4.9 Option Pricing Models
ASC 718-10 — Glossary
Closed-Form Model
A valuation model that uses an equation to produce an estimated fair value. The Black-Scholes-Merton formula is a closed-form model. In the context of option valuation, both closed-form models and lattice models are based on risk-neutral valuation and a contingent claims framework. The payoff of a contingent claim, and thus its value, depends on the value(s) of one or more other assets. The contingent claims framework is a valuation methodology that explicitly recognizes that dependency and values the contingent claim as a function of the value of the underlying asset(s). One application of that methodology is risk-neutral valuation in which the contingent claim can be replicated by a combination of the underlying asset and a risk-free bond. If that replication is possible, the value of the contingent claim can be determined without estimating the expected returns on the underlying asset. The Black-Scholes-Merton formula is a special case of that replication.
Intrinsic Value
The amount by which the fair value of the
underlying stock exceeds the exercise price of an option.
For example, an option with an exercise price of $20 on a
stock whose current market price is $25 has an intrinsic
value of $5. (A nonvested share may be described as an
option on that share with an exercise price of zero. Thus,
the fair value of a share is the same as the intrinsic value
of such an option on that share.)
Lattice Model
A model that produces an estimated fair
value based on the assumed changes in prices of a financial
instrument over successive periods of time. The binomial
model is an example of a lattice model. In each time period,
the model assumes that at least two price movements are
possible. The lattice represents the evolution of the value
of either a financial instrument or a market variable for
the purpose of valuing a financial instrument. In this
context, a lattice model is based on risk-neutral valuation
and a contingent claims framework. See Closed-Form Model for
an explanation of the terms risk-neutral valuation and
contingent claims framework.
Time Value
The portion of the fair value of an option that exceeds its intrinsic value. For example, a call option with an exercise price of $20 on a stock whose current market price is $25 has intrinsic value of $5. If the fair value of that option is $7, the time value of the option is $2 ($7 – $5).
ASC 718-10
30-7 The fair value of an equity share option or similar instrument shall be measured based on the observable market price of an option with the same or similar terms and conditions, if one is available (see paragraph 718-10-55-10).
30-8 Such market prices for equity
share options and similar instruments granted in share-based
payment transactions are frequently not available; however, they
may become so in the future.
30-9 As such, the fair value of an equity share option or similar instrument shall be estimated using a valuation technique such as an option-pricing model. For this purpose, a similar instrument is one whose fair value differs from its intrinsic value, that is, an instrument that has time value. For example, a share appreciation right that requires net settlement in equity shares has time value; an equity share does not. Paragraphs 718-10-55-4 through 55-47 provide additional guidance on estimating the fair value of equity instruments, including the factors to be taken into account in estimating the fair value of equity share options or similar instruments as described in paragraphs 718-10-55-21 through 55-22.
Valuation Techniques
55-15 Valuation techniques used for
share options and similar instruments granted in share-based
payment transactions estimate the fair value of those
instruments at a single point in time (for example, at the grant
date). The assumptions used in a fair value measurement are
based on expectations at the time the measurement is made, and
those expectations reflect the information that is available at
the time of measurement. The fair value of those instruments
will change over time as factors used in estimating their fair
value subsequently change, for instance, as share prices
fluctuate, risk-free interest rates change, or dividend streams
are modified. Changes in the fair value of those instruments are
a normal economic process to which any valuable resource is
subject and do not indicate that the expectations on which
previous fair value measurements were based were incorrect. 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.
55-16 A lattice model (for example,
a binomial model) and a closed-form model (for example, the
Black-Scholes-Merton formula) are among the valuation techniques
that meet the criteria required by this Topic for estimating the
fair values of share options and similar instruments granted in
share-based payment transactions. A Monte Carlo simulation
technique is another type of valuation technique that satisfies
the requirements in paragraph 718-10-55-11. Other valuation
techniques not mentioned in this Topic also may satisfy the
requirements in that paragraph. Those valuation techniques or
models, sometimes referred to as option-pricing models, are
based on established principles of financial economic theory.
Those techniques are used by valuation professionals, dealers of
derivative instruments, and others to estimate the fair values
of options and similar instruments related to equity securities,
currencies, interest rates, and commodities. Those techniques
are used to establish trade prices for derivative instruments
and to establish values in adjudications. As discussed in
paragraphs 718-10-55-21 through 55-50, both lattice models and
closed-form models can be adjusted to account for the
substantive characteristics of share options and similar
instruments granted in share-based payment transactions.
55-17 This Topic does not specify a
preference for a particular valuation technique or model in
estimating the fair values of share options and similar
instruments granted in share-based payment transactions. Rather,
this Topic requires the use of a valuation technique or model
that meets the measurement objective in paragraph 718-10-30-6
and the requirements in paragraph 718-10-55-11. The selection of
an appropriate valuation technique or model will depend on the
substantive characteristics of the instrument being valued.
Because an entity may grant different types of instruments, each
with its own unique set of substantive characteristics, an
entity may use a different valuation technique for each
different type of instrument. The appropriate valuation
technique or model selected to estimate the fair value of an
instrument with a market condition must take into account the
effect of that market condition. The designs of some techniques
and models better reflect the substantive characteristics of a
particular share option or similar instrument granted in
share-based payment transactions. Paragraphs 718-10-55-18
through 55-20 discuss certain factors that an entity should
consider in selecting a valuation technique or model for its
share options or similar instruments.
