Topic 14: Share-Based Payment
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Removed by SAB 120
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Removed by SAB 114
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Removed by SAB 114
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Removed by SAB 114
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Removed by SAB 114
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Removed by SAB 114
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Removed by SAB 114
The interpretations in this SAB express views of the staff regarding the
interaction between FASB ASC Topic 718, Compensation — Stock Compensation, and certain
SEC rules and regulations and provide the staff’s views regarding the valuation of
share-based payment arrangements for public companies. FASB ASC Topic 718 is based on
the underlying accounting principle that compensation cost resulting from share-based
payment transactions be recognized in financial statements at fair value.1 Recognition of compensation cost at fair value will provide investors and other
users of financial statements with more complete and comparable financial
information.
FASB ASC Topic 718 addresses a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans.
FASB ASC Topic 718 replaced guidance originally issued in 1995 that established
as preferable, but did not require, a fair-value-based method of accounting for
share-based payment transactions with employees. It also replaced guidance originally
issued in 1996 that provided different recognition and measurement requirements for
share-based payment awards granted to nonemployees than for those granted to
employees.
The staff believes the guidance in this SAB will assist issuers in their
application of FASB ASC Topic 718 and enhance the information received by investors and
other users of financial statements, thereby assisting them in making investment and
other decisions. This SAB includes interpretive guidance related to the transition from
nonpublic to public entity2 status, valuation methods (including assumptions such as expected volatility,
expected term, and current price of the underlying share, particularly when valuing
spring-loaded awards3), the accounting for certain redeemable financial instruments issued under
share-based payment arrangements, the classification of compensation expense, and
capitalization of compensation cost related to share-based payment arrangements.
The staff recognizes that there is a range of conduct that a reasonable issuer
might use to make estimates and valuations and otherwise apply FASB ASC Topic 718, and
the interpretive guidance provided by this SAB. Thus, throughout this SAB the use of the
terms "reasonable" and "reasonably" is not meant to imply a single conclusion or
methodology, but to encompass the full range of potential conduct, conclusions or
methodologies upon which an issuer may reasonably base its valuation decisions.
Different conduct, conclusions or methodologies by different issuers in a given
situation does not of itself raise an inference that any of those issuers is acting
unreasonably. While the zone of reasonable conduct is not unlimited, the staff expects
that it will be rare, except when observable market prices of identical or similar
equity or liability instruments in active markets are available, when there is only one
acceptable choice in estimating the fair value of share-based payment arrangements under
the provisions of FASB ASC Topic 718 and the interpretive guidance provided by this SAB
in any given situation. In addition, as discussed in the Interpretive Response to
Question 1 of Section C, Valuation Methods, estimates of fair value are not intended to
predict actual future events, and subsequent events are not indicative of the
reasonableness of the original estimates of fair value made under FASB ASC Topic
718.
A. Removed by SAB 120
B. Transition from Nonpublic to Public Entity Status
Facts: Company A is a nonpublic entity4 that first files a registration statement with the SEC to register its equity
securities for sale in a public market on January 2, 20X8. As a nonpublic entity,
Company A had been assigning value to its share options5 under the calculated value method prescribed by FASB ASC Topic 718,
Compensation — Stock Compensation,6 and had elected to measure its liability awards based on intrinsic value.
Company A is considered a public entity on January 2, 20X8 when it makes its initial
filing with the SEC in preparation for the sale of its shares in a public
market.
Question 1: How should Company A account for the share
options that were granted prior to January 2, 20X8 for which the requisite service
has not been rendered by January 2, 20X8?
Interpretive Response: Prior to becoming a public
entity, Company A had been assigning value to its share options under the calculated
value method. The staff believes that Company A should continue to follow that
approach for those share options that were granted prior to January 2, 20X8, unless
those share options are subsequently modified, repurchased or cancelled.7 If the share options are subsequently modified, repurchased or cancelled,
Company A would assess the event under the public company provisions of FASB ASC
Topic 718. For example, if Company A modified the share options on February 1, 20X8,
any incremental compensation cost would be measured under FASB ASC subparagraph
718-20-35-3(a), as the fair value of the modified share options over the fair value
of the original share options measured immediately before the terms were
modified.8
Question 2: How should Company A account for its
liability awards granted prior to January 2, 20X8 that are fully vested but have not
been settled by January 2, 20X8?
Interpretive Response: As a nonpublic entity, Company A
had elected to measure its liability awards subject to FASB ASC Topic 718 at
intrinsic value.9 When Company A becomes a public entity, it should measure the liability awards
at their fair value determined in accordance with FASB ASC Topic 718.10 In that reporting period there will be an incremental amount of measured cost
for the difference between fair value as determined under FASB ASC Topic 718 and
intrinsic value. For example, assume the intrinsic value in the period ended
December 31, 20X7 was $10 per award. At the end of the first reporting period ending
after January 2, 20X8 (when Company A becomes a public entity), assume the intrinsic
value of the award is $12 and the fair value as determined in accordance with FASB
ASC Topic 718 is $15. The measured cost in the first reporting period after December
31, 20X7 would be $5.11
Question 3: After becoming a public entity, may Company A retrospectively apply the fair-value-based method to its awards that were granted prior to the date Company A became a public entity?
Interpretive Response: No. Before becoming a public
entity, Company A did not use the fair-value-based method for either its share
options or its liability awards. The staff does not believe it is appropriate for
Company A to apply the fair-value-based method on a retrospective basis, because it
would require the entity to make estimates of a prior period, which, due to
hindsight, may vary significantly from estimates that would have been made
contemporaneously in prior periods.12
Question 4: Upon becoming a public entity, what
disclosures should Company A consider in addition to those prescribed by FASB ASC
Topic 718?13
Interpretive Response: In the registration statement
filed on January 2, 20X8, Company A should clearly describe in MD&A the change
in accounting policy that will be required by FASB ASC Topic 718 in subsequent
periods and the reasonably likely material future effects.14 In subsequent filings, Company A should provide financial statement disclosure
of the effects of the changes in accounting policy. In addition, Company A should
consider the requirements of Item 303(b)(3) of Regulation S-K regarding critical
accounting estimates in MD&A.
C. Valuation Methods
FASB ASC paragraph 718-10-30-6 (Compensation — Stock Compensation Topic)
indicates that the measurement objective for equity instruments awarded to grantees
is to estimate at the grant date the fair value of the equity instruments the entity
is obligated to issue when grantees have delivered the good or rendered the service
and satisfied any other conditions necessary to earn the right to benefit from the
instruments.15 The Topic also states that observable market prices of identical or similar
equity or liability instruments in active markets are the best evidence of fair
value and, if available, should be used as the basis for the measurement for equity
and liability instruments awarded in a share-based payment transaction.16 However, if observable market prices of identical or similar equity or
liability instruments are not available, the fair value shall be estimated by using
a valuation technique or model that complies with the measurement objective, as
described in FASB ASC Topic 718.17
Question 1: If a valuation technique or model is used to
estimate fair value, to what extent will the staff consider a company’s estimates of
fair value to be materially misleading because the estimates of fair value do not
correspond to the value ultimately realized by the grantees who received the share
options?
Interpretive Response: The staff understands that
estimates of fair value of share options, while derived from expected value
calculations, cannot predict actual future events.18 The estimate of fair value represents the measurement of the cost of the
grantee’s goods or services to the company. The estimate of fair value should
reflect the assumptions marketplace participants would use in determining how much
to pay for an instrument on the fair value measurement date.19 For example, valuation techniques used in estimating the fair value of share
options may consider information about a large number of possible share price paths,
while, of course, only one share price path will ultimately emerge. If a company
makes a good faith fair value estimate in accordance with the provisions of FASB ASC
Topic 718 in a way that is designed to take into account the assumptions that
underlie the instrument’s value that marketplace participants would reasonably make,
then subsequent future events that affect the instrument’s value do not provide
meaningful information about the quality of the original fair value estimate. As
long as the share options were originally so measured, changes in a share option’s
value, no matter how significant, subsequent to its grant date do not call into
question the reasonableness of the grant date fair value estimate.
