4.2 Measurement Objective

ASC 718-10

Measurement Objective — Fair Value at Grant Date

30-6 The measurement objective for equity instruments awarded to grantees is to estimate the fair value at the grant date 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 (for example, to exercise share options). That estimate is based on the share price and other pertinent factors, such as expected volatility, at the grant date.

Fair Value Measurement Objectives and Application

55-4 The measurement objective for equity instruments granted in share-based payment transactions 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 have rendered the service and satisfied any other conditions necessary to earn the right to benefit from the instruments. That estimate is based on the share price and other pertinent factors (including those enumerated in paragraphs 718-10-55-21 through 55-22, if applicable) at the grant date and is not remeasured in subsequent periods under the fair-value-based method.

55-5 A restriction that continues in effect after the entity has issued instruments to grantees, such as the inability to transfer vested equity share options to third parties or the inability to sell vested shares for a period of time, is considered in estimating the fair value of the instruments at the grant date. For instance, if shares are traded in an active market, postvesting restrictions may have little, if any, effect on the amount at which the shares being valued would be exchanged. For share options and similar instruments, the effect of nontransferability (and nonhedgeability, which has a similar effect) is taken into account by reflecting the effects of grantees’ expected exercise and postvesting termination behavior in estimating fair value (referred to as an option’s expected term).

55-6 In contrast, a restriction that stems from the forfeitability of instruments to which grantees have not yet earned the right, such as the inability either to exercise a nonvested equity share option or to sell nonvested shares, is not reflected in the fair value of the instruments at the grant date. Instead, those restrictions are taken into account by recognizing compensation cost only for awards for which grantees deliver the goods or render the service.

55-7 Note that performance and service conditions are vesting conditions for purposes of this Topic. Market conditions are not vesting conditions for purposes of this Topic but market conditions may affect exercisability of an award. Market conditions are included in the estimate of the grant-date fair value of awards (see paragraphs 718-10-55-64 through 55-66).

55-8 Reload features and contingent features that require a grantee to transfer equity shares earned, or realized gains from the sale of equity instruments earned, to the issuing entity for consideration that is less than fair value on the date of transfer (including no consideration), such as a clawback feature, shall not be reflected in the grant-date fair value of an equity award. Those features are accounted for if and when a reload grant or contingent event occurs. A clawback feature can take various forms but often functions as a noncompete mechanism. For example, an employee that terminates the employment relationship and begins to work for a competitor is required to transfer to the issuing entity (former employer) equity shares granted and earned in a share-based payment transaction.

55-9 The fair value measurement objective for liabilities incurred in a share-based payment transaction is the same as for equity instruments. However, awards classified as liabilities are subsequently remeasured to their fair values (or a portion thereof until the promised good has been delivered or the service has been rendered) at the end of each reporting period until the liability is settled.

Fair-Value-Based Instruments in a Share-Based Transaction

55-10 The definition of fair value refers explicitly only to assets and liabilities, but the concept of value in a current exchange embodied in it applies equally to the equity instruments subject to this Topic. Observable market prices of identical or similar equity or liability instruments in active markets are the best evidence of fair value and, if available, shall be used as the basis for the measurement of equity and liability instruments awarded in a share-based payment transaction. Determining whether an equity or liability instrument is similar is a matter of judgment, based on an analysis of the terms of the instrument and other relevant facts and circumstances. For example, awards to grantees of a public entity of shares of its common stock, subject only to a service or performance condition for vesting (nonvested shares), shall be measured based on the market price of otherwise identical (that is, identical except for the vesting condition) common stock at the grant date.

55-11 If observable market prices of identical or similar equity or liability instruments of the entity are not available, the fair value of equity and liability instruments awarded to grantees shall be estimated by using a valuation technique that meets all of the following criteria:

It is applied in a manner consistent with the fair value measurement objective and the other requirements of this Topic.
It is based on established principles of financial economic theory and generally applied in that field (see paragraph 718-10-55-16). Established principles of financial economic theory represent fundamental propositions that form the basis of modern corporate finance (for example, the time value of money and risk-neutral valuation).
It reflects all substantive characteristics of the instrument (except for those explicitly excluded by this Topic, such as vesting conditions and reload features).