55-18 The Black-Scholes-Merton
formula assumes that option exercises occur at the end of an
option’s contractual term, and that expected volatility,
expected dividends, and risk-free interest rates are constant
over the option’s term. If used to estimate the fair value of
instruments in the scope of this Topic, the Black-Scholes-Merton
formula must be adjusted to take account of certain
characteristics of share options and similar instruments that
are not consistent with the model’s assumptions (for example,
exercising before the end of the option’s contractual term when
estimating expected term). Because of the nature of the formula,
those adjustments take the form of weighted-average assumptions
about those characteristics. In contrast, a lattice model can be
designed to accommodate dynamic assumptions of expected
volatility and dividends over the option’s contractual term, and
estimates of expected option exercise patterns during the
option’s contractual term, including the effect of blackout
periods. Therefore, the design of a lattice model more fully
reflects the substantive characteristics of particular share
options or similar instruments. Nevertheless, both a lattice
model and the Black-Scholes-Merton formula, as well as other
valuation techniques that meet the requirements in paragraph
718-10-55-11, can provide a fair value estimate that is
consistent with the measurement objective and fair-value-based
method of this Topic.
55-19 Regardless of the valuation
technique or model selected, an entity shall develop reasonable
and supportable estimates for each assumption used in the model,
including the share option or similar instrument’s expected
term, taking into account both the contractual term of the
option and the effects of grantees’ expected exercise and
postvesting termination behavior. The term supportable is
used in its general sense: capable of being maintained,
confirmed, or made good; defensible. An application is
supportable if it is based on reasonable arguments that consider
the substantive characteristics of the instruments being valued
and other relevant facts and circumstances.
ASC 718 describes fair value, in a fair-value-based measurement, as the amount
at which market participants would be willing to conduct transactions. In situations in
which there is an absence of an observable market price, which is generally the case for
options and similar instruments granted to an employee or nonemployee, an entity should
use a valuation technique to estimate the fair-value-based measure. Currently, the
Black-Scholes-Merton (closed-form) and binomial (lattice or open-form) models are the
most commonly used valuation techniques for options and similar instruments. While ASC
718 does not prescribe a particular valuation technique, it should (1) be applied in a
manner consistent with the fair-value-based measurement objective and the other
requirements in ASC 718, (2) be based on established principles of financial theory (and
generally applied in the valuation field), and (3) reflect all substantive
characteristics of an award.
In a closed-form model, such as the Black-Scholes-Merton model, an entity
employs an equation to estimate the fair-value-based measure by using key determinants
of a stock option’s value, such as the current market price of the underlying share,
exercise price, expected volatility of the underlying share, time to exercise (i.e.,
expected term), dividend rate, and a risk-free interest rate for the expected term of
the award. Because of the nature of the formula, those inputs are held constant
throughout the option’s term.
The key difference between a closed-form model and a lattice model is that in a
lattice model, entities may assume variations to the inputs during the contractual term
of the award. The selection of an appropriate valuation technique will therefore depend
on the substantive characteristics of the award being valued. For example, with a
lattice model, the expected term of the award is an output that will depend on a
grantee’s exercise and postvesting behavior. The lattice model also allows entities to
vary the volatility of the underlying share price, the risk-free interest rate, and the
expected dividends on the underlying shares, since changes in these factors are expected
to occur over the contractual term of the option. A lattice approach can be used to
directly model the effect of different expected periods before exercise on the
fair-value-based measure of the option, whereas it is assumed under the
Black-Scholes-Merton model that exercise occurs at the end of the option’s expected
term.
A lattice model may therefore be better suited to capture and reflect the substantive characteristics of certain types of share-based payment awards. For example, it would generally not be appropriate for an entity to use the Black-Scholes-Merton model to value a stock option in which the exercisability depends on a specified increase in the price of the underlying shares (i.e., a market condition). This is because the Black-Scholes-Merton model is not designed to take into account this type of market condition and therefore does not incorporate all of the substantive characteristics unique to the stock option that is being valued. However, a lattice model such as a Monte Carlo simulation can be used to determine the fair-value-based measure of an award containing a market condition. This is because it can incorporate path-dependent options related to when the market condition will be met, thereby reflecting the substantive characteristics of the stock option being valued. Whether it is practical to use a lattice model is based on a variety of factors, including the availability of reliable data to support the variations in the inputs. Entities should develop reasonable and supportable estimates for inputs and underlying assumptions, regardless of the valuation technique applied.
The Interpretive Response to Question 2 of SAB Topic 14.C states that the SEC staff understands that an entity may consider multiple techniques or models that meet the fair-value-based measurement objective and that the entity would not be required to select a model (e.g., a lattice model) “simply because that model [is] the most complex of the models . . . considered.” If an entity’s choice of model or technique meets the fair-value-based measurement objective, the SEC will not object to it.
Entities may use a different valuation technique to estimate the
fair-value-based measure of different types of share-based payment awards. However, they
should use the selected model consistently for similar types of awards with similar
characteristics. For example, an entity may use a lattice model to estimate the
fair-value-based measure of awards with market conditions and use the
Black-Scholes-Merton formula to estimate the fair-value-based measure of awards that
contain only a service or performance condition. In addition, an entity may use a
lattice model to estimate the fair-value-based measure of employee stock options and the
Black-Scholes-Merton formula to estimate the fair-value-based measure of awards in an
employee stock purchase plan (ESPP).
Regardless of the valuation technique used, an option’s value is generally
composed of its intrinsic value and time value. Intrinsic value is the excess of the
fair value of the underlying stock over the exercise price. In many cases, options are
granted “at-the-money,” which means the exercise price is equal to the fair value of the
underlying stock (i.e., the intrinsic value is zero). If the fair value of the
underlying stock exceeds the exercise price, the option is “in-the-money,” and if the
fair value of the underlying stock is less than the exercise price, the option is
“out-of-the-money,” or “underwater.”
