ASC 718-10, Overall, contains the high-level objectives for the Topic
ASC 718-20, Awards Classified as Equity, deals with share-based awards to employees classified as equity
ASC 718-30, Awards Classified as Liabilities, deals with share-based awards to employees classified as liabilities
ASC 718-40, Employee Stock Ownership Plans, contains the following subsections:
- General
- Leveraged employee stock ownership plans
- Nonleveraged employee stock ownership plans
ASC 718-50, Employee Share Purchase Plans,
ASC 718-60, Income Taxes, which addresses accounting for income taxes related to share-based payment arrangements.

Scope and Scope Exceptions

ASC 718 applies to all entities and to all share-based payment transactions where the entity acquires employee services by issuing or offering to issue equity instruments or incurring liabilities to an employee that meet these conditions:

The amounts are based in whole or in part on the price of the entity's equity instruments
The awards require or may require settlement by issuing the entity's equity instruments.

If the purpose of awarding the shares is other than compensation, ASC 718 does not apply. ASC 718 does not apply to share-based payments for other than employee services.

Overview

The Financial Accounting Standards Board (FASB) has concluded that the economic substance of stock-based compensation is to provide compensation, and that results in an expense that should logically be reported by the entity (using the fair value method of accounting); this view is reflected in Accounting Standards Codification (ASC) 718, Compensation—Stock Compensation, which imposes fair value accounting on almost all share-based payment plans.

ASC 718 contains the accounting for employers' contributions to employee stock ownership plans (ESOP). This includes the measurement of compensation cost and the accounting for dividends paid on unallocated shares.

ASC 718 holds that freestanding financial instruments issued to employees in exchange for past or future employee services are subject to the recognition and measurement provisions of ASC 718 throughout the life of the instruments, unless their terms are modified when the holder is no longer an employee. ASC 718 also holds that, for instruments originally issued as employee compensation and then modified, and where that modification to the terms of the instrument is made solely to reflect an equity restructuring that occurs when the holders are no longer employees, no change in the recognition or the measurement (due to a change in classification) of those instruments will result if both of the following conditions are met:

There is no increase in the fair value of the award (or the ratio of intrinsic value to the exercise price of the award is preserved—i.e., the holder is made whole), or the antidilution provision is not added to the terms of the award in contemplation of an equity restructuring; and
All holders of the same class of equity instruments (for example, stock options) are treated in the same manner.

Other modifications of the instrument (that is, any modification that fails to meet the dual tests above) that take place when the holder is no longer an employee, are subject to the modification accounting guidance set forth by ASC 718, as addressed above. Following modification, the accounting for such instruments, no longer held by employees, must follow GAAP, including ASC 480 if applicable.

The definition of short-term inducement in the glossary of terms included the phrase or settlement of an award. This reference raised a question about possible interaction between different provisions of the standard. FASB did not intend for a short-term inducement deemed to be a settlement to affect the classification of the award for the period it remains outstanding (for example, change the award from an equity instrument to a liability instrument). Therefore, an offer (for a limited time period) to repurchase an award should be excluded from the definition of a short-term inducement, and not be accounted for as a modification. However, if an entity has a history of settling its awards for cash, the entity should consider whether at the inception of the awards it has a substantive liability.

DEFINITIONS OF TERMS

The following definitions are from the Glossary section of ASC 718.

Allocated shares. Allocated shares are shares in an employee stock ownership plan trust that have been assigned to individual participant accounts based on a known formula. Internal Revenue Service (IRS) rules require allocations to be nondiscriminatory generally based on compensation, length of service, or a combination of both. For any particular participant such shares may be vested, unvested, or partially vested.

Award. The collective noun for multiple instruments with the same terms and conditions granted at the same time either to a single employee or to a group of employees. An award may specify multiple vesting dates, referred to as graded vesting, and different parts of an award may have different expected terms. References to an award also apply to a portion of an award.

Blackout period. A period of time during which exercise of an equity share option is contractually or legally prohibited.

Broker-assisted cashless exercise. The simultaneous exercise by an employee of a share option and sale of the shares through a broker (commonly referred to as a broker-assisted exercise).

Generally, under this method of exercise:

The employee authorizes the exercise of an option and the immediate sale of the option shares in the open market.
On the same day, the entity notifies the broker of the sale order.
The broker executes the sale and notifies the entity of the sales price.
The entity determines the minimum statutory tax-withholding requirements.
By the settlement day (generally three days later), the entity delivers the stock certificates to the broker.
On the settlement day, the broker makes payment to the entity for the exercise price and the minimum statutory withholding taxes and remits the balance of the net sales proceeds to the employee.

Calculated value. A measure of the value of a share option or similar instrument determined by substituting the historical volatility of an appropriate industry sector index for the expected volatility of a nonpublic entity's share price in an option-pricing model.

Call option. A contract that allows the holder to buy a specified quantity of stock from the writer of the contract at a fixed price for a given period. See Option and Purchased call option.

Closed-form model. A valuation model that uses an equation to produce an estimated fair value. The Black-Scholes-Merton formula is a closed-form model. In the context of option valuation, both closed-form models and lattice models are based on risk-neutral valuation and a contingent claims framework. The payoff of a contingent claim, and thus its value, depends on the value(s) of one or more other assets. The contingent claims framework is a valuation methodology that explicitly recognizes that dependency and values the contingent claim as a function of the value of the underlying asset(s). One application of that methodology is risk-neutral valuation in which the contingent claim can be replicated by a combination of the underlying asset and a risk-free bond. If that replication is possible, the value of the contingent claim can be determined without estimating the expected returns on the underlying asset. The Black-Scholes-Merton formula is a special case of that replication.

Combination award. An award with two or more separate components, each of which can be separately exercised. Each component of the award is actually a separate award, and compensation cost is measured and recognized for each component.

Committed-to-be-released shares. Committed-to-be-released shares are shares that, although not legally released, will be released by a future scheduled and committed debt service payment and will be allocated to employees for service rendered in the current accounting period. The period of employee service to which shares relate is generally defined in the employee stock ownership plan documents. Shares are legally released from suspense and from serving as collateral for employee stock ownership plan debt as a result of payment of debt service. Those shares are required to be allocated to participant accounts as of the end of the employee stock ownership plan's fiscal year. Formulas used to determine the number of shares released can be based on either of the following:

The ratio of the current principal amount to the total original principal amount (in which case unearned employee stock ownership plan shares and debt balance will move in tandem)
The ratio of the current principal plus interest amount to the total original principal plus interest to be paid.

Shares are released more rapidly under the second method than under the first. Tax law permits the first method only if the employee stock ownership plan debt meets certain criteria.

Cross-Volatility. A measure of the relationship between the volatilities of the prices of two assets taking into account the correlation between movements in the prices of the assets.

Derived service period. A service period for an award with a market condition that is inferred from the application of certain valuation techniques used to estimate fair value. For example, the derived service period for an award of share options that the employee can exercise only if the share price increases by 25% at any time during a five-year period can be inferred from certain valuation techniques. In a lattice model, that derived service period represents the duration of the median of the distribution of share price paths on which the market condition is satisfied. That median is the middle share price path (the midpoint of the distribution of paths) on which the market condition is satisfied. The duration is the period of time from the service inception date to the expected date of satisfaction (as inferred from the valuation technique). If the derived service period is three years, the estimated requisite service period is three years, and all compensation cost would be recognized over that period, unless the market condition was satisfied at an earlier date. Compensation cost would not be recognized beyond three years even if after the grant date the entity determines that it is not probable that the market condition will be satisfied within that period. Further, an award of fully vested, deep out-of-the-money share options has a derived service period that must be determined from the valuation techniques used to estimate fair value. (See Explicit service period, Implicit service period and Requisite service period.)

Direct loan. A direct loan is a loan made by a lender other than the employer to the employee stock ownership plan. Such loans often include some formal guarantee or commitment by the employer.

Economic interest in an entity. Any type or form of pecuniary interest or arrangement that an entity could issue or be a party to, including equity securities; financial instruments with characteristics of equity, liabilities, or both; long-term debt and other debt-financing arrangements; leases; and contractual arrangements such as management contracts, service contracts, or intellectual property licenses.

Employee. An individual over whom the grantor of a share-based compensation award exercises or has the right to exercise sufficient control to establish an employer–employee relationship based on common law as illustrated in case law and currently under US Internal Revenue Service (IRS) Revenue Ruling 87-41. A reporting entity based in a foreign jurisdiction would determine whether an employee–employer relationship exists based on the pertinent laws of the jurisdiction. Accordingly, a grantee meets the definition of an employee if the grantor consistently represents that individual to be an employee under common law. The definition of an employee for payroll tax purposes under the US Internal Revenue Code includes common law employees. Accordingly, a grantor that classifies a grantee potentially subject to US payroll taxes as an employee also must represent that individual as an employee for payroll tax purposes (unless the grantee is a leased employee as described below). A grantee does not meet the definition of an employee solely because the grantor represents that individual as an employee for some, but not all, purposes. For example, a requirement or decision to classify a grantee as an employee for US payroll tax purposes does not, by itself, indicate that the grantee is an employee, because the grantee also must be an employee of the grantor under common law.

A leased individual is deemed to be an employee of the lessee if all of the following requirements are met:

The leased individual qualifies as a common law employee of the lessee, and the lessor is contractually required to remit payroll taxes on the compensation paid to the leased individual for the services provided to the lessee.
The lessor and lessee agree in writing to all of the following conditions related to the leased individual:
1. The lessee has the exclusive right to grant stock compensation to the individual for the employee service to the lessee.
2. The lessee has a right to hire, fire, and control the activities of the individual. (The lessor also may have that right.)
3. The lessee has the exclusive right to determine the economic value of the services performed by the individual (including wages and the number of units and value of stock compensation granted).
4. The individual has the ability to participate in the lessee's employee benefit plans, if any, on the same basis as other comparable employees of the lessee.
5. The lessee agrees to and remits to the lessor funds sufficient to cover the complete compensation, including all payroll taxes, of the individual on or before a contractually agreed-upon date or dates.

A nonemployee director does not satisfy this definition of employee. Nevertheless, nonemployee directors acting in their role as members of a board of directors are treated as employees if those directors were elected by the employer's shareholders or appointed to a board position that will be filled by shareholder election when the existing term expires. However, that requirement applies only to awards granted to nonemployee directors for their services as directors. Awards granted to those individuals for other services shall be accounted for as awards to nonemployees.

Employee stock ownership plan (ESOP). An ESOP is an employee benefit plan described by the Employee Retirement Income Security Act (ERISA) of 1974 and the Internal Revenue Code of 1986 as a stock bonus plan, or combination stock bonus and money purchase pension plan, designed to invest primarily in employer stock. Also called an employee share ownership plan.

Employer loan. An employer loan is a loan made by the employer to the employee stock ownership plan, with no related outside loan.

Equity restructuring. A nonreciprocal transaction between an entity and its shareholders that causes the per-share fair value of the shares underlying an option or similar award to change, such as a stock dividend, stock split, spinoff, rights offering, or recapitalization through a large, nonrecurring cash dividend.

Excess tax benefit. The realized tax benefit related to the amount (caused by changes in the fair value of the entity's shares after the measurement date for financial reporting) of deductible compensation cost reported on an employer's tax return for equity instruments in excess of the compensation cost for those instruments recognized for financial reporting purposes.