Question 2: In order to meet the fair value measurement objective in FASB ASC Topic 718, are certain valuation techniques preferred over others?
Interpretive Response: FASB ASC paragraph 718-10-55-17
clarifies that the Topic does not specify a preference for a particular valuation
technique or model. As stated in FASB ASC paragraph 718-10-55-11 in order to meet
the fair value measurement objective, a company should select a valuation technique
or model that (a) is applied in a manner consistent with the fair value measurement
objective and other requirements of FASB ASC Topic 718, (b) is based on established
principles of financial economic theory and generally applied in that field and (c)
reflects all substantive characteristics of the instrument (except for those
explicitly excluded by FASB ASC Topic 718).
The chosen valuation technique or model must meet all three of the requirements
stated above. In valuing a particular instrument, certain techniques or models may
meet the first and second criteria but may not meet the third criterion because the
techniques or models are not designed to reflect certain characteristics contained
in the instrument. For example, for a share option in which the exercisability is
conditional on a specified increase in the price of the underlying shares, the
Black-Scholes-Merton closed-form model would not generally be an appropriate
valuation model because, while it meets both the first and second criteria, it is
not designed to take into account that type of market condition.20
Further, the staff understands that a company may consider multiple techniques or models that meet the fair value measurement objective before making its selection as to the appropriate technique or model. The staff would not object to a company’s choice of a technique or model as long as the technique or model meets the fair value measurement objective. For example, a company is not required to use a lattice model simply because that model was the most complex of the models the company considered.
Question 3: In subsequent periods, may a company change
the valuation technique or model chosen to value instruments with similar
characteristics?21
Interpretive Response: As long as the new technique or
model meets the fair value measurement objective as described in Question 2 above,
the staff would not object to a company changing its valuation technique or
model.22 A change in the valuation technique or model used to meet the fair value
measurement objective would not be considered a change in accounting principle. As
such, a company would not be required to file a preferability letter from its
independent accountants as described in Rule 10-01(b)(6) of Regulation S-X when it
changes valuation techniques or models.23 However, the staff would not expect that a company would frequently switch
between valuation techniques or models, particularly in circumstances where there
was no significant variation in the form of share-based payments being valued.
Disclosure in the footnotes of the basis for any change in technique or model would
be appropriate.24
Question 4: Must every company that issues share options or similar instruments hire an outside third party to assist in determining the fair value of the share options?
Interpretive Response: No. However, the valuation of a company’s share options or similar instruments should be performed by a person with the requisite expertise.
D. Certain Assumptions Used in Valuation Methods
FASB ASC Topic 718’s (Compensation — Stock Compensation Topic) fair value
measurement objective for equity instruments awarded to grantees for goods or
services is to estimate the grant-date fair value of the equity instruments that the
entity is obligated to issue when grantees have delivered the good or rendered the
service and satisfied any other conditions necessary to earn the right to benefit
from the instruments.25 In order to meet this fair value measurement objective, management will
generally be required to develop estimates regarding (1) the expected volatility of
its company’s share price; (2) the expected term of the option, taking into account
both the contractual term of the option and the effects of grantees’ expected
exercise and post-vesting termination behavior; and (3) the determination of the
current price of the underlying share. The staff is providing guidance in the
following sections related to the expected volatility, expected term and current
share price assumptions to assist public entities in applying those
requirements.
1. Expected Volatility
FASB ASC paragraph 718-10-55-36 states, “Volatility is a measure of the amount by which a financial variable, such as share price, has fluctuated (historical volatility) or is expected to fluctuate (expected volatility) during a period. Option-pricing models require an estimate of expected volatility as an assumption because an option’s value is dependent on potential share returns over the option’s term. The higher the volatility, the more the returns on the share can be expected to vary — up or down. Because an option’s value is unaffected by expected negative returns on the shares, other things [being] equal, an option on a share with higher volatility is worth more than an option on a share with lower volatility.”
Facts: Company B is a public entity whose common shares have been publicly traded for over twenty years. Company B also has multiple options on its shares outstanding that are traded on an exchange (“traded options”). Company B grants share options on January 2, 20X6.
Question 1: What should Company B consider when estimating expected volatility for purposes of measuring the fair value of its share options?
Interpretive Response: FASB ASC Topic 718 does not
specify a particular method of estimating expected volatility. However, the
Topic does clarify that the objective in estimating expected volatility is to
ascertain the assumption about expected volatility that marketplace participants
would likely use in determining an exchange price for an option.26 FASB ASC Topic 718 provides a list of factors entities should consider in
estimating expected volatility.27 Company B may begin its process of estimating expected volatility by
considering its historical volatility.28 However, Company B should also then consider, based on available
information, how the expected volatility of its share price may differ from
historical volatility.29 Implied volatility30 can be useful in estimating expected volatility because it is generally
reflective of both historical volatility and expectations of how future
volatility will differ from historical volatility.
The staff believes that companies should make good faith efforts to identify and
use sufficient information in determining whether taking historical volatility,
implied volatility or a combination of both into account will result in the best
estimate of expected volatility. The staff believes companies that have
appropriate traded financial instruments from which they can derive an implied
volatility should generally consider this measure. The extent of the ultimate
reliance on implied volatility will depend on a company’s facts and
circumstances; however, the staff believes that a company with actively traded
options or other financial instruments with embedded options31 generally could place greater (or even exclusive) reliance on implied
volatility. (See the Interpretive Responses to Questions 3 and 4
below.)
The process used to gather and review available information to estimate expected volatility should be applied consistently from period to period. When circumstances indicate the availability of new or different information that would be useful in estimating expected volatility, a company should incorporate that information.
Question 2: What should Company B consider if computing
historical volatility?32
Interpretive Response: The following should be considered in the computation of historical volatility:
1. Method of Computing Historical Volatility —
The staff believes the method selected by Company B to compute its historical
volatility should produce an estimate that is representative of a marketplace
participant’s expectations about Company B’s future volatility over the expected
(if using a Black-Scholes-Merton closed-form model) or contractual (if using a
lattice model) term33 of its share options. Certain methods may not be appropriate for longer
term share options if they weight the most recent periods of Company B’s
historical volatility much more heavily than earlier periods.34 For example, a method that applies a factor to certain historical price
intervals to reflect a decay or loss of relevance of that historical information
emphasizes the most recent historical periods and thus would likely bias the
estimate to this recent history.35
2. Amount of Historical Data —
FASB ASC subparagraph 718-10-55-37(a) indicates entities should consider historical volatility over a period generally commensurate with the expected or contractual term, as applicable, of the share option. The staff believes Company B could utilize a period of historical data longer than the expected or contractual term, as applicable, if it reasonably believes the additional historical information will improve the estimate. For example, assume Company B decided to utilize a Black-Scholes-Merton closed-form model to estimate the value of the share options granted on January 2, 20X6 and determined that the expected term was six years. Company B would not be precluded from using historical data longer than six years if it concludes that data would be relevant.
