A road map for share-based compensation: find the best strategy for rewarding employees.

EXECUTIVE SUMMARY

* Since FASB Statement no. 123(R) began requiring companies to recognize an expense equal to the grant-date fair value of options awarded as compensation, there has been a significant change in share-based payments to employees. Companies are taking a fresh look at the alternatives available to compensate employees and minimize the effect on financial statements.

* Share-based employee compensation awards are classified as either equity instruments or liability instruments. The measurement date for estimating the fair value of equity instruments is the grant date; the measurement date for liability instruments is the settlement date. Different rules also apply to public vs. private companies depending on the type of award instrument.

* Restricted stock and stock units are popular with public companies; stock options continue to be the most popular choice for private companies.

* When weighing the pros and cons of various compensation awards, CPAs should help companies consider factors such as the potential dilutive effect on earnings per share, the accounting costs of competing alternatives and the tax implications to both employer and employee.

* Since options have long been an attractive tool in recruiting and retaining employees, companies should keep employees' interests in mind as they consider the types of awards they grant as compensation. Companies should also consider vesting criteria, exercise period and overall employee eligibility.

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Before FASB issued Statement no. 123(R), Share-Based Payment, at-the-money options, with an exercise price equal to the market price on the grant date, were the most popular form of share-based compensation. Companies typically used the alternative intrinsic value method to value those options; with a grant-date intrinsic value of zero, the company recognized no compensation expense. Since the release of Statement no. 123(R), companies have had to recognize an expense equal to the option's grant-date fair value. This article summarizes the valuation requirements of Statement no. 123(R) and provides information CPAs can use to help management choose the best share-based strategy for compensating employees.

EQUITY AND LIABILITY AWARD INSTRUMENTS

Share-based compensation awards are classified as either equity instruments or liability instruments. Statement no. 123(R) provides criteria for the classification and guidance on applying FASB Statement no. 150, Accounting for Certain Instruments With Characteristics of Both Liabilities and Equity, to this issue.

Equity instruments require a company to issue equity shares to employees in a share-based payment arrangement. Common types of equity instruments include equity shares, share-settled stock units (also known as phantom stock), stock options and similar share-settled stock appreciation rights (share-settled SARs). Liability instruments generally require the entity to use cash or noncash assets to settle a share-based payment arrangement. The common liability instruments are cash-settled stock units and cash-settled SARs.

Although the best estimate of fair value for both types of awards is the observable price of identical or similar instruments in an active market, such information is generally not available. Consequently, companies need to estimate fair value. Statement no. 123(R) says the measurement date for equity instruments awarded to employees is the grant date; the measurement date for liability instruments is the settlement date. Because settlement occurs after the employee has rendered the services, companies must remeasure a liability instrument's grant-date fair value at each reporting date until all award units are settled--either by forfeiture, exercise or expiration.

VALUATION MEASUREMENT GUIDELINES 

Whether a company is public or private will determine how it measures the value of share-based employee compensation awards. Here are some guidelines CPAs can use to value employee compensation awards commonly granted by the two types of companies. (Statement no. 123(R) does not change the accounting guidance for share-based transactions with nonemployees as prescribed in Statement no. 123 and EITF Issue no. 96-18.)

EQUITY SHARES OR SHARE-SETTLED STOCK UNITS

Public entity. The fair value of equity shares or share-settled stock units awarded to public company employees is the grant-date market price. Nonvested shares are valued as if they were vested and issued on the grant date. For shares with a restriction on transferability after vesting, CPAs should include a discount reflecting that restriction in the estimated fair value.

Nonpublic entity. Due to the absence of an observable external market price for its shares, a nonpublic entity may use its internal price or a private transaction price if such information provides a reasonable basis to measure the grant-date fair value. Otherwise, CPAs can determine fair value using an appropriate valuation method. The 2004 AICPA Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, discusses three general approaches to valuation and various associated methods.

STOCK OPTIONS OR SHARE-SETTLED SARs

Public entity. Such companies must estimate the grant-date fair value of employee stock options and share-settled SARs using an option-pricing model or technique. The two most common are Black-Scholes-Merton (a closed-form option-pricing model) and a binomial model (a lattice option-pricing model). CPAs will encounter situations where a lattice model is more appropriate. (See resource box for a list of JofA articles on this and related subjects.) These option-pricing models use a probability-based mathematical formula designed to estimate the fair value of options at a given time. Estimated fair value is not a forecast of the actual future value.

