Fair value era.

FASB Statement No. 123(R), Share-Based Payment, has a single goal: to report the fair value of employee compensation paid in the form of stock options and other share-based payments in financial statements.

Some 800 public companies already use fair value. However, for years beginning after June 15, 2005, all public companies--other than small businesses--must do so. And all other public and private companies will use fair value for years beginning after Dec. 15, 2005.

While share-based payment arrangements include stock options, restricted and unrestricted stock, share appreciation rights and employee stock purchase plans, this article focuses on accounting for stock options.

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WHAT, AND WHEN, TO RECOGNIZE

The fair value method requires an issuer to recognize compensation for employee stock options as employees perform services to earn those options. The value of that compensation is determined on the option grant date. No further compensation is recognized once employees have earned the options, unless the options are modified.

For example, Entity X awards Jones 1,000 options Jan. 1, 2006, to acquire Entity X common stock. On that date, each option has a fair value of $10. Jones must remain an employee of Entity X for three years to exercise the options. Under FAS 123(R), Entity X recognizes $10,000 of compensation cost ratably over the three-year service period--if Jones remains with the company. If Jones leaves before vesting in the shares, and loses all of the options, Entity X recognizes no compensation cost. If Entity X has recognized a portion of the compensation cost prior to Jones' departure, then it must reverse that cost.

An issuer treats compensation cost recognized under the fair value method the same as cash compensation. That is, compensation cost arising from the issuance of stock options may be expensed or capitalized in the same way as cash compensation. Compensation cost is offset by an entry to paid-in capital. When a holder exercises options the issuer transfers a portion of paid-in capital to its outstanding stock account, but does not recognize any additional compensation cost.

The issuer ordinarily will receive a tax benefit from the issuance and exercise of stock options, and must estimate and account for that benefit in the same period that it recognizes compensation cost for financial reporting purposes. Until the actual tax benefit is known, the amount of accrued benefit (deferred tax asset) is based on the amount of compensation cost recognized for financial reporting purposes. Once the amount is known, an adjustment is made to match the accrued benefit to the actual benefit.

For example, if an issuer recognizes $10,000 of compensation cost in connection with the issuance of an option, and the issuer's tax rate is 35 percent, the issuer accrues a deferred tax asset of $3,500, and increases income with an associated tax benefit. The deferred tax asset remains on the books until the option is settled. The actual tax benefit, in most cases, will differ from the deferred tax asset. If the actual tax benefit is higher, then the difference is ordinarily recorded as additional paid-in capital. If lower, then the difference is either a reduction of paid-in capital or a current period expense, based on FAS 123(R).

FAIR VALUE

Under FAS 123(R), the fair value of a stock option is based on observable market prices, if they exist. However, usually there is no market price for employee options, so issuers calculate fair value using option-pricing models. A pricing model estimates fair value using six factors--stock price, exercise price, volatility, risk-free interest rate, dividends and option term--that interact to create value.

The stock price and option exercise price combine to create the intrinsic value of an option. For example, if the stock price is $110 and the option exercise price is $100, the intrinsic value is $10, which is the minimum value of the option.

The risk-free interest rate is the benefit received for owning rights in stock without having to pay cash to purchase the stock. If, for example, an individual holds an option to purchase stock, then the holder controls that stock without having to pay cash to buy it. The option confers upon the holder a benefit equal to the risk-free interest rate on the cash saved.

Stock volatility has value to an option holder because the holder benefits from stock increases without being hurt by stock decreases. For example, if a holder can buy stock at a price of $13, and the stock price varies between $8 and $18, the holder can earn $5, and cannot lose anything.

A dividend paid on optioned stock is a reduction of option value, if the option holder does not receive the dividend.

The longer the term of an option the more valuable it is. A longer term increases the benefit from control of the stock, and increases the chances of profiting from stock volatility.

Option pricing formulas, such as Black Scholes Merton or the binomial lattice, combine the values associated with the above factors to calculate fair value, using sophisticated mathematics. Until recently most public companies used BSM. However, the binomial lattice is gaining popularity among pricing experts because of its superior ability to account for unique factors of employee stock options, such as vesting periods and early exercise of options.

STOCK PRICE AND VOLATILITY

Once a company has the data, an option valuation is relatively easy using one of the pricing models. The question is, where to get the data?

Most of the information required is company specific, derived from analysis of trades in company stock. Public companies can usually determine stock price from the market, and calculate stock volatility by analyzing past trading in its stock, and adjusting for changing conditions expected in the future.

Private companies have limited information available. One of the most difficult things to do will be to obtain the current value of stock. A private company obtains stock value by appraisal. Employee options are ordinarily given on common stock.

For most private companies, common stock is never traded. If the company issues to outsiders it usually issues preferred stock. So there is ordinarily no independent price history for common stock. Some suggest the board of directors can set a price; others suggest a rule-of-thumb that bases the common stock price on the most recent issuance of preferred stock. There is no sanction for either of these methods.

In a 2004 practice aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, the AICPA recommends the method for valuing optioned stock: appraising the specific shares subject to option. Where a company has both common and preferred shares, the appraisal of the common shares should take into account the rights and preferences of the preferred shares, among other things.

Volatility is an important component of the value of a private company's options. Just as with public companies, the appraised value of a private company fluctuates over time, and this fluctuation, or volatility, is a key driver of stock option value. We cannot measure a private company's stock volatility directly because it does not trade. Therefore, under FAS 123(R), instead of using the volatility of its own stock, a private company uses, as a proxy, the volatility of a basket of publicly traded stocks of similar companies.

If a private company cannot determine volatility using either its own shares or the shares of similar companies, then it can use the volatility of a suitable industry index. When an industry index is used, the private company is using the "calculated" value method--an acceptable variation of the fair value method. This method is the same as fair value, except for the substitution of the volatility of an industry index for the volatility of the shares of similar companies.

WHEN OPTIONS CANNOT BE VALUED

Though rare, there will be times when both public and private companies cannot determine the fair value of options. When an issuer cannot determine fair value, the company can account for options using intrinsic value.

Under this method, the company calculates compensation based on the excess of the value of stock over the option exercise price on each reporting period. However, unlike the fair value method, where the value is determined only on the grant date, compensation recognized based on the intrinsic method is determined each reporting period until the options are settled.

TRANSITION RULES

Most stock options that predate the effective date of FAS 123(R) are subject to the new rules. However, the rules are modified slightly when applied to old options.

Under transition rules, FAS 123(R) applies to non-vested awards issued before its effective date. An issuer will recognize compensation cost in its financial statements for the non-vested portions of these awards as employees vest in the awards through the performance of services. Compensation cost is measured based on grant-date fair value, using the old rules of FAS 123.

Also, issuers have the option of restating certain prior financial statements to show the effect of expensing share-based payments.

OTHER INSTRUMENTS

Equity instruments similar to stock options, such as share appreciation rights settled in stock, also use the rules discussed above. FAS 123(R) also provides rules for share-based payments that are issuer liabilities, such as share appreciation rights settled in cash. Such liabilities are accounted for based on fair value.

However, unlike equity instruments, where fair value is determined only once, the fair value of liability instruments is measured each reporting period until the instruments are settled in cash, and compensation is recognized based on the periodic change in value, through the settlement date.

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CONCLUSION

As companies get used to applying the new rules, financial statements will move closer to a fair presentation of company finances.

BY DAVID E. HARDESTY, CPA 

David Hardesty, CPA is the author of Share-Based Payments: An Analysis of FASB Statement 123(R). You can reach him at [e-mail].