from an excess of compensation expense deducted for income tax purposes over compensation expense recognized for financial reporting purposes should be credited to paid-in capital in the period of the reduction.
A reduction of diluted earnings per share occurs as a result of the incremental number of common shares of the employer's stock deemed to be outstanding as a result of such awards if the award is dilutive. The incremental number of outstanding shares, if any, is computed using the treasury stock method in accordance with FASB Statement No. 128.
A Stock Appreciation Right (SAR) is a right granted by an employer to an employee that entitles the employee to receive the excess of the quoted market price of a specified number of shares of the employer's capital stock over a specified value (usually the market price of the specified number of shares of the employer's capital stock at the date the right is granted). An SAR sometimes contains a limitation on the amount an employee may receive upon exercise. Further, an SAR may be the only compensation feature of an award; however, an SAR is often granted as part of a combination award in tandem with a nonstatutory stock option, whereby an employee or the employer must make an election to settle the award pursuant to either (but not both) the SAR or the nonstatutory stock option. The form of payment for amounts earned pursuant to an SAR may be specified by the award (i.e., stock, cash, or a combination thereof), or the award may allow the employee or employer to elect the form of payment. If the award is settled in stock, the number of shares issued to the employee is determined by dividing the amount earned by the fair market value of this stock, determined as of the exercise date. The employee's right to exercise an SAR normally vests after a specified period (e.g., 5 years) and the right to exercise expires after a specified period (e.g., 10 years). In the case of an SAR granted in tandem with a nonstatutory award (or other alternate award), the vesting and expiration dates for both awards are usually identical.
An SAR is a variable award, that is, the number of shares, or the amount of cash, an individual is entitled to receive is not known at the date the award is granted. The measurement date and, thus, the determination of total compensation cost associated with an SAR, occur at the exercise date. Total compensation, determined at the exercise date, is equal to the number of rights multiplied by the difference between the quoted market price of the employer's capital stock at the exercise date and the value specified in the award (normally the quoted market price of the employer's capital stock at the grant date).
For purposes of allocating compensation cost to expense of interim periods between the date of grant and the measurement date, compensation cost is estimated at the end of each interim period by multiplying the number of options expected to become exercisable times the intrinsic value of each option as of the end of the period. During the service period, this estimate of compensation cost is allocated to interim periods by recognizing expense (or a decrease in expense) in an amount required to adjust accrued compensation at the end of each period to an amount equal to the percentage of the total service period that has elapsed times the estimated compensation cost.
In some cases, an SAR awarded to an employee vests over various periods (e.g., 25 percent per year for four years). In these situations, each portion of the SAR that vests on a different vesting date is accounted for as a separate award. Thus, compensation cost attributable to each group should be separately determined and allocated to expense of interim periods from the date of grant to the measurement date in the manner set forth in the preceding paragraph. The accounting for an SAR that vests in this manner is illustrated in Appendix B to FASB Interpretation No. 28.
When the amount earned by an employee under an SAR is settled by payment of cash, the employer is entitled to a tax deduction for compensation expense, in the year of payment, equal to the amount of cash paid. Accordingly, the entire amount of the tax benefit is credited to previously recorded deferred taxes and/or income tax expense.
When the amount earned by an employee under an SAR is settled by issuance of shares of the employer's capital stock, the employer is entitled to a tax deduction for compensation expense in the year in which the shares to be issued are delivered to the transfer agent. The amount of the deduction is equal to the fair market value of the shares, determined as of the date of delivery to the transfer agent. Thus, the deduction for compensation expense for tax purposes may differ from the amount of compensation expense recognized for financial reporting purposes if shares are delivered to the transfer agent after the measurement date (i.e., the exercise date). The treatment of this difference is discussed in Subsection 39.3(f), "Accounting for Income Taxes under APB Opinion No. 25.'
Earnings per share are affected each period from the date of the award of an SAR to the measurement (exercise) date as a result of compensation expense (net of related income taxes) recognized for financial reporting purposes. If the award is expected to be settled in cash, there would be no impact on earnings per share other than the impact due to compensation expense charged against earnings. However, if the award is expected to be settled by issuance of shares of the employer's common stock, additional dilution may occur as a result of the incremental number of shares of the employer's common stock deemed to be outstanding. It should be noted that for SARs "that may be settled in common stock or in cash at the election of either the entity or the holder, the determination of whether that contract shall be reflected in the computation of diluted earnings per share shall be made based on the facts available each period. It shall be presumed that the contract will be settled in common stock and the resulting potential common shares included in diluted earnings per share' if the effect is more dilutive. "The presumption that the contract will be settled in common stock may be overcome if past experience or a stated policy provides a reasonable basis to believe that the contract will be paid partially or wholly in cash.' The incremental number of shares, if any, deemed to be outstanding is computed under the treasury stock method in accordance with FASB Statement No. 128. Appendix C of FASB Statement No. 128 includes an illustration of the computation of earnings per share for SARs.
Exhibit 39.4 shows the consequences of a hypothetical SAR award.
A performance stock option is an employee stock option that entitles the employee to purchase shares of the employer's stock subject to the achievement of specified performance criteria. There are numerous different types of performance stock options; however, the most common performance stock option only becomes exercisable upon the achievement of the performance criteria. For example, a typical performance stock option plan might provide for the grant of stock options that would vest and become exercisable if specified performance targets such as return on assets or earnings per share growth are met.
A performance stock option is a variable award since the number of shares the employee is entitled to receive or the exercise price the employee is required to pay is not known at the date of grant. The measurement date and, thus, the determination of total compensation is not determined until the date at which performance ultimately can be measured. Total compensation cost is equal to the number of stock options that become exercisable multiplied by the intrinsic value of each option at the measurement date.
For purposes of allocating compensation cost to expense of interim periods between the date of grant and the measurement date, compensation cost is estimated at the end of each interim period by multiplying the number of options expected to become exercisable times the intrinsic value of each option as of the end of the period. During the service period, this estimate of compensation cost is allocated to interim periods by recognizing expense (or a decrease in expense) in an amount required to adjust accrued compensation at the end of each period to an amount equal to the percentage of the total service period that has elapsed times the estimated compensation cost.
Accounting for income taxes for a nonstatutory performance stock option is similar to the accounting for income taxes for a nonstatutory (non performance) stock option addressed above.
Performance-based employee stock options (and performance-based nonvested stock) are treated as contingently issuable shares in diluted earnings per share computations. Contingently issuable shares are included in the computation of diluted earnings per share as of the beginning of the period in which the conditions are satisfied (or as of the date of the agreement providing for contingently issuable shares, if later). If all necessary conditions have not been satisfied by the end of the period, the number of contingently issuable shares included in diluted earnings per share is based on the number of shares, if any, that would be issuable if the end of the reporting period were the end of the contingency period.
Exhibit 39.5 demonstrates the accounting and earnings per share consequences of a hypothetical performance stock option award.