The excess of the total fair value of an option over its intrinsic value is referred to as time value. While an option may not have intrinsic value at the time of grant, all options typically have time value. This is because the holder of an option (1) does not have to pay the exercise price until the option is exercised and (2) has the ability to profit from appreciation of the underlying stock while limiting its loss or downside risk. Therefore, all else being equal, the longer the time until option expiration and the higher the volatility of the underlying stock, the greater the time value. See Section 4.9.2 for a discussion of the effect of the various inputs used in an option pricing model on the estimation of the fair-value-based measure of a share-based payment award.
4.9.1 Change in Valuation Technique
ASC 718-10
55-20 An entity shall change the valuation technique it uses to estimate fair value if it concludes that a different technique is likely to result in a better estimate of fair value (see paragraph 718-10-55-27). For example, an entity that uses a closed-form model might conclude, when information becomes available, that a lattice model or another valuation technique would provide a fair value estimate that better achieves the fair value measurement objective and, therefore, change the valuation technique it uses.
Consistent Use of Valuation Techniques and Methods for Selecting Assumptions
55-27 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. The valuation technique
an entity selects to estimate fair value for a
particular type of instrument also shall be used
consistently and shall not be changed unless a different
valuation technique is expected to produce a better
estimate of fair value. A change in either the valuation
technique or the method of determining appropriate
assumptions used in a valuation technique is a change in
accounting estimate for purposes of applying Topic 250,
and shall be applied prospectively to new awards.
SEC Staff Accounting Bulletins
SAB Topic 14.C, Valuation Methods
[Excerpt]
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.23 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. 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
SAB Topic 14.D, Certain Assumptions Used
in Valuation Methods [Excerpt]
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.
______________________________
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.
24See 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.
In the Interpretive Response to Question 3 of SAB Topic 14.C, the SEC staff
indicated that an entity may change its valuation technique or model as long as
the new technique or model meets the fair-value-based measurement objective in
ASC 718 (see Section 4.9
for more information about selecting a technique for valuing a share-based
payment award). However, the staff also stated that it would not expect an
entity to frequently switch between valuation techniques or models, especially
when there is “no significant variation in the form of share-based payments
being valued.” An entity should change its valuation technique or model only to
improve the estimate of the fair-value-based measure, not simply to reduce the
amount of compensation cost recognized.
An entity’s change to its valuation technique, model, or assumptions should be accounted for as a change in estimate and should be applied prospectively to new or modified awards. A change in valuation method will not affect the fair-value-based measure of previously issued awards; awards issued before the application of the new technique should not be remeasured or revalued unless they are modified.
4.9.2 Assumptions in an Option Pricing Model
ASC 718-10
Selecting Assumptions for Use in an Option Pricing Model
55-21 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 takes into account, at a minimum, all of the following:
- The exercise price of the option.
- The expected term of the option. This should take into account both the contractual term of the option and the effects of grantees’ expected exercise and postvesting termination behavior. In a closed-form model, the expected term is an assumption used in (or input to) the model, while in a lattice model, the expected term is an output of the model (see paragraphs 718-10-55-29 through 55-34, which provide further explanation of the expected term in the context of a lattice model).
- The current price of the underlying share.
- The expected volatility of the price of the underlying share for the expected term of the option.
- The expected dividends on the underlying share for the expected term of the option (except as provided in paragraphs 718-10-55-44 through 55-45).
- The risk-free interest rate(s) for the expected term of the option.
55-22 The term
expected in (b); (d); (e); and (f) in
paragraph 718-10-55-21 relates to expectations at the
measurement date about the future evolution of the
factor that is used as an assumption in a valuation
model. The term is not necessarily used in the same
sense as in the term expected future cash flows
that appears elsewhere in the Codification. The phrase
expected term of the option in (d); (e); and
(f) in paragraph 718-10-55-21 applies to both
closed-form models and lattice models (as well as all
other valuation techniques). However, if an entity uses
a lattice model (or other similar valuation technique,
for instance, a Monte Carlo simulation technique) that
has been modified to take into account an option’s
contractual term and grantees’ expected exercise and
postvesting termination behavior, then (d); (e); and (f)
in paragraph 718-10-55-21 apply to the contractual term
of the option.
55-23 There is likely to be a range of reasonable estimates for expected volatility, dividends, and term of the option. If no amount within the range is more or less likely than any other amount, an average of the amounts in the range (the expected value) shall be used. In a lattice model, the assumptions used are to be determined for a particular node (or multiple nodes during a particular time period) of the lattice and not over multiple periods, unless such application is supportable.
While ASC 718 does not require entities to use a particular valuation model to determine the fair-value-based measure of options and similar instruments, the valuation model used must, at a minimum, incorporate the following inputs in accordance with ASC 718-10-55-21:
- The exercise price of the award.
- The expected term of the award.
- The current market price of the underlying share.
- The expected volatility of the underlying share price over the expected term of the award.
- The expected dividends on the underlying share over the expected term of the award.
- The risk-free interest rate over the expected term of the award.
If a lattice model is used, the expected term would be an output of the model. Accordingly, the expected volatility, expected dividends, and risk-free interest rate would be determined for the option’s contractual term.
An individual option pricing model input that fluctuates might affect the other
inputs. For example, as volatility increases, more option holders might take
advantage of the increases in share prices by exercising their options earlier.
