Principles in the New Accounting for Stock Options
Roadmap for Navigating SFAS 123(R)
Robert A. Dyson
2005 - In December 2004, FASB issued a revised SFAS 123, Share-Based
Payment. Although presented as a revision to existing
accounting standards, SFAS 123(R) is an extensive (295-page)
rewrite of the existing standards. The SEC has since issued
two interpretations of SFAS 123(R). The first, Staff Accounting
Bulletin (SAB) 107, Share-Based Payment, adds Topic
14 to the staff accounting bulletin series and provides guidance
on valuation methods, transitional matters, and other areas.
The second, and amendment to Regulation S-X, revises the effective
dates of SFAS 123(R) for public companies.
123(R) requires public companies to recognize compensation
cost from most share-based payment arrangements with employees.
Companies will not be able to simply recognize the pro forma
cost currently calculated under the original SFAS 123, however,
because SFAS 123(R) modifies certain assumptions for computing
that cost; for example, it requires expected rather than
historical volatility. (Although the original SFAS 123 theoretically
required the use of expected volatility, the computations
presented in its Appendix B were based primarily on historical
volatility.) In addition, companies must recognize an incremental
cost associated with modified stock option awards rather
than account for them as variable options according to FASB
Interpretation (FIN) 44, Accounting for Certain Transactions
Involving Stock Compensation. Finally, in calculating
total compensation cost, companies are required to estimate
the number of instruments for which the requisite service
is expected to be rendered, rather than account for forfeitures
as they occur.
public companies can no longer apply the intrinsic method,
nonpublic entities may continue to do so if it is not practicable
to estimate the fair value of their stock options. Nonpublic
companies applying the intrinsic method, however, must measure
the stock options each reporting period and recognize changes
in intrinsic value as compensation cost. Otherwise, nonpublic
companies are required to measure awards of equity instruments
at fair value.
123(R) also requires excess tax benefits to be reported
as a financing cash inflow on the statement of cash flows
rather than as a reduction to income tax paid.
limited exceptions, SFAS 123(R) applies to share-based payment
arrangements, whereby suppliers of goods and services, including
both employees and nonemployees, receive equity instruments,
such as shares or stock options, as payment. Share-based
payment arrangements also include transactions where the
entity incurs liabilities in amounts based on the price
of the company’s shares or other equity instruments,
or liabilities that might require settlement by issuing
the company’s shares.
123(R) defines an employee as 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 and
applicable IRS revenue rulings. This definition includes
nonemployee directors acting in their role as members of
the entity’s board of directors, and certain leased
123(R) does not apply to employee share option plans that
are noncompensatory or to capital contributions. A plan
is noncompensatory if substantially all employees meeting
limited qualifications may participate, the plan incorporates
no option features (with limited exceptions), and its terms
are no more favorable than those available to all holders
of the same class of shares, or if any purchase discount
from the market price is 5% or less. Companies must justify
the classification of plans with purchase discounts greater
than 5% as noncompensatory every year.
as described above, SFAS 123(R) requires reporting entities
to recognize in their financial statements the costs resulting
from all share-based payment transactions at fair value.
Companies engaging in share-based arrangements with employees
recognize the cost of services received over the requisite
service period, while entities engaging in share-based arrangements
with nonemployees recognize the cost of goods acquired or
services received. The accounting for goods acquired or
services received in share-based arrangements, whether from
employees or nonemployees, is the same regardless of settlement
by cash or equity securities. For example, a company constructing
a building would capitalize the architect’s fees regardless
of whether those fees are settled in cash, stock, or stock
options. In addition to recording the costs of the goods
acquired or services received, companies should record a
corresponding increase in equity or liability. Companies
issuing equity instruments before receiving the actual goods
or services should record a prepaid expense.
of Compensation Cost
basic calculation of compensation cost incurred to employees
in a stock option plan consists of the following steps:
Estimate the fair value of one option at the measurement
date, assuming that the option is already vested. This
fair value does not change during the life of the award,
unless the option’s terms are modified or the measurement
date is changed.
Calculate the total compensation cost, which is the fair
value of one option multiplied by the number of options
expected to vest.
Determine the requisite service period.
Allocate the total compensation cost over the requisite
service period (or to the period when specified conditions
Estimate any income-tax effect.
Adjust the total compensation cost and income-tax effect
as a change in estimate to reflect any changes in the
number of options expected to vest.
1 presents a standard example for accounting for stock
options issued to employees.
for Share-Based Transactions with Nonemployees
recording of goods acquired or services received occurs
when the company obtains those goods or receives those services,
but not necessarily when the equity instruments are issued.