Book value shares must be sold back to the company upon retirement or earlier termination of employment, and the arrangement may also permit the employee to sell some or all of his shares back to the company at other fixed or determinable dates. The initial purchase price (or, in the case of a full value award where the employee is not required to pay for the shares, the initial measurement of compensation cost) is equal to the book value of the shares. When the shares are subsequently sold back to the company, the selling price is determined in the same manner as the initial valuation (i.e., book value). An employee-holder of book value shares is entitled to the same voting and dividend rights as other holders of the same class of stock. Shares for which the valuations are based on a multiple of book value, or on another formula based on earnings, are similar to book value shares, and the guidance in this illustration is generally applicable to such shares.
As previously discussed, and as addressed in EITF Issue Nos. 87–23 and 88–6, there is a distinction, for accounting purposes, between book value shares of publicly held and privately held companies. Subsection 39.3(c)(vii) provides a detailed discussion of the accounting for these plans.
The federal income tax treatment of book value plans differ based on specific provisions and elections made by the employee. Accordingly, the authors strongly urge companies to consult with their tax advisors. Suffice it to say, the tax deduction can differ from the expense recognized in the financial statements. The treatment of this difference is discussed in Subsection 39.3(f), "Accounting for Income Taxes Under APB Opinion No. 25."
For publicly held companies, book value shares that are viewed as a form of mandatorily redeemable security (see ASR No. 268) should be classified outside of stockholders' equity. As a result, such shares do not increase the number of shares used in the computation of earnings per share for publicly held companies. Private companies are not required to present earnings per share.
Exhibit 39.6 illustrates the consequences of a hypothetical book value purchase award made by a privately held company.
FASB Statement No. 123 provides elective accounting for stock-based employee compensation arrangements using a fair value model. Companies currently accounting for such arrangements under APB Opinion No. 25, "Accounting for Stock Issued to Employees," may continue to do so; however, FASB Statement No. 123 superseded the disclosure requirements of APB Opinion No. 25 and is applicable to all companies with stock-based compensation arrangements. Companies not electing the fair value accounting method must disclose the pro forma net income and, for public companies, earnings per share as if this method had been elected. The guidance provided by FASB Statement No. 123 applies equally to companies adopting the fair value accounting as to companies determining the pro forma amounts that must be disclosed if a company continues to apply APB Opinion No. 25.
FASB Statement No. 123 applies to all transactions in which an employer grants shares of its common stock, stock options, or other equity instruments to employees, except for employee stock ownership plans (ESOPs). Accounting for ESOPs is specified in AICPA Statement of Position No. 93–6, "Employers" Accounting for Employee Stock Ownership Plans." FASB Statement No. 123 also applies to transactions in which an employer incurs a liability to employees that will be settled in cash based on the market price of the employer's stock or other equity instruments (e.g., cash-based SARs). A company may not elect accounting on a plan-by-plan basis (e.g., elect FASB Statement No. 123 for variable plans and retain accounting under APB Opinion No. 25 for fixed plans).
Shares of stock, stock options, or other equity instruments transferred directly to employees or other provider of goods or services by a principal shareholder (generally a shareholder who owns 10 percent or more of a company's common stock) are subject to the provisions of FASB Statement No. 123, unless the transfer was for a purpose other than compensation. In substance, these arrangements are considered to be capital contributions by a principal shareholder to the entity, with a subsequent award of equity instruments by the entity to its employees or other provider of goods or services.
FASB Statement No. 123 requires compensation cost for all stock-based compensation awards, including most plans currently considered noncompensatory under APB Opinion No. 25 (i.e., broad-based plans), to be measured by a new fair value-based method of accounting. For those companies adopting the recognition provisions of FASB Statement No. 123, the current accounting distinction between fixed options and performance options will be substantially eliminated.
As discussed earlier in the chapter, compensation cost for fixed and variable stock-based awards under APB Opinion No. 25 is measured by the excess, if any, of the market price of the underlying stock over the amount the individual is required to pay (the intrinsic value). Compensation cost for fixed awards is measured at the grant date, while compensation cost for variable awards is estimated until both the number of shares an individual is entitled to receive and the exercise or purchase price are known (measurement date). Compensation cost under variable awards is ultimately based on the intrinsic value on the vesting or settlement date.
FASB Statement No. 123 calls for different accounting and recognition of compensation cost for stock-based compensation plans, depending on whether an award qualifies as a liability or an equity instrument at the grant date. Inherent in the distinction between a liability and an equity instrument is an expectation as to the manner in which the award will ultimately be settled. A stock-based plan expected to be settled by issuance of equity securities would be considered an equity instrument when it is granted. Accordingly, compensation cost would be based on the stock price at the date of grant and would not be adjusted for subsequent changes in the stock price. In contrast, a stock-based plan that requires settlement in cash, or that allows an employee to require settlement in cash, indicates that the employer has incurred a liability. The amount of the liability for such an award would be measured each period based on the end-of-period stock price, similar to variable plan accounting under APB Opinion No. 25.
FASB Statement No. 123 specifies that measurement of an equity instrument award should be based on its estimated fair value at grant date, with the resulting compensation cost recognized over the employee service period (typically the vesting period). Changes in the stock price subsequent to the grant date will have no impact on determining the value of an award at grant date.
The fair value of a stock option award will be estimated using an option-pricing model that considers certain variables and assumptions. Restricted stock awards (called nonvested stock in FASB Statement No. 123) will be measured using the market price of an unrestricted share (or vested share) of the same stock if the stock is publicly traded, or the estimated market price if it is not publicly traded. In other words, shares subject to vesting provisions will not be afforded a discount in measuring compensation cost.
Exhibit 39.7 provides a comparison of compensation cost measured under FASB Statement No. 123 and APB Opinion No. 25 for a fixed stock option and a performance stock award.
FASB Statement No. 123 indicates that the measurement date for stock options or other equity instruments granted to employees as compensation should be the date at which the stock price that enters into measurement of the fair value of an award is fixed. Measurement of compensation cost should be based on the underlying stock price at the date the terms of a stock-based award are agreed to by the employer and the employee (in most cases, the grant date). Awards made under a plan that is subject to shareholder approval are not deemed to be granted until that approval is obtained unless approval is essentially a formality.
The estimated fair value at the grant date should be subsequently adjusted, if necessary, to reflect the outcome of both performance conditions and service-related factors. No compensation cost will be recognized for options that do not vest due to either forfeitures upon termination of service or failure to meet specified performance targets or conditions. Companies may base their accruals of compensation cost on the best estimate of the number of options or other equity instruments expected to vest and revise that estimate, if necessary, to reflect actual forfeitures. Alternatively, for awards subject only to a service requirement, a company may begin accruing compensation cost as if all instruments were expected to vest and recognize the effect of actual forfeitures when they occur. However, vested options that expire unexercised at the end of their contractual terms do not avoid recognition of compensation cost. Only options forfeited because of failure to meet vesting requirements are excluded from determination of compensation cost.