The increase in the number of exercises will affect the expected term, which in
turn may necessitate an adjustment to the expected dividend and risk-free
interest rates. Therefore, as long as all other variables
are held constant, the effects of a change in each individual input
factor on the fair-value-based measure of a stock option are as follows:
-
Exercise price of the award and current market price of the underlying share — The current market price of the underlying share for an award granted by a public entity is usually the quoted market price of the entity’s common stock on the grant date. However, there may be instances in which a public entity adjusts the quoted market price of its common stock on the grant date for certain share-based payment awards that are granted when the entity possesses material nonpublic information (i.e., spring-loaded awards; see Section 4.9.2.6 for additional considerations related to such awards). In addition, if the share has a postvesting restriction, see Section 4.8.1 for guidance on incorporating the postvesting restriction in the option pricing model. The exercise price is the amount of cash a grantee is required to pay to exercise the award. An increase in the exercise price will result in a decrease in the award’s fair-value-based measure, whereas an increase in the current market price will result in an increase in that measure. Accordingly, the relationship between the exercise price of an award and the current market price of the entity’s common stock will affect the award’s fair-value-based measure. That is, on the grant date, an option that is issued in-the-money (i.e., the exercise price is less than the current market price of the entity’s common stock so the option has intrinsic value) will have a greater fair-value-based measure than an option issued at-the-money or out-of-the-money.
-
Expected term of the award — The expected term of an award is the period during which the award is expected to be outstanding (i.e., the period from the service inception date, which is usually the grant date, to the date of expected exercise or settlement). An award’s fair-value-based measure increases as its expected term increases as a result of the increase in the award’s time value. The time value of an award is the portion of an award’s fair-value-based measure that is based on (1) the amount of time remaining until the expiration date of the award and (2) the notion that the underlying components that constitute the value of the award may change during that time. See Section 4.9.2.2 for a discussion of factors to consider in the estimation of the expected term of an award and of the SEC staff’s views on estimating the expected term.
-
Expected volatility of the underlying share price — Expected volatility of the underlying share price is a probability-weighted measure of the expected dispersion of share prices about the mean share price over the expected term of the award. The fair value of an option increases with an increase in volatility. A high volatility indicates a greater fluctuation in the share price (up or down from the mean share price), potentially resulting in a greater benefit for the option holder. For example, if an option is issued at-the-money, the holder of an option with a highly volatile share price will be more likely to exercise the option when the share price fluctuates to a higher value (and sell that share for a profit) than a holder of a similar option with a less volatile underlying share price. See Section 4.9.2.3 for a discussion of (1) factors to consider in the estimation of the expected volatility of the underlying share price and (2) the SEC staff’s views on estimating the expected volatility. In addition, an entity that is valuing a spring-loaded award would consider whether a marketplace participant would take into account the material nonpublic information when estimating expected volatility.
-
Expected dividends on the underlying share — The expected dividends on the underlying share represent the expected dividends or dividend rate that will be paid out on the underlying shares during the expected term of the award. Expected dividends should be included in the valuation model only if the award holders are not entitled to receive those dividends before exercise. Consequently, as expected dividends increase, the fair-value-based measure of the award decreases. See Section 4.9.2.4 for a discussion of how dividends paid on stock options before exercise affect the valuation of such awards.
-
Risk-free interest rate for the expected term of the award — The risk-free rate is a theoretical rate at which an investment earns interest without incurring any risk (i.e., the valuation is risk neutral). This risk-neutral notion is used extensively in option pricing theory, under which all assets may be assumed to have expected returns equal to the risk-free rate. Higher interest rates will increase the fair-value-based measure of an award by increasing the award’s time value. See Section 4.9.2.1 for guidance on selecting an appropriate risk-free interest rate.
The effect of an increase in each of the above inputs (assuming that all other
inputs remain constant) is summarized in the table below.
Increase in Input | Effect on Award’s Fair Value |
|---|---|
Current market price of underlying share | Increase |
Exercise price | Decrease |
Expected term | Increase |
Expected volatility | Increase |
Expected dividends | Decrease |
Risk-free interest rate | Increase |
Developing assumptions to be used in an option-pricing model generally involves assessing historical experience and considering whether such historical experience is relevant to the development of future expectations. See ASC 718-10-55-24 and 55-25 below.
ASC 718-10
55-24 Historical experience
is generally the starting point for developing
expectations about the future. Expectations based on
historical experience shall be modified to reflect ways
in which currently available information indicates that
the future is reasonably expected to differ from the
past. The appropriate weight to place on historical
experience is a matter of judgment, based on relevant
facts and circumstances. For example, an entity with two
distinctly different lines of business of approximately
equal size may dispose of the one that was significantly
less volatile and generated more cash than the other. In
that situation, the entity might place relatively little
weight on volatility, dividends, and perhaps grantees’
exercise and postvesting termination behavior from the
predisposition (or disposition) period in developing
reasonable expectations about the future. In contrast,
an entity that has not undergone such a restructuring
might place heavier weight on historical experience.
That entity might conclude, based on its analysis of
information available at the time of measurement, that
its historical experience provides a reasonable estimate
of expected volatility, dividends, and grantees’
exercise and postvesting termination behavior. This
guidance is not intended to suggest either that
historical volatility is the only indicator of expected
volatility or that an entity must identify a specific
event in order to place less weight on historical
experience. Expected volatility is an expectation of
volatility over the expected term of an option or
similar instrument; that expectation shall consider all
relevant factors in paragraph 718-10-55-37, including
possible mean reversion. Paragraphs 718-10-55-35 through
55-41 provide further guidance on estimating expected
volatility.