3. Frequency of Price Observations —
FASB ASC subparagraph 718-10-55-37(d) indicates an entity should use appropriate
and regular intervals for price observations based on facts and circumstances
that provide the basis for a reasonable fair value estimate. Accordingly, the
staff believes Company B should consider the frequency of the trading of its
shares and the length of its trading history in determining the appropriate
frequency of price observations. The staff believes using daily, weekly or
monthly price observations may provide a sufficient basis to estimate expected
volatility if the history provides enough data points on which to base the
estimate.36 Company B should select a consistent point in time within each interval
when selecting data points.37
4. Consideration of Future Events —
The objective in estimating expected volatility is to ascertain the assumptions
that marketplace participants would likely use in determining an exchange price
for an option.38 Accordingly, the staff believes that Company B should consider those
future events that it reasonably concludes a marketplace participant would also
consider in making the estimation. For example, if Company B has recently
announced a merger with a company that would change its business risk in the
future, then it should consider the impact of the merger in estimating the
expected volatility if it reasonably believes a marketplace participant would
also consider this event.
The staff believes that careful consideration is required to determine whether
material non-public information is currently available (or would be available)
to the issuer that would be considered by a marketplace participant in
estimating the expected volatility.39 For example, if Company B has entered into a material transaction that has
not yet been announced prior to its grant of equity instruments, the specific
facts and circumstances of the material transaction may lead Company B to
conclude that the impact of this event should be included in estimating the
expected volatility when determining the grant-date fair value of those equity
instruments.
5. Exclusion of Periods of Historical Data —
In some instances, due to a company’s particular business situations, a period
of historical volatility data may not be relevant in evaluating expected
volatility.40 In these instances, that period should be disregarded. The staff believes
that if Company B disregards a period of historical volatility, it should be
prepared to support its conclusion that its historical share price during that
previous period is not relevant to estimating expected volatility due to one or
more discrete and specific historical events and that similar events are not
expected to occur during the expected term of the share option. The staff
believes these situations would be rare.
Question 3: What should Company B consider when evaluating the extent of its reliance on the implied volatility derived from its traded options?
Interpretive Response: To achieve the objective of
estimating expected volatility as stated in FASB ASC paragraphs 718-10-55-35
through 718-10-55-41, the staff believes Company B generally should consider the
following in its evaluation: 1) the volume of market activity of the underlying
shares and traded options; 2) the ability to synchronize the variables used to
derive implied volatility; 3) the similarity of the exercise prices of the
traded options to the exercise price of the newly-granted share options; 4) the
similarity of the length of the term of the traded and newly-granted share
options;41 and 5) consideration of material non-public information.
1. Volume of Market Activity —
The staff believes Company B should consider the volume of trading in its underlying shares as well as the traded options. For example, prices for instruments in actively traded markets are more likely to reflect a marketplace participant’s expectations regarding expected volatility.
2. Synchronization of the Variables —
Company B should synchronize the variables used to derive implied volatility.
For example, to the extent reasonably practicable, Company B should use market
prices (either traded prices or the average of bid and asked quotes) of the
traded options and its shares measured at the same point in time. This
measurement should also be synchronized with the grant of the share options;
however, when this is not reasonably practicable, the staff believes Company B
should derive implied volatility as of a point in time as close to the grant of
the share options as reasonably practicable.
3. Similarity of the Exercise Prices —
The staff believes that when valuing an at-the-money share option, the implied
volatility derived from at- or near-the-money traded options generally would be
most relevant.42 If, however, it is not possible to find at- or near-the-money traded
options, Company B should select multiple traded options with an average
exercise price close to the exercise price of the share option.43
4. Similarity of Length of Terms —
The staff believes that when valuing a share option with a given expected or
contractual term, as applicable, the implied volatility derived from a traded
option with a similar term would be the most relevant. However, if there are no
traded options with maturities that are similar to the share option’s
contractual or expected term, as applicable, then the staff believes Company B
could consider traded options with a remaining maturity of six months or
greater.44 However, when using traded options with a term of less than one year,45 the staff would expect the company to also consider other relevant
information in estimating expected volatility. In general, the staff believes
more reliance on the implied volatility derived from a traded option would be
expected the closer the remaining term of the traded option is to the expected
or contractual term, as applicable, of the share option.
5. Consideration of Material Nonpublic Information —
When a company is in possession of material non-public information, the staff
believes that the related guidance in the interpretive response to Question 2
above would also be relevant in determining whether the implied volatility
appropriately reflects a marketplace participant's expectations of future
volatility.
The staff believes Company B’s evaluation of the factors above should assist in determining whether the implied volatility appropriately reflects the market’s expectations of future volatility and thus the extent of reliance that Company B reasonably places on the implied volatility.
Question 4: Are there situations in which it is acceptable for Company B to rely exclusively on either implied volatility or historical volatility in its estimate of expected volatility?
Interpretive Response: As stated above, FASB ASC Topic
718 does not specify a method of estimating expected volatility; rather, it
provides a list of factors that should be considered and requires that an
entity’s estimate of expected volatility be reasonable and supportable.46 Many of the factors listed in FASB ASC Topic 718 are discussed in
Questions 2 and 3 above. The objective of estimating volatility, as stated in
FASB ASC Topic 718, is to ascertain the assumption about expected volatility
that marketplace participants would likely use in determining an exchange price
for an option.47 The staff believes that a company, after considering the factors listed in
FASB ASC Topic 718, could, in certain situations, reasonably conclude that
exclusive reliance on either historical or implied volatility would provide an
estimate of expected volatility that meets this stated objective.
The staff would not object to Company B placing exclusive reliance on implied volatility when the following factors are present, as long as the methodology is consistently applied:
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Company B utilizes a valuation model that is based upon a constant volatility assumption to value its share options;48
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The implied volatility is derived from options that are actively traded;
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The market prices (trades or quotes) of both the traded options and underlying shares are measured at a similar point in time to each other and on a date reasonably close to the fair value measurement date of the share options;
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The traded options have exercise prices that are both (a) near-the-money and (b) close to the exercise price of the share options;49
- The remaining maturities of the traded options on which the estimate is based are at least one year, and
- Material nonpublic information that would be considered in a marketplace participant's expectation of future volatility does not exist.
The staff would not object to Company B placing exclusive reliance on historical volatility when the following factors are present, so long as the methodology is consistently applied:
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Company B has no reason to believe that its future volatility over the expected or contractual term, as applicable, is likely to differ from its past;50
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The computation of historical volatility uses a simple average calculation method;
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A sequential period of historical data at least equal to the expected or contractual term of the share option, as applicable, is used; and
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A reasonably sufficient number of price observations are used, measured at a consistent point throughout the applicable historical period.51
Question 5: What disclosures would the staff expect Company B to include in its financial statements and MD&A regarding its assumption of expected volatility?
Interpretive Response: FASB ASC paragraph 718-10-50-2
prescribes the minimum information needed to achieve the Topic’s disclosure
objectives.52 Under that guidance, Company B is required to disclose the expected
volatility and the method used to estimate it.53 Accordingly, the staff expects that, at a minimum, Company B would
disclose in a footnote to its financial statements how it determined the
expected volatility assumption for purposes of determining the fair value of its
share options in accordance with FASB ASC Topic 718. For example, at a minimum,
the staff would expect Company B to disclose whether it used only implied
volatility, historical volatility, or a combination of both, and how it
determined any significant adjustments to historical volatility.
In addition, Company B should consider the requirements of Regulation S-K Item
303(b)(3) regarding critical accounting estimates in MD&A. A company should
determine whether its evaluation of any of the factors listed in Questions 2 and
3 of this section, such as consideration of future events in estimating expected
volatility, resulted in an estimate that involves a significant level of
estimation uncertainty and has had or is reasonably likely to have a material
impact on the financial condition or results of operations of the company.