In certain circumstances, due to the terms of a stock option or other equity instrument, it may not be feasible to reasonably estimate the fair value of a stock-based award at the grant date. For example, the fair value of a stock option whose exercise price adjusts by a specified amount with each change in the underlying price of the stock cannot be reasonably estimated using an option pricing model. If the fair value cannot be estimated at the grant date, fair value at the first date at which it is possible to reasonably estimate that value should be used as the final measure of compensation cost. For interim periods during which it is not possible to determine fair value, companies should estimate compensation cost based on the current intrinsic value of the award.
In addressing the issue of estimating fair value of equity instruments, the FASB noted that it was not aware of any quoted market prices that would be appropriate for employee stock options. Accordingly, FASB Statement No. 123 requires that the fair value of a stock option (or its equivalent) be estimated using an option-pricing model, such as the Black-Scholes or a binomial pricing model, that considers the following assumptions or variables:
Exercise price of the option.
Expected life of the option—Considers the outcome of service-related conditions (i.e., vesting requirements and forfeitures) and performance-related conditions. Expected life is typically less than the contractual term.
Current price of the underlying stock—Stock price at date of grant.
Expected volatility of the underlying stock—An estimate of the future price fluctuation of the underlying stock for a term commensurate with the expected life of the option. Volatility is not required for nonpublic companies.
Expected dividend yield on the underlying stock—Should reflect a reasonable expectation of dividend yield commensurate with the expected life of the option.
Risk-free interest rate during the expected term of the option—The rate currently available for zero-coupon U.S. government issues with a remaining term equal to the expected life of the options.
FASB Statement No. 123 requires that the option pricing model utilized consider management's expectations relative to the life of the option, future dividends, and stock price volatility. Both the volatility and dividend yield components should reflect reasonable expectations commensurate with the expected life of the option. As there is likely to be a range of reasonable expectations about factors such as expected volatility, dividend yield, and lives of options, a company may use the low end of the range for expected volatility and expected option lives and the high end of the range for dividend yield (assuming that one point within the ranges is no better estimate than another). These estimates introduce significant judgments in determining the value of stock-based compensation awards.
During the FASB's discussions prior to issuance of FASB Statement No. 123, those favoring retention of the basic requirements of APB Opinion No. 25 emphasized the imprecision of measuring fair value through option pricing models, particularly in light of the fact that most stock options issued to employees are not transferable and are forfeitable. The Board believes that it has addressed these issues by valuing at zero options that are expected to be forfeited, and by valuing options that vest based on the length of time they are expected to remain outstanding rather than on the stated term of the options.
During the last 20 years, a number of mathematical models for estimating the fair value of traded options have been developed. The most commonly used methodologies for valuing options include the Black-Scholes model, binomial pricing models, and the minimum value method. The minimum value of a stock option can be determined by a simple present value calculation which ignores the effect of expected volatility. (See for an illustration of the minimum value method.) The fair value of an option exceeds the minimum value because of the volatility component of an option's value, which represents the benefit of the option holder's right to participate in stock price increases without having to bear the risk of stock price decreases.
The Black–Scholes and binomial pricing models were originally developed for valuing traded options with relatively short lives and are based on complex mathematical formulas. Option values derived under these models are sensitive to both the expected stock volatility and the expected dividend yield. illustrates the relative effect of changes in expected volatility and dividend rates using a generalized Black-Scholes option-pricing model. Software packages that include option pricing models are readily available from numerous software vendors.
As demonstrated in, option values increase as expected volatility increases, and option values decrease as expected dividend yield increases. It is interesting to note that in instances where higher expected volatility is coupled with higher dividend yields, the binomial model generally produces higher option values than the Black-Scholes model due primarily to increased sensitivity to compounded dividend yields in the binomial model. Nevertheless, FASB Statement No. 123 permits the use of either model.
Volatility is the measure of the amount that a stock's price has fluctuated (historical volatility) or is expected to fluctuate (expected volatility) during a specified period. Volatility is expressed as a percentage; a stock with a volatility of 25 percent would be expected to have its annual rate of return fall within a range of plus or minus 25 percentage points of its expected rate about two-thirds of the time. For example, if a stock currently trades at $100 with a volatility of 25 percent and an expected rate of return of 12 percent, after one year the stock price should fall within the range of $87 to $137 approximately two-thirds of the time (using simple interest for illustration). Stocks with high volatility provide option holders with greater economic "up-side' potential and, accordingly, result in higher option values under the Black–Scholes and binomial option pricing models.
FASB Statement No. 123 suggests that estimating expected future volatility should begin with calculating historical volatility over the most recent period equal to the expected life of the options. Thus, if the weighted-average expected life of the options is six years, historical volatility should be calculated for the six years immediately preceding the option grant. FASB Statement No. 123 provides an illustrative example for calculating historical volatility. Companies should modify historical stock volatility to the extent that recent experience indicates that the future is reasonably expected to differ from the past. Although historical averages may be the best available indicator of expected future volatility for some mature companies, there are legitimate exceptions including: (1) a company whose common stock has only recently become publicly traded with little, if any, historical data on its stock price volatility, (2) a company with only a few years of public trading history where recent experience indicates that the stock has generally become less volatile, and (3) a company that sells off a line of business with significantly different volatility than the remaining line of business. In such cases, it is appropriate for companies to adjust historical volatility for current circumstances or use the average volatilities of similar companies until a longer series of historical data is available.
FASB Statement No. 123 does not allow for a company with publicly traded stock to ignore volatility simply because its stock has little or no trading history. A company with only publicly traded debt is not considered a public company under FASB Statement No. 123. Subsidiaries of public companies are considered public companies for purposes of applying FASB Statement No. 123's provisions.
The assumption about expected dividends should be based on publicly available information. While standard option pricing models generally call for expected dividend yield, the model may be modified to use an expected dividend amount rather than a yield. If a company uses expected payments, any history of regular increases in dividends should be considered. For example, if a company's policy has been to increase dividends by approximately three percent per year, its estimated option value should not assume a fixed dividend amount throughout the expected life of the option.
Some companies with no history of paying dividends might reasonably expect to begin paying small dividends during the expected lives of their employee stock options. These companies may use an average of their past dividend yield (zero) and the mean dividend yield of an appropriately comparable peer group.
The expected life of an employee stock option award should be estimated based on reasonable facts and assumptions on the grant date. The following factors should be considered: (1) the vesting period of the grant, (2) the average length of time similar grants have remained outstanding, and (3) historical and expected volatility of the underlying stock. The expected life must at least include the vesting period and, in most circumstances, will be less than the contractual life of the option.
Option value increases at a higher rate during the earlier part of an option term. For example, a two-year option is worth less than twice as much as a one-year option if all other assumptions are equal. As a result, calculating estimated option values based on a single weighted-average life that includes widely differing individual lives may overstate the value of the entire award. Companies are encouraged to group option recipients into relatively homogeneous groups and calculate the related option values based on appropriate weighted-average expectations for each group. For example, if top level executives tend to hold their options longer than middle management, and nonmanagement employees tend to exercise their options sooner than any other groups, it would be appropriate to stratify the employees into these three groups in calculating the weighted-average estimated life of the options.