55-25 In certain circumstances, historical information may not be available. For example, an entity whose common stock has only recently become publicly traded may have little, if any, historical information on the volatility of its own shares. That entity might base expectations about future volatility on the average volatilities of similar entities for an appropriate period following their going public. A nonpublic entity will need to exercise judgment in selecting a method to estimate expected volatility and might do so by basing its expected volatility on the average volatilities of otherwise similar public entities. For purposes of identifying otherwise similar entities, an entity would likely consider characteristics such as industry, stage of life cycle, size, and financial leverage. Because of the effects of diversification that are present in an industry sector index, the volatility of an index should not be substituted for the average of volatilities of otherwise similar entities in a fair value measurement.
4.9.2.1 Risk-Free Interest Rate
ASC 718-10
Selecting or Estimating the Risk-Free Rate for the Expected Term
55-28 Option-pricing models call for the risk-free interest rate as an assumption to take into account, among other things, the time value of money. A U.S. entity issuing an option on its own shares must use as the risk-free interest rates the implied yields currently available from the U.S. Treasury zero-coupon yield curve over the contractual term of the option if the entity is using a lattice model incorporating the option’s contractual term. If the entity is using a closed-form model, the risk-free interest rate is the implied yield currently available on U.S. Treasury zero-coupon issues with a remaining term equal to the expected term used as the assumption in the model. For entities based in jurisdictions outside the United States, the risk-free interest rate is the implied yield currently available on zero-coupon government issues denominated in the currency of the market in which the share (or underlying share), which is the basis for the instrument awarded, primarily trades. It may be necessary to use an appropriate substitute if no such government issues exist or if circumstances indicate that the implied yield on zero-coupon government issues is not representative of a risk-free interest rate.
The risk-free interest rate is the theoretical rate of return of an investment with zero risk (since option pricing models are risk-neutral valuations). The risk-free interest rate represents the interest an investor would expect from a risk-free investment over a specified period. This rate is associated with the time value of money since an option holder does not have to pay for the underlying stock until the option is exercised. In the United States, the risk-free interest rate is assumed to be a treasury rate, with a remaining term equal to the expected term of the award (e.g., U.S. Treasury zero-coupon issues).
4.9.2.2 Expected Term
ASC 718-10
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).
Selecting or Estimating the Expected Term
55-29 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 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 because exercise prior to the option’s expiration terminates its remaining life and thus its remaining time value. In addition, some employee share options contain prohibitions on exercise during blackout periods. To reflect the effect of those restrictions (which may lead to exercise before the end of the option’s contractual term) on employee options relative to transferable options, this Topic requires that the fair value of an employee share option or similar instrument be based on its expected term, rather than its contractual term (see paragraphs 718-10-55-5 and 718-10-55-21).
55-29A Paragraph
718-10-30-10A states that, 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
this Topic 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.
55-30 The expected term of an employee share option or similar instrument is the period of time for which the instrument is expected to be outstanding (that is, the period of time from the service inception date to the date of expected exercise or other expected settlement). The expected term is an assumption in a closed-form model. However, if an entity uses a lattice model that has been modified to take into account an option’s contractual term and employees’ expected exercise and post-vesting employment termination behavior, the expected term is estimated based on the resulting output of the lattice. For example, an entity’s experience might indicate that option holders tend to exercise their options when the share price reaches 200 percent of the exercise price. If so, that entity might use a lattice model that assumes exercise of the option at each node along each share price path in a lattice at which the early exercise expectation is met, provided that the option is vested and exercisable at that point. Moreover, such a model would assume exercise at the end of the contractual term on price paths along which the exercise expectation is not met but the options are in-the-money at the end of the contractual term. The terms at-the-money, in-the-money, and out-of-the-money are used to describe share options whose exercise price is equal to, less than, or greater than the market price of the underlying share, respectively. The valuation approach described recognizes that employees’ exercise behavior is correlated with the price of the underlying share. Employees’ expected post-vesting employment termination behavior also would be factored in. Expected term, which is a required disclosure (see paragraphs 718-10-50-2 through 50-2A), then could be estimated based on the output of the resulting lattice. An example of an acceptable method for purposes of financial statement disclosures of estimating the expected term based on the results of a lattice model is to use the lattice model’s estimated fair value of a share option as an input to a closed-form model, and then to solve the closed-form model for the expected term. Other methods also are available to estimate expected term.
55-31 Other factors that may affect expectations about employees’ exercise and post-vesting employment termination behavior include the following:
- The vesting period of the award. An option’s expected term must at least include the vesting period. Under some share option arrangements, an option holder may exercise an option prior to vesting(usually to obtain a specific tax treatment); however, such arrangements generally require that any shares received upon exercise be returned to the entity (with or without a return of the exercise price to the holder) if the vesting conditions are not satisfied. Such an exercise is not substantive for accounting purposes.
- Employees’ historical exercise and post-vesting employment termination behavior for similar grants.
- Expected volatility of the price of the underlying share. An entity also might consider whether the evolution of the share price affects an employee’s exercise behavior (for example, an employee may be more likely to exercise a share option shortly after it becomes in-the-money if the option had been out-of-the-money for a long period of time).
- Blackout periods and other coexisting arrangements such as agreements that allow for exercise to automatically occur during blackout periods if certain conditions are satisfied.
- Employees’ ages, lengths of service, and home jurisdictions (that is, domestic or foreign).