Explicit service period. A service period that is explicitly stated in the terms of a share-based payment award. For example, an award that vests after three years of continuous employee service from a given date (usually the grant date) has an explicit service period of three years. See Derived service period, Implicit service period, and Requisite service period.

Fair value. The amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.

Freestanding financial instrument. A financial instrument that meets either of the following conditions:

It is entered into separately and apart from any of the entity's other financial instruments or equity transactions.
It is entered into in conjunction with some other transaction and is legally detachable and separately exercisable.

Grant date. The date at which employer and employee reach a mutual understanding of the key terms and conditions of a share-based payment award. The employer becomes contingently obligated on the grant date to issue equity instruments or transfer assets to an employee who renders the requisite service. Awards made under an arrangement that is subject to shareholder approval are not deemed to be granted until that approval is obtained, unless approval is essentially a formality (or perfunctory)—for example, if management and the members of the board of directors control enough votes to approve the arrangement. Similarly, individual awards that are subject to approval by the board of directors, management, or both are not deemed to be granted until all such approvals are obtained. The grant date for an award of equity instruments is the date that an employee begins to benefit from, or be adversely affected by, subsequent changes in the price of the employer's equity shares. ASC 718-10-25-5 provides guidance on determining the grant date. See Service inception date.

Implicit service period. A service period that is not explicitly stated in the terms of a share-based payment award but that may be inferred from an analysis of those terms and other facts and circumstances. For instance, if an award of share options vests upon the completion of a new product design, which is deemed probable in 18 months, the implicit service period is 18 months. See Derived service period, Explicit service period, and Requisite service period.

Indirect loan. An indirect loan is a loan made by the employer to the employee stock ownership plan, with a related outside loan to the employer.

Intrinsic value. The amount by which the fair value of the underlying stock exceeds the exercise price of an option. For example, an option with an exercise price of $20 on a stock whose current market price is $25 has an intrinsic value of $5. (A nonvested share may be described as an option on that share with an exercise price of zero. Thus, the fair value of a share is the same as the intrinsic value of such an option on that share.)

Lattice model. A model that produces an estimated fair value based on the assumed changes in prices of a financial instrument over successive periods of time. The binomial model is an example of a lattice model. In each time period, the model assumes that at least two price movements are possible. The lattice represents the evolution of the value of either a financial instrument or a market variable for the purpose of valuing a financial instrument. In this context, a lattice model is based on a risk-neutral valuation and a contingent claims framework. See Closed-form model for an explanation of the terms risk-neutral valuation and contingent claims framework.

Market condition. A condition affecting the exercise price, exercisability, or other pertinent factors used in determining the fair value of an award under a share-based payment arrangement that relates to the achievement of either of the following:

A specified price of the issuer's shares or a specified amount of intrinsic value indexed solely to the issuer's shares
A specified price of the issuer's shares in terms of a similar (or index of similar) equity security (securities). The term “similar,” as used in this definition, refers to an equity security of another entity that has the same type of residual rights. For example, common stock of one entity generally would be similar to the common stock of another entity for this purpose.

Measurement date. The date at which the equity share price and other pertinent factors, such as expected volatility, that enter into measurement of the total recognized amount of compensation cost for an award of share-based payment fixed.

Modification. A change in any of the terms or conditions of a share-based payment award.

Nonpublic entity. Any entity other than one that meets any of the following criteria:

Has equity securities that 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
Makes a filing with a regulatory agency in preparation for the sale of any class of equity securities in a public market
Is controlled by an entity covered by the preceding criteria.

An entity that has only debt securities trading in a public market (or that has made a filing with a regulatory agency in preparation to trade only debt securities) is a nonpublic entity.

Nonvested shares. Shares that an entity has not yet issued because the agreed upon consideration, such as employee services, has not yet been received. Nonvested shares cannot be sold. The restriction on sale of nonvested shares is due to the forfeitability of the shares if specified events occur (or do not occur).

Option. Unless otherwise stated, a call option that gives the holder the right to purchase shares of common stock from the reporting entity in accordance with an agreement upon payment of a specified amount. Options include, but are not limited to, options granted to employees and stock purchase agreements entered into with employees. Options are considered securities. See Call option.

Performance condition. A condition affecting the vesting, exercisability, exercise price, or other pertinent factors used in determining the fair value of an award that relates to both of the following:

An employee's rendering service for a specified (either explicitly or implicitly) period of time
Achieving a specified performance target that is defined solely by reference to the employer's own operations (or activities).

Attaining a specified growth rate in return on assets, obtaining regulatory approval to market a specified product, selling shares in an initial public offering or other financing event, and a change in control are examples of performance conditions. A performance target also may be defined by reference to the same performance measure of another entity or group of entities. For example, attaining a growth rate in earnings per share (EPS) that exceeds the average growth rate in EPS of other entities in the same industry is a performance condition. A performance target might pertain either to the performance of the entity as a whole or to some part of the entity, such as a division or an individual employee.

Probable. The future event or events are likely to occur.

Public entity. An entity that meets any of the following criteria:

Has equity securities that trade in a public market, either a stock exchange (domestic or foreign) or in an over-the-counter market, including securities quoted only locally or regionally
Makes a filing with a regulatory agency in preparation for the sale of any class of equity securities in a public market
Is controlled by an entity covered by the preceding criteria—that is, a subsidiary of a public entity is itself a public entity.

An entity that has only debt securities trading in a public market (or that has made a filing with a regulatory agency in preparation to trade only debt securities) is not a public entity.

Purchased call option. A contract that allows the reporting entity to buy a specified quantity of its own stock from the writer of the contract at a fixed price for a given period. See Call option.

Related parties. These include:

Affiliates of the entity
Entities for which investments in their equity securities would be required, absent the election of the fair value option under the Fair Value Option Subsection of Section 825-10-15, to be accounted for by the equity method by the investing entity
Trusts for the benefit of employees, such as pension and profit-sharing trusts that are managed by or under the trusteeship of management
Principal owners of the entity and members of their immediate families
Management of the entity and members of their immediate families
Other parties with which the entity may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests
Other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests.

Reload feature and reload option. A reload feature provides for automatic grants of additional options whenever an employee exercises previously granted options using the entity's shares, rather than cash, to satisfy the exercise price. At the time of exercise using shares, the employee is automatically granted a new option, called a reload option, for the shares used to exercise the previous option.

Replacement award. An award of share-based compensation that is granted (or offered to grant) concurrently with the cancellation of another award.

Requisite service period. The period or periods during which an employee is required to provide service in exchange for an award under a share-based payment arrangement. The service that an employee is required to render during that period is referred to as the requisite service. The requisite service period for an award that has only a service condition is presumed to be the vesting period, unless there is clear evidence to the contrary. If an award requires future service for vesting, the entity cannot define a prior period as the requisite service period. Requisite service periods may be explicit, implicit, or derived, depending on the terms of the share-based payment award.

Restricted share. A share for which sale is contractually or governmentally prohibited for a specified period of time. Most grants of shares to employees are better termed “nonvested shares” because the limitation on sale stems solely from the forfeitability of the shares before employees have satisfied the necessary service or performance condition(s) to earn the rights to the shares. Restricted shares issued for consideration other than employee services, on the other hand, are fully paid immediately. For those shares, there is no period analogous to a requisite service period during which the issuer is unilaterally obligated to issue shares when the purchaser pays for those shares, but the purchaser is not obligated to buy the shares. The term restricted shares refers only to fully vested and outstanding shares whose sale is contractually or governmentally prohibited for a specified period of time. Vested equity instruments that are transferable to an employee's immediate family members or to a trust that benefits only those family members are restricted if the transferred instruments retain the same prohibition on sale to third parties. See Nonvested shares.

Restriction. A contractual or governmental provision that prohibits sale (or substantive sale by using derivatives or other means to effectively terminate the risk of future changes in the share price) of an equity instrument for a specified period of time.

Securities and Exchange Commission (SEC) registrant. An entity (or an entity that is controlled by an entity) that meets any of the following criteria:

It has issued or will issue debt or equity securities that are traded in a public market (a domestic or foreign stock exchange or an over-the counter market, including local or regional markets).
It is required to file financial statements with the SEC.
It provides financial statements for the purpose of issuing any class of securities in a public market.

Service condition. A condition affecting the vesting, exercisability, exercise price, or other pertinent factors used in determining the fair value of an award that depends solely on an employee rendering service to the employer for the requisite service period. A condition that results in the acceleration of vesting in the event of an employee's death, disability, or termination without cause is a service condition.

Service inception date. The date at which the requisite service period begins. The service inception date usually is the grant date, but the service inception date may differ from the grant date (see Example 6 [see ASC 718-10-55-107]).

Settlement of an award. An action or event that irrevocably extinguishes the issuing entity's obligation under a share-based payment award. Transactions and events that constitute settlements include the following:

Exercise of a share option or lapse of an option at the end of its contractual term
Vesting of shares
Forfeiture of shares or share options due to failure to satisfy a vesting condition
An entity's repurchase of instruments in exchange for assets or for fully vested and transferable equity instruments.

The vesting of a share option is not a settlement because the entity remains obligated to issue shares upon exercise of the option.

Share-based payment arrangement. An arrangement under which either of the following conditions is met:

One or more suppliers of goods or services (including employees) receive awards of equity shares, equity share options, or other equity instruments
The entity incurs liabilities to suppliers that meet either of the following conditions:
1. The amounts based, at least in part, on the price of the entity's shares or other equity instruments. (The phrase at least in part is used because an award may be indexed to both the price of the entity's shares and something other than either the price of the entity's shares or a market, performance, or service condition.)
2. The awards require or may require settlement by issuance of the entity's shares.

The term shares includes various forms of ownership interest that may not take the legal form of securities (for example, partnership interests), as well as other interests, including those that are liabilities in substance but not in form. Equity shares refers only to shares that are accounted for as equity. Also called share-based compensation arrangements.

Share-based payment transaction. A transaction under a share-based payment arrangement, including a transaction in which an entity acquires goods or services because related parties or other holders of economic interest in that entity awards a share-based payment to an employee or other supplier of goods or services for the entity's benefit. Also called share-based compensation transactions.

Share option. A contract that gives the holder the right, but not the obligation, either to purchase (to call) or to sell (to put) a certain number of shares at a predetermined price for a specified period of time. Most share options granted to employees under share-based compensation arrangements are call options, but some may be put options.

Share unit. A contract under which the holder has the right to convert each unit into a specified number of shares of the issuing entity.

Short-term inducement. An offer by the entity that would result in modification of an award to which an award holder may subscribe for a limited period of time.

Suspense shares. The shares initially held by the employee stock ownership plan in a suspense account are called suspense shares. Suspense shares are shares that have not been released, committed to be released, or allocated to participant accounts. Suspense shares generally collateralize employee stock ownership plan debt.

Tandem award. An award with two or more components in which exercise of one part cancels the other(s).