FASB Statement No. 123 indicates that a nonpublic company may estimate the value of options issued to employees without consideration of the expected volatility of its stock. This method of estimating an option's value is commonly referred to as the minimum value method. The underlying concept of the minimum value method is that an individual would be willing to pay at least an amount that represents the benefit of the right to defer payment of the exercise price until a future date (time value benefit). For a dividend-paying stock, that amount is reduced by the present value of dividends forgone due to deferring exercise of the option.
Minimum value can be determined by a present value calculation of the difference between the current stock price and the present value of the exercise price, less the present value of expected dividends, if any. Minimum value also can be computed using an option-pricing model and an expected volatility of effectively zero. Although the amounts computed using present value techniques may produce slightly different results than option-pricing models for dividend-paying stocks, the Board decided to permit either method of computing minimum value.
illustrates a minimum value computation for an option, assuming an expected five-year life with an exercise price equal to the current stock price of $40, an expected annual dividend yield of 1.25 percent, and a risk-free interest rate available for five-year investments of 6 percent.
The FASB Statement No. 123 does not allow public companies to account for employee stock options based on the minimum value method because that approach was considered inconsistent with the overall fair value concept. However, the FASB acknowledged that estimating expected volatility for the stock of nonpublic companies is not feasible. Accordingly, FASB Statement No. 123 permits nonpublic companies to ignore expected volatility in estimating the value of options granted. As a result, nonpublic entities are allowed to use the minimum value method for stock options issued to employees. However, during the EITF's discussion of EITF Issue No. 96–18, "Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services," an FASB staff representative stated that when applying the consensuses in that Issue, the minimum value method is not an acceptable method for determining the fair value of nonemployee awards by nonpublic companies.
As previously discussed, FASB Statement No. 123 requires either recognition of compensation cost in an employer's financial statements for those companies adopting the new standard or disclosure of pro forma net income and earnings per share for companies remaining under APB Opinion No. 25 for all awards of stock options and other stock-based instruments. FASB Statement No. 123 applies the same basic accounting principles to all stock-based plans, including those currently considered noncompensatory under APB Opinion No. 25. At the date of grant, compensation cost is measured as the fair value of the total number of awards expected to vest. Adjustments to the amount of compensation cost recognized should be made for actual experience in performance and service-related factors (i.e., forfeitures, attainment of performance goals, etc.). Changes in the price of the underlying stock or its volatility, the life of the option, dividends on the stock, or the risk-free interest rate subsequent to the grant date do not adjust the fair value of options or the related compensation cost.
A stock option for which vesting or exercisability is conditioned upon achievement of a targeted stock price or specified amount of intrinsic value does not constitute a performance award for which compensation expense would be subsequently adjusted. For awards that incorporate such features, compensation cost is recognized for employees who remain in service over the service period regardless of whether the target stock price or amount of intrinsic value is reached. FASB Statement No. 123 does indicate, however, that a target stock price condition generally affects the value of such options. Previously recognized compensation cost should not be reversed if a vested employee stock option expires unexercised.
Awards for past services would be recognized as a cost in the period the award is granted. Compensation expense related to awards for future services would be recognized over the period the related services are rendered by a charge to compensation cost and a corresponding credit to equity (paid-in capital). Unless otherwise defined, the service period would be considered equivalent to the vesting period. Vesting occurs when the employee's right to receive the award is not contingent upon performance of additional services or achievement of a specified target.
Compensation cost for an award with a graded vesting schedule should be recognized in accordance with the method described in FASB Interpretation 28, "Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans," if the fair value of the award is determined based on different expected lives for the options that vest each year, as it would be if the award is viewed as several separate awards, each with a different vesting date. However, if the value of the award is determined based on a composite expected life, or if the award vests at the end of a period (i.e., cliff vesting), the related compensation cost may be recognized on a straight-line basis over the service period, presumed to be the vesting period. FASB Statement No. 123 does require that the amount of compensation cost recognized at any date must at least equal the value of the vested portion of the award at that date.
FASB Statement No. 123 requires that dividends or dividend equivalents paid to employees on the portion of restricted stock or other equity award that is not expected to vest be recognized as additional compensation cost during the vesting period. Also, certain awards provide for reductions in the exercise or purchase price for dividends paid on the underlying stock. In these circumstances, FASB Statement No. 123 requires use of a dividend yield of zero in estimating the fair value of the related award. This provision would have the effect of increasing the fair value of a stock option on a dividend-paying stock.
Measurement of the value of stock options at grant date requires estimates relative to the outcome of service- and performance-related conditions. FASB Statement No. 123 adopts a grant date approach for stock-based awards with service requirements or performance conditions and specifies that resulting compensation cost should be adjusted for subsequent changes in the expected or actual outcome of these factors. Subsequent adjustments would not be made to the original volatility, dividend yield, expected life, and interest rate assumptions or for changes in the price of the underlying stock. Exhibit 39.10 illustrates the impact on compensation cost when actual forfeitures resulting from terminations deviate from the rate anticipated at grant date.
A performance requirement adds another condition that must be met in order for employees to vest in certain awards, in addition to rendering services over a period of years. Compensation cost for these awards should be recognized each period based on an assessment of the probability that the performance-related conditions will be met. Those estimates should be subsequently adjusted to reflect differences between expectations and actual outcomes. The cumulative effect of such changes in estimates on current and prior periods should be recognized in the period of change.
FASB Statement No. 123 requires that a modification to the terms of an award that increases the award's fair value at the modification date be treated, in substance, as the repurchase of the original award in exchange for a new award of greater value. Additional compensation cost arising from a modification of a vested award should be recognized for the difference between the fair value of the new award at the modification date and the fair value of the original award immediately before its terms are modified, determined based on the shorter of (a) its remaining expected life or (b) the expected life of the modified option. For modifications of nonvested options, compensation cost related to the original award not yet recognized must be added to the incremental compensation cost of the new award and recognized over the remainder of the employee's service period.
As an example of a modification of a vested option, assume that, on January 1, 2000, Company A granted its employees 300,000 stock options with an exercise price of $50 per share and a contractual term of 10 years. The options vested at the end of three years and 15,000 of the original 300,000 options were forfeited prior to vesting. On January 1, 2004, the market price of Company A stock has declined to $40 per share, and Company A decides to reduce the exercise price of the options. Under FASB Statement No. 123, Company A has effectively issued new options and would recognize additional compensation cost as a result of the reduction in exercise price. The estimated fair value of the original award at the modification date would be determined using the assumptions for dividend yield, volatility, and risk-free interest rate at the modification date. Exhibit 39.11 illustrates the measurement of additional compensation cost upon modification of the terms of this award.
In certain cases, modifications may be made to options that were granted before FASB Statement No. 123 was effective. Under APB Opinion No. 25, compensation cost would not have been recognized upon initial issuance of an option if the exercise price was equal to the market price on the grant date. Because no compensation cost was recognized for the original options, the modified options are treated as a new grant. For modifications of vested options, compensation cost is recognized immediately for the fair value of the new option on the modification date. However, if the options had intrinsic value on the modification date (i.e., the options were in the money), the intrinsic value would be excluded from the amount of compensation cost recognized because an employee could have exercised the options immediately before the modification and received the intrinsic value without affecting the amount of compensation cost recognized by the company. For modifications to nonvested options, previously unrecognized compensation cost, if any, is added to incremental compensation cost from the new award and recognized over the employee's service period.