55-32 If sufficient information about employees’ expected exercise and post-vesting employment termination behavior is available, a method like the one described in paragraph 718-10-55-30 might be used because that method reflects more information about the instrument being valued (see paragraph 718-10-55-18). However, 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.
SEC Staff Accounting Bulletins
SAB Topic 14.D.2, Certain
Assumptions Used in Valuation Methods: Expected Term
[Excerpt]
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 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.
______________________________
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.
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.
ASC 718 does not specify a method for estimating the expected term of an award; however, such a method must be objectively supportable. Similarly, historical observations should be accompanied by information about why future observations are not expected to change, and any adjustments to these observations should be supported by objective data. ASC 718-10-55-31 provides the following factors an entity may consider in estimating the expected term of an award:
- The vesting period of the award — Options generally cannot be exercised before vesting; thus, an option’s expected term cannot be less than its vesting period.
- Historical exercise and postvesting employment termination behavior for similar grants — Historical experience should be an entity’s starting point in determining expectations of future exercise and postvesting behavior. Historical exercise patterns should be modified when current information suggests that future behavior will differ from past behavior. For example, rapid increases in an entity’s stock price after the release of a new product in the past could have caused more grantees to exercise their options as soon as the options vested. If a similar increase in the entity’s stock price is not expected, the entity should consider whether adjusting the historical exercise patterns is appropriate.
- Expected volatility of the underlying share price — An increase in the volatility of the underlying share price tends to result in an increase in exercise activity because more grantees take advantage of increases in an entity’s share price to realize potential gains on the exercise of the option and subsequent sale of the underlying shares. ASC 718-10-55-31(c) states, “An entity also might consider whether the evolution of the share price affects [a grantee’s] exercise behavior (for example, [a grantee] may be more likely to exercise a share option shortly after it becomes in-the-money if the option had been out-of-the-money for a long period of time).” The exercise behavior based on the evolution of an entity’s share price can be more easily incorporated into a lattice model than into a closed-form model.
- Blackout periods — A blackout period is a period during which exercise of an option is contractually or legally prohibited. Blackout periods and other arrangements that affect the exercise behavior associated with options can be included in a lattice model. Unlike a closed-form model, a lattice model can be used to calculate the expected term of an option by taking into account restrictions on exercises and other postvesting exercise behavior.
- Employees’ ages, lengths of service, and home jurisdictions — Historical exercise information could have been affected by the profile of the employee group. For example, during a bull market, some entities are more likely to have greater turnover of employees since more opportunities are available. Many such employees will exercise their options as early as possible. These historical exercise patterns should be adjusted if similar turnover rates are not expected to recur in the future.
If historical exercise and postvesting behavior are not readily available or do
not provide a reasonable basis upon which to estimate the expected term,
alternative sources of information may be used. For example, an entity may
use a lattice model to estimate the expected term (the expected term is not
an input in the lattice model but rather is inferred on the basis of the
output of the lattice model). In addition, an entity may consider using
other relevant and supportable information such as industry averages or
published academic research. When an entity takes external peer group
information into account, there should be evidence that such information has
been sourced from entities with comparable facts and circumstances. Further,
entities may use practical expedients to estimate the expected term for
certain awards. See Section
4.9.2.2.2 for a discussion of a public entity’s use of the SEC’s
“simplified method” to estimate the expected term for “plain-vanilla”
options. See Section
4.9.2.2.3 for a discussion of a nonpublic entity’s use of a
practical expedient to estimate the expected term for certain options that
is similar to the simplified method available to public entities.
As discussed above, an entity measures stock options under
ASC 718 by using an expected term that takes into account the effects of
grantees’ expected exercise and postvesting behavior. However, determining
an expected term for nonemployee awards could be challenging because
entities may not have sufficient historical data related to the early
exercise behavior of nonemployees, particularly if nonemployee awards are
not frequently granted. In addition, nonemployee stock option awards may not
be exercised before the end of the contractual term if they do not contain
certain features typically found in employee stock option awards (e.g.,
nontransferability, nonhedgeability, and truncation of the contractual term
because of postvesting service termination). Accordingly, ASC 718 allows an
entity to elect on an award-by-award basis to use the contractual term as
the expected term for nonemployee awards. If an entity elects not to use the
contractual term for a particular award, the entity must estimate the
expected term. However, a nonpublic entity can make an accounting policy
election to apply a practical expedient to estimate the expected term for
awards that meet the conditions in ASC 718-10-30-20B (see discussion in
Section
9.4.2.1). See Section 9.4.1 for additional
information. In accordance with ASC 718-10-55-29A, if an entity does not
elect to use the contractual term as the expected term for a particular
award and, for a nonpublic entity, does not apply the practical expedient to
estimate the expected term, the entity should consider factors similar to
those in ASC 718-10-55-29 when estimating the expected term for nonemployee
awards.
4.9.2.2.1 Aggregation Into Homogenous Groups
ASC 718-10
55-33 Option value increases at a decreasing rate as the term lengthens (for most, if not all, options). For example, a two-year option is worth less than twice as much as a one-year option, other things equal. Accordingly, estimating the fair value of an option based on a single expected term that effectively averages the differing exercise and postvesting employment termination behaviors of identifiable groups of employees will potentially misstate the value of the entire award.
55-34 Aggregating individual awards into relatively homogeneous groups with respect to exercise and postvesting employment termination behaviors and estimating the fair value of the options granted to each group separately reduces such potential misstatement. An entity shall aggregate individual awards into relatively homogeneous groups with respect to exercise and postvesting employment termination behaviors regardless of the valuation technique or model used to estimate the fair value. For example, the historical experience of an employer that grants options broadly to all levels of employees might indicate that hourly employees tend to exercise for a smaller percentage gain than do salaried employees.