Terms of a share-based payment award. The contractual provisions that determine the nature and scope of a share-based payment award. For example, the exercise price of share options is one of the terms of an award of share options. As indicated in ASC 718-10-25-5, the written terms of a share-based payment award and its related arrangement, if any, usually provide the best evidence of its terms. However, an entity's past practice or other factors may indicate that some aspects of the substantive terms differ from the written terms. The substantive terms of a share-based payment award as those terms are mutually understood by the entity and a party (either an employee or a nonemployee) who receives the award, provide the basis for determining the rights conveyed to a party and the obligations imposed on the issuer, regardless of how the award and related arrangement, if any, are structured. See ASC 718-10-30-5.

Time value. The portion of the fair value of an option that exceeds its intrinsic value. For example, a call option with an exercise price of $20 on a stock whose current market price is $25 has intrinsic value of $5. If the fair value of that option is $7, the time value of the option is $2 ($7 − $5).

Top-up shares. Top-up shares are shares or cash that an employer contributes to an employee stock ownership plan because the fair value of the shares released is less than the employer's liability for a particular benefit, such as a savings plan match.

Vest. To earn the rights to. A share-based payment award becomes vested at the date that the employee's right to receive or retain shares, other instruments, or cash under the award is no longer contingent on satisfaction of either a service condition or a performance condition. Market conditions are not vesting conditions.

The stated vesting provisions of an award often establish the requisite service period, and an award that has reached the end of the requisite service period is vested. However, as indicated in the definition of requisite service period, the stated vesting period may differ from the requisite service period in certain circumstances. Thus, the more precise (but cumbersome) terms would be options, shares, or awards for which the requisite service has been rendered and end of the requisite service period.

Volatility. A measure of the amount by which a financial variable such as a share price has fluctuated (historical volatility) or is expected to fluctuate (expected volatility) during a period. Volatility also may be defined as a probability-weighted measure of the dispersion of returns about the mean. The volatility of a share price is the standard deviation of the continuously compounded rates of return on the share over a specified period. That is the same as the standard deviation of the differences in the natural logarithms of the stock prices plus dividends, if any, over the period. The higher the volatility, the more the returns on the shares can be expected to vary—up or down. Volatility is typically expressed in annualized terms.

CONCEPTS, RULES, AND EXAMPLES

Accounting for Share-Based Payments

Under ASC 718, one must use fair value to measure the cost of all share-based payment plans. There is still an optional exception available for nonpublic companies, where measures of stock price volatility required to apply the normal fair value approach simply do not exist, but under such circumstances a modified fair value model is prescribed, where an industry group-based surrogate for the entity's stock price volatility is employed. Thus, all stock-based compensation arrangements, where equity instruments are issued to employees, will result in compensation cost that is measured using a variant of the fair value model.

There are several ways to calculate the fair value of stock-based compensation arrangements. Lattice models provide greater flexibility than the Black-Scholes-Merton model for including or excluding variables, or changing variable parameters, from one period to the other. ASC 718 does not require the use of lattice-type models, of which the binomial model is the most widely employed, but the advantages of such approaches are worthwhile.

In determining the fair value of share options, all the features and attributes of the options must be taken into consideration, including the expected volatility of the underlying equity instrument.

In addition, ASC 718 requires that excess tax benefits be reported as a financing cash inflow rather than as a reduction of taxes paid. This is more consistent with the view that the issuance of employee stock option shares is part of the capital raising process, and the tax advantages attendant to this are equivalently part of that same process.

The business combinations codification, ASC 805, reinforces ASC 718 by requiring that an acquiring entity use ASC 718 to measure the liability associated with the replacement of an acquiree's share-based payment awards with its own share-based payment awards.

ASC 718: Detailed Explanation

ASC 718 broadly addresses share-based payments. It covers plans for employees that convey shares of the employer's stock, derivatives (such as options) related to the employer's shares, or cash in amounts tied to the value of the employer's shares. All share-based plans are considered compensatory unless the benefit to employees is no greater than that which is available to shareholders generally. The benefit to recipients is assessed based both on the discount from market price and the number of shares they are eligible to buy. Consequently, virtually all plans will be considered compensatory for accounting purposes, including employee stock purchase plans that are noncompensatory under the federal tax laws.

Additionally, ASC 718 describes (1) the prescribed pattern of compensation cost recognition, (2) the accounting for employee stock purchase plans, and (3) accounting for the income tax effects of share-based transactions. It also requires that excess tax benefits be reported in the cash flow statement as a financing activity, rather than as an operating activity (these are currently reported as a reduction of income taxes paid).

Scope.

ASC 718 applies to

Public and nonpublic companies, and
Accounting for all share-based awards to employees, including employee stock purchase plans.

ASC 718 does not apply to

Accounting for ESOP transactions, or
Awards to nonemployees, with an exception made in the case of awards to nonemployee members of the board of directors in their capacity as directors.

These exclusions will reportedly be taken up in a later phase of FASB's project on equity-based compensation arrangements.

Measurement of compensation cost from share-based payment arrangements with employees.

The objective is to estimate, as of the grant date, the fair value of the award that an employee earns as a result of requisite service and satisfying vesting requirements. The estimate of fair value would reflect transferability and other restrictions if they are in effect when the award vests. Compensation cost is to be recognized only for those awards that vest (which obviously demands that estimates be made).

Classifying awards as liabilities or equity. ASC 718 requires that the classification criteria of ASC 480 be applied in determining whether an instrument granted to an employee is a liability or equity. In particular, some stock-based compensation awards that call for settlement by issuing an entity's own equity instruments may be classified as liabilities if they meet the criteria of ASC 480.
Valuation models. In the absence of an observable market price for an award—often the reality for employee share options—reporting entities are now required to use a valuation method that takes into account the factors set forth in the standard.
While ASC 718 does not dictate a valuation model, reportedly FASB believes and prefers that most companies will use the binomial or other so-called lattice models of value, rather than a closed-form model such as the Black-Scholes-Merton. The binomial model is favored, however, because it accommodates more potential postvesting behaviors than the closed-form models.

Binomial or other lattice models value options by constructing lattices or trees that represent different possible stock prices at different future points in time. The value of the option is determined at each node or branch of the tree. To determine these values, companies need to develop information about expected volatility, dividends, and risk-free rates that will apply at each of the possible branches or nodes of the model. In addition, information about employee postvesting behavior is needed to determine likely exercise dates. Note that under ASC 718 it is necessary to use expected volatility of share prices.
Liability-classified awards. The provisions dealing with share-based payments that involve liabilities, rather than equity, are affected by the issuance of ASC 480. Certain share-based payments create liabilities under ASC 480, (e.g., awards that result in the issuance of mandatorily redeemable shares, or those that require cash settlements or give the holders the right to demand cash, as do some stock appreciation rights). Liability-classified awards are to be remeasured at fair value each reporting period. Prior to vesting, the cumulative compensation costs would equal the proportionate amount of the award earned to date, and thus the periodic compensation cost would reflect both the passage of time (service period) and change in the fair value of the ultimate award. Subsequent to vesting, any further change in fair value would be recorded as a charge against earnings.
The use of grant date to fix the value of equity-based awards and settlement date to fix the value of liability-based awards, may seem inconsistent and/or confusing.

FASB presents a rather detailed explanation for its decisions in the standard, but essentially the logic is that to recognize changes in compensation based on post-grant-date changes to the value of the underlying equity would be equivalent to recognizing changes in the value of the entity's own equity shares in earnings, which is prohibited under GAAP. Also, grant date is when the parties (the entity and its employees) have fixed the terms of their arrangement, which provides a meaningful measure of the cost to be incurred by the entity. This differs importantly from the situation with equity-based compensation that is classified as a liability because it is to be settled for cash (e.g., cash stock appreciation rights, or SARs). In that scenario, the entity is obligated to distribute assets, and the relevant measure of compensation cost, ultimately, is the amount of assets disbursed.
Equity-classified awards. Equity-classified awards that are publicly traded and have observable market prices are to be valued using the market price. Few, if any, employee stock compensation awards (i.e., employee stock options) would have this characteristic, however. If not publicly traded, equity-classified awards are valued using a model such as the binomial or the Black-Scholes-Merton.
Valuation for graded-vesting awards. Companies that grant awards with graded vesting are to elect whether to measure the awards as if it were a cliff-vested award, or alternatively whether they are to be treated as several separate awards. If the former is chosen, the amount expensed each year would be the pro rata portion of compensation cost determined with reference to the entire package. If the latter approach is selected, each separately vesting portion will be valued and the associated compensation cost will be accrued over the term until that portion vests.
Measurement alternatives for nonpublic companies. Nonpublic companies must now choose to use either continually updated intrinsic values or fair values to measure share-option or liability-classified awards. Note that no such choice would be available for nonvested or vested stock awards, which are to be measured using grant-date fair values.
If a nonpublic reporting entity chooses to use the intrinsic value alternative, the intrinsic value of an equity-classified award will have to be reestimated each reporting period. However, if a company uses the fair value alternative no reestimation is required, which could reduce fluctuations in reported earnings. If nonpublic companies choose the fair value approach, they will not later be able to return to the use of intrinsic value, because fair value is deemed preferable for purposes of applying ASC 250 (accounting changes).

While fair value is to be determined as of grant date, in practice there has been some ambiguity regarding the precise definition of this term. ASC 718 does set forth criteria for determining that a share-based payment award has been granted. One of the criteria is a mutual understanding by the employer and employee of the key terms and conditions of a share-based payment award. However, the “mutual” aspect may not occur until some time after the formal grant, when actual communications between employer and employee are held, sometimes not until, for example, a regularly scheduled performance review that might not occur for weeks or months thereafter. To address these practical concerns, ASC 718-10-25-5 holds that, assuming all other criteria in the grant date definition have been met, a mutual understanding of the key terms and conditions of an award to an individual employee is presumed to exist at the date the award is approved in accordance with the relevant corporate governance requirements (that is, by the board or management with the relevant authority), if both the following conditions are met:

The award is a unilateral grant and, therefore, the recipient does not have the ability to negotiate the key terms and conditions of the award with the employer, and
It is expected that the key terms and conditions of the award will be communicated to an individual recipient within a relatively short time period from the date of approval.

Recognizing compensation.

Vesting can be based on a service condition, performance condition, or a combination of both.

Service conditions are requirements to achieve a specified duration of employment (e.g., number of years' continuous full-time service).
Performance conditions are requirements to achieve company-specific operating or financial goals (e.g., net income over $3 million).

Compensation cost is to be recognized based on the actual number of awards that eventually vest. Estimates are used to make accruals each period, and adjustments are made based on current estimates of expected future vesting until the actual number of awards that vest are known.

Under provisions of ASC 718, compensation cost for equity-based awards is to be measured at the grant date and not subsequently revised (apart from recognizing changed likelihood of forfeitures).

Market conditions affect the exercisability of an award, but not its vesting. ASC 718 defines a market condition as an exercisability requirement based on achieving a specified share price (e.g., reaching a market price of $22 per share before exercise is allowed). Market conditions can affect the grant-date fair value, and hence the compensation expense to be recognized by the reporting entity. If an employee forfeits an award because a market condition is not satisfied, compensation previously accrued is not reversed, unlike what is done in the event of ordinary forfeitures, which necessitate reversal of previously accrued compensation cost (or, equivalently, adjustment of compensation cost prospectively until the vesting date).