Exchanges of options or changes in their terms in conjunction with business combinations, spin-offs, or other equity restructurings are considered modifications under FASB Statement No. 123, with the exception of those changes made to reflect the terms of the exchange of shares in a business combination accounted for as a pooling of interests. This represents a change in practice, as such modifications do not typically result in a new measurement date under APB Opinion No. 25, and, therefore, additional compensation expense is not recorded. However, changing the terms of an award in accordance with antidilution provisions that are designed, for example, to equalize an option's value before and after a stock split or a stock dividend is not considered a modification.
Reload stock options are granted to employees upon exercise of previously granted options whose original terms provide for the use of "mature" shares of stock that the employee has owned for a specified period of time (generally six months) rather than cash to satisfy the exercise price. When an employee exercises the original options using mature shares (a stock for stock exercise), the employee is automatically granted a reload option for the same number of shares used to exercise the original option. The exercise price of the reload option is the market price of the stock at the date the reload option is granted, and the term is equal to the remainder of the term of the original option. Compensation cost related to options with reload features should be calculated separately for the initial option grant and each subsequent grant of a reload option.
In the "Basis for Conclusions" (Appendix A to FASB Statement No. 123), the FASB states its belief that, ideally, the value of an option with a reload feature should be estimated at the grant date, taking into account all of its features. However, the Board concluded that it is not feasible to do so because no reasonable method currently exists to estimate the value added by a reload feature. Accordingly, the Board decided that compensation cost for an option with a reload feature should be calculated separately for the initial option grant and for each subsequent grant of a reload option as if it were a new grant.
Employers occasionally repurchase vested equity instruments issued to employees for cash or other assets. Under FASB Statement No. 123, amounts paid up to the fair value of the instrument at the date of repurchase should be charged to equity, and amounts paid in excess of fair value should be recognized as additional compensation cost. For example, a company that repurchases a vested share of stock for its market price does not incur additional compensation cost. A company that settles a nonvested award for cash has, in effect, vested the award, and the amount of compensation cost measured at the grant date and not yet recognized should be recognized at the repurchase date.
A repurchase of vested stock options would be treated in a manner similar to a modification of an option grant. Incremental compensation cost, if any, to be recognized upon cash settlement should be determined as the excess of cash paid over the fair value of the option on the date the employee accepts the repurchase offer, determined based on the remainder of its original expected life at that date. Additionally, if unvested stock options are repurchased, the amount of previously unrecognized compensation cost should be recognized at the repurchase date because the repurchase of the option effectively vests the award. Exhibit 39.12 illustrates the accounting for the repurchase of an award by the employer.
In certain circumstances, awards granted prior to adoption of FASB Statement No. 123 may be settled in cash subsequent to adoption of FASB Statement No. 123. Compensation cost would not have been recognized for the original award under APB Opinion No. 25 if the exercise price equaled the market price on the grant date. Because no cost was previously recognized for the original award, the cash settlement of the vested options is treated as a new grant and recognized as compensation cost on the repurchase date. However, if the original options had been in-the-money and thus had intrinsic value immediately before the settlement, the intrinsic value is excluded from compensation cost, similar to the accounting for a grant modification.
Employers may have compensation plans that offer employees a choice of receiving either cash or shares of stock in settlement of their stock-based awards. Such plans are considered tandem plans. For example, an employee may be given an award consisting of a cash SARs and an SAR with the same terms except that it calls for settlement in shares of stock with an equivalent value. The employee may demand settlement in either cash or in shares of stock and the election of one component of the plan (cash or stock) cancels the other. Because the employee has the choice of receiving cash, this plan results in the company incurring a liability. The amount of the liability will be adjusted each period to reflect the current stock price. If employees subsequently choose to receive shares of stock rather than receive cash, the liability is settled by issuing stock.
If the terms of a stock-based compensation plan provide that settlement of awards to employees will be made in a combination of stock and cash, the plan is considered a combination plan. In a combination plan, each part of the award is treated as a separate grant and accounted for separately. The portion to be settled in stock is accounted for as an equity instrument and the cash portion is accrued as a liability and adjusted each period based on fluctuations in the underlying stock price.
Exhibit 39.13 illustrates the accounting for an award expected to be settled in a combination of cash and stock.
Some companies offer employees the opportunity to purchase company stock, typically at a discount from market price. If certain conditions are met, the plan may qualify under Section 423 of the Internal Revenue Code, which allows employees to defer taxation on the difference between the market price and the discounted purchase price. APB Opinion No. 25 generally treats employee stock purchase plans that qualify under Section 423 as noncompensatory.
Under FASB Statement No. 123, broad-based employee stock purchase plans are compensatory unless the discount from market price is relatively small. Plans that provide a discount of no more than five percent would be considered noncompensatory; discounts in excess of this amount would be considered compensatory under FASB Statement No. 123 unless the company could justify a higher discount. A company may justify a discount in excess of five percent if the discount from market price does not exceed the greater of (a) the per-share discount that would be reasonable in a recurring offer of stock to stockholders or (b) the per-share amount of stock issuance costs avoided by not having to raise a significant amount of capital by a public offering. If a company cannot provide adequate support for a discount in excess of five percent, the entire amount of the discount should be treated as compensation cost.
For example, if an employee stock purchase plan provides that employees can purchase the employer's common stock at a price equal to 85 percent of its market price as of the date of purchase, compensation cost would be based on the entire discount of 15 percent unless the discount in excess of 5 percent can be justified.
If an employee stock purchase plan meets the following three criteria, the discount from market price is not considered stock-based compensation:
The plan incorporates no option features other than the following, which may be incorporated: (a) employees are permitted a short period of time (not exceeding 31 days) after the purchase price has been fixed in which to enroll in the plan, and (b) the purchase price is based solely on the stock's market price at the date of purchase and employees are permitted to cancel participation before the purchase date.
The discount from the market price is five percent or less (or the company is able to justify a higher discount).
Substantially all full-time employees meeting limited employment qualifications may participate on an equitable basis.
Some companies offer options to employees under Section 423 of the Internal Revenue Code, which allows employees to defer taxation on the difference between the market price of the stock and a discounted purchase price if certain requirements are met. One requirement is that the option price may not be less than the smaller of (a) 85 percent of the market price when the option is granted or (b) 85 percent of the market price at exercise date. Options that provide for the more favorable of several exercise prices are referred to as look-back options. Under APB Opinion No. 25, Section 423 look-back plans generally are considered noncompensatory.
Under the FASB Statement No. 123, the effect of a look-back feature would be recorded at fair value at the grant date similar to other stock-based compensation. Accordingly, the fair value of a look-back option should be estimated based on the stock price and terms of the option at the grant date by breaking it into its components and valuing the option as a combination position.