Statement no. 123(R) does not state a preference for one model or technique as long as the one a company uses:

* Takes into account the exercise price; the expected term of the option; the current price, expected volatility and expected dividends of the underlying share; and the risk-free interest rate.

* Is generally accepted in the field of financial economics in theory and practice.

* Appropriately reflects the characteristics of the award instrument.

Estimating fair value involves making reasonable and supportable assumptions and judgments. Price valuation estimates should be performed by someone with the requisite expertise. Although FASB does not require that a third-party valuation professional perform the price modeling, companies often use one for this task.

In the case of a newly public entity that lacks sufficient historical information on its own stock price, CPAs can estimate the expected volatility using the average volatility of similar public entities--comparable in industry sector, size, stage of life cycle and financial leverage--together with its own internal data. For example, the Nasdaq Indexes section of the Nasdaq Web site (www.nasdaq.com/services/indexes/ default.aspx.) provides indexes, including some industry-specific ones. Each industry-specific index allows you to download to a spreadsheet a list of company names that make up the index, ticker symbols and descriptions filed with the SEC. CPAs can use this information to identify similar public entities.

Nonpublic entity. Such companies should estimate the fair value of stock options or share-settled SAPs using the same option-pricing techniques required for public entities. However, if the expected volatility of a nonpublic entity's share price cannot be reasonably estimated due to insufficient historical share information or because it is not possible to identify similar public entities, CPAs should use the historical volatility of an appropriate industry sector index. This is called the "calculated value" method. The NYSE Web site provides a list of 104 industry classification benchmark (ICB) subsectors (www.nyse.com/about/listed/industry. shtml). Dow Jones Indexes offers historical industry subsector index data with criteria specified by the user (www. djindexes.com/mdsidx/index.cfm?event =showtotalmarketindexdata).

CASH-SETTLED STOCK UNITS

Public and nonpublic entities. Both should measure the grant-date fair value of cash-settled stock units in the same manner as share-settled stock units described above, except subsequent remeasurement of the fair value is required at each reporting date until all award units are settled.

CASH-SETTLED SARs

Public entity. These companies should estimate the fair value of cash-settled SAPs in the same manner as sham-settled SAPS described above, except that subsequent remeasurement of the fair value is required at each reporting date until all award units are settled.

Nonpublic entity. To lower the implementation cost of the option grant, a nonpublic entity may elect either the fair value method (including the default calculated value method) or the intrinsic value method to estimate its liability award instruments. The entity should subsequently remeasure the liability using the same method at each reporting date until all award units are settled.

EXCEPTION

In rare circumstances, when the complexity of an award instrument's terms makes it impossible to reasonably estimate the fair value at the grant date, a company can use the intrinsic value method to measure and remeasure the award unit at each reporting date, even if it later becomes possible for the entity to reasonably estimate the fair value or the calculated value.

CURRENT TRENDS

Based strictly on the amount of work required to implement fair value accounting, it is clear equity instruments are a more attractive alternative than liability instruments for companies today because the latter require remeasurement at each reporting date. Within the equity instrument category, shares or stock units are more attractive than stock options or option-like instruments, as options require companies to apply onerous pricing models for grant-date fair value measurement.

Deloitte's 2005 Stock Compensation Survey said 75% of the public and private companies surveyed planned to cut back the number of stock options granted to minimize the expense they would have to recognize. The reduction would mostly target lower-level employees. Some 89% of public and 55% of private companies were considering alternative forms of equity-based compensation. Given all forms of equity-based compensation, the most popular choices mentioned by public companies were restricted stock or stock units with either a time-vested (52%) or performance-vested (40%) condition. At private companies, stock options continued to be the most popular choice, with either a time-vested (39%) or performance-vested (33%) condition.

It's difficult for private companies to use stock or stock units as award instruments since they impose a financial burden on employees, who must pay taxes when the shares vest. Employees may have difficulty raising cash for taxes on the vesting date with shares that are not publicly traded. On the other hand, employee stock options are attractive as they normally are taxed on the exercise or sale date, and the option holder controls the timing of these dates. Private company employees typically exercise options when the company undergoes an IPO, merger or buyout, at which time the shares have a ready market value.