These transactions are measured at the fair value of the
goods acquired or services received if those fair values
are more reliably measurable (generally, at the market price)
than the fair value of the equity instruments issued in
exchange. The company should measure the transaction at
the fair value of the equity instruments issued if that
fair value is more reliably measured.
the fair value method is applied to the equity instruments
issued, the measurement date is the earlier of 1) the date
at which a commitment for performance by the nonemployee
to earn the equity instruments is reached, or 2) the date
at which the nonemployee’s performance is complete.
Additional guidance in determining a measurement date is
presented in EITF Issue 96-18, Accounting for Equity
Instruments that are Issued to Other than Employees for
Acquiring, or in Conjunction with Selling, Goods or Services.
Date of Share-Based Transactions
company begins recognizing compensation cost as of the service
inception date, which is the beginning of the period during
which the employee performs the services for which he is
compensated (the requisite service period). The service
inception date is usually the grant date, or the date on
which an employer and an employee reach a mutual understanding
of the key terms and conditions of a stock-based payment
award. At the grant date, the employer becomes contingently
liable to issue equity instruments or to transfer assets
to an employee who renders the required service.
service inception date may precede the grant date if an
award is authorized, if service begins before both parties
reach a mutual understanding of the key terms, and if certain
other conditions are met. This can occur when an employee
is working during a period that counts as part of the vesting
period, but before the final understanding on matters such
as exercise price is completed. In these circumstances,
the company recognizes compensation costs over the requisite
service period based on the fair value of the options as
of the service inception date, measures a new fair value
as of the grant date, and then adjusts the cumulative compensation
cost to reflect the new fair value. Sidebar 1, “Accounting
for Stock Options with Service Condition,” presents
an example of accounting for an adjusted total compensation
of Share-Based Transactions
objective of accounting for transactions under share-based
arrangements with employees is to recognize compensation
costs related to employee services received in exchange
for equity instruments issued or liabilities incurred. The
total compensation cost is the fair value of the instruments
issued multiplied by the number of instruments that actually
vest. This cost is recognized over the requisite service
period with a corresponding credit to equity (generally
paid-in capital). The number of instruments expected to
vest is estimated at the service inception date, and is
revised during the requisite service period to reflect subsequent
information. Total compensation cost is also revised accordingly.
of share-based employee compensation vest when an employee
earns the right to benefit from the award by satisfying
a specific service or performance condition, or both. A
service condition is based solely on an employee’s
rendering service to the employer for the requisite service
period. A performance condition pertains to an employee’s
both rendering service for a specified period of time and
achieving a specified performance target defined solely
by the employer’s own operations (for example, a requirement
that a division sell a certain number of units within a
specified period in order for an award to vest). The requirement
that an individual remain an employee for that period is
a service condition.
award may also include a market condition, which specifies
a share price or a target in terms of a similar equity security
or an index that must be achieved. A market condition affects
the determination of the fair value of a share-based employee
compensation award, but is not a vesting condition.
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. Considering such evidence
requires the classification of the requisite service period
as explicit, implicit, or derived. An explicit service period
is explicitly stated in the terms of a share-based award
(e.g., three years of continuous employee service from January
3, 2005). An implicit service period is not explicitly stated
in the terms of a share-based award, but can be inferred
from an analysis of those terms or consideration of a performance
condition (e.g., for an award with a service inception date
of January 1, 2006, that vests when new software is ready
for market, expected at June 30, 2007, the implicit service
period is 18 months). A derived service period for an award
with a market condition is inferred from the application
of certain valuation techniques used to estimate fair value.
For example, an award that vests only if the market share
price increases by at least 40% for a period of not less
than one year over the next five years can be inferred from
certain valuation techniques, such as the lattice model
(as discussed below).
accounting purposes, only one requisite service period can
be used for each award. An award having a combination of
market, performance, and service conditions may have two
or even all three types of service periods: explicit, implicit,
and derived. If the vesting of an award is based on satisfying
both a market condition and a performance or service condition
and it is probable that the latter will be satisfied, the
initial estimate of the requisite service period should
be the longest of the periods. If the vesting of an award
is based on satisfying either a market condition or a performance
or service condition and it is probable that the performance
or service condition will be satisfied, the initial estimate
of the requisite service period should be the shortest of
the requisite service period, awards with a performance
condition are measured based on the probable outcome of
that performance condition. An award with a performance
condition is accrued if it is probable that a performance
condition will be achieved. If the company concludes that
a required performance condition will not be met, it will
not recognize any compensation cost even if the award contains
other conditions that probably will be satisfied. Companies
should reverse any compensation cost recognized on an award
whose performance condition is ultimately not achieved.