For example, on January 1, 2004, a company offers its employees the opportunity to sign up for payroll deductions to purchase its stock at either 85 percent of the stock's current $50 price or 85 percent of the stock price at the end of the year when the options expire, whichever is lower. Assume that the dividend yield is zero, expected volatility is 35 percent, and the risk-free interest rate available for the next 12 months is 7 percent.
The look-back option consists of 15 percent of a share of nonvested stock and 85 percent of a one-year call option. The underlying logic is that the holder of the look-back option will always receive 15 percent of a share of stock upon exercise, regardless of the stock price at that date. For example, if the stock price fell to $40, the exercise price will be $34 (40 × .85), and the holder will benefit by $6 ($40 − $34), or 15 percent of the exercise price. If the stock price exceeds the $50 exercise price, the holder of the look-back option receives a benefit that is more than equivalent to 15 percent of a share of stock. A standard option-pricing model can be used to value the one-year call option on 85 percent of a share of stock represented by the second component.
Total compensation cost at the grant date is computed in Exhibit 39.14.
FASB Technical Bulletin No. 97–1, "Accounting under Statement 123 for Certain Employee Stock Purchase Plans with a Look-Back Option," discusses various types of look-back options and provides illustrations of the related fair value calculations.
In most cases, an employer settles stock options by issuing stock rather than paying cash. However, under certain stock-based plans, an employer may elect or may be required to settle the award in cash. For example, a cash SAR derives its value from increases in the price of the employer's stock but is ultimately settled in cash. Such plans include phantom stock plans, cash SARs, and cash performance unit awards. In other instances, an employee may have the option of requesting settlement in cash or stock.
Under APB Opinion No. 25, cash paid to settle a stock-based award is the final measure of compensation cost. The repurchase of stock shortly after exercise of an option is also considered cash paid to settle an earlier award and ultimately determines compensation cost. FASB Statement No. 123 indicates that awards calling for settlement in stock are considered equity instruments when issued, and their subsequent repurchase for cash would not necessarily require an adjustment to compensation cost if the amount paid does not exceed the fair value of the instruments repurchased. Awards calling for settlement in cash (or other assets of the employer) are considered liabilities when issued, and their settlement would require an adjustment to previously recognized compensation cost if the settlement amount differs from the carrying amount of the liability. Also, if the choice of settlement (cash or stock) is the employee's, FASB Statement No. 123 specifies that the employer would be settling a liability rather than issuing an equity security; accordingly, compensation cost should be adjusted if the settlement amount differs from the carrying amount of the liability.
FASB Statement No. 123 indicates that the accounting for stock compensation plans, as equity or liability instruments should reflect the terms as understood by the employer and the employee. While the written plan generally provides the best evidence of its terms, an employer's past practices may indicate substantive terms that differ from written terms. For example, an employer that is not legally obligated to settle an award in cash but that generally does so upon exercise of stock options whenever an employee asks for cash settlement is probably settling a substantive liability rather than repurchasing an equity instrument. In that instance, the Statement requires accounting for the substantive terms of the plan.
FASB Statement No. 123 does not change current accounting practice for nonpublic companies with stock repurchase agreements, provided that the repurchase price is the fair value of the stock at the date of repurchase. Alternatively, many nonpublic companies sponsor stock purchase plans that provide for employees to acquire shares in the company at book value or a formula price based on book value or earnings. In addition, these arrangements frequently require the company to repurchase the shares when the employee terminates at a price determined in the same manner as the purchase price.
Under current practice, a nonpublic company is not required to recognize compensation cost for share repurchases under book value or formula plans if the employee has made a substantive investment that will be at risk for a reasonable period of time. FASB Statement No. 123, however, requires fair value as the basic method of measuring compensation cost for all stock-based plans, including those of private companies. FASB Statement No. 123 indicates that each plan will need to be assessed on a case-by-case basis to determine whether the book value or formula price is a reasonable estimate of fair value and whether the plan is subject to additional compensation cost.
Except for stock-based awards to employees that are currently within the scope of APB Opinion No. 25, FASB Statement No. 123 provides that all transactions in which goods or services are the consideration received for the issuance of equity instruments should be accounted for based on the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measurable. In some cases, the fair value of goods or services received from suppliers, consultants, attorneys, or other nonemployees is more reliably measurable and indicates the fair value of the equity instrument issued.
If the fair value of goods or services received is not reliably measurable, the measure of the cost of goods or services acquired in a transaction with nonemployees should be based on the fair value of the equity instruments issued. However, FASB Statement No. 123 does not specify the date that should be used to value the equity instruments or the methodology that should be used to determine the total cost to be recognized when the number or terms of the equity instruments are variable. These issues are addressed in EITF Issue No. 96–18, "Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services."
Further, some such transactions are more complex: the exchange may span several periods, the issuance of the equity instruments is contingent on service or delivery of goods that must be completed by the provider of the goods or services in order to vest in the equity instrument, or fully vested, nonforfeitable equity instruments issued to a grantee may contain terms that may vary based on the achievement of a performance condition or certain market conditions. In certain cases, the fair value of the equity instruments to be received may be more reliably measurable than the fair value of the goods or services to be given as consideration.
In EITF Issue No. 00–8, the Task Force agreed that for transactions in which an entity provides goods or services in exchange for equity instruments, the grantee should measure the fair value of the equity instruments using the stock price and other measurement assumptions as of the earlier of either of these dates:
The date the parties come to a mutual understanding of the terms of the equity-based compensation arrangement and commitment for performance by the grantee to earn the equity instruments (a "performance commitment" in the sense used in EITF Issue No. 96–18) is reached
The date at which the grantee's performance necessary to earn the equity instruments is complete, which is the vesting date
The Task Force agreed that if on the measurement date the quantity or any of the terms of the equity instrument depend on the achievement of a market condition, the grantee should measure revenue based on the fair value of the equity instruments inclusive of the adjustment provisions, calculated as the fair value of the equity instruments without regard to the market condition plus the fair value of the commitment to change the quantity or terms of the equity instruments if the market condition is met. Footnote 10 to FASB Statement No. 123 indicates that pricing models have been adapted to value many of those path-dependent instruments.
The Task Force agreed that if on the measurement date the quantity or any of the terms of the equity instrument depend on the achievement of grantee performance conditions beyond those for which a performance commitment exists, changes in the fair value of the equity instrument that result from an adjustment to the instrument on the achievement of a performance condition should be measured as additional revenue from the transaction using a methodology consistent with "modification accounting" described in paragraph 35 of FASB Statement No. 123. The adjustment should thus be measured at the date of the revision of the quantity or terms of the instrument as the difference between (a) the then-current fair value of the revised instruments using the then-known quantity and terms and (b) the then-current fair value of the old equity instruments immediately before the adjustment.
EITF Issue Nos. 96–18 and 00–8 do not address the periods or manner in which the fair value of the transactions should be recognized other than to observe that a transaction should be recognized in the same periods and in the same manner as if cash were being exchanged in the transaction instead of the equity instruments.