FACTORS TO CONSIDER

In weighing the pros and cons of various employee compensation award instruments, CPAs should advise employers or clients to consider the following:

Accounting impact on financial statements. It's important for companies to understand how judgments and underlying assumptions affect fair value when using a pricing model or technique. One way to control the expense charge-off is to first estimate the fair value of the instrument, then work backward to decide the number of award units to grant to employees based on the amount of expense the company finds acceptable.

Potential dilutive effect on earnings per share, book value per share and ownership distribution. Existing shareholders--particularly those of public companies--typically are very concerned about the negative effect of this dilution.

Tax implications. The tax deductibility of share-based compensation expense by the employer mirrors the taxability to employees as ordinary income, both in timing and amount. That means the more attractive an instrument is to employees tax-wise, the less attractive it is to the employer in terms of deductibility.

What employees think. This group is typically most concerned about the income tax advantages and potential cash outlay of option alternatives.

Effectiveness vis-a-vis purpose. Most companies grant options to accomplish a specific purpose. Is the company using the award to be competitive in employee recruitment and retention or as motivation to achieve a particular performance goal? Companies can use award terms strategically by settling the obligation in shares only, in cash only, in shares or cash (a tandem award), or in shares and cash (a combination award). The company also can set service and performance conditions, length of vesting and exercise period, graded and nongraded vesting (also called graduated vesting and cliff vesting wherein vesting is completed in phases or entirely after a fixed time period) and employee eligibility criteria.

Valuation under IRC section 409A. This recent tax law change affects certain deferred compensation arrangements. One important IRS requirement for employees to receive favorable tax treatment for stock options and similar share-based awards is that the option exercise price must be equal to or higher than the grant-date fair value of the underlying share. Instead of management's good faith attempt--an acceptable practice in the past--section 409A requires private companies to use a "reasonable valuation method" to estimate the grant-date fair value of the underlying stock. CPAs should coordinate the valuation requirements of section 409A and Statement no. 123(R).

Valuation costs. Companies should evaluate both the external cost of professional services and the internal cost of identifying and accumulating the needed information for their chosen option valuation method. CPAs should be proactive in educating clients and employers on factors that drive up the cost of accounting for share-based compensation programs. For private companies, the cost of a business valuation--necessary for both section 409A and Statement no. 123(R)--and the cost of option-pricing modeling may be considerable. To control costs, companies can minimize the number of grant dates in a calendar year, grade the vesting period not more than once a year and keep the variety of options to a minimum. Companies should seek professional advice before adopting a compensation plan--particularly when they are in the start-up stage.

Internal controls and section 404 of Sarbanes-Oxley. The recent scandals involving the backdating of stock options to maximize executive pay call into question the effectiveness of internal controls and compliance with section 404. Backdating options could subject a company to legal action, sanctions and tax penalties. When assessing the effectiveness of internal controls, companies should make sure to include share-based employee compensation programs.

New models. In December, Google announced a new compensation program for its employees called transferable stock options. When options vest, employees can sell them online to the highest-bidding financial institution. Some believe such options are worth more to employees and will allow Google to issue fewer options. Compensation experts say compensation programs such as this one communicate more clearly to employees the value of the incentive the company has awarded them.

In January the SEC approved another market-based options model presented by Zions Bancorporation. The Zions model uses the public auctioning of tracking securities called Employee Stock Option Appreciation Rights Securities (ESOARS) to determine the fair value of underlying employee stock options. Reports in The Wall Street Journal and elsewhere indicate valuations using this new model may be lower than those produced by models such as Black-Scholes-Merton, thus reducing employers' share-based compensation expense.

Whether either of these new models, or similar ones, will become popular is yet to be seen, but they bear watching.

Practical Tips

* Many companies will find equity option instruments more attractive than liability instruments because equity instruments do not require remeasurement at each reporting date.

* To control the expense charge-off for a share-based compensation grant, first estimate the instrument's fair value, then work backward to decide the number of award units to grant based on the amount of expense the company finds acceptable.

* The more attractive an instrument is to employees tax-wise, the less attractive it is to the employer in terms of deductibility. Since employees are most concerned about the income tax advantages and potential cash outlay, consider these factors first if the company's primary goal in making option awards is to motivate employees.

Anne L. Leahey, CPA, is an assistant professor of accounting at the University of Texas at El Paso. Her e-mail address is [e-mail].

Raymond A. Zimmermann, Ph.D., is an associate professor of accounting at the University of Texas at El Paso. His e-mail address is [e-mail].