Facts: Company C is a newly public entity with limited
historical data on the price of its publicly-traded shares and no other traded
financial instruments. Company C believes that it does not have sufficient
company-specific information regarding the volatility of its share price on
which to base an estimate of expected volatility.
Question 6: What other sources of information should Company C consider in order to estimate the expected volatility of its share price?
Interpretive Response: FASB ASC Topic 718 provides
guidance on estimating expected volatility for newly-public and nonpublic
entities that do not have company-specific historical or implied volatility
information available.54 Company C may base its estimate of expected volatility on the historical,
expected or implied volatility of similar entities whose share or option prices
are publicly available. In making its determination as to similarity, Company C
would likely consider the industry, stage of life cycle, size and financial
leverage of such other entities.55
The staff would not object to Company C looking to an industry sector index
(e.g., NASDAQ Computer Index) that is representative of Company C’s
industry, and possibly its size, to identify one or more similar entities.56 Once Company C has identified similar entities, it would substitute a
measure of the individual volatilities of the similar entities for the expected
volatility of its share price as an assumption in its valuation model.57 Because of the effects of diversification that are present in an industry
sector index, Company C should not substitute the volatility of an index for the
expected volatility of its share price as an assumption in its valuation
model.58
After similar entities have been identified, Company C should continue to
consider the volatilities of those entities unless circumstances change such
that the identified entities are no longer similar to Company C. Until Company C
has sufficient information available, the staff would not object to Company C
basing its estimate of expected volatility on the volatility of similar entities
for those periods for which it does not have sufficient information
available.59 Until Company C has either a sufficient amount of historical information
regarding the volatility of its share price or other traded financial
instruments are available to derive an implied volatility to support an estimate
of expected volatility, it should consistently apply a process as described
above to estimate expected volatility based on the volatilities of similar
entities.60
2. Expected Term
FASB ASC paragraph 718-10-55-29 states, “The fair value of a traded (or
transferable) share option is based on its contractual term because rarely is it
economically advantageous to exercise, rather than sell, a transferable share
option before the end of its contractual term. Employee share options generally
differ from transferable [or tradable] share options in that employees cannot
sell (or hedge) their share options — they can only exercise them; because of
this, employees generally exercise their options before the end of the options’
contractual term. Thus, the inability to sell or hedge an employee share option
effectively reduces the option’s value [compared to a transferable option]
because exercise prior to the option’s expiration terminates its remaining life
and thus its remaining time value.” Accordingly, FASB ASC Topic 718 requires
that when valuing an employee share option under the Black-Scholes-Merton
framework the fair value of employee share options be based on the share
options’ expected term rather than the contractual term.
FASB ASC paragraph 718-10-55-29A states, "On an award-by-award basis, an entity
may elect to use the contractual term as the expected term when estimating the
fair value of a nonemployee award to satisfy the measurement objective in
paragraph 718-10-30-6. Otherwise, an entity shall apply the guidance in [Topic
718] in estimating the expected term of a nonemployee award, which may result in
a term less than the contractual term of the award. If an entity does not elect
to use the contractual term as the expected term, similar considerations
discussed in paragraph 718-10-55-29, such as the inability to sell or hedge a
nonemployee award, apply when estimating its expected term."
The staff believes the estimate of expected term should be based on the facts
and circumstances available in each particular case. Consistent with our Topic
14 introductory guidance regarding reasonableness, the fact that other possible
estimates are later determined to have more accurately reflected the term does
not necessarily mean that the particular choice was unreasonable. The staff
reminds registrants of the expected term disclosure requirements described in
FASB ASC subparagraph 718-10-50-2(f)(2)(i).
Facts: Company D utilizes the Black-Scholes-Merton closed-form model to value its share options for the purposes of determining the fair value of the options under FASB ASC Topic 718. Company D recently granted share options to its employees. Based on its review of various factors, Company D determines that the expected term of the options is six years, which is less than the contractual term of ten years.
Question 1: When determining the fair value of the share options in accordance with FASB ASC Topic 718, should Company D consider an additional discount for nonhedgability and nontransferability?
Interpretive Response: No. FASB ASC paragraph
718-10-55-29 indicates that nonhedgability and nontransferability have the
effect of increasing the likelihood that an employee share option will be
exercised before the end of its contractual term. Nonhedgability and
nontransferability therefore factor into the expected term assumption (in this
case reducing the term assumption from ten years to six years), and the expected
term reasonably adjusts for the effect of these factors. Accordingly, the staff
believes that no additional reduction in the term assumption or other discount
to the estimated fair value is appropriate for these particular factors.61
Question 2: Should forfeitures or terms that stem from forfeitability be factored into the determination of expected term?
Interpretive Response: No. FASB ASC Topic 718 indicates
that the expected term that is utilized as an assumption in a closed-form
option-pricing model or a resulting output of a lattice option pricing model
when determining the fair value of the share options should not incorporate
restrictions or other terms that stem from the pre-vesting forfeitability of the
instruments. Under FASB ASC Topic 718, these pre-vesting restrictions or other
terms are taken into account by ultimately recognizing compensation cost only
for awards for which grantees deliver the good or render the service.62
Question 3: Can a company’s estimate of expected term ever be shorter than the vesting period?
Interpretive Response: No. The vesting period forms the
lower bound of the estimate of expected term.63
Question 4: FASB ASC paragraph 718-10-55-34 indicates that an entity shall aggregate individual awards into relatively homogenous groups with respect to exercise and post-vesting employment termination behaviors for the purpose of determining expected term, regardless of the valuation technique or model used to estimate the fair value. How many groupings are typically considered sufficient?
Interpretive Response: As it relates to employee
groupings, the staff believes that an entity may generally make a reasonable
fair value estimate with as few as one or two groupings.64
Question 5: What approaches could a company use to estimate the expected term of its employee share options?
Interpretive Response: A company should use an approach
that is reasonable and supportable under FASB ASC Topic 718’s fair value
measurement objective, which establishes that assumptions and measurement
techniques should be consistent with those that marketplace participants would
be likely to use in determining an exchange price for the share options.65 If, in developing its estimate of expected term, a company determines that
its historical share option exercise experience is the best estimate of future
exercise patterns, the staff will not object to the use of the historical share
option exercise experience to estimate expected term.66
A company may also conclude that its historical share option exercise experience
does not provide a reasonable basis upon which to estimate expected term. This
may be the case for a variety of reasons, including, but not limited to, the
life of the company and its relative stage of development, past or expected
structural changes in the business, differences in terms of past equity-based
share option grants,67 or a lack of variety of price paths that the company may have
experienced.68
FASB ASC Topic 718 describes other alternative sources of information that might
be used in those cases when a company determines that its historical share
option exercise experience does not provide a reasonable basis upon which to
estimate expected term. For example, a lattice model (which by definition
incorporates multiple price paths) can be used to estimate expected term as an
input into a Black-Scholes-Merton closed-form model.69 In addition, FASB ASC paragraph 718-10-55-32 states “…that expected term
might be estimated in some other manner, taking into account whatever relevant
and supportable information is available, including industry averages and other
pertinent evidence such as published academic research.” For example, data about
exercise patterns of employees in similar industries and/or situations as the
company's might be used.
Facts: Company E grants equity share options to its
employees that have the following basic characteristics:70
-
The share options are granted at-the-money;
-
Exercisability is conditional only on performing service through the vesting date;71
-
If an employee terminates service prior to vesting, the employee would forfeit the share options;
-
If an employee terminates service after vesting, the employee would have a limited time to exercise the share options (typically 30-90 days); and
-
The share options are nontransferable and nonhedgeable.
Company E utilizes the Black-Scholes-Merton closed-form model for valuing its employee share options.