EITF Issue No. 00–18 addresses those issues but does not readdress the issues addressed by EITF Issue Nos. 96–18 and 00–8.
The Task Force agreed that if fully vested, exercisable, nonforfeitable equity instruments are issued at the date the grantor and grantee enter into an agreement, any obligation on the part of the counterparty to earn the equity instruments has been eliminated, and thus a measurement date has been reached. The grantor should therefore recognize the equity instruments when they are issued, usually when the agreement is entered into. Most of the Task Force generally agreed that the specific facts and circumstances determine whether the corresponding cost is an immediate expense, a prepaid asset, or an amount that should be classified as contra-equity.
The Task Force generally agreed that if fully vested, nonforfeitable equity instruments exercisable by the grantee only after a specified period of time, but the agreement provides for earlier exercisability if the grantee achieves specified performance conditions, the grantor should measure the fair value of the equity instruments at the date of grant and should recognize that measured cost as indicated in the preceding paragraph. Footnote 5 in EITF Issue No. 96–18 should be amended to eliminate the reference to immediate exercisability. Most of the Task Force agreed that if, after the arrangement date, the grantee performs as specified in the agreement and exercisability is accelerated, the grantor should measure and report the resulting increase in the fair value of the equity instruments using "modification accounting."
If a transaction includes a grantee performance commitment with the grantee having a contingent right to receive, on performing under the commitment, grantor equity instruments that are consideration for the grantee's future performance, the grantee treats the arrangement as an executory contract, with no accounting before performance, the same as the grantee would have agreed to pay cash on vesting for the goods or services.
The cumulative amount of compensation cost recognized that ordinarily results in a future tax deduction under existing tax law is a deductible temporary difference under FASB Statement No. 109, "Accounting for Income Taxes." Under current tax law, incentive stock options do not result in tax deductions for an employer (provided employees comply with requisite holding periods) and, accordingly, do not create a future deductible temporary difference. Tax benefits arising because employees do not comply with requisite holding periods (i.e., disqualifying dispositions) are recognized in the financial statements only when such events occur.
Nonqualified stock options and grants of restricted stock do generate tax deductions for employers. In general, the tax deduction equals the intrinsic value of the award at the date of exercise. Under FASB Statement No. 123, the cumulative amount of compensation cost recognized in a company's income statement is considered to be a deductible temporary difference under FASB Statement No. 109. Deferred tax assets recognized for deductible temporary differences should be reduced by a valuation allowance if, based on available evidence, such an allowance is deemed necessary. The deferred tax benefit or expense resulting from increases or decreases in that temporary difference (e.g., as additional compensation cost is recognized over the vesting period) is recognized in the income statement because those tax effects relate to continuing operations. Similar to the provisions of APB Opinion No. 25 on accounting for the income tax effects of stock compensation awards, the amount of tax benefits recognized in the income statement is limited to the effects of deductions based on reported compensation cost. If the deduction for income tax purposes exceeds the amount of compensation cost recognized for financial reporting purposes, the benefit of the excess tax deduction is credited to additional paid-in capital.
The disclosure provisions of FASB Statement No. 123, as discussed below, are effective for fiscal years beginning after December 15, 1995. However, disclosure of pro forma net income and earnings per share, as if the fair value method had been used to account for stock-based compensation, is required for all awards granted in fiscal years beginning after December 5, 1994.
During the initial phase-in period, the effects of applying FASB Statement No. 123 for either recognizing compensation cost or providing pro forma disclosures may not be representative of the effects on reported net income for future years. Financial statements should include a disclosure to this effect if applicable.
Computation of the impact of stock-based compensation awards on earnings per share is addressed in FASB Statement No. 128, and the same concepts apply to the earnings per share computations regardless of the method of accounting for stock-based compensation. Accordingly, much of the discussion of earnings per share computations for stock-based awards under APB Opinion No. 25 in Section 39.4 is relevant to earnings per share computations for stock-based awards under FASB Statement No. 123. However, the impact of stock-based compensation awards accounted for under FASB Statement No. 123 usually differs from the impact of awards accounted for under APB Opinion No. 25. Net income available to common stockholders (the numerator) frequently differs because of the differences in the methods of determining compensation cost under each of these standards. Furthermore, the weighted-average number of common shares outstanding (the denominator) in computations of diluted earnings per share may differ due to the differences in the determination of assumed proceeds in application of the Treasury stock method. For example, the amount of compensation cost attributed to future services and not yet recognized and the amount of tax benefits that would be credited to stockholders' equity assuming exercise of the options generally would differ depending on whether a company is accounting for stock-based compensation under FASB Statement No. 123 or APB Opinion No. 25. Discussed below are a few other points to consider in computing the impact of stock-based awards on earnings per share.
Under FASB Statement No. 128, forfeitures of stock-based awards do not affect the computation of assumed proceeds in application of the treasury stock method until the forfeitures actually occur. This practice may be inconsistent with the method that a company uses for determining compensation expense since, under FASB Statement No. 123, a company can determine compensation expense based on actual forfeitures as they occur or based on an estimate of forfeitures with adjustments to actual forfeitures.
There also is an inconsistency in when compensation cost for performance awards is included in the numerator of the diluted earnings per share computation pursuant to FASB Statement No. 123 and when the related contingent shares are included in the denominator of the same computation pursuant to FASB Statement No. 128. Interim accruals of compensation cost for performance awards are based on the best estimate of the outcome of the performance condition. In other words, for each reporting period, compensation cost is estimated for the awards that are expected to vest based on performance-related conditions. However, pursuant to FASB Statement No. 128, diluted earnings per share reflects only those awards that would be issued if the end of the reporting period were the end of the contingency period. In most cases, performance awards will not be reflected in diluted earnings per share until the performance condition has been satisfied.
In applying the Treasury stock method to awards accounted for pursuant to FASB Statement No. 123, the awards may be antidilutive even when the market price of the underlying stock exceeds the related exercise price. This result is possible because compensation cost attributed to future services and not yet recognized is included as a component of assumed proceeds upon exercise in applying the Treasury stock method. Since this component represents an amount over and above the intrinsic value of the award at the grant date, it is possible that stock options with a positive intrinsic value would be considered antidilutive and thereby excluded from diluted earnings per share computations under to FASB Statement No. 128.
Exhibit 39.15 illustrates basic and diluted earnings per share computations under APB Opinion No. 25 and FASB Statement No. 123.
FASB Statement No. 123 superseded the disclosure requirements under APB Opinion No. 25 and requires disclosure of the following information by employers with one or more stock-based compensation plans regardless of whether a company has elected the recognition provisions or retained accounting under APB Opinion No. 25:
A description of the method used to account for all stock-based employee compensation arrangements should be included in the company's summary of significant accounting policies.
A description of the plans, including the general terms of the awards under the plans such as vesting requirements, the maximum term of options granted, and the number of shares authorized for grants of options or other equity instruments.
The following information should be disclosed for each year for which an income statement is presented:
The number and weighted-average exercise prices of options for each of the following groups of options: (1) those outstanding at the beginning and end of the year, (2) those exercisable at the end of the year, and (3) the number of options granted, exercised, forfeited, or expired during the year.