Under provisions of ASC 718, compensation cost for liability-based awards will be measured at the exercise or settlement date, but compensation is estimated at each reporting date from grant date to exercise or settlement date.

Modified awards.

The incremental compensation cost resulting from a modification of an award will be measured as the excess of the fair value of the modified award over the fair value of the original award measured immediately prior to the modification. Modifications can occur because of repricing, extending the life, or changing the vesting condition of the award. Cancellations of existing awards and concurrent replacement with new ones have to be accounted for as modifications. In practice, modifications will rarely result in recognized compensation costs less than the fair value of the award at the grant date, but this could conceivably result if the original service or performance vesting conditions were not expected to be satisfied at the modification date.

Accounting for Employee Stock Options under ASC 718

Under ASC 718, fair value accounting must be applied in measuring compensation expense. Ideally, fair value would be market-observed. An observable market price, if available for an option with similar features, should be used as the estimate of fair value of the employee option. However, in most cases, due to the nature of employee stock options (which lack exchangeability, etc.), observable market prices will not be available. Therefore, the reporting entity will have to estimate the fair value of the employee share option using a valuation model that meets the requirements of ASC 718. The valuation model takes into account the following factors, at a minimum:

Exercise price of the option
Expected term of the option, taking into account several things including the contractual term of the option, vesting requirements, and postvesting employee termination behaviors (The SEC states in 718-10-S99 that a registrant cannot use an expected term that is shorter than the vesting period.)
Current price of the underlying share
Expected volatility of the price of the underlying share (According to the SEC in 718-10-S99, a registrant may consider historical volatility in determining expected volatility, which in turn should take into consideration historical volatility over a period generally commensurate with the expected or contractual option term, as well as regular intervals for price observations. A registrant can also ignore a period of historical volatility if it can support a conclusion that the period is not relevant to estimating expected volatility due to nonrecurring historical events. The SEC would also not object to the use of an industry sector index to determine the expected volatility of its share price.)
Expected dividends on the underlying share
Risk-free interest rate(s) for the expected term of the option.

In practice, there are likely to be ranges of reasonable estimates for expected volatility, dividends, and option term. The closed-form models, of which Black-Scholes (now Black-Scholes-Merton) is the most widely regarded, are predicated on a set of deterministic assumptions that remain invariate over the full term of the option. In the real world, this condition is almost always not met. For this reason, current thinking is that a lattice model, of which the binomial model is an example, would be preferred. Lattice models explicitly identify nodes, such as the anniversaries of the grant date, at each of which new parameter values can be specified (e.g., expected dividends can be independently defined each period).

If a reporting entity changes from the BSM model to a binomial model, the change will be deemed a change in accounting estimate, not a change in accounting principle. A change from a binomial model back to a less desirable BSM model is to be discouraged, but apparently not prohibited if use of BSM or a similar closed-form model is supportable. The presumption is that moving from a binomial model to the BSM model would not be well received.

Other features that may affect the value of the option include changes in the issuer's credit risk, if the value of the awards contains cash settlement features (i.e., if they are liability instruments). Also, contingent features that could cause either a loss of equity shares earned or a reduction of realized gains from sale of equity instruments earned, such as a clawback feature (for example, where an employee who terminates the employment relationship and begins to work for a competitor is required to transfer to the issuing enterprise shares granted and earned under a share-based payment arrangement—see the illustrations in ASC 718) would be factors affecting the valuation model.

Market, performance, or service conditions may affect vesting. An award becomes vested at the date the employee's right to receive or retain shares no longer has any of these conditions. Vesting may be conditional on satisfying two or more conditions. Regardless of the conditions that must be satisfied, the existence of a market condition requires recognition of compensation cost if service has been rendered, even if the market condition is never satisfied.

The definition of an employee used in ASC 718 is that given by IRS Ruling 87-41. In addition, ASC 718 requires that nonemployee directors, acting in their role as members of the company's board of directors, be treated as employees if they were elected by the shareholders or appointed to the board and will be subject to election at the next shareholder election. Any awards granted to these individuals for their service as directors would be considered to be employee compensation.

The grant date is defined as the date when the employer and employee have a mutual understanding of the key terms and conditions of the share-based compensation arrangement and all necessary authorizations of those conditions have occurred. The service inception date is the first day of the requisite service period. Compensation cost is attributed over the service period.

If a given option plan involves the payment of compensation to the employees, such compensation cost should be recognized in the period(s) in which the services being compensated are performed. If the grant is unconditional, which means it effectively is in recognition of past services rendered by the employees and does not depend on the rendering of further service, then compensation is reported in full in the period of the grant. If the stock options are granted before the service inception date, compensation cost should be recognized over the periods in which the performance is scheduled to occur. Whether compensation cost is recognized ratably over the periods or not is a function of the vesting provisions of the plan. If the plan provides for cliff vesting, compensation will be accrued on an essentially straight-line basis, while if it provides for graded vesting, the pattern of recognition is subject to election and may be more complex. The accounting for graded vesting plans under ASC 718 represents a change from current practice.

Option fair value calculations.

Before presenting specific examples of accounting for stock options, simple examples of calculating the fair value of options using both the Black-Scholes-Merton and the binomial/lattice methods are provided. First, an example of the Black-Scholes-Merton closed-form model is provided.

Black-Scholes-Merton actually computes the theoretical value of a so-called European call option, where exercise can occur only on the expiration date. American options, which include most employee stock options, can be exercised at any time until expiration. The value of an American-style option on dividend paying stocks is generally greater than a European-style option, since preexercise the holder does not have a right to receive dividends that are paid on the stock. (For non-dividend-paying stocks, the value of American and European options will tend to converge.) Black-Scholes-Merton ignores dividends, but this is readily dealt with, as shown below, by deducting from the computed option value the present value of expected dividend stream over the option holding period.

Black-Scholes-Merton also is predicated on constant volatility over the option term, which available evidence suggests may not be a wholly accurate description of stock price behavior. On the other hand, the reporting entity would find it very difficult, if not impossible, to compute differing volatilities for each node in the lattice model described later in this section, lacking a factual basis for presuming that volatility would increase or decrease in specific future periods.

The Black-Scholes-Merton model:

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The Black-Scholes-Merton valuation is illustrated with the following assumed facts; note that dividends are ignored in the initial calculation, but will be addressed once the theoretical value is computed. Also note that volatility is defined in terms of the variability of the entity's stock price, measured by the standard deviation of prices over, say, the past three years, which is used as a surrogate for expected volatility over the next twelve months.

Example—Determining the fair value of options using the Black-Scholes-Merton model

Black-Scholes-Merton is a closed-form model, meaning that it solves for an option price from an equation. It computes a theoretical call price based on five parameters—the current stock price, the option exercise price, the expected volatility of the stock price, the time until option expiration, and the short-term risk-free interest rate. Of these, expected volatility is the most difficult to ascertain. Volatility is generally computed as the standard deviation of recent historical returns on the stock. In the following example, the stock is currently selling at $40 and the standard deviation of prices (daily closing prices can be used, among other possible choices) over the past several years was $6.50, yielding an estimated volatility of $6.50/$40 = 16.25%.

Assume the following facts:

S =	$40
t =	2 years
K =	$45
r =	3% annual rate
s =	standard deviation of percentage returns = 16.25% (based on $6.50 standard deviation of stock price compared to current $40 price)

From the foregoing data, all of which is known information (the volatility, s, is computed or assumed, as discussed above), the factors d₁ and d₂ can be computed. The cumulative standard normal variates (N) of these values must then be determined (using a table or formula), following which the Black-Scholes-Merton option value is calculated, before the effect of dividends. In this example, the computed amounts are:

N(d₁) =	0.2758
N(d₂) =	0.2048

With these assumptions the value of the stock options is approximately $2.35. This is derived from the Black-Scholes-Merton as follows:

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The foregone two-year stream of dividends, which in this example are projected to be $0.50 annually, have a present value of $0.96. Therefore, the net value of this option is $1.39 ($2.35 − .96).

Example—Determining the fair value of options using the binomial/lattice model

In contrast to the Black-Scholes-Merton, the binomial/lattice model is an open form, inductive model. It allows for multiple (theoretically, unlimited) branches of possible outcomes on a “tree” of possible price movements and induces the option's price. As compared to the Black-Scholes-Merton approach, this relaxes the constraint on exercise timing. It can be assumed that exercise occurs at any point in the option period, and past experience may guide the reporting entity to make certain such assumptions (e.g., that one-half the options will be exercised when the market price of the stock reaches 150% of the strike price, etc.). It also allows for varying dividends from period to period.

It is assumed that the common (Cox, Ross, and Rubinstein) binomial model will be used in practice. To keep this preliminary example relatively simple in order to focus on the concepts involved, a single-step binomial model is provided here for illustrative purposes. Assume an option is granted on a $20 stock that will expire in one year. The option exercise price equals the stock price of $20. Also, assume there is a 50% chance that the price will jump 20% over the year and a 50% chance the stock will drop 20%, and that no other outcomes are possible. The risk-free interest rate is 4%. With these assumptions there are three basic calculations.

Plot the two possible future stock prices.
Translate these stock prices into future options values.
Discount these future values into a single present value.

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In this case, the option will only have value if the stock price increases, and otherwise the option would expire worthless and unexercised. In this simplistic example, there is only a 50% chance of the option having a value of $3.84, and therefore the option is worth $1.92 at grant date.

The foregoing was a simplistic single-period, two-outcome model. A more complicated and realistic binomial model extends this single-period model into a randomized walk of many steps or intervals. In theory, the time to expiration can be broken into a large number of ever-smaller time intervals, such as months, weeks, or days. The advantage is that the parameter values (volatility, etc.) can then be varied with greater precision from one period to the next (assuming, of course, that there is a factual basis upon which to base these estimates). Calculating the binomial model, then, involves the same three calculation steps. First, the possible future stock prices are determined for each branch, using the volatility input and time to expiration (which grows shorter with each successive node in the model). This permits computation of terminal values for each branch of the tree. Second, future stock prices are translated into option values at each node of the tree. Third, these future option values are discounted and added to produce a single present value of the option, taking into account the probabilities of each series of price moves in the model.

Example—Multiperiod option valuation using binomial model

Consider the following example of a two-period binomial model. Again, certain simplifying assumptions will be made so that a manual calculation can be illustrated (in general, computer programs will be necessary to compute option values). Eager Corp. grants 10,000 options to its employees at a time when the market price of shares is $40. The options expire in two years; expected dividends on the stock will be $0.50 per year; and the risk-free rate is currently 3%, which is not expected to change over the two-year horizon. The option exercise price is $43.

The entity's past experience suggests that, after one year (of the two-year term) elapses, if the market price of the stock exceeds the option exercise price, one-half of the options will be exercised by the holders. The other holders will wait another year to decide. If at the end of the second year—without regard to what the stock value was at the end of the first year—the market value exceeds the exercise price, all the remaining options will be exercised. The workforce has been unusually stable and it is not anticipated that option holders will cease employment before the end the option period.

The stock price moves randomly from period to period. Based on recent experience, it is anticipated that in each period the stock may increase by $5, stay the same, or decrease by $5, with equal probability, versus the price at the period year-end. Thus, since the price is $40 at grant date, one year hence it might be either $45, $40, or $35. The price at the end of the second year will follow the same pattern, based on the price when the first year ends.