If, during the requisite service period, the company changes
its mind and concludes that a performance condition will
likely be met after all, it will recognize cumulative compensation
cost in the current period as a change in estimate in a
manner similar to that presented in Sidebar 1.
2 presents an example.
of Share-Based Arrangements Classified as Equity
Equity instruments awarded to employees are measured at
fair value as of the grant date. Unless the award is modified
or the measurement date changed, the estimated fair value
of each unit of the equity instrument is not remeasured
in subsequent periods.
estimated fair value of each equity instrument is based
on either observable market prices of identical or similar
equity or liability instruments in active markets, or on
an established valuation technique. Because employee stock
options generally cannot be bought and sold on the open
market, they cannot be compared to actively traded options.
In those cases, the company should apply a valuation technique
consistent with SFAS 123(R) requirements, reflecting all
substantive (again, with certain exceptions) characteristics
of the instrument. For example, restrictions that remain
in effect after the company issued the instruments, such
as the inability to sell vested stock options to third parties,
or restrictions on selling exercised shares for a specified
period of time, should be reflected in the measurement of
instrument characteristics are reflected in recognized compensation
cost but are not included in the measurement of the fair
value, such as the following:
Restrictions regarding vesting, such as service period
or performance conditions.
Restrictions related to forfeiting instruments that the
employee has not earned, such as the inability to exercise
a nonvested stock option or to sell nonvested shares.
or contingent features that require an employee to transfer
equity shares earned or gains realized from the sale of
equity instruments earned to the issuing entity for an
amount less than the fair value on the date of transfer
(including a zero amount). These features are accounted
for if and when the contingent event occurs (see Sidebar
valuation technique should include assumptions about the
The exercise price of the option.
The expected term of the option, reflecting both the contractual
term and the employees’ expected exercise and employment
The current price of the underlying share.
The expected volatility of the underlying share for the
expected term of the option.
The expected dividends on the underlying share during
the expected option term.
The risk-free interest rate for the expected term of the
techniques meeting SFAS 123(R)’s criteria are closed-form
models, such as the Black-Scholes-Merton formula, and binomial
models, such as the lattice model. The Black-Scholes-Merton
formula is generally applied the same way to awards accounted
for under SFAS 123 and prior pronouncements, except for
the use of expected (as opposed to historical) volatility.
Under SFAS 123(R), it must be adjusted to reflect certain
characteristics of employee stock options that are not consistent
with the model’s assumptions, such as the ability
to exercise the option prior to the end of its contractual
model produces an estimated fair value based on the assumed
changes in prices of a financial instrument during each
successive reporting period within the context of the option’s
contractual term. Results will differ if the reporting entity
uses the lattice model rather than the Black-Scholes-Merton
formula. For example, determining the expected option term
using the lattice model requires the consideration of vesting
period, employees’ historical exercise and employment
behavior for similar grants, expected share-price volatility,
blackout periods, and employee demographic information such
as age and length of service. Volatility affects the expected
term because although option pricing theory contends that
the optimal time to exercise an option is at the end of
its term, the option holder may exercise the option early
if the price of the stock reaches a certain level. Employee
exercise behavior is described as the suboptimal exercise
factor. For example, a determination that an appreciable
number of individuals will exercise the option if the price
of the stock is twice the exercise price will result in
a suboptimal exercise factor of two.
in its exposure draft FASB expressed a preference for the
lattice model, SFAS 123(R) does not require the use of a
particular valuation technique. In any event, no acceptable
lattice computer model is available as of this writing,
although a number of binomial models are on the market.
FASB has indicated it will not provide a list of vendors
offering software that complies with SFAS 123(R)’s
estimating the expected term of the option reflecting both
the contractual term and the employees’ expected exercise
and employment behavior, companies should identify separate
homogenous employee groups with similar exercise and employment
behavior. This procedure effectively results in different
fair values for the options issued to each group. For example,
a company may classify managers and hourly employees as
separate groups and estimate the expected term of the award
relative to each group, based on its historical experience
of forfeitures (due to employees resigning before the vesting
period is complete) and exercise behavior. The company can
then estimate the fair value for the instruments issued
to managers and hourly employees based on behavior unique
to each group. In this scenario, the company, in effect,
accounts for two awards with different values based on different
123(R) does not specify a method for estimating expected
share price volatility, but it does require a process for
making such estimates and for evaluating factors incorporated
in that process. The factors for estimating expected volatility
include historical volatility of the price of the underlying
share, the implied volatility of other publicly traded instruments,
the length of time the company’s shares have been
traded, and the corporate and capital structure. In considering
historical volatility, SFAS 123(R) permits disregarding
an identifiable period in which the stock was extremely
volatile because of a unique event, such as a failed merger
bid, that is not expected to occur during the option term.