Question 6: As share options with these “plain vanilla” characteristics have been granted in significant quantities by many companies in the past, is the staff aware of any “simple” methodologies that can be used to estimate expected term?
Interpretive Response: The staff understands that an
entity that is unable to rely on its historical exercise data may find that
certain alternative information, such as exercise data relating to employees of
other companies, is not easily obtainable. As such, some companies may encounter
difficulties in making a refined estimate of expected term. Accordingly, if a
company concludes that its historical share option exercise experience does not
provide a reasonable basis upon which to estimate expected term, the staff will
accept the following “simplified” method for “plain vanilla” options consistent
with those in the fact set above: expected term = ((vesting term + original
contractual term) / 2). Assuming a ten year original contractual term and graded
vesting over four years (25% of the options in each grant vest annually) for the
share options in the fact set described above, the resultant expected term would
be 6.25 years.72 Academic research on the exercise of options issued to executives provides
some general support for outcomes that would be produced by the application of
this method.73
Examples of situations in which the staff believes that it may be appropriate to use this simplified method include the following:
-
A company does not have sufficient historical exercise data to provide a reasonable basis upon which to estimate expected term due to the limited period of time its equity shares have been publicly traded.
-
A company significantly changes the terms of its share option grants or the types of employees that receive share option grants such that its historical exercise data may no longer provide a reasonable basis upon which to estimate expected term.
-
A company has or expects to have significant structural changes in its business such that its historical exercise data may no longer provide a reasonable basis upon which to estimate expected term.
The staff understands that a company may have sufficient historical exercise data for some of its share option grants but not for others. In such cases, the staff will accept the use of the simplified method for only some but not all share option grants. The staff also does not believe that it is necessary for a company to consider using a lattice model before it decides that it is eligible to use this simplified method. Further, the staff will not object to the use of this simplified method in periods prior to the time a company’s equity shares are traded in a public market.
If a company uses this simplified method, the company should disclose in the
notes to its financial statements the use of the method, the reason why the
method was used, the types of share option grants for which the method was used
if the method was not used for all share option grants, and the periods for
which the method was used if the method was not used in all periods. Companies
that have sufficient historical share option exercise experience upon which to
estimate expected term may not apply this simplified method. In addition, this
simplified method is not intended to be applied as a benchmark in evaluating the
appropriateness of more refined estimates of expected term.
The staff does not expect that such a simplified method would be used for share
option grants when more relevant detailed information is available to the
company.
3. Current Price of the Underlying Share (Including Considerations for Spring-Loaded Grants)
FASB ASC paragraph 718-10-55-21 states that "if an observable market price is
not available for a share option or similar instrument with the same or
similar terms and conditions, an entity shall estimate the fair value of
that instrument using a valuation technique or model that meets the
requirements in paragraph 718-10-55-11," and requires such valuation
technique or model to take into account, at a minimum a number of factors
including the current price of the underlying share.
FASB ASC paragraph 718-10-55-27 states, "Assumptions used to estimate the
fair value of equity and liability instruments granted in share-based
payment transactions shall be determined in a consistent manner from period
to period. For example, an entity might use the closing share price or the
share price at another specified time as the current share price on the
grant date in estimating fair value, but whichever method is selected, it
shall be used consistently."
For a valuation technique to be consistent with the fair value measurement
objective and the other requirements of Topic 718, the staff believes that a
consistently applied method to determine the current price of the underlying
share should include consideration of whether adjustments to observable
market prices (e.g., the closing share price or the share price at another
specified time) are required. Such adjustments may be required, for example,
when the observable market price does not reflect certain material
non-public information known to the company but unavailable to marketplace
participants at the time the market price is observed.
Determining whether an adjustment to the observable market price is
necessary, and if so, the magnitude of any adjustment, requires significant
judgment. The staff acknowledges that companies generally possess non-public
information when entering into share-based payment transactions. The staff
believes that an observable market price on the grant date is generally a
reasonable and supportable estimate of the current price of the underlying
share in a share-based payment transaction, for example, when estimating the
grant-date fair value of a routine annual grant to employees that is not
designed to be spring-loaded.
However, companies should carefully consider whether an adjustment to the
observable market price is required, for example, when share-based payments
arrangements are entered into in contemplation of or shortly before a
planned release of material non-public information, and such information is
expected to result in a material increase in share price. The staff believes
that non-routine spring-loaded grants merit particular scrutiny by those
charged with compensation and financial reporting governance. Additionally,
when a company has a planned release of material non-public information
within a short period of time after the measurement date of a share-based
payment, the staff believes a material increase in the market price of the
company's shares upon release of such information indicates marketplace
participants would have considered an adjustment to the observable market
price on the measurement date to determine the current price of the
underlying share.
Facts: Company D is a public company that entered into a material
contract with a customer after market close. Subsequent to entering into the
contract but before the market opens the next trading day, Company D awards
share options to its executives. The share option award is non-routine, and
the award is approved by the Board of Directors in contemplation of the
material contract. Company D expects the share price to increase
significantly once the announcement of the contract is made the next day.
Company D's accounting policy is to consistently use the closing share price
on the day of the grant as the current share price in estimating the
grant-date fair value of share options.
Question 1: Should Company D make an adjustment to the closing share
price to determine the current price of shares underlying share options?
Interpretive Response: Prior to awarding share options in this fact
pattern, the staff expects Company D to consider whether such awards are
consistent with its policies and procedures, including the terms of the
compensation plan approved by shareholders, other governance policies, and
legal requirements. The staff reminds companies of the importance of strong
corporate governance and controls in granting share options, as well as the
requirements to maintain effective internal control over financial reporting
and disclosure controls and procedures.
In estimating the grant-date fair value of share options in this fact
pattern, absent an adjustment to the closing share price to reflect the
impact of Company D's new material contract with a customer, the staff
believes the closing share price would not be a reasonable and supportable
estimate and, without an adjustment the valuation of the award would not
meet the fair value measurement objective of FASB ASC Topic 718 because the
closing share price would not reflect a price that is unbiased for
marketplace participants at the time of the grant.74
Question 2: What disclosures would the staff expect Company D to
include in its financial statements regarding its determination of the
current price of shares underlying newly-granted share options?
Interpretive Response: FASB ASC paragraph 718-10-50-1 requires
disclosure of information that enables users of the financial statements to
understand, among other things, the nature and terms of share-based payment
arrangements that existed during the period and the potential effects of
those arrangements on shareholders. FASB ASC paragraph 718-10-50-2
prescribes the minimum information needed to achieve the Topic's disclosure
objectives, including a description of the method used and significant
assumptions used to estimate the fair value of awards under share-based
payment arrangements.
Accordingly, the staff expects that, at a minimum, Company D would disclose
in a footnote to its financial statements how it determined the current
price of shares underlying share options for purposes of determining the
grant-date fair value of its share options in accordance with FASB ASC Topic
718. For example, the staff would expect Company D to disclose its
accounting policy related to how it identifies when an adjustment to the
closing price is required, how it determined the amount of the adjustment to
the closing share price, and any significant assumptions used to determine
such adjustment, if material. Further, the characteristics of the share
options, including their spring-loaded nature, may differ from Company D's
other share-based payment arrangements to such an extent Company D should
disclose information regarding these share options separately from other
share-based payment arrangements to allow investors to understand Company
D's use of share-based compensation.75
Additionally, Company D should consider the applicability of MD&A and
other disclosure requirements, including those related to liquidity and
capital resources, results of operations, critical accounting estimates,
executive compensation, and transactions with related persons.76
E. FASB ASC Topic 718, Compensation — Stock Compensation, and Certain Redeemable Financial Instruments
Certain financial instruments awarded in conjunction with share-based payment
arrangements have redemption features that require settlement by cash or other
assets upon the occurrence of events that are outside the control of the issuer.77 FASB ASC Topic 718 provides guidance for determining whether instruments
granted in conjunction with share-based payment arrangements should be classified as
liability or equity instruments. Under that guidance, most instruments with
redemption features that are outside the control of the issuer are required to be
classified as liabilities; however, some redeemable instruments will qualify for
equity classification.78 SEC Accounting Series Release No. 268, Presentation in Financial Statements of
“Redeemable Preferred Stocks,”79 (“ASR 268”) and related guidance80 address the classification and measurement of certain redeemable equity
instruments.