SEC Staff Accounting
Bulletins
SAB Topic 14.D.2, Certain
Assumptions Used in Valuation Methods: Expected
Term [Excerpt]
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
______________________________
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.
When estimating the expected-term assumption, entities should aggregate
individual awards into relatively homogeneous groups if identifiable
groups of grantees display or are expected to display significantly
different exercise behaviors. For employee groupings, the SEC staff
believes that a reasonable fair-value-based estimate can be made on the
basis of as few as one or two groupings. The SEC staff believes that the
focus should be on groups of employees with significantly different
exercise behavior, such as executives and nonexecutives.
4.9.2.2.2 Simplified Method for Public Entities
SEC Staff Accounting
Bulletins
SAB Topic 14.D.2, Certain
Assumptions Used in Valuation Methods: Expected
Term [Excerpt]
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.
______________________________
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.
Under the SEC’s guidance in Questions 5 and 6 of SAB Topic 14.D.2, if a public
entity concludes that “its historical share option exercise experience
does not provide a reasonable basis upon which to estimate expected
term,” the entity may use what the SEC staff describes as a “simplified
method” to develop the expected-term estimate. (A practical expedient
similar to the simplified method is available to nonpublic entities; see
Section
4.9.2.2.3.) Under the simplified method, the public entity
uses an average of the vesting term and the original contractual term of
an award. The method applies only to awards that qualify as
“plain-vanilla” options (see Section 4.9.2.2.2.1).
The SEC staff believes that public entities should stop using the simplified
method for stock option grants if more detailed external information
about exercise behavior becomes available. In addition, the staff issues
comments related to the use of the simplified method and, in certain
instances, registrants have been asked to explain why they believe that
they were unable to reasonably estimate the expected term on the basis
of their historical stock option exercise information.
In accordance with the SEC’s guidance in Question 6 of SAB Topic 14.D.2, a
registrant that uses the simplified method should disclose in the notes
to its financial statements (1) that the simplified method was used, (2)
the reason the method was used, (3) the types of stock option grants for
which the simplified method was used if it was not used for all stock
option grants, and (4) the period(s) for which the simplified method was
used if it was not used in all periods presented.
4.9.2.2.2.1 Characteristics of a Plain-Vanilla Option
As the SEC states in SAB Topic 14.D.2, the simplified method applies only to awards that qualify as plain-vanilla options. A share-based payment award must possess all of the following characteristics to qualify as a plain-vanilla option:
- “The share options are granted at-the-money.”
- “Exercisability is conditional only on performing service through the vesting date” (i.e., the requisite service period equals the vesting period).
- “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).”
- “The share options are nontransferable and nonhedgeable.”
If an award has a performance or market condition, it would not be considered a plain-vanilla option. The examples below illustrate two types of awards, among other types, that do not qualify as plain-vanilla options and therefore would not be eligible for the simplified method of estimating the expected term of an award. Entities should evaluate all awards to determine whether they qualify as plain-vanilla options.
Example 4-2
In 20X1, an entity granted employee stock options and used the simplified method
to estimate the options’ expected term. After the
original grant date, the entity established that
it had incorrectly determined the grant date for
its options granted in 20X1 and that the options
were actually granted in-the-money. Because the
options were not granted at-the-money, they do not
qualify as plain-vanilla options.
Example 4-3
In 20X1, an entity granted employee stock options that either (1) vest at the end of the seventh year of service or (2) accelerate vesting if certain defined EBITDA targets are met before that date. Because the options’ exercisability depends on a performance condition as well as a service condition, they do not qualify as plain-vanilla options.
4.9.2.2.2.2 Calculating the Expected Term by Using the Simplified Method
The examples below illustrate how to calculate the expected term for
plain-vanilla options with a graded-vesting schedule and a
cliff-vesting schedule.
Example 4-4
Simplified Method for an Award With Graded Vesting
An entity grants at-the-money employee stock options, each with a contractual
term of 10 years. The options meet the criteria
for plain-vanilla options outlined in Question 6
of SAB Topic 14.D.2 and vest in 33.3 percent
increments (tranches) each year over the next
three years. Therefore, under the simplified
method, the expected term of the options would be
six years, calculated as follows:
Example 4-5
Simplified Method for an Award With Cliff Vesting
An entity grants at-the-money employee stock options, each with a contractual
term of 10 years. The options meet the criteria
for plain-vanilla options outlined in Question 6
of SAB Topic 14.D.2. The options vest at the end
of the fourth year of service. Therefore, under
the simplified method, the expected term of the
awards would be 7 years, or (4-year vesting term +
10-year contractual life) ÷ 2.
4.9.2.2.3 Expected-Term Practical Expedient for Nonpublic Entities
ASC 718-10
Nonpublic Entity — Practical Expedient for Expected Term
30-20A For an award that meets the conditions in paragraph 718-10-30-20B, a nonpublic entity may make an
entity-wide accounting policy election to estimate the expected term using the following practical expedient:
- If vesting is only dependent upon a service condition, a nonpublic entity shall estimate the expected term as the midpoint between the employee’s requisite service period or the nonemployee’s vesting period and the contractual term of the award.
- If vesting is dependent upon satisfying a performance condition, a nonpublic entity first would determine whether the performance condition is probable of being achieved.
-
If the nonpublic entity concludes that the performance condition is probable of being achieved, the nonpublic entity shall estimate the expected term as the midpoint between the employee’s requisite service period (a nonpublic entity shall consider the guidance in paragraphs 718-10-55-69 through 55-79 when determining the requisite service period of the award) or the nonemployee’s vesting period and the contractual term.