SFAS 123(R) also allows volatility to be deemphasized during
a period of general market decline. SFAS 123(R) gives no
substantive guidance about entities without historical experience,
such as entities that have only recently become a public
107 provides additional guidance on estimating expected
volatility, including factors that would justify the use
of either historical or implied volatility. Implied volatility
is derived from the market prices of the reporting entity’s
publicly traded options or other financial instruments with
companies are encouraged to estimate expected volatility
based on those reported by similar-sized publicly traded
entities in the same industry. At least some of these companies
will find it is not practicable to estimate the expected
volatility of the entity’s share price. Nonpublic
companies are explicitly prohibited from using a broad-based
market index, such as the S&P 500, that is not representative
of the industry sector in which the nonpublic entity operates.
risk-free interest rate should be based on the implied yields
currently available on U.S. Treasury zero-coupon issues
with a remaining term used in the model.
Transactions Classified as Liabilities
options are classified as liabilities if the underlying
securities are classified as liabilities, or if the company
can be required, under any circumstances, to settle the
option or similar instrument by transferring cash or other
assets. For example, SFAS 150, Accounting for Certain
Financial Instruments with Characteristics of Both Liabilities
and Equity, classifies certain equity instruments as
liabilities. Public companies classify options to purchase
mandatory redeemable preferred stock as liabilities, because
the underlying security is classified as a liability. In
contrast, FASB Staff Position (FSP) FAS 150-3 permits nonpublic
entities to classify mandatory redeemable stock as equity.
Because the underlying security is considered equity, the
option to buy that equity is also classified as equity.
option may be puttable if the reporting entity is required
to repurchase the shares issued when the option is exercised.
A puttable or callable share option awarded to an employee
may be classified as a liability if either 1) the repurchase
feature permits the employee to avoid bearing the risks
and rewards normally associated with 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 after the share is issued. An example of an employee
avoiding the risks and rewards associated with ownership
would be a plan that permitted an employee to sell stock,
acquired through the exercise of a stock option, back to
the employer at the exercise price. A reasonable period
of time is a period of at least six months.
award indexed to a factor, such as a commodity price, in
addition to the entity’s share price is classified
as a liability if that additional factor is not a market,
performance, or service condition.
company measures a liability related to a share-based payment
arrangement based on the award’s fair value, which
is determined using a methodology similar to that used in
determining the fair value of equity instruments. At the
service inception date, the company estimates the comprehensive
fair value of the liability and allocates that value over
the requisite service period. During each reporting period
until settlement, the company remeasures the fair value
of the liability and recognizes the cumulative effect of
the change in estimate.
entities have the option to measure liabilities arising
from share-based payment arrangements at either the fair
value or the intrinsic value. Regardless of the measurement
method applied, nonpublic entities must remeasure the liabilities
at each reporting date until settlement.
of Awards of Equity Instruments
of the terms or conditions of an equity award is considered
an exchange of the original award for a new award.
the original options are expected to vest, the entity should
recognize the total compensation cost of the original award
plus any incremental costs derived from the modification.
The incremental costs are the excess of the fair value of
the modified awards over the fair value of the original
awards just prior to the effective modification date. A
company modifying an existing award must determine the fair
value of the original award just prior to the effective
modification date and then after the modification date.
If the fair value of the modified award is less than the
fair value of the original award, the company would recognize
the fair value of the original award as compensation cost.
4 presents an example of accounting for a modification
of nonvested share options.
the original options are not expected to vest, the company
should recognize the total compensation cost based on the
fair value of the modified award. This is consistent with
the idea that no compensation cost is recognized when no
instruments vest and that a modified award is considered
a new award.
following transactions are considered modifications to awards:
A short-term inducement available for a limited period
Exchanges of awards or modifications of the terms resulting
from equity restructurings.
replacements for a cancelled award.
that repurchases an award for which the requisite service
or performance has not yet been rendered has effectively
modified the requisite service period and must recognize
any previously unrecognized compensation cost (as calculated
at the grant date) at the repurchase date. The amount of
cash or other assets transferred (or liabilities incurred)
to repurchase an award is charged to equity, up to the fair
value of the equity instruments repurchased. Any excess
of the repurchase price over the fair value of the instruments
repurchased is charged as an additional compensation cost.
of an award that is not accompanied with a replacement award,
cash, or other consideration is deemed to be a repurchase
for no consideration. Consequently, the company should recognize
any previously unrecognized compensation cost at the cancellation
date. The replacement award must be issued concurrently
in order to avoid recognizing this additional compensation
cost. After the effective date of SFAS 123(R), companies
no longer have six months to issue replacement awards.
