4.5 Market Conditions

55-51 This Example illustrates the guidance in paragraph 718-10-30-15.

55-51A This Example (see paragraphs 718-20-55-52 through 55-60) describes employee awards. However, the principles on how to account for the various aspects of employee awards, except for the compensation cost attribution and certain inputs to valuation, are the same for nonemployee awards. Consequently, the concepts about valuation in paragraphs 718-20-55-52 through 55-60 are equally applicable to nonemployee awards with the same features as the awards in this Example (that is, awards with market conditions that affect exercise prices). Therefore, the guidance in those paragraphs may serve as implementation guidance for similar nonemployee awards.

55-51B Compensation cost attribution for awards to nonemployees may be the same or different for employee awards. That is because an entity is required to recognize compensation cost for nonemployee awards in the same manner as if the entity had paid cash in accordance with paragraph 718-10-25-2C. Additionally, valuation amounts used in this Example could be different because an entity may elect to use the contractual term as the expected term of share options and similar instruments when valuing nonemployee share-based payment transactions.

55-52 Entity T grants share options whose exercise price varies with an index of the share prices of a group of entities in the same industry, that is, a market condition. Assume that on January 1, 20X5, Entity T grants 100 share options on its common stock with an initial exercise price of $30 to each of 1,000 employees. The share options have a maximum term of 10 years. The exercise price of the share options increases or decreases on December 31 of each year by the same percentage that the index has increased or decreased during the year. For example, if the peer group index increases by 10 percent in 20X5, the exercise price of the share options during 20X6 increases to $33 ($30 × 1.10). On January 1, 20X5, the peer group index is assumed to be 400. The dividend yield on the index is assumed to be 1.25 percent.

55-53 Each indexed share option may be analyzed as a share option to exchange 0.0750 (30 ÷ 400) shares of the peer group index for a share of Entity T stock — that is, to exchange one noncash asset for another noncash asset. A share option to purchase stock for cash also can be thought of as a share option to exchange one asset (cash in the amount of the exercise price) for another (the share of stock). The intrinsic value of a cash share option equals the difference between the price of the stock upon exercise and the amount — the price — of the cash exchanged for the stock. The intrinsic value of a share option to exchange 0.0750 shares of the peer group index for a share of Entity T stock also equals the difference between the prices of the two assets exchanged.

55-54 To illustrate the equivalence of an indexed share option and the share option above, assume that an employee exercises the indexed share option when Entity T’s share price has increased 100 percent to $60 and the peer group index has increased 75 percent, from 400 to 700. The exercise price of the indexed share option thus is $52.50 ($30 × 1.75).

55-55 That is the same as the intrinsic value of a share option to exchange 0.0750 shares of the index for 1 share of Entity T stock.

55-56 Option-pricing models can be extended to value a share option to exchange one asset for another. The principal extension is that the volatility of a share option to exchange two noncash assets is based on the relationship between the volatilities of the prices of the assets to be exchanged — their cross-volatility. In a share option with an exercise price payable in cash, the amount of cash to be paid has zero volatility, so only the volatility of the stock needs to be considered in estimating that option’s fair value. In contrast, the fair value of a share option to exchange two noncash assets depends on possible movements in the prices of both assets — in this Example, fair value depends on the cross-volatility of a share of the peer group index and a share of Entity T stock. Historical cross-volatility can be computed directly based on measures of Entity T’s share price in shares of the peer group index. For example, Entity T’s share price was 0.0750 shares at the grant date and 0.0857 (60 ÷ 700) shares at the exercise date. Those share amounts then are used to compute cross-volatility. Cross-volatility also can be computed indirectly based on the respective volatilities of Entity T stock and the peer group index and the correlation between them. The expected cross-volatility between Entity T stock and the peer group index is assumed to be 30 percent.

55-57 In a share option with an exercise price payable in cash, the assumed risk-free interest rate (discount rate) represents the return on the cash that will not be paid until exercise. In this Example, an equivalent share of the index, rather than cash, is what will not be paid until exercise. Therefore, the dividend yield on the peer group index of 1.25 percent is used in place of the risk-free interest rate as an input to the option-pricing model.

55-58 The initial exercise price for the indexed share option is the value of an equivalent share of the peer group index, which is $30 (0.0750 × $400). The fair value of each share option granted is $7.55 based on the following inputs.

55-59 In this Example, the suboptimal exercise factor is 1.1. In Example 1 (see paragraph 718-20-55-4), the suboptimal exercise factor is 2.0. See paragraph 718-20-55-8 for an explanation of the meaning of a suboptimal exercise factor of 2.0.

