FASB Statement 123(R): Accounting for Share-Based Payments

FASB Statement 123(R), Share-Based Payment, is now integrated into the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) under Topic 718, Compensation—Stock Compensation. The standard requires companies to recognize the cost of services or goods paid for with equity instruments, like stock options or restricted stock. This cost is measured based on the fair value of the awards on their grant date.

This approach replaced the previous guidance under APB Opinion No. 25, Accounting for Stock Issued to Employees. That older rule used the “intrinsic value” method—the difference between the stock’s market price and the option’s exercise price on the grant date. For many plans where the exercise price equaled the market price, this method resulted in zero recorded compensation expense, a point of concern for investors.

The implementation of ASC 718 became effective for most public companies for periods starting after June 15, 2005. It applies to all share-based payment transactions where a company issues its stock for goods or services, including awards to both employees and nonemployees. Mandating a fair value approach provides a more faithful representation of a company’s financial activities.

The Core Principle of Fair Value Measurement

ASC 718 requires that share-based payments be measured at their fair value on a specific date known as the “grant date.” The grant date is established when a company and the recipient reach a mutual understanding of the award’s key terms, the company becomes obligated to issue the equity upon vesting, and the recipient begins to be affected by changes in the company’s stock price. For most equity awards, this fair value is calculated once and is not adjusted for later changes in the stock price.

The objective of this fair value measurement is to determine what the award is worth at that single point in time. It reflects the estimated value of the instruments the company is obligated to provide once the recipient fulfills the necessary service or performance conditions. This “fair-value-based measure” is specific to ASC 718 and accounts for the unique features of these awards, such as restrictions on transferability.

The establishment of the grant date is a factual determination. It requires that the necessary corporate approvals are in place and that the terms have been communicated to the award recipient. The recipient must also have begun providing services to the company, as the grant date cannot precede the start of this relationship.

Valuation Models for Determining Fair Value

Since share-based awards like stock options do not have an observable market price, ASC 718 requires companies to use a valuation model to estimate their fair value. The standard does not mandate a specific model, but it does require the chosen method to be applied consistently. The two most prevalent models are the Black-Scholes-Merton formula and lattice models, such as the binomial model.

The Black-Scholes-Merton model is a mathematical formula that calculates the theoretical value of an option based on a set of six core inputs. This model operates on the assumption of a stable, predictable market environment and provides a single value for the option at the grant date.

Lattice models, like the binomial model, are more flexible and can incorporate a wider range of assumptions about future events. A lattice model builds a tree of potential future stock prices and calculates the option’s value at each node. This allows the model to account for more complex award features and dynamic exercise behavior.

Valuation models require several specific inputs to perform the calculation:

• Exercise price: The price at which the award holder can purchase the stock.
• Current market price: The stock’s value on the grant date.
• Expected volatility: Measures how much the stock price is anticipated to fluctuate over the option’s life; higher volatility leads to a higher option value. Companies often estimate this by looking at their own historical stock price movements or by using the historical volatility of comparable public companies.
• Expected term: The period of time the option is expected to be outstanding before it is exercised. This is often shorter than the full contractual term because award holders may exercise their options early.
• Expected dividend yield: A higher dividend yield lowers the option’s value because the stock price is expected to decrease when a dividend is paid.
• Risk-free interest rate: Usually based on the yield of U.S. Treasury securities with a term corresponding to the option’s expected term, is used to discount future cash flows.

Recognition of Compensation Cost

After determining an award’s total fair value, the company recognizes that amount as a compensation expense. The cost is not recorded all at once but is allocated over the requisite service period, which is the time the recipient must work to earn the award, commonly known as the vesting period.

The expense recognition pattern depends on the vesting schedule. For awards with “cliff” vesting, where the entire award vests on a single future date, companies recognize the expense on a straight-line basis. For example, an award with a $10,000 fair value that vests after four years results in a $2,500 expense each year.

For awards with “graded” vesting, where portions of the award vest over time, companies have two options. They can recognize the cost on a straight-line basis over the full service period. Alternatively, they can use a graded attribution method, which treats each vesting portion as a separate award and results in accelerated expense recognition.

Companies must also account for forfeitures. A company can elect to either estimate the number of awards expected to be forfeited or account for them as they occur. If a company estimates forfeitures, it adjusts its compensation cost each period, and any expense for an award that is ultimately forfeited must be reversed.

Required Financial Statement Disclosures

To provide financial statement users with a clear understanding of a company’s share-based payment arrangements, ASC 718 mandates a series of detailed disclosures. These disclosures explain the nature and terms of the plans, how the fair value of the awards was determined, and the effect of the compensation cost on the income statement.

A company must provide a description of its share-based payment plans, including the general terms of the awards, the requisite service periods, and the maximum contractual term of the options. It must also disclose the method used to measure the compensation cost and its policy for handling forfeitures.

The disclosures must also include a detailed roll-forward of stock option activity for the most recent year. This includes providing the number and weighted-average exercise prices for options that were outstanding at the beginning of the year, granted during the year, exercised, forfeited, and expired. For awards other than options, similar information about nonvested awards must be provided.

Furthermore, companies are required to disclose:

• The weighted-average grant-date fair value of awards granted during the year.
• A description of the valuation method used (e.g., Black-Scholes) and the significant assumptions used as inputs to that model, including the expected volatility, expected term, expected dividend yield, and risk-free interest rate.
• The total compensation cost recognized in the income statement for all share-based payment arrangements.
• The total intrinsic value of options that were exercised during the period.