Facts: Under a share-based payment arrangement, Company F grants to an employee shares (or share options) that all vest at the end of four years (cliff vest). The shares (or shares underlying the share options) are redeemable for cash at fair value at the holder’s option, but only after six months from the date of share issuance (as defined in FASB ASC Topic 718). Company F has determined that the shares (or share options) would be classified as equity instruments under the guidance of FASB ASC Topic 718. However, under ASR 268 and related guidance, the instruments would be considered to be redeemable for cash or other assets upon the occurrence of events (e.g., redemption at the option of the holder) that are outside the control of the issuer.
Question 1: While the instruments are subject to FASB
ASC Topic 718, is ASR 268 and related guidance applicable to instruments issued
under share-based payment arrangements that are classified as equity instruments
under FASB ASC Topic 718?
Interpretive Response: Yes. The staff believes that
registrants must evaluate whether the terms of instruments granted in conjunction
with share-based payment arrangements that are not classified as liabilities under
FASB ASC Topic 718 result in the need to present certain amounts outside of
permanent equity (also referred to as being presented in “temporary equity”) in
accordance with ASR 268 and related guidance.81
When an instrument ceases to be subject to FASB ASC Topic 718 and becomes subject to the recognition and measurement requirements of other applicable GAAP, the staff believes that the company should reassess the classification of the instrument as a liability or equity at that time and consequently may need to reconsider the applicability of ASR 268.
Question 2: How should Company F apply ASR 268 and related guidance to the shares (or share options) granted under the share-based payment arrangements with employees that may be unvested at the date of grant?
Interpretive Response: Under FASB ASC Topic 718, when
compensation cost is recognized for instruments classified as equity instruments,
additional paid-in-capital82 is increased. If the award is not fully vested at the grant date, compensation
cost is recognized and additional paid-in-capital is increased over time as services
are rendered over the requisite service period. A similar pattern of recognition
should be used to reflect the amount presented as temporary equity for share-based
payment awards that have redemption features that are outside the issuer’s control
but are classified as equity instruments under FASB ASC Topic 718. The staff
believes Company F should present as temporary equity at each balance sheet date an
amount that is based on the redemption amount of the instrument, but takes into
account the proportion of consideration received in the form of employee services.
Thus, for example, if a nonvested share that qualifies for equity classification
under FASB ASC Topic 718 is redeemable at fair value more than six months after
vesting, and that nonvested share is 75% vested at the balance sheet date, an amount
equal to 75% of the fair value of the share should be presented as temporary equity
at that date. Similarly, if an option on a share of redeemable stock that qualifies
for equity classification under FASB ASC Topic 718 is 75% vested at the balance
sheet date, an amount equal to 75% of the intrinsic83 value of the option should be presented as temporary equity at that date.
Question 3: Would the methodology described for employee awards in the Interpretive Response to Question 2 above apply to nonemployee awards to be issued in exchange for goods or services with similar terms to those described above?
Interpretive Response: The staff believes it would
generally be appropriate to apply the methodology described in the Interpretive
Response to Question 2 above to nonemployee awards.
F. Classification of Compensation Expense Associated with Share-Based Payment Arrangements
Facts: Company G utilizes both cash and share-based payment arrangements to compensate its employees and nonemployee service providers. Company G would like to emphasize in its income statement the amount of its compensation that did not involve a cash outlay.
Question: How should Company G present in its income statement the non-cash nature of its expense related to share-based payment arrangements?
Interpretive Response: The staff believes Company G
should present the expense related to share-based payment arrangements in the same
line or lines as cash compensation paid to the same employees or nonemployees.84 The staff believes a company could consider disclosing the amount of expense
related to share-based payment arrangements included in specific line items in the
financial statements. Disclosure of this information might be appropriate in a
parenthetical note to the appropriate income statement line items, on the cash flow
statement, in the footnotes to the financial statements, or within MD&A.
G. Removed by SAB 114
H. Removed by SAB 114
I. Capitalization of Compensation Cost Related to Share-Based Payment Arrangements
Facts: Company K is a manufacturing company that grants
share options to its production employees. Company K has determined that the cost of
the production employees’ service is an inventoriable cost. As such, Company K is
required to initially capitalize the cost of the share option grants to these
production employees as inventory and later recognize the cost in the income
statement when the inventory is consumed.85
Question: If Company K elects to adjust its period end inventory balance for the allocable amount of share-option cost through a period end adjustment to its financial statements, instead of incorporating the share-option cost through its inventory costing system, would this be considered a deficiency in internal controls?
Interpretive Response: No. FASB ASC Topic 718,
Compensation — Stock Compensation, does not prescribe the mechanism a company should
use to incorporate a portion of share-option costs in an inventory-costing system.
The staff believes Company K may accomplish this through a period end adjustment to
its financial statements. Company K should establish appropriate controls
surrounding the calculation and recording of this period end adjustment, as it would
any other period end adjustment. The fact that the entry is recorded as a period end
adjustment, by itself, should not impact management’s ability to determine that the
internal control over financial reporting, as defined by the SEC’s rules
implementing Section 404 of the Sarbanes-Oxley Act of 2002,86 is effective.
J. Removed by SAB 114
K. Removed by SAB 114
L. Removed by SAB 114
M. Removed by SAB 114
Footnotes
1
FASB ASC paragraphs 718-10-30-2 through 718-10-30-4.
2
Defined in the FASB ASC Master Glossary.
3
A share-based payment award granted when a company is in possession of material
nonpublic information to which the market is likely to react positively when the
information is announced is sometimes referred to as being "spring-loaded." The
interpretive guidance included in this SAB with respect to spring-loaded
share-based payment awards is not limited to share options, and applies to all
instruments including, for example, restricted stock units.
4
Defined in the FASB ASC Master Glossary.
5
For purposes of this staff accounting bulletin, the phrase
“share options” is used to refer to “share options or similar
instruments.”
6
FASB ASC paragraph 718-10-30-20 requires a nonpublic entity
to use the calculated value method when it is not able to reasonably
estimate the fair value of its equity share options and similar instruments
because it is not practicable for it to estimate the expected volatility of
its share price. FASB ASC paragraph 718-10-55-51 indicates that a nonpublic
entity may be able to identify similar public entities for which share or
option price information is available and may consider the historical,
expected, or implied volatility of those entities’ share prices in
estimating expected volatility. The staff would expect an entity that
becomes a public entity and had previously measured its share options under
the calculated value method to be able to support its previous decision to
use calculated value and to provide the disclosures required by FASB ASC
subparagraph 718-10-50-2(f)(2)(ii).
7
This view is consistent with the FASB’s basis for rejecting full retrospective application of FASB ASC Topic 718 as described in the basis for conclusions of Statement 123R, paragraph B251.
8
FASB ASC paragraph 718-20-55-94. The staff believes that
because Company A is a public entity as of the date of the modification, it
would be inappropriate to use the calculated value method to measure the
original share options immediately before the terms were modified.