55-60 The indexed share options have a three-year explicit service period. The market condition affects the grant-date fair value of the award and its exercisability; however, vesting is based solely on the explicit service period of three years. The at-the-money nature of the award makes the derived service period irrelevant in determining the requisite service period in this Example; therefore, the requisite service period of the award is three years based on the explicit service period. The accrual of compensation cost would be based on the number of options for which the requisite service is rendered or is expected to be rendered depending on an entity’s accounting policy in accordance with paragraph 718-10-35-3 (which is not addressed in this Example). That cost would be recognized over the requisite service period as shown in Example 1 (see paragraph 718-20-55-4).

55-61 This Example illustrates the guidance in paragraphs 718-10-25-20 through 25-21, 718-10-30-27, and 718-10-35-4.

55-61A This Example (see paragraphs 718-20-55-62 through 55-67) describes employee awards. However, the principles on how to account for the various aspects of employee awards, except for the compensation cost attribution and certain inputs to valuation, are the same for nonemployee awards. Consequently, both of the following are equally applicable to nonemployee awards with the same features as the awards in this Example (that is, awards with a specified time period for vesting and the recognition of compensation cost based on the achievement of particular performance conditions):

1. The performance conditions in paragraph 718-20-55-62
2. Concepts about valuation, compensation cost reversal, and total compensation cost that should be recognized (that is, the consideration of whether it is probable that performance conditions will be achieved) in paragraphs 718-20-55-63 and 718-20-55-65 through 55-67.

Therefore, the guidance in those paragraphs may serve as implementation guidance for similar nonemployee awards.

55-61B Compensation cost attribution for awards to nonemployees may be the same or different for employee awards. That is because an entity is required to recognize compensation cost for nonemployee awards in the same manner as if the entity had paid cash in accordance with paragraph 718-10-25-2C. Additionally, valuation amounts used in this Example could be different because an entity may elect to use the contractual term as the expected term of share options and similar instruments when valuing nonemployee share-based payment transactions.

55-62 Entity T grants 100,000 share units to each of 10 vice presidents (1 million share units in total) on January 1, 20X5. Each share unit has a contractual term of three years and a vesting condition based on performance. The performance condition is different for each vice president and is based on specified goals to be achieved over three years (an explicit three-year service period). If the specified goals are not achieved at the end of three years, the share units will not vest. Each share unit is convertible into shares of Entity T at contractual maturity as follows:

1. If Entity T’s share price has appreciated by a percentage that exceeds the percentage appreciation of the S&P 500 index by at least 10 percent (that is, the relative percentage increase is at least 10 percent), each share unit converts into 3 shares of Entity T stock.
2. If the relative percentage increase is less than 10 percent but greater than zero percent, each share unit converts into 2 shares of Entity T stock.
3. If the relative percentage increase is less than or equal to zero percent, each share unit converts into 1 share of Entity T stock.
4. If Entity T’s share price has depreciated, each share unit converts into zero shares of Entity T stock.

55-63 Appreciation or depreciation for Entity T’s share price and the S&P 500 index is measured from the grant date.

55-64 This market condition affects the ability to retain the award because the conversion ratio could be zero; however, vesting is based solely on the explicit service period of three years, which is equal to the contractual maturity of the award. That set of circumstances makes the derived service period irrelevant in determining the requisite service period; therefore, the requisite service period of the award is three years based on the explicit service period.

55-65 The share units’ conversion feature is based on a variable target stock price (that is, the target stock price varies based on the S&P 500 index); hence, it is a market condition. That market condition affects the fair value of the share units that vest. Each vice president’s share units vest only if the individual’s performance condition is achieved; consequently, this award is accounted for as an award with a performance condition (see paragraphs 718-10-55-60 through 55-63). This Example assumes that all share units become fully vested; however, if the share units do not vest because the performance conditions are not achieved, Entity T would reverse any previously recognized compensation cost associated with the nonvested share units.

55-66 The grant-date fair value of each share unit is assumed for purposes of this Example to be $36. Certain option-pricing models, including Monte Carlo simulation techniques, have been adapted to value path-dependent options and other complex instruments. In this case, the entity concludes that a Monte Carlo simulation technique provides a reasonable estimate of fair value. Each simulation represents a potential outcome, which determines whether a share unit would convert into three, two, one, or zero shares of stock. For simplicity, this Example assumes that no forfeitures will occur during the vesting period. The grant-date fair value of the award is $36 million (1 million × $36); management of Entity T expects that all share units will vest because the performance conditions are probable of achievement. Entity T recognizes compensation cost of $12 million ($36 million ÷ 3) in each year of the 3-year service period; the following journal entries are recognized by Entity T in 20X5, 20X6, and 20X7.

55-67 Upon contractual maturity of the share units, four outcomes are possible; however, because all possible outcomes of the market condition were incorporated into the share units’ grant-date fair value, no other entry related to compensation cost is necessary to account for the actual outcome of the market condition. However, if the share units’ conversion ratio was based on achieving a performance condition rather than on satisfying a market condition, compensation cost would be adjusted according to the actual outcome of the performance condition (see Example 4 [paragraph 718-20-55-47]).