Logically, holders will exercise their options rather than see them expire, as long as there is gain to be realized. Since dividends are not paid on options, holders have a motive to exercise earlier than the expiration date, which explains why historically one-half the options are exercised after one year elapses, as long as the market price exceeds the exercise price at that date, even though the exercising holders risk future market declines.

The binomial model formulation requires that each sequence of events and actions be explicated. This gives rise to the commonly seen decision tree representation. In this simple example, following the grant of the options, one of three possible events occur: (1) the stock price rises $5 over the next year, (2) it remains constant, or (3) it falls by $5. Since these outcomes have equal a priori probabilities, p = 1/3 is assigned to each outcome of this first year event. If the price does rise, one half the option holders will exercise at the end of the first year, to reap the economic gain and capture the second year's dividend. The other holders will forego this immediate gain and wait to see what the stock price does in the second year before making an exercise decision.

If the stock price in the first year either remains flat or falls by $5, no option holders are expected to exercise. However, there remains the opportunity to exercise after the second year elapses, if the stock price recovers. Of course, holding the options for the second year means that no dividends will be received.

The cost of the options granted by Eager Corp., measured by fair value using the binomial model approach, is computed by the sum of the probability-weighted outcomes, discounted to present value using the risk-free rate. In this example, the rate is expected to remain at 3% per year throughout the option period, but it could be independently specified for each period—another advantage the binomial model has over the more rigid Black-Scholes-Merton. The sum of these present value computations measures the cost of compensation incorporated in the option grant, regardless of what pattern of exercise ultimately is revealed, since at the grant date, using the available information about stock price volatility, expected dividends, exercise behavior and the risk-free rate, this best measures the value of what was promised to the employees.

The following graphic offers a visual representation of the model, although in practice it is not necessary to prepare such a document. The actual calculations can be made by computer program, but to illustrate the application of the binomial model, the computation will be presented explicitly here. There are four possible scenarios under which, in this example, holders will exercise the options, and thus the options will have value. All other scenarios (combinations of stock price movements over the two-year horizon) will cause the holders to allow the options to expire unexercised.

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First, if the stock price goes to $45 in the first year, one-half the holders will exercise at that point, paying the exercise price of $43 per share. This results in a gain of $2 ($45 − $43) per share. However, having waited until the first year-end, they lost the opportunity to receive the $0.50 per share dividend, so the net economic gain is only $1.50 ($2.00 − $0.50) per share. As this occurs after one year, the present value is only $1.50 × 1.03⁻¹ = $1.46 per share. When this is weighted by the probability of this outcome obtaining (given that the stock price rise to $45 in the first year has only a 1/3 probability of happening, and given further that only one-half the option holders would elect to exercise under such conditions), the actual expected value of this outcome is [(1/3)(1/2)($1.46)] = $0.24. More formally,

[(1/3)(1/2)($2.00 − $0.50)] × 1.03⁻¹ = $0.2427

The second potentially favorable outcome to holders would be if the stock price rises to $45 the first year and then either rises another $5 the second year or holds steady at $45 during the second year. In either event, the option holders who did not exercise after the first year's stock price rise will all exercise at the end of the second year, before the options expire. If the price goes to $50 the second year, the holders will reap a gross gain of $7 ($50 − $43) per share; if it remains constant at $45, the gross gain is only $2 per share. In either case, dividends in both the first and second years will have been foregone. To calculate the compensation cost associated with these branches of the model, the first-year dividend lost must be discounted for one year, and the gross gain and second-year dividend must be discounted for two years. Also, the probabilities of the entire sequence of events must be used, taking into account the likelihood of the first year's stock price rise, the proclivity of holders to wait for a second year to elapse, and the likelihood of a second-year price rise or price stability. These computations are shown below.

For the outcome if the stock price rises again:

[(1/3)(1/2)(1/3)]{[($7.00) × 1.03⁻²] − [($0.50) × 1.03⁻¹] − [$0.50 × 1.03⁻²]} = [0.05544]{$6.59 − $0.48 −$0.47} = $0.31276

For the outcome if the stock price remains stable:

[(1/3)(1/2)(1/3)]{[($2.00) × 1.03⁻²] − [($0.50) × 1.03⁻¹] − [($0.50) × 1.03⁻²]} = [0.05544]{$1.88 − $0.48 −$0.47} = $0.05147

The final, favorable outcome for holders would occur if the stock price holds constant at $40 the first year but rises to $45 the second year, making exercise the right decision. Note that none of the holders would exercise after the first year given that the price, $40, was below exercise price. The calculation for this sequence of events is as follows:

[(1/3)(1/3)]{[($2.00) × 1.03⁻²] − [($0.50) × 1.03⁻¹] − [($0.50) × 1.03⁻²]} = [0.1111]{$1.88 − $0.48 − $0.47} = $0.10295

Summing these values yields $0.709879 ($0.2427 + $0.31276 + $0.05147 + $0.10295), which is the expected value per option granted. When this per-unit value is then multiplied by the number of options granted (10,000), the total compensation cost to be recognized, $7,098.79, is derived. This would be attributed over the required service period, which is illustrated later in this section. (In the facts of this example, no vesting requirements were specified; in such cases, the employees would not have to provide future service in order to earn the right to the options, and the entire cost would be recognized upon grant.)

A big advantage of the binomial model is that it can value an option that is exercisable before the end of its term (an American-style option). This is the style that employee share-based compensation arrangements normally take. FASB prefers the binomial model, because it can incorporate the unique features of employee stock options. Two key features that FASB recommends that companies incorporate into the binomial model are vesting restrictions and early exercise. Doing so, however, requires that the reporting entity had previous experience with employee behaviors (e.g., gained with past employee option programs) that would provide it with a basis for making estimates of future behavior. In some instances, there will be no obvious bases upon which such assumptions can be developed.

The binomial model permits the specification of more assumptions than does the Black-Scholes-Merton, which has generated the perception that the binomial will more readily be manipulated so as to result in lower option values, and hence lower compensation costs, than the Black-Scholes-Merton. But this is not necessarily the case: switching from Black-Scholes-Merton to the binomial model can increase, maintain, or decrease the option's value. Having the ability to specify additional parameters, however, probably does give management greater flexibility and, accordingly, will present additional challenges for the auditors who must attest to the financial statement effects of management's specification of these variables.

To calculate option values using either the Black-Scholes-Merton or binomial models without the aid of computer software would be very difficult, but hardly impossible. Fortunately, reasonably priced software is now widely available to perform these calculations. What managers must do is determine the assumptions that should be used to create an unbiased, representative value of the options. We now turn to specific examples of accounting for share-based compensation as required under ASC 718.

NOTE: All examples ignore deferred tax effects for simplicity.

Example—Accounting for stock options for a publicly held entity

Options are granted to corporate officers to purchase 10,000 shares of $1 par stock at a price of $50 per share, which is equal to the current market price. The options may not be exercised until three years from the grant date (that is, they vest in three years). ASC 718 provides that public companies must use the fair value method to measure compensation cost associated with share-based equity programs. This means that it will be necessary to determine the expected volatility of the share price over the service period. Assume that either a lattice model or Black-Scholes-Merton has been used and that the fair value per option has been determined to be $7. Past experience suggests that forfeitures will be 4% per year, so that compensation cost under ASC 718 will be based on the net number of shares expected to vest, given as (.96 × .96 × .96 =) .885. Total share-based compensation will be ($7 × .885 × 10,000 =) $61,932. The annual entries would be:

If all the options are subsequently exercised, the derived proceeds of the stock issuance will be $566,000. The entry would be

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Example—Accounting for stock options for a nonpublic entity that is not an SEC registrant and elects the calculated value method

Options are granted to corporate officers to purchase 10,000 shares of $1 par stock at a price of $50 per share, which is the current market price. The options may not be exercised until three years from the grant date (that is, they vest in three years). ASC 718 provides that nonpublic companies may use a surrogate measure of fair value, called calculated fair value, when it is not possible to determine the expected volatility of the share price over the service period. Essentially, this requires that a relevant industry sector–specific index be identified for use in place of the volatility factor in the normal Black-Scholes-Merton or lattice models.

In this case, the reporting entity identifies such an index and proceeds to compute a value of $6.60 per option. The total compensation cost thereby calculated, $66,000, is accrued over the three-year period ratably. The annual entries would be:

If all the options are subsequently exercised, the derived proceeds of the stock issuance will be $566,000. The entry would be:

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Example—Accounting for stock options for a nonpublic entity that is not an SEC registrant and elects the intrinsic value method

As discussed above, nonpublic companies are permitted to elect the intrinsic value method of accounting for the cost of share-based compensation plans. Using this method, the intrinsic value must be measured at each reporting date, and used to accrue compensation cost for the period.

Assume again that options are granted to corporate officers to purchase 10,000 shares of $1 par stock at a price of $50 per share, which is the current market price. The options may not be exercised until three years from the grant date. These options have no intrinsic value ($50 − $50 = 0) at the grant date. The intrinsic value method and fair value method require the same measurement date (grant date) for shares and similar instruments whose fair value does not differ from their intrinsic value (and instruments with no time value). This example assumes there is no forfeiture before vesting occurs. Because of the company's decision to use the intrinsic value method, its share options are recognized at intrinsic value at each reporting date through the date of settlement, and the periodic adjustment in intrinsic value, prorated over the service period, is included in compensation cost for that period. Consequently, the compensation cost recognized each year of the three-year requisite service period will vary based on changes in the share option's intrinsic value. For example, assume that at the end of the first year, stock is valued at $55 per share, resulting in a ($55 − $50) $5 intrinsic value per share—thus, a total value of $50,000 for the award. In the first year, the compensation cost would be 1/3 of $50,000. This entry would be:

Assume now that at the end of the second year the stock is valued at $53 per share, and thus the intrinsic value is ($53 − $50 =) $3 per share option, for an intrinsic value of the award of $30,000 at that date. The intrinsic value of the award has declined by ($50,000 − $30,000 =) $20,000. Because services for two of the three years of service have now been rendered, the company must recognize cumulative compensation cost for two-thirds of the intrinsic value of the award, or ($30,000 × 2/3 =) $20,000. Because the company already recognized $16,667 in the first year, only $3,333 in further compensation cost is to be recognized in the second.

Note that, depending on the change in intrinsic value from the prior reporting date, the current period could be credited with negative compensation expense. To illustrate, assume instead that at the end of the second year, the stock is valued at $52 per share, for an intrinsic value of $20,000. Since two years of the three-year service period have elapsed, the cumulative compensation cost to be recognized is ($20,000 × 2/3 =) $13,333. Because the company already recognized $16,667 in the first year, negative $3,333 compensation cost is to be recognized in the second year.