The weighted-average grant-date fair values of options granted during the year. If the exercise prices of some options differ from the market price of the stock on the grant date, weighted-average exercise prices and fair values of options would be disclosed separately for options whose exercise price (1) equals, (2) exceeds, or (3) is less than the market price of the stock on the date of grant.
The number and weighted-average grant-date fair value of equity instruments other than options (e.g., shares of nonvested stock) granted during the year.
A description of the method and significant assumptions used to estimate the fair values of options, including the weighted-average (1) risk-free interest rate, (2) expected life, (3) expected volatility, and (4) expected dividend yield.
Total compensation cost recognized in income for stock-based compensation awards.
The terms of significant modifications to outstanding awards.
A company that has both fixed and indexed or performance-based plans should provide certain of the foregoing information separately for different types of plans. For example, the weighted-average exercise price at the end of the year would be shown separately for plans with a fixed exercise price and those with an indexed exercise price.
For options outstanding at the date of the latest balance sheet presented, disclosure of the range of exercise prices, the weighted-average exercise price, and the weighted-average remaining contractual life. If the range of exercise prices is wide (e.g., the highest exercise price exceeds 150 percent of the lowest exercise price), the exercise prices should be segregated into meaningful ranges. The following information should be disclosed for each range:
The number, weighted-average exercise price, and weighted-average remaining contractual life of options outstanding, and
The number and weighted-average exercise price of options currently exercisable.
FASB Statement No. 123 provides an extensive example disclosure.
In addition to the disclosures described above, companies that continue to apply the provisions of APB Opinion No. 25 must disclose the following for each year an income statement is presented:
The pro forma net income and, for public entities, the pro forma earnings per share, as if the fair value-based accounting method prescribed by FASB Statement No. 123 had been used to account for stock-based compensation cost
Those pro forma amounts should reflect the difference between compensation cost, if any, included in net income in accordance with APB Opinion No. 25 and the related cost measured by the fair value-based method, as well as additional tax effects, if any, that would have been recognized in the income statement if the fair value-based method had been used
The required pro forma amounts should reflect no other adjustments to reported net income or earnings per share
FASB Statement No. 123 provides an extensive example disclosure.
Accounting Principles Board, "Accounting for Stock Issued to Employees," APB Opinion No. 25. AICPA, New York, 1972.
———, "Stock Plans Established by a Principle Stockholder," Accounting for Stock Issued to Employees: Interpretation of APB Opinion No. 25. AICPA, New York, 1973.
Financial Accounting Standards Board, "Purchase of Stock Options and Stock Appreciation Rights in a Leveraged Buyout," EITF Issue No. 84–13. FASB, Stamford, CT, 1984.
———, "Stock Option Pyramiding," EITF Issue No. 84–18. FASB, Stamford, CT, 1984.
———, "Permanent Discount Restricted Stock Purchase Plans," EITF Issue No. 84–34. FASB, Stamford, CT, 1984.
———, "Business Combinations: Settlement of Stock Options and Awards," EITF Issue No. 85–45. FASB, Stamford, CT, 1985.
———, "Adjustments Relating to Stock Compensation Plans," EITF Issue No. 87–6. FASB, Stamford, CT, 1987.
———, "Book Value Stock Purchase Plans," EITF Issue No. 87–23. FASB, Stamford, CT, 1987.
———, "Stock Compensation Issues Related to Market Decline," EITF Issue No. 87–33. FASB, Stamford, CT, 1987.
———, "Book Value Stock Plans in an Initial Public Offering," EITF Issue No. 88–6. FASB, Norwalk, CT, 1988.
———, "Accounting for a Reload Stock Option," EITF Issue No. 90–7. FASB, Norwalk, CT, 1990.
———, "Changes to Fixed Employee Stock Option Plans as a Result of Equity Restructuring," EITF Issue No. 90–9. FASB, Norwalk, CT, 1990.
———, "Accounting for the Buyout of Compensatory Stock Options," EITF Issue No. 94–6. FASB, Norwalk, CT, 1994.
———, "Accounting for Stock Compensation Arrangements with Employer Loan Features under APB Opinion No. 25," EITF Issue No. 95–16. FASB, Norwalk, CT, 1995.
———, "Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services," EITF Issue No. 96–18. FASB, Norwalk, CT, 1997.
———, "Accounting for the Delayed Receipt of Option Shares upon Exercise under APB Opinion No. 25," EITF Issue No. 97–5. FASB, Norwalk, CT, 1997.
———, "Accounting for Increased Share Authorizations in an IRS Section 423 Employee Stock Purchase Plan under APB Opinion No. 25," EITF Issue No. 97–12. FASB, Norwalk, CT, 1997.
———, "Accounting by a Grantee for an Equity Instrument to Be Received in Conjunction with Providing Goods or Services," EITF Issue No. 00–8, FASB, Norwalk, CT, 2000.
———, "Accounting Recognition for Certain Transactions Involving Equity Instruments Granted to Other Than Employees," EITF Issue No. 00–18, FASB, Norwalk, CT, 2000.
———, "Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans," FASB Interpretation No. 28. FASB, Stamford, CT, 1978.
———, "Determining the Measurement Date for Stock Option, Purchase, and Award Plans Involving Junior Stock," FASB Interpretation No. 38. FASB, Stamford, CT, 1984.
———, "Accounting for Certain Transactions Involving Stock Compensation," FASB Interpretation No. 44, FASB, Norwalk, CT, 2000.
———, "Accounting for the Conversion of Stock Options into Incentive Stock Options as a Result of the Economic Recovery Tax Act of 1981," FASB Technical Bulletin No. 82–2. FASB, Stamford, CT, 1982.
———, "Accounting under Statement 123 for Certain Employee Stock Purchase Plans with a Look-Back Option," FASB Technical Bulletin 97–1. FASB, Norwalk, CT, 1997.
———, "Accounting for Income Taxes," Statement of Financial Accounting Standards No. 109. FASB, Norwalk, CT, 1992.
———, "Accounting for Stock-Based Compensation," Statement of Financial Accounting Standards No. 123. FASB, Norwalk, CT, 1995.
———, "Earnings Per Share," Statement of Financial Accounting Standards No. 128. FASB, Norwalk, CT, 1997.
Securities and Exchange Commission, "Codification of Financial Reporting Policies," Financial Reporting Release No. 1, § 211 (ASR No. 268). SEC, Washington, DC, 1982.
[33] FASB, Statement of Standards No. 123, "Accounting for Stock-Based Compensation," par. 89.
[34] Id., Invitation to Comment, "Accounting for Compensation Plans Involving Certain Rights Granted to Employees," May 31, 1984, par. 155.
[35] John Helyar and Joann S. Lublin, "Corporate Coffers Gush with Currency of an Opulent Age," Wall Street Journal. August 10, 1998, p. B.5.
[36] Dennis R. Beresford, "How to Succeed as a Standard Setter by Trying Really Hard," Accounting Horizons, September 1997, p. 83.