123(R) has complex procedures for accounting for an award
whose modification in terms results in a change in classification
from equity to a liability.
with one or more share-based payment arrangements must disclose
information that enables financial statement users to understand
The nature and terms of such arrangements that existed
during the period, and the potential effects of those
arrangements on shareholders.
The effect of compensation costs arising from share-based
payment arrangements on the income statement.
The method of estimating fair value of the goods or services
received, or the fair value of the equity instruments
The cash flow effects resulting from share-based payment
123(R) provides a sample disclosure of an ongoing plan.
Date and Transition
to the SEC, SFAS 123(R) applies to all awards with service
inception dates occurring as follows:
Public companies that do not file as small business issuers,
such as accelerated filers, should apply SFAS 123(R) to
the first interim or annual reporting period of the first
fiscal year beginning after June 15, 2005.
companies that file as small business issuers (pursuant
to Regulation S-B) should apply SFAS 123(R) to the first
interim or annual reporting period of the first fiscal
year beginning after December 15, 2005.
Nonpublic companies should apply SFAS 123(R) to the first
annual reporting period that begins after December 15,
SEC’s revision affects non–small business public
companies with different fiscal years in different ways.
Companies with a calendar fiscal year must apply SFAS 123(R)
on January 1, 2006, six months later than the original requirement.
Companies with a fiscal year beginning on November 1, 2005,
must apply SFAS 123(R) on that date, rather than the quarter
beginning August 1, 2005. Companies with a fiscal year beginning
on July 1, 2005, must apply SFAS 123(R) on the original
implementation date, with no delay permitted.
of the required effective date, all public and nonpublic
companies that previously used the fair value method for
either recognition or disclosure must use a modified prospective
method. This method requires that SFAS 123(R) be applied
to all awards whose service inception date follows the applicable
effective date and all existing awards modified, repurchased,
or cancelled after that effective date. For awards for which
the requisite conditions have not been fully satisfied and
are outstanding as of the applicable effective date, the
modified prospective method requires the recognition of
the portion of the requisite service period not yet rendered
as compensation cost using the valuation methodology required
under the old SFAS 123. Companies should apply the guidance
in SFAS 123(R) in measuring new awards or existing awards
that were modified, repurchased, or cancelled after the
required effective date. Sidebar
5 presents an example of applying the modified prospective
public entities and those nonpublic entities that used the
fair value method for either recognition or disclosure have
the option of applying the modified retrospective application.
The modified retrospective application requires entities
to recognize, as compensation cost, the pro forma disclosures
made under the old SFAS 123 (see Sidebar
6) to prior financial periods. The modified retrospective
application requires the restatement of prior annual and
interim financial statements presented in the filing to
recognize compensation cost and an adjustment to beginning
capital accounts of the earliest period shown.
123(R) provides additional transition guidance pertaining
to instruments classified as liabilities under the new rules
and certain forfeitures, deferred tax assets, and valuation
123(R) requires entities to disclose, in the period of adoption,
the effect of the change from applying the original provisions
of SFAS 123 on income from continuing operations, income
before income taxes, net income, cash flows from operations,
cash flows from financing activities, and basic and diluted
earnings per share. In addition, public entities that accounted
for share-based payment arrangements with employees using
the intrinsic method under APB Opinion 25 shall continue
to provide the following information (in tabular form),
as required by SFAS 123, for all periods:
Net income and basic and diluted earnings per share, as
The share-based employee compensation cost, net of related
tax effects, that would have been included in net income,
The share-based employee compensation cost, net of related
tax effects, that would have been included in net income
if the fair value–based method had been applied
to all awards.
Pro forma net income, as if the fair value–based
method had been applied in all awards.
Pro forma basic and diluted earnings per share as if the
fair value–based method had been applied in all
encourages, but does not require, early adoption of SFAS
123(R) for interim or annual periods for which financial
statements or interims have not been issued.
A. Dyson, CPA, is with American Express Tax &
Business Services Inc., New York, N.Y. He is also immediate
past chair and a current member of the NYSSCPA’s Financial
Accounting Standards Committee and a current member of the
FASB Small Business Advisory Committee. He can be reached