9
FASB ASC paragraph 718-30-30-2.
10
FASB ASC paragraph 718-30-35-3.
11
$15 fair value less $10 intrinsic value equals $5 of
incremental cost.
12
This view is consistent with the FASB’s basis for rejecting
full retrospective application of FASB ASC Topic 718 as described in the basis for conclusions of Statement 123R, paragraph B251.
13
FASB ASC Section 718-10-50.
14
See Item 303 of Regulation S-K.
15
FASB ASC paragraph 718-10-30-1 states that this guidance applies equally to
awards classified as liabilities.
16
FASB ASC paragraph 718-10-55-10.
17
FASB ASC paragraph 718-10-55-11.
18
FASB ASC paragraph 718-10-55-15 states, “The fair value of
those instruments at a single point in time is not a forecast of what the
estimated fair value of those instruments may be in the future.”
19
Generally, the grant date for equity awards or the reporting
date for liability-classified awards.
20
See FASB ASC paragraphs 718-10-55-16 and 718-10-55-20.
21
FASB ASC paragraph 718-10-55-17 indicates that an entity
may use different valuation techniques or models for instruments with
different characteristics.
22
The staff believes that a company should take into account
the reason for the change in technique or model in determining whether the
new technique or model meets the fair value measurement objective. For
example, changing a technique or model from period to period for the sole
purpose of lowering the fair value estimate of a share option would not meet
the fair value measurement objective of the Topic.
23
FASB ASC paragraph 718-10-55-27.
24
See generally FASB ASC paragraph 718-10-50-1.
25
FASB ASC paragraph 718-10-30-6. FASB ASC paragraph
718-10-30-1 states that this guidance applies equally to awards classified
as liabilities.
26
FASB ASC paragraph 718-10-55-35.
27
FASB ASC paragraph 718-10-55-37.
28
FASB ASC paragraph 718-10-55-40.
29
Ibid.
30
Implied volatility is the volatility assumption
inherent in the market prices of a company’s traded options or other
financial instruments that have option-like features. Implied volatility
is derived by entering the market price of the traded financial
instrument, along with assumptions specific to the financial options
being valued, into a model based on a constant volatility estimate
(e.g., the Black-Scholes-Merton closed-form model) and
solving for the unknown assumption of volatility.
31
The staff believes implied volatility derived from
embedded options can be utilized in determining expected volatility if,
in deriving the implied volatility, the company considers all relevant
features of the instruments (e.g., value of the host instrument,
value of the option, etc.). The staff believes the derivation of implied
volatility from other than simple instruments (e.g., a simple
convertible bond) can, in some cases, be impracticable due to the
complexity of multiple features.
32
See FASB ASC paragraph 718-10-55-37.
33
For purposes of this staff accounting bulletin, the
phrase “expected or contractual term, as applicable” has the same
meaning as the phrase “expected (if using a Black-Scholes-Merton
closed-form model) or contractual (if using a lattice model) term of a
share option.”
34
FASB ASC subparagraph 718-10-55-37(a) states that
entities should consider historical volatility over a period generally
commensurate with the expected or contractual term, as applicable, of
the share option. Accordingly, the staff believes methods that place
extreme emphasis on the most recent periods may be inconsistent with
this guidance.
35
Generalized Autoregressive Conditional
Heteroskedasticity (“GARCH”) is an example of a method that demonstrates
this characteristic.
36
Further, if shares of a company are thinly traded the
staff believes the use of weekly or monthly price observations would
generally be more appropriate than the use of daily price observations.
The volatility calculation using daily observations for such shares
could be artificially inflated due to a larger spread between the bid
and asked quotes and lack of consistent trading in the market.
37
FASB ASC paragraph 718-10-55-40 states that a company
should establish a process for estimating expected volatility and apply
that process consistently from period to period. In addition, FASB ASC
paragraph 718-10-55-27 indicates that assumptions used to estimate the
fair value of instruments granted in share-based payment transactions
should be determined in a consistent manner from period to period.
38
FASB ASC paragraph 718-10-55-35.
39
FASB ASC paragraph 718-10-55-13 states "assumptions shall reflect
information that is (or would be) available to form the basis for an
amount at which the instruments being valued would be exchanged. In
estimating fair value, the assumptions used shall not represent the
biases of a particular party."
40
FASB ASC paragraph 718-10-55-37.
41
See generally Options, Futures, and Other Derivatives by John C.
Hull (Pearson, 11th Edition, 2021).
42
Implied volatilities of options differ systematically
over the “moneyness” of the option. This pattern of implied volatilities
across exercise prices is known as the “volatility smile” or “volatility
skew.” Studies such as “Implied Volatility” by Stewart Mayhew, Financial
Analysts Journal, July-August 1995, as well as more recent studies, have
found that implied volatilities based on near-the-money options do as
well as sophisticated weighted implied volatilities in estimating
expected volatility. In addition, the staff believes that because
near-the-money options are generally more actively traded, they may
provide a better basis for deriving implied volatility.
43
The staff believes a company could use a
weighted-average implied volatility based on traded options that are
either in-the-money or out-of-the-money. For example, if the share
option has an exercise price of $52, but the only traded options
available have exercise prices of $50 and $55, then the staff believes
that it is appropriate to use a weighted average based on the implied
volatilities from the two traded options; for this example, a 40% weight
on the implied volatility calculated from the option with an exercise
price of $55 and a 60% weight on the option with an exercise price of
$50.
44
The staff believes it may also be appropriate to
consider the entire term structure of volatility provided by traded
options with a variety of remaining maturities. If a company considers
the entire term structure in deriving implied volatility, the staff
would expect a company to include some options in the term structure
with a remaining maturity of six months or greater.
45
The staff believes the implied volatility derived from
a traded option with a term of one year or greater would typically not
be significantly different from the implied volatility that would be
derived from a traded option with a significantly longer term.
46
FASB ASC paragraphs 718-10-55-36 through
718-10-55-37.
47
FASB ASC paragraph 718-10-55-35.
48
FASB ASC paragraphs 718-10-55-18 and
718-10-55-39 discuss the incorporation of a range of expected
volatilities into option pricing models. The staff believes that
a company that utilizes an option pricing model that
incorporates a range of expected volatilities over the option’s
contractual term should consider the factors listed in FASB ASC
Topic 718, and those discussed in the Interpretive Responses to
Questions 2 and 3 above, to determine the extent of its reliance
(including exclusive reliance) on the derived implied
volatility.
49
When near-the-money options are not available,
the staff believes the use of a weighted-average approach, as
noted previously, may be appropriate.
50
See FASB ASC paragraph 718-10-55-38. A change in a
company’s business model that results in a material alteration
to the company’s risk profile is an example of a circumstance in
which the company’s future volatility would be expected to
differ from its historical volatility. Other examples may
include, but are not limited to, the introduction of a new
product that is central to a company’s business model or the
receipt of U.S. Food and Drug Administration approval for the
sale of a new prescription drug.
51
If the expected or contractual term, as
applicable, of the employee share option is less than three
years, the staff believes monthly price observations would not
provide a sufficient amount of data.
52
FASB ASC paragraph 718-10-50-1.
53
FASB ASC subparagraph 718-10-50-2(f) (2) (ii).
54
FASB ASC paragraphs 718-10-55-25 and 718-10-55-51.
55
FASB ASC paragraph 718-10-55-25.
56
If a company operates in a number of different
industries, it could look to several industry indices. However, when
considering the volatilities of multiple companies, each operating only
in a single industry, the staff believes a company should take into
account its own leverage, the leverages of each of the entities, and the
correlation of the entities’ stock returns.