Example of fair value accounting for stock options with cliff vesting—measurement and grant date the same

Options are granted to corporate officers to purchase 10,000 shares of $1 par stock at a price of $50 per share, which is also the market price on the grant date. The options may not be exercised until three years from the grant date, and only if the employees remain employed through that date. The company has no reason to expect that any of the options will be forfeited by the employees to whom they are granted (i.e., after the completion of the service period). The company uses the following assumptions to apply the binomial model:

Share options granted	10,000
Employees granted options	100
Expected forfeitures per year	3.0%
Share price at the grant date	$50
Exercise price	$50
Par value per share	$1
Number of years to vest	3 years
Contractual term (CT) of options	10 years
Risk-free interest rate over CT	2 to 5%
Expected volatility over CT	40 to 700%
Expected dividend yield	1.0%
Suboptimal exercise factor	2

Given these assumptions needed to construct a binomial model to value the options, a fair value estimate of approximately $6 per option is determined (details not presented). It is estimated that 3% of employees will turn over each year during the service period. The number of share options expected to vest is estimated at the grant date of (10,000 × .97 × .97 × .97 =) $9,127. The estimated fair value of the award on the grant date would be (9,127 × $6 =) $54,762. The entry to record the compensation cost [($54,762 ÷ 3) = $18,254] in each of the three years is:

If in the first year the actual forfeiture rate is 6% instead of the 3% expected rate, and management determines that the forfeiture rate should change to 6%, then in the second year an adjustment would be needed. The revised estimate of the number of options expected to vest is (10,000 × .94 × .94 × .94 =) 8,306. The revised cumulative compensation cost would be (8,306 × $6 =) $49,836. The cumulative adjustment to reflect adjustment of the forfeiture rate is the difference between two-thirds of the revised cost of the award and the cost already recognized in the first year. The related entries and computations are:

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At the end of the third year, the company would examine actual forfeitures and make any necessary adjustments to reflect compensation cost for the number of shares actually vested. Assuming vesting equals expected, the journal entry at exercise of the options would be:

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The difference between the market price of the shares and the exercise price at the date of exercise is deductible for tax purposes because the share options do not qualify as incentive stock options. The realized tax benefits result in a credit to additional paid-in capital and a reduction in the deferred tax asset.

The statement of cash flows, as amended by ASC 718, requires that the cash flow benefit that results from the tax benefit be classified as a cash inflow from financing activities and a cash outflow from operating activities.

Example of accounting for stock options with graded vesting—measurement and grant date the same

In a shift from the position espoused in the exposure draft, ASC 718 requires each reporting entity to make a policy decision about whether to recognize compensation cost for an award with only service conditions that has a graded vesting schedule either (1) on a straight-line basis over the requisite service period for each separately vesting portion of the award as if the award was, in-substance, multiple awards, or (2) on a straight-line basis over the requisite service period for the entire award (that is, over the requisite service period of the last separately vesting portion of the award). However, ASC 718 requires that the amount of compensation cost recognized at any date must at least equal the portion of the grant-date value of the award that is vested at that date.

For this example, assume the basic facts from the prior example, but now the 10,000 options vest according to a graded schedule of 25% for the first and second years of service and 50% for the third year. Using the 3% annual employee turnover forfeiture rate, 300 options are expected to never vest, leaving 9,700 options expected to vest at 25% of the award—or 2,425 options vested. In the second year, it is anticipated that another 3% will be forfeited, leaving 9,409 to vest at 25% of the award—or 2,352 options vested. In the final year another 3% are forfeited and vesting occurs at 50% of the remaining—or 4,563 vested options. (Data upon which value per option amounts are derived are not presented in this example.)

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The value of the option is determined separately for different vesting periods after which exercise might occur. Thus, the compensation cost associated with the options is less in the earlier years, as reflected in the table above. Compensation cost is recognized over the periods of requisite service during which each group of share options is earned. In the first year, therefore, compensation cost is [$12,125 + ($12,936 ÷ 2) + ($27,378 ÷ 3) = ] $27,719. The journal entry for the first year would be:

Accounting for Stock Appreciation Rights and Tandem Plans

Background.

The accounting for variable stock plans is addressed by ASC 718. Under this standard, share-based compensation arrangements that provide for cash payments or that give to grantees the choice of receiving stock or cash in settlement are accounted for as liabilities, not equity, as compensation is accrued over the requisite service period. Publicly held entities are required to measure liabilities incurred to employees in share-based payment transactions at fair value. Nonpublic entities, on the other hand, may elect to measure their liabilities to employees incurred in share-based payment transactions at their intrinsic value.

Whether measured at fair value (using an option-pricing model such as Black-Scholes-Merton or binomial) or at intrinsic value (measured simply as the excess of market or other defined value over reference value as of the date of the statement of financial position), these amounts are updated as of each financial reporting date. Thus, when share-based compensation plans give rise to liabilities, these are continually updated as to value, whereas under the fair value measurement approach to equity instruments arising from such compensation plans, value is assessed as of the grant date in most instances, never later to be revised.

Determining whether a share-based payment should be categorized as a liability requires close attention to the guidance of ASC 718, which invokes the requirements of ASC 480. It states that, for example, a puttable share (giving the grantee the right to demand the issuer to redeem it) awarded to an employee as compensation is to be classified as a liability if either (1) the repurchase feature permits the employee to avoid bearing the risks and rewards normally associated with equity share ownership for a reasonable period of time from the date the requisite service is rendered and the share is issued, or (2) it is probable that the employer would prevent the employee from bearing those risks and rewards for a reasonable period of time from the date the share is issued. For this purpose, a period of six months or more is defined as a reasonable period of time.

Note that a share that is mandatorily or optionally redeemable upon the occurrence of a defined contingency, such as an initial public offering by the grantor entity, would not make this share-based payment a liability, unless the contingency were deemed probable of occurrence within a reasonable period of time. For example, if the entity had begun the regulatory approval and registration process, this might trigger liability classification.

ASC 718 stipulates that options or similar instruments on shares are to be categorized as liabilities if the underlying shares are classified as liabilities (which is logical) or if the reporting entity is subject to a requirement to transfer cash or other assets under any circumstances in order to settle the option. However, ASC 718-10-35-15 holds that a cash settlement feature that can be exercised only upon the occurrence of a contingent event that is outside the employee's control does not meet the condition set forth by ASC 718.

Furthermore, an option or similar instrument that is first classified as equity, but subsequently becomes a liability because the contingent cash settlement event becomes probable of occurring, is to be accounted for similar to a modification from an equity to liability award. Accordingly, on the date the contingent event becomes probable of occurring (thus triggering reclassification of the award as a liability) the entity recognizes a share-based liability equal to the portion of the award attributed to past service (reflecting any provision for acceleration of vesting) multiplied by the award's fair value on that date. To the extent the liability equals or is less than the amount previously recognized in equity, that is the amount transferred from equity to the liability. To the extent that the liability exceeds the amount previously recognized in equity, the excess is recognized as additional compensation cost in that period. The total recognized compensation cost for an award with a contingent cash settlement feature must at least equal the fair value of the award at the grant date.

A puttable share that does not meet either of the foregoing conditions is to be classified as equity. Options or similar instruments on shares are to be classified as liabilities if (1) the underlying shares are classified as liabilities, or (2) the reporting entity can be required under any circumstances to settle the option or similar instrument by transferring cash or other assets. If the entity grants an option to an employee that, upon exercise, would be settled by issuing a mandatorily redeemable share, the option must be classified as a liability.

According to ASC 718, a freestanding financial instrument ceases to be subject to this standard and becomes subject to the recognition and measurement requirements of ASC 480 or other applicable GAAP when the rights conveyed by the instrument to the holder are no longer dependent on the holder being an employee of the entity. Thus, once the requisite service has been provided and the grantee has, say, elected to receive stock or another instrument, guidance on the appropriate accounting would be given by ASC 480. For example, a mandatorily redeemable share becomes subject to ASC 480 or other applicable GAAP when an employee (1) has rendered the requisite service in exchange for the instrument and (2) could terminate the employment relationship and receive that share. Similarly, a share option or similar instrument that is not transferable and whose contractual term is shortened upon employment termination continues to be subject to ASC 718 until the rights conveyed by the instrument to the holder are no longer dependent on the holder being an employee of the entity (generally, when the instrument is exercised).

An award may be indexed to a factor beyond the entity's share price. ASC 718 holds that, if that additional factor is not a market, performance, or service condition, the award is to be classified as a liability. In such a case, the additional factor is to be reflected in estimating the fair value of the award. An example of such a circumstance would be an award of options whose exercise price is indexed to the market price of the commodity (e.g., wheat or gold). Another example: a share award that will vest based on the appreciation in the price of that commodity; such an award is indexed to both the value of that commodity and the issuing entity's shares. If an award is so indexed, the relevant factors (expected commodity price change) should be included in the fair value estimate of the award. ASC 718 states that the award would be classified as a liability even if the entity granting the share-based payment instrument were a producer of the commodity whose price changes are part or all of the conditions that affect an award's vesting conditions or fair value.

Stock appreciation rights and similar instruments.

Stock Appreciation Rights (SARs) are a popular means of providing share-based compensation awards to employees. Essentially, the bonus arrangement is to pay employees the amount by which the share price at a defined date (say, three years hence) exceeds what it was at the measurement date. Depending on the plan, the award may be payable in the entity's shares, in cash, or in either at the option of the grantee. If the optionee has the right to demand cash or the SAR is payable in cash only, the grantor entity recognizes a liability for the accrued compensation.

If the entity is publicly held, measurement at fair value is required, with revaluation at each reporting date through final settlement. For nonpublicly held entities, an election must be made to use fair value or intrinsic value—but again, in either case, remeasurement at each reporting date until final settlement is required.

Example of accounting for SARs—Share-based liabilities

The company grants SARs with the same terms and conditions used in the examples above. Each SAR entitles the holder to receive an amount in cash equal to the increase in value of one share of company stock over $50. Using the same assumptions and option-pricing model, the fair value of the share options is computed to be $6 per SAR (details not presented). The awards cliff-vest at the end of three years. The forfeitures are expected to be 3% a year: thus, SARs expected to vest are (10,000 × .97 × .97 × .97 =) 9,127, and the fair value of the award at the beginning of the first year is (9,127 × $6 =) $54,762. It is assumed that expected and actual forfeitures are the same. The share-based compensation liability at the end of the first year is ($54,762 ÷ 3 =) $18,254. The journal entry for the first year is:

Under ASC 718, compensation arising in connection with share-based liabilities must be valued at fair value at each reporting date. At the end of the second year, the estimated fair value is assumed to be $10 per SAR. Therefore, the award's fair value is (9,270 × $10 =) $91,270, and the corresponding liability at that date is ($91,270 × 2/3 =) $60,847 because service has now been provided for two of the three years required. Compensation cost recognized for the award in the second year is ($60,847 − $18,254 =) $42,593. The journal entry for the second year is:

At the end of the third year, the estimated fair value is assumed to be $9 per SAR. Therefore, the award's fair value is (9,270 × $9 =) $83,430 and the corresponding liability at that date is the same because the award is fully vested. Compensation cost for the third year is ($83,430 − $42,593 − $18,254 =) $22,583. The journal entry for the third year is:

Stock SARs.

If the SARs were to be redeemed (only) in common stock of the entity, “Stock rights outstanding” (a paid-in capital account) would replace the liability account in the above entries. Fair value would be assessed at the grant date (measurement date), and then not altered over the time to final settlement, consistent with how other equity compensation awards are measured under ASC 718.

Tandem plans.

Often stock option plans and SAR are joined in tandem plans, under the terms of which the exercise of one automatically cancels the other. In the absence of evidence to the contrary, however, the presumption is that the SAR, not the options, will be exercised. If the SAR portion of the tandem plan is such that classification as a liability is required, as described above, then remeasurement through the settlement date is required.