That is, the fair values of equity and liability instruments granted in a share-based payment transaction shall be estimated by applying a valuation technique that would be used in determining an amount at which instruments with the same characteristics (except for those explicitly excluded by this Topic) would be exchanged.

55-12 An estimate of the amount at which instruments similar to share options and other instruments granted in share-based payment transactions would be exchanged would factor in expectations of the probability that the good would be delivered or the service would be rendered and the instruments would vest (that is, that the performance or service conditions would be satisfied). However, as noted in paragraph 718-10-55-4, the measurement objective in this Topic is to estimate the fair value at the grant date 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. Therefore, the estimated fair value of the instruments at grant date does not take into account the effect on fair value of vesting conditions and other restrictions that apply only during the employee’s requisite service period or the nonemployee’s vesting period. Under the fair-value-based method required by this Topic, the effect of vesting conditions and other restrictions that apply only during the employee’s requisite service period or the nonemployee’s vesting period is reflected by recognizing compensation cost only for instruments for which the good is delivered or the service is rendered.

Valuation Techniques

55-13 In applying a valuation technique, the assumptions used shall be consistent with the fair value measurement objective. That is, 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. Some of those assumptions will be based on or determined from external data. Other assumptions, such as the employees’ expected exercise behavior, may be derived from the entity’s own historical experience with share-based payment arrangements.

55-14 The fair value of any equity or liability instrument depends on its substantive characteristics. Paragraphs 718-10-55-21 through 55-22 list the minimum set of substantive characteristics of instruments with option (or option-like) features that shall be considered in estimating those instruments’ fair value. However, a share-based payment award could contain other characteristics, such as a market condition, that should be included in a fair value estimate. Judgment is required to identify an award’s substantive characteristics and, as described in paragraphs 718-10-55-15 through 55-20, to select a valuation technique that incorporates those characteristics.

As indicated above, ASC 718-10-30-6 specifies that the measurement objective for share-based payment arrangements is to estimate the fair-value-based measure, on the measurement date, “of the equity [and liability] 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.” This estimate is based on the share price and other measurement assumptions (e.g., the option pricing model inputs as described in ASC 718-10-55-21 in estimating the fair-value-based measure of stock options) on the measurement date.

In SAB Topic 14, the SEC provides the following general guidance on estimating the fair-value-based measure of share-based payment arrangements:

SEC Staff Accounting Bulletins

SAB Topic 14, Share-Based Payment [Excerpt]

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.

SAB Topic 14.C, Valuation Methods [Excerpt]

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: [Omitted]

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.

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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.

As indicated in SAB Topic 14, fair-value-based estimates are not predictions of actual future events. As long as an entity makes a good faith estimate in accordance with the principles in ASC 718, subsequent changes to the fair-value-based measurement will not call into question the reasonableness of the estimate. However, entities must consider the substantive terms of an award in a manner in which a market participant would consider them. In addition, the SEC staff will not object to an entity’s valuation technique provided that it meets all three of the following criteria in ASC 718-10-55-11:

“It is applied in a manner consistent with the fair value measurement objective and the other requirements of this Topic [ASC 718].”
“It is based on established principles of financial economic theory and generally applied in that field. . . . Established principles of financial economic theory represent fundamental propositions that form the basis of modern corporate finance (for example, the time value of money and risk-neutral valuation).”
“It reflects all substantive characteristics of the instrument (except for those explicitly excluded by this Topic [ASC 718], such as vesting conditions and reload features).”

For example, if an award contains a market condition, a Monte Carlo simulation is often used as a valuation technique rather than a Black-Scholes-Merton model.

Further, as long as fair-value-based estimates are prepared by a person with the “requisite expertise,” entities are not required to hire an outside third-party expert to assist in the valuation. For example, if a Black-Scholes-Merton model is applied, a valuation expert may not be required for many types of stock options.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.