FAS 123R: accounting for stock options; Tips for an increasingly complex task

California CPA, March-April, 2007 by Greg Regan, Matt Lombardi

With apologies to Baskin-Robbins, stock options seem to be available in at least 31 flavors. Consider the following varieties: premium options (strike price above grant date stock price); purchased options (employee pays a fraction of the strike price at grant); indexed options (strike price varies based upon an index); and options with performance conditions (e.g., vesting or share award depending on growth in earnings per share).

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These compensation measures were designed to align employee performance with the company's success. The result, however, is a tremendously complex world for those faced with accounting for these instruments.

WHAT GAAP IS APPLICABLE TO STOCK OPTIONS?

FAS 123R, Share Based Payment, provides the accounting guidance for a broad spectrum of compensation instruments, including equity shares, equity share options, other equity instruments or liabilities that are based, at least in part, on the price of the issuer's shares.

FAS 123R revised FAS 123, replaced APB 25 and amended FAS 95. However, it did not modify the accounting promulgated by Emerging Issues Task Force 96-18, impacting equity awards to non-employees, or SOP 93-6, relating to employee stock ownership plans.

FAS 123R requires companies to recognize the cost of employee services received in exchange for share-based payments based on the respective grant date fair value of the award. This objective is consistent with FASB's theme that the "economic consequences," or fair value, of transactions be reflected in financial statements. Subsequent to FAS 123R, both the SEC and the PCAOB issued guidance concerning the implementation of FAS 123R (see Staff Accounting Bulletin No. 107, www.sec.gov/interps/account/sabl07.pdf, and PCAOB Audit Practice Alert No. 1, www.pcaobus.org/Standards/Staff_Questions_and_Answers/2006/07-28_APA_1.pdf).

Still, as many companies complete their first year of compliance with the new standard, questions abound.

KEY IMPLEMENTATION ISSUES OF FAS 123R

One of the first steps is determining the most suitable valuation model. There are two primary models in use: the Modified Black-Scholes model and the binomial lattice model.

The MBS model uses a pre-established equation to determine an estimated fair value. Conversely, a binomial lattice model provides a framework for computing the fair value using discounted cash flows.

Under the two models, FAS 123R generally requires--at a minimum--the consideration of: the exercise price of the option, the expected term of the option, the current price of the underlying share, the expected volatility of the price of the underlying share, the expected dividends on the underlying share and the risk-free interest rate.

For purposes of FAS 123R, the Black-Scholes model is modified to use the "expected term" of the option as opposed to its contractual term, if different. This is permitted due to the differences between employee stock options, which generally may be exercised anytime after vesting, and options that are traded on the open market, which are typically not exercised prior to expiration (FAS 123R Sec. A26).

This modification raises an important consideration relative to the model decision: What are the key inputs to the valuation of an option, and how is the valuation sensitive to these factors? Some general guidelines include:

                                               When Input Increases,
Input                 Difficulty to Determine  Option Value:

Current Market Price  Low                      Increases
Strike Price          Low                      Decreases
Risk-Free Rate        Medium                   Increases
Dividend Yield        Medium                   Decreases
Expected Term         High                     Increases; due to longer
                                               time to realize gains
                                               without downside
Expected Volatility   High                     Increases; due to higher
                                               potential for market
                                               price appreciation

The decision is driven, in part, by how these inputs are determined. In general, many small- to middle-market companies have utilized the MBS model. However, large companies, such as Google and Oracle, are employing the MBS. In practice, this model appears to be simpler and more cost effective, which is in part due to existing familiarity with the prior valuation practices typically applied under FAS 123.

However, some studies have found that the MBS results in higher fair values and consequent expenses when compared with a lattice model [Rudkin, Ronald. April 2006. Valuation of Employee Stock Options and Other Equity-Based Instruments: Short Term and Long-Term Strategies for Complying with FAS 123R and for Optimizing the Performance of Equity-Based Compensation Programs under the New Standard. Pg 1; and Plank, Jeffery. Wynn, Bruce. Expensing Stock Options under FAS 123(R)].

As for the lattice model, FAS 123R suggests it "more fully reflects the substantive characteristics of a particular employee share option" (FAS 123R Sec. 15). The explanation is that lattice models have the capacity to vary the fair value inputs over time, whereas the MBS utilizes constant values for the life of the instrument.