57
FASB ASC paragraph 718-10-55-51.
58
FASB ASC paragraph 718-10-55-25.
59
FASB ASC paragraph 718-10-55-37. The staff believes
that at least two years of daily or weekly historical data could provide
a reasonable basis on which to base an estimate of expected volatility
if a company has no reason to believe that its future volatility will
differ materially during the expected or contractual term, as
applicable, from the volatility calculated from this past information.
If the expected or contractual term, as applicable, of a share option is
shorter than two years, the staff believes a company should use daily or
weekly historical data for at least the length of that applicable
term.
60
FASB ASC paragraph 718-10-55-40.
61
The staff notes the existence of academic literature
that supports the assertion that the Black-Scholes-Merton closed-form
model, with expected term as an input, can produce reasonable estimates
of fair value. Such literature includes J. Carpenter, "The exercise and
valuation of executive stock options," Journal of Financial Economics,
May 1998, pp.127-158; C. Marquardt, "The Cost of Employee Stock Option
Grants: An Empirical Analysis," Journal of Accounting Research,
September 2002, pp. 1191-1217); and J. Bettis, J. Bizjak and M. Lemmon,
"Exercise behavior, valuation, and the incentive effect of employee
stock options," Journal of Financial Economics, May 2005, pp. 445-470,
as well as more recent studies.
62
FASB ASC paragraph 718-10-30-11.
63
FASB ASC paragraph 718-10-55-31.
64
The staff believes the focus should be on groups of
employees with significantly different expected exercise behavior.
Academic research suggests two such groups might be executives and
non-executives. A study by S. Huddart found executives and other senior
managers to be significantly more patient in their exercise behavior
than more junior employees. (Employee rank was proxied for by the number
of options issued to that employee.) See S. Huddart, “Patterns of
stock option exercise in the United States,” in: J. Carpenter and D.
Yermack, eds., Executive Compensation and Shareholder Value: Theory and
Evidence (Kluwer, Boston, MA, 1999), pp. 115-142. See also S.
Huddart and M. Lang, “Employee stock option exercises: An empirical
analysis,” Journal of Accounting and Economics, 1996, pp. 5-43.
65
FASB ASC paragraph 718-10-55-13.
66
Historical share option exercise experience encompasses
data related to share option exercise, post-vesting termination, and
share option contractual term expiration.
67
For example, if a company had historically granted
share options that were always in-the-money, and will grant at-the-money
options prospectively, the exercise behavior related to the in-the-money
options may not be sufficient as the sole basis to form the estimate of
expected term for the at-the-money grants.
68
For example, if a company had a history of previous
equity-based share option grants and exercises only in periods in which
the company’s share price was rising, the exercise behavior related to
those options may not be sufficient as the sole basis to form the
estimate of expected term for current option grants.
69
FASB ASC paragraph 718-10-55-30.
70
Employee share options with these features are
sometimes referred to as “plain vanilla” options.
71
In this fact pattern the requisite service
period equals the vesting period.
72
Calculated as [[[1 year vesting term (for the first 25%
vested) plus 2 year vesting term (for the second 25% vested) plus 3 year
vesting term (for the third 25% vested) plus 4 year vesting term (for
the last 25% vested)] divided by 4 total years of vesting] plus 10 year
contractual life] divided by 2; that is, (((1+2+3+4)/4) + 10) /2 = 6.25
years.
73
J.N. Carpenter, "The exercise and valuation of executive
stock options," Journal of Financial Economics, 1998, pp.127-158 studies
a sample of 40 NYSE and AMEX firms over the period 1979-1994 with share
option terms reasonably consistent to the terms presented in the fact
set and example. The mean time to exercise after grant was 5.83 years
and the median was 6.08 years. The "mean time to exercise" is shorter
than expected term since the study's sample included only exercised
options. Other research on executive options includes (but is not
limited to) J. Carr Bettis; John M. Bizjak; and Michael L. Lemmon,
"Exercise behavior, valuation, and the incentive effects of employee
stock options," Journal of Financial Economics, May 2005, pp. 445-470.
One of the few studies on nonexecutive employee options the staff is
aware of is S. Huddart, "Patterns of stock option exercise in the United
States," in: J. Carpenter and D. Yermack, eds., Executive Compensation
and Shareholder Value: Theory and Evidence (Kluwer, Boston, MA, 1999),
pp. 115-142.
74
FASB ASC paragraph 718-10-55-13.
75
ASC 718-10-50-1 and 718-10-50-2(g).
76
Items 303, 402, and 404 of Regulation S-K.
77
The terminology “outside the control of the issuer” is used
to refer to any of the three redemption conditions described in Rule 5-02.27
of Regulation S-X that would require classification outside permanent
equity. That rule requires preferred securities that are redeemable for cash
or other assets to be classified outside of permanent equity if they are
redeemable (1) at a fixed or determinable price on a fixed or determinable
date, (2) at the option of the holder, or (3) upon the occurrence of an
event that is not solely within the control of the issuer.
78
FASB ASC paragraphs 718-10-25-6 through 718-10-25-19A.
79
ASR 268, July 27, 1979, Rule 5-02.27 of Regulation S-X.
80
Related guidance includes EITF Topic No. D-98,
Classification and Measurement of Redeemable Securities, included
in the FASB ASC in paragraph 480-10-S99-3A.
81
Instruments granted in conjunction with share-based payment
arrangements with employees that do not by their terms require redemption
for cash or other assets (at a fixed or determinable price on a fixed or
determinable date, at the option of the holder, or upon the occurrence of an
event that is not solely within the control of the issuer) would not be
assumed by the staff to require net cash settlement for purposes of applying
ASR 268 in circumstances in which FASB ASC Section 815-40-25, Derivatives
and Hedging – Contracts in Entity's Own Equity – Recognition, would
otherwise require the assumption of net cash settlement. See FASB
ASC paragraph 815-40-25-11 (See FASB ASC paragraph 815-10-65-1 for the
transition and effective date information related to FASB ASU No. 2020-06,
Debt–Debt with Conversion and Other Options (Subtopic 470-20) and
Derivatives and Hedging–Contracts in Entity's Own Equity (Subtopic
815-40): Accounting for Convertible Instruments and Contracts in an
Entity's Own Equity, which superseded FASB ASC paragraph
815-40-25-11.), which states, in part: "...the events or actions
necessary to deliver registered shares are not controlled by an entity and,
therefore, except under the circumstances described in FASB ASC paragraph
815-40-25-16, if the contract permits the entity to net share or physically
settle the contract only by delivering registered shares, it is assumed that
the entity will be required to net cash settle the contract." See
also FASB ASC subparagraph 718-10-25-15(a).
82
Depending on the fact pattern, this may be recorded as
common stock and additional paid in capital.
83
The potential redemption amount of the share option in this
illustration is its intrinsic value because the holder would pay the
exercise price upon exercise of the option and then, upon redemption of the
underlying shares, the company would pay the holder the fair value of those
shares. Thus, the net cash outflow from the arrangement would be equal to
the intrinsic value of the share option. In situations where there would be
no cash inflows from the share option holder, the cash required to be paid
to redeem the underlying shares upon the exercise of the put option would be
the redemption value.
84
FASB ASC Topic 718 does not identify a specific line item
in the income statement for presentation of the expense related to
share-based payment arrangements, with the exception of the guidance in ASC
718-10-15-5A on share-based payment awards granted to a customer.
85
FASB ASC paragraph 718-10-25-2A.
86
Release No. 34-47986, June 5, 2003, Management’s Report on
Internal Control Over Financial Reporting and Certification of Disclosure in
Exchange Act Period Reports.