FAS123R: Accounting for Share-Based Payments

Statement of Financial Accounting Standards 123(R) was a regulation that reshaped how companies account for compensation given to employees as company stock. Before this rule, businesses frequently granted stock options without recording any related expense, which could distort their true profitability. The principles established by FAS 123(R) are now a part of U.S. Generally Accepted Accounting Principles (GAAP).

The Financial Accounting Standards Board (FASB) issued these principles, which became effective for most companies starting in 2005. The rules are now codified within FASB Accounting Standards Codification (ASC) Topic 718, Compensation–Stock Compensation. This topic is the current authoritative source for the accounting of share-based payments, carrying forward the principles of FAS 123(R).

The Mandate to Expense Share-Based Payments

The primary change introduced by the standard was the requirement for companies to recognize the costs of employee services paid for with equity instruments. This meant arrangements like stock options, which previously might have resulted in no recognized expense, now had to be accounted for as a cost. The rule mandates that this cost be measured based on the fair value of the award on its grant date, which represents the economic cost of the compensation.

This approach contrasted with the prior guidance under Accounting Principles Board Opinion No. 25. Under APB 25, a stock option’s cost was measured by its intrinsic value, which is the difference between the stock’s market price and the option’s exercise price. If an option was granted with an exercise price equal to the market price, its intrinsic value was zero, and no compensation expense was recorded.

The shift to a fair value model was based on the concept that granting stock or options to employees is a form of compensation with real economic value, regardless of its intrinsic value at the grant date. By requiring this value to be expensed, the standard provides investors with a more complete picture of a company’s operating costs. This change affected how companies structured their compensation and how analysts evaluated corporate performance.

Calculating Compensation Cost

Companies must determine the fair value of share-based awards using a financial model. The most common valuation methods are the Black-Scholes model and binomial, or lattice, models. These models calculate a theoretical value for an award by considering inputs that reflect its characteristics and market conditions. The selection of a model depends on the award’s features; for instance, awards with market conditions may require a lattice model or a Monte Carlo simulation.

The calculation relies on a specific set of inputs. The fair value of the underlying stock on the grant date and the award’s exercise price are foundational components. The exercise price is the price at which the employee can purchase the stock, and its relationship to the market price influences the award’s value.

Several other assumptions are required to complete the valuation. The expected term is an estimate of the time between the grant date and when the option is expected to be exercised or forfeited. Expected volatility measures how much the stock price is anticipated to fluctuate over the award’s expected term. Companies also must factor in the expected dividend yield and the risk-free interest rate, which is based on U.S. Treasury yields. Each of these inputs requires judgment and can have a material impact on the final compensation cost.

Types of Awards Governed by the Standard

The accounting principles for share-based payments apply to a wide variety of compensation instruments. The rules cover any arrangement where a company provides equity as payment for employee services, ensuring the substance of the transaction dictates the accounting treatment. The rules apply to many types of awards, including:

• Stock options, including both incentive stock options (ISOs) and non-qualified stock options (NQSOs).
• Restricted stock awards (RSAs) and restricted stock units (RSUs), which grant an employee the right to receive shares of stock after a specified vesting period.
• Stock appreciation rights (SARs), which give an employee the right to receive a payment, in cash or stock, equal to the increase in the company’s stock price over a predetermined period.
• Employee stock purchase plans (ESPPs), if the plan allows employees to purchase company stock at a discount greater than what is considered reasonable to cover issuance costs.

Impact on Financial Statements and Disclosures

The calculated compensation cost directly affects a company’s reported financial results. The expense is recognized over the period in which the employee is required to provide service to earn the award, known as the vesting period. This non-cash expense is recorded on the income statement, reducing a company’s net income and its earnings per share (EPS).

Beyond the income statement, the standard mandates extensive disclosures in the footnotes to the financial statements. These disclosures give investors a clear understanding of a company’s share-based payment plans and their financial impact. Companies must provide a description of their stock compensation plans, including the general terms of the awards.

The disclosures must also detail the methods and assumptions used to estimate the fair value of the awards. This includes identifying the specific valuation model used and reporting the key inputs entered into that model. Finally, the company must disclose the total compensation cost recognized for the period and the total unrecognized compensation cost related to awards that have not yet vested.