Modifications of Awards of Equity Instruments

In some instances awards previously issued but not yet settled are later modified in ways that may or may not change the classification (e.g., liability to equity). ASC 718 requires that modification of the terms or conditions of an equity award is to be treated as an exchange of the original award for a new award. In substance, the event is accounted for as if the entity repurchases the original instrument by issuing a new instrument of equal or greater value, incurring additional compensation cost for any incremental value.

Incremental compensation cost in such circumstances is to be measured as the excess, if any, of the fair value of the modified award—determined in accordance with the provisions of ASC 718—over the fair value of the original award immediately before its terms are modified. These measures are to be based on the share price and other pertinent factors at the modification date. Any effect of the modification on the number of instruments expected to vest is also to be reflected in determining incremental compensation cost. The estimate at the modification date of the portion of the award expected to vest may also be subsequently adjusted, if necessary, as estimates or experience may dictate prior to final settlement.

The total recognized compensation cost for an equity award will at least equal the fair value of the award at the grant date, except for those instances when, at the date of the modification, the performance or service conditions of the original award are not expected to be satisfied. Accordingly, the total compensation cost measured at the date of a modification will be (1) the portion of the grant-date fair value of the original award for which the requisite service is expected to be rendered (or has already been rendered) at that date, plus (2) the incremental cost resulting from the modification.

The change in compensation cost for an equity award measured at intrinsic value (if elected for nonpublicly held companies) is to be measured by comparing the intrinsic value of the modified award, if any, with the intrinsic value of the original award, if any, immediately before the modification.

If a modification results in what had been a liability award becoming an equity award, the amount of the fair value (or implicit value, if such were elected as a measurement strategy by a nonpublic company), the amount becomes “fixed” as of the modification date, and this will differ from the amount that would have been recognized had the award been classified as equity at inception. On the other hand, if an award was originally equity and after modification becomes a liability, to the extent that the liability equals or is less than the amount recognized in equity for the original award, the offsetting debit is a charge to equity. To the extent that the liability exceeds the amount recognized in equity for the original award, the excess is recognized as compensation cost.

Example of a liability-to-equity modification

Assume that a cash payment SAR plan is created, with features similar to earlier examples (10,000 SARs granted, with three-year term, 3% forfeiture per year expectation). The share-based compensation liability is (9,127 × $10 ÷ 3 =) $30,423, based on reporting date fair value measurement. On January 1 of the second year, the company modifies the SAR by replacing the cash-settlement feature with a net-share settlement feature, which converts the award from a liability award to an equity award, because there is no longer an obligation to settle for cash, or an obligation classified as a liability per ASC 480. For the equity award, fair value is to be measured at grant date only. Per ASC 718, when no other terms are altered by the modification, the fair value at the modification date is used to measure the amount of the total compensation to be awarded in equity instruments.

The journal entry to reclassify the liability to equity would be:

Since no further remeasurement would be permitted, additional compensation cost of $30,423 per year will be recorded at the end of the second and third years, with credits to the additional paid-in capital account. In this example, total compensation cost was greater because the effective measurement date was the end of the first year, but it could also have happened that compensation cost was reduced for the same reason.

Example of an equity-to-liability modification

Assume that a SAR plan, payable in shares, is created, with features similar to earlier examples (10,000 SARs granted, with three-year term, 3% forfeiture per year expectation). Using a valuation model, the amount of compensation is determined to be $40,000 in total, computed at grant date. At the end of the first year, compensation expense and additional paid-in capital of $13,333 is recorded, based on completion of one of the three years' required service. At that date the fair value of the SARs amount to $45,000. If the plan is amended at the start of the second year to offer grantees the right to a cash payout, the equity must be reclassified to liability and the value must be remeasured at each reporting date. At the time of modification, since the fair value exceeds what had been accrued, additional compensation cost must be recognized. The entry would be:

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On the other hand, if the fair value of the liability for the SAR at the modification date had been only $30,000, the difference between the amount accrued in the first year and the modified value would have been left in the additional paid-in capital account. The entry follows:

A share-based payment award may also be modified as a result of an acquisition. ASC 805 describes the accounting for several instances where an acquirer exchanges its share-based payment awards for rewards held by the employees of an acquiree. If the acquiring entity replaces an acquiree's share-based awards when it is not obligated to do so, then all of the fair-value replacement cost is to be recognized as postcombination compensation expense. If the acquirer's replacement award requires some additional employee service, a portion of the replacement award's fair-value cost should be attributed to postcombination compensation expense.

Accounting for Income Tax Effects of Share-Based Compensation

Under US income tax laws, the amount that is deductible in connection with a share-based compensation arrangement is limited to intrinsic value. This is generally defined by the amount by which the fair (market) value of the compensation exceeds the amount paid, if any, by the recipient, at the exercise date (not the grant date). For example, if an option grant is made when the underlying stock is trading at $34, and the option is exercisable at that price, and it is later exercised when the stock is trading at $55, the deductible amount will be $21 per share, based on the intrinsic value of the option as of the exercise date, which becomes observable only upon actual exercise. However, under ASC 718, compensation expense will have been recognized for the fair value of the option when granted, computed using either the Black-Scholes-Merton or lattice model as illustrated earlier in this section. Depending on other facts, that option value may have been $5, $10, or some other amount per share; it would not, however, be the same as the intrinsic amount other than by sheer coincidence.

Additionally, the timing of the compensation expense recognition will differ between tax and financial reporting. For financial reporting, expense is recognized over the expected service period, as explained above. For tax, the expense is deductible at the actual exercise date. Options not exercised (i.e., forfeited) thus never give rise to taxable deductions, whereas under GAAP the compensation cost would have been expensed.

It is thus inevitable that both the timing and the amounts of compensation expense related to share-based compensation will differ. To the extent that these are timing differences, interperiod tax allocation (deferred tax accounting) will be appropriate. The cumulative amount of compensation cost that will result in a tax deduction is to be considered a deductible temporary difference. This applies both for instruments classified as equity and for those categorized as liabilities. Any compensation cost recognized in the financial statements for instruments that will not result in a tax deduction should not be considered to result in a deductible temporary difference under ASC 740.

In general, the fair value of stock-based compensation, which is computed at grant date and recognized over the vesting period as compensation cost in the financial statements, will not be tax deductible currently, giving rise to deferred tax benefits measured with reference to the book compensation expense recognized. Ultimately, when the employee's options vest and are exercised, the company is able to deduct the intrinsic value, measured by the spread between fair value on exercise date and exercise price. To the extent this exceeds the fair value of the stock-based compensation recognized as GAAP-basis expense, the tax effect of that excess tax deduction is treated as a contribution to paid-in capital. If (less likely, but quite possible) the tax deduction is lower than the compensation already recognized for financial reporting purposes, this shortfall in tax benefits is additional compensation cost—in effect, the employer entity incurred higher compensation cost in connection with the share option program since it received less than the anticipated tax benefits related thereto.

If the exercise results in a tax deduction prior to the actual realization of the related tax benefit—because the entity, for example, has a net operating loss carryforward—then the tax benefit and the credit to additional paid-in capital for the excess deduction would not be recognized until that deduction reduces taxes payable.

However, to the extent that the excess stems from a reason other than changes in fair value of the entity's shares between the measurement date for accounting purposes (grant date, generally) and the later measurement date for income tax purposes (exercise date), that portion of the tax effect is to be reported in income (i.e., in the tax provision). For example, a change in the tax rate could result in such a difference.

Differences between the deductible temporary difference that arises and the tax deduction that would have resulted based on the current fair value of the entity's shares should not be considered either in measuring the gross deferred tax asset or in determining the need for a valuation allowance created by the application of ASC 718.

If there should be an excess of cumulative compensation cost recognized for financial reporting purposes over the tax deductible amount (e.g., due to options lapsing unexercised), the write-off of the deferred tax asset (net of valuation allowance, if any) is first to be offset against any remaining additional paid-in capital from previous awards accounted for under the fair value method; any remaining excess should be recognized in income (the tax provision). The additional paid-in capital available to absorb tax effects is referred to as the APIC pool.

Consistent with the treatment of excess tax deductions for share-based compensation as being essentially similar to capital contributions, ASC 718 requires that the realized tax benefit applicable to the excess of the deductible amount over the compensation cost recognized under GAAP be reported in the cash flow statement as both a cash inflow from financing activities and a cash outflow from operating activities. This is required whether the cash flow statement is being presented under the direct method or the indirect method.

It is possible that an entity has issued dividends to employees holding nonvested shares, nonvested share units, or outstanding options. If so, it should recognize the income tax benefit as an increase to additional paid-in-capital, but only if the deduction reduces income taxes payable.

Other ASC 718 Matters

The most common share-based compensation arrangements have been presented. Other more complicated awards have been developed. Some of these are presented below. For a further discussion with examples refer to ASC 718.

Share options with performance conditions and/or market conditions.

Some option arrangements provide grants of share options with a performance condition. These types of plans permit employees to vest in differing numbers of options depending on the increase in market value of one of the company's products (or other condition) over a vesting period. These performance conditions can include factors such as market share increases, passing clinical trials, and other performance goals.

In addition to performance conditions, market conditions may also affect the option arrangements. These would include such things as indexing share prices to an industry group and the exercise price of options tied to this index. Therefore, the exercise price could go up or down depending on how the index performs. Arrangements exist for share units to have both performance and market conditions. These are accounted for in the same way as other options. The difficulty is in determining the fair values, as there are more factors contributing to uncertainty. These factors can, however, be modeled in a binomial valuation model.

Other modifications of share option awards.

A company may modify the vesting conditions of an award. The accounting treatment for these modifications depends on the probability of vesting under the original conditions or the modified conditions. Other modifications are whether SAR will be settled in cash or equity or some combination, different from the original plan assumptions. A modification of vesting conditions is accounted for based on the principles set forth in ASC 718. Illustrations of different potential modifications are illustrated in ASC 718-10-55.

Other types of share-based compensation awards covered in ASC 718.

Other share awards that ASC 718 addresses are outlined below.

Share award with a clawback feature. These are restrictions on the employee's subsequent employment with a direct competitor, that if violated, cause the exemployee to return the value of the share award to the company.
Tandem plan—share options or cash SAR. Employees are granted awards with two separate components, in which exercise of one component cancels the other.
Tandem plan—phantom shares or share options. Similar to the plan above, but the employee's choice of which component to exercise depends on the relative value of the components when the award is exercised.
Look-back share options. Share options awarded under Section 423 of the Internal Revenue Code, which provides that employees will not be immediately taxed on the difference between the market price of the stock and a discounted purchase price if certain requirements are met.
Employee share purchase plans. Employee share purchase plans are not compensatory if their terms are no more favorable than those available to all holders of the same class of shares and if all employees that meet limited employment qualifications may participate in the plan on an equitable basis.
Escrowed share arrangements. The SEC has stated in ASC 718-10-S99 that it considers the release of shares from an escrowed share arrangement based on performance-related criteria to be compensation.
Book value share purchase plans (nonpublic companies only). Companies with two classes of stock—one of which is available to all employees and the price is based on book value.
Voluntary (or involuntary) change to fair-value-based method (nonpublic companies only). A nonpublic company elects as accounting policy the intrinsic value method and grants share awards to employees. Subsequently, the accounting for the value of these awards is changed to fair value because it is preferable under GAAP. Estimating grant date values is very difficult in hindsight. Therefore, these companies do not have to retrospectively apply fair value methods to unvested awards at the date of change.
Certain instruments become subject to ASC 480. Certain instruments will become subject to ASC 480 when an employee could terminate service and receive or retain the fair value of the instrument for the remaining contractual term of that instrument.

Reload feature and reload option.

A reload feature provides for automatic grants of additional options whenever an employee exercises previously granted options using the entity's shares, rather than cash, to satisfy the exercise price. At the time of exercise using shares, the employee is automatically granted a new option, called a reload option, for the shares used to exercise the previous option.

Example of reload options

Mr. Jones has 6,000 shares of ABC Company's $1 par value common stock, as well as options to purchase an additional 8,000 shares at an exercise price of $12. It will cost Jones $96,000 to exercise the options. The current market price of ABC stock is $16, so he trades in his existing 6,000 shares, which have a market value of $96,000, to purchase 8,000 shares with his options. The option plan has a reload feature, so ABC issues 6,000 replacement options (matching the number of shares traded in), for which the exercise price is set at the current market value of $16. ABC records the stock sale with the following entry:

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Jones elects to exercise his options when the market value of ABC Company's stock reaches $24. At an exercise price of $16, it will again cost Jones $96,000 to purchase shares. At the current market price of $24, Jones can trade in 4,000 of his existing shares to acquire new shares. However, he chooses to trade in only 3,000 shares and pay for the remaining options with cash. ABC records the stock sale with the following entry:

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The reload feature still applies, but now ABC only issues 3,000 replacement options, which matches the number of shares Jones traded in to acquire new shares. The new options are assigned at an exercise price of $24, to match the market value on the grant date.

Effect of employer payroll taxes.

ASC 718-10-25-22 discusses (1) when a liability for employer payroll taxes on employee stock compensation should be recognized in the employer's financial statements and (2) how that liability should be measured. A liability for employee payroll taxes on stock compensation should be recognized and measured on the date of the event triggering the measurement and payment of the tax to the taxing authority (which would generally be the exercise date).

Payments in lieu of dividends on options.

Normally dividends are not paid on shares that have not been issued; thus, unexercised options do not gain the benefit of any dividends declared on the underlying stock. However, an entity can choose to pay dividend equivalents on options.

Since the codification requires, effectively, that forfeitures be estimated and accounted for over the service period, in the author's view it would be consistent to likewise charge retained earnings only for the estimated number of options to be exercised (changing from period to period, if a lattice model is used), with the remainder of any payments in lieu of dividends charged currently to compensation expense.

Example of payments in lieu of dividends on options

Gary Ironworks declares dividends of $2 per share of common stock. Its president, Mr. Jones, has 5,000 unvested options. Gary's board of directors chooses to pay Mr. Jones dividends on the 5,000 shares represented by the unvested options, on the assumption that all the options will vest. The resulting entry follows:

There are several other employees who have 20,000 unvested options. The board also declares dividends for these options, with the provision that dividends paid can be retained even if the associated options do not vest. The controller expects that only 70% of the options will vest, so she creates the following entry to charge the other 30% of the dividends to compensation expense:

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Disclosure requirements under ASC 718.

For a company to achieve the objectives of ASC 718, the minimum information needed to achieve disclosure objectives are set forth below.

A description of the share-based payment arrangements, including the terms of the awards. A nonpublic company should disclose its policy for measuring compensation cost.
The most recent income statement should provide the number and weighted-average exercise prices of the share options and equity instruments.
Each year for which an income statement is provided, a company should provide the weighted-average grant-date fair value of equity options and the intrinsic value of options exercised during the year.
For fully vested share options and those expected to vest at date of the latest statement of financial position, the company should provide the number, weighted-average exercise price, aggregate intrinsic value, and contractual terms of options outstanding and currently exercisable.
If more than one share-based plan is in effect, the information should be provided separately for different types of awards.
For each year for which an income statement is provided, companies should provide the following:
- Companies that do not use the intrinsic value method should provide a description of the method of determining fair value and a description of the assumptions used.
- Total compensation cost for share-based payment arrangements, including tax benefits and capitalization of compensation costs, should be stated.
- Descriptions of significant modifications and numbers of employees affected should also be provided.
On the date of the latest statement of financial position, the total compensation cost related to nonvested awards not yet recognized and the period over which they are expected to be recognized.
The amount of cash received from exercise of share-based compensation and the amount of cash used to settle equity instruments should be disclosed.
Description of the company's policy for issuing shares upon share options exercise, including the source of the shares.

Accounting for Stock Issued to ESOPs

There has been a steady increase in the number of corporations that are entirely or partially employee-owned under terms of ESOPs. The accounting for ESOP is governed by ASC 718-40.

Depending on what motivated the creation of the ESOP (e.g., estate planning by the controlling shareholder, expanding the capital base of the entity, rewarding and motivating the work force), the sponsor's shares may be contributed to the plan in annual installments in a block of shares from the sponsor, or shares from an existing shareholder may be purchased by the plan.

ESOPs are defined contribution plans in which shares of the sponsoring entity are awarded to employees as additional compensation. Briefly, ESOPs are created by a sponsoring corporation which either funds the plan directly (unleveraged ESOP) or, more commonly, facilitates the borrowing of money either directly from an outside lender (directly leveraged ESOP) or from the employer, which in turn will borrow from an outside lender (indirectly leveraged ESOP).

Borrowings from outside lenders may or may not be guaranteed by the sponsor. However, since effectively the only source of funds for debt repayment are future contributions by the sponsor, GAAP requires that the ESOP's debt be considered debt of the sponsor even absent a guarantee.

When recording the direct or indirect borrowings by the ESOP as debt in the sponsor's statement of financial position, a debit to a contra equity account, not to an asset, is also reported. This is necessary since the borrowings represent a commitment (morally if not always legally) to make future contributions to the plan and this is certainly not a claim to resources. Significantly, this results in a “double hit” to the sponsor's statement of financial position (i.e., the recording of a liability and the reduction of net stockholders' equity), which is often an unanticipated and unpleasant surprise to plan sponsors. This contra equity account is referred to as “unearned ESOP shares” in accordance with provisions of ASC 718-40. If the sponsor itself lends funds to the ESOP without a “mirror loan” from an outside lender, this loan should not be reported in the employer's statement of financial position as debt, although the debit should still be reported as a contra equity account.

As the ESOP services the debt, using contributions made by the sponsor and/or dividends received on sponsor shares held by the plan, it reflects the reduction of the obligation by reducing both the debt and the contra equity account on its statement of financial position. Simultaneously, income and thus retained earnings will be impacted as the contributions to the plan are reported in the sponsor's current statement of earnings. Thus, the “double hit” is eliminated, but net worth continues to reflect the economic fact that compensation costs have been incurred.

The interest cost component of debt service must be separated from the remaining compensation expense. That is, the sponsor's income statement should reflect the true character of the expenses being incurred, rather than aggregating the entire amount into a category which might have been denoted as “ESOP contribution.”

In a leveraged ESOP, shares held serve as collateral for the debt and are not allocated to employees until the debt is retired. In general, shares must be allocated by the end of the year in which the debt is repaid. However, to satisfy the tax laws, the allocation of shares may take place at a faster pace than the retirement of the principal portion of the debt.

Under ASC 718-40, the cost of ESOP shares allocated is measured based upon the fair value on the release date for purposes of reporting compensation expense in the sponsor's income statements. This is in contradistinction to the actual historical cost of the shares to the plan.

Furthermore, dividends paid on unallocated shares (i.e., shares held by the ESOP) are not treated as dividends, but rather must be reported in the sponsor's income statement as compensation cost and/or as interest expense. Of less significance to nonpublic companies is the fact that under the new rules only common shares released and committed to be released are treated as being outstanding, with the resultant need to be considered in calculating both basic and diluted EPS.

Example of accounting for ESOP transactions

Assume that Intrepid Corp. establishes an ESOP, which then borrows $500,000 from Second Interstate Bank. The ESOP then purchases 50,000 shares of Intrepid no-par shares from the company; none of these shares are allocated to individual participants. The entries would be:

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The ESOP then borrows an additional $250,000 from the sponsor, Intrepid, and uses the cash to purchase a further 25,000 shares, all of which are allocated to participants.

Intrepid Corp. contributes $50,000 to the plan, which the plan uses to service its bank debt, consisting of $40,000 principal reduction and $10,000 interest cost. The debt reduction causes 4,000 shares to be allocated to participants at a time when the average market value had been $12 per share.

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Dividends of $.10 per share are declared (only the ESOP shares are represented in the following entry, but dividends are paid equally on all outstanding shares):

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Note that in all the foregoing illustrations the effect of income taxes is ignored. Since the difference between the cost and fair values of shares committed to be released is analogous to differences in the expense recognized for tax and accounting purposes with regard to stock options, the same treatment should be applied. That is, the tax effect should be reported directly in stockholders' equity, rather than in earnings.

Other Sources

*See ASC Location – Wiley GAAP* Chapter...**	For information on...
From ASC 718-10, Overall
ASC 505-10-25-3	An investor providing stock compensation on behalf of an investee
ASC 805-20-55-50 through 51	Accounting for contractual termination benefits and curtailment losses under employee benefit plans that will be triggered by the consummation of a business combination
ASC 815-40-15-15a	Equity-linked financial instruments issued to investors for purposes of establishing a market-based measure of the grant-date fair value of employee stock options
ASC 815-10-55-46 through 55-48	Stock options in an unrelated entity given to employees
ASC 718-40, Employee Stock Ownership Plans
ASC 718-740-25-6 and 718-740-45-6 and 45-7	Determining the accounting for the effect of income tax factors on employee stock ownership plans

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Table of Contents for 41 ASC 718 COMPENSATION—STOCK COMPENSATION

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41 ASC 718 COMPENSATION—STOCK COMPENSATION

PERSPECTIVE AND ISSUES

Subtopics

Scope and Scope Exceptions

Overview

DEFINITIONS OF TERMS

CONCEPTS, RULES, AND EXAMPLES

Accounting for Share-Based Payments

ASC 718: Detailed Explanation

Scope.

Measurement of compensation cost from share-based payment arrangements with employees.

Recognizing compensation.

Modified awards.

Accounting for Employee Stock Options under ASC 718

Option fair value calculations.

Accounting for Stock Appreciation Rights and Tandem Plans

Background.

Stock appreciation rights and similar instruments.

Stock SARs.

Tandem plans.

Modifications of Awards of Equity Instruments

Accounting for Income Tax Effects of Share-Based Compensation

Other ASC 718 Matters

Share options with performance conditions and/or market conditions.

Other modifications of share option awards.

Other types of share-based compensation awards covered in ASC 718.

Reload feature and reload option.

Effect of employer payroll taxes.

Payments in lieu of dividends on options.

Disclosure requirements under ASC 718.

Accounting for Stock Issued to ESOPs

Other Sources

Table of Contents for
41 ASC 718 COMPENSATION—STOCK COMPENSATION