-
If the nonpublic entity concludes that the performance condition is not probable of being achieved, the nonpublic entity shall estimate the expected term as either:
-
The contractual term if the service period is implied (that is, the requisite service period or the nonemployee’s vesting period is not explicitly stated but inferred based on the achievement of the performance condition at some undetermined point in the future)
-
The midpoint between the employee’s requisite service period or the nonemployee’s vesting period and the contractual term if the requisite service period is stated explicitly.
-
-
Paragraph 718-10-55-50A provides implementation guidance on the practical expedient.
30-20B A nonpublic entity that elects to apply the practical expedient in paragraph 718-10-30-20A shall apply
the practical expedient to a share option or similar award that has all of the following characteristics:
- The share option or similar award is granted at the money.
- The grantee has only a limited time to exercise the award (typically 30–90 days) if the grantee no longer provides goods, terminates service after vesting, or ceases to be a customer.
- The grantee can only exercise the award. The grantee cannot sell or hedge the award.
- The award does not include a market condition.
A nonpublic entity that elects to apply the
practical expedient in paragraph 718-10-30-20A may
always elect to use the contractual term as the
expected term when estimating the fair value of a
nonemployee award as described in paragraph
718-10-30-10A. However, a nonpublic entity must
apply the practical expedient in paragraph
718-10-30-20A for all nonemployee awards that have
all the characteristics listed in this paragraph
if that nonpublic entity does not elect to use the
contractual term as the expected term and that
nonpublic entity elects the accounting policy
election to apply the practical expedient in
paragraph 718-10-30-20A.
Selecting or Estimating the Expected Term
55-34A A nonpublic entity may make an accounting policy election to apply a practical expedient to estimate
the expected term for certain awards that do not include a market condition (see paragraphs 718-10-30-20A
through 30-20B). Paragraph 718-10-55-50A provides implementation guidance on the practical expedient.
Nonpublic Entity — Practical Expedient for Expected Term
55-50A In accordance with paragraph 718-10-30-20A, a nonpublic entity may elect a practical expedient to
estimate the expected term. For liability-classified awards, an entity would update the estimate of the expected
term each reporting period until settlement. The updated estimate should reflect the loss of time value
associated with the award and any change in the assessment of whether a performance condition is probable
of being achieved.
A nonpublic entity may make an entity-wide accounting policy election to estimate the expected term of
its awards by using a practical expedient similar to the simplified method available to public companies
(see Section 4.9.2.2.2). Awards for which the practical expedient may be used must have satisfied
all the requirements described in ASC 718-10-30-20B above. Those requirements are similar to the
conditions that must be met for public entities to use the simplified method, but there are some notable
differences. For example, nonpublic entities can apply the practical expedient to awards with service
or performance conditions; however, public entities can apply the simplified method only to awards
with service conditions. In addition, to use the simplified method, a public company is required under
SAB Topic 14.D.2 to “conclude that its historical share option exercise experience does not provide a
reasonable basis upon which to estimate [the] expected term” of its awards, whereas a nonpublic entity
can elect to use the practical expedient irrespective of its historical exercise experience.
The practical expedient for nonpublic entities also applies to
liability-classified awards measured at a fair-value-based amount even
if the award ceases to be at-the-money upon remeasurement. For these
awards, an entity should update its estimate of the expected term as of
each reporting period until settlement. The updated estimate should
reflect any change in the assessment of whether it is probable that a
performance condition will be met (if applicable).
Determination of the expected term under this practical
expedient is based on whether the awards have service or performance
conditions. If vesting depends only on a service condition, the expected
term is the midpoint between the employee’s requisite service period or
the nonemployee’s vesting period and the contractual term of the award.
For example, if the requisite service period is 4 years and the
contractual term is 10 years, the expected term would be 7 years. If
vesting is based on satisfaction of a performance condition, the
expected term depends on whether it is probable that the performance
condition will be met. If it is probable that the performance condition
will be met, the expected term is the midpoint between the employee’s
requisite service period or the nonemployee’s vesting period (whether
explicit or implicit) and the contractual term of the award. However, if
it is not probable that the performance condition will be met, the
expected term can be either (1) the contractual term of the award if the
vesting period is implied (see Section 3.6.2) or (2) the midpoint
between the employee’s requisite service period or the nonemployee’s
vesting period and the contractual term of the award if the service
period is explicitly stated (see Section 3.6.1).
For nonemployee awards, a nonpublic entity may elect the practical expedient in
ASC 718-10-30-20A described above. However, on an award-by-award basis,
a nonpublic entity can always elect to estimate the fair value of the
award by using the contractual term as the expected term. If a nonpublic
entity elects to use this practical expedient, it must do so for all
nonemployee awards that meet the criteria described in ASC 718-10-30-20B
and for which the nonpublic entity does not use the contractual
term.
The decision tree below shows how to determine the expected term under the
practical expedient for nonpublic entities.1
4.9.2.3 Expected Volatility
ASC 718-10
55-25 In certain circumstances, historical information may not be available. For example, an entity whose
common stock has only recently become publicly traded may have little, if any, historical information on the
volatility of its own shares. That entity might base expectations about future volatility on the average volatilities
of similar entities for an appropriate period following their going public. A nonpublic entity will need to exercise
judgment in selecting a method to estimate expected volatility and might do so by basing its expected volatility
on the average volatilities of otherwise similar public entities. For purposes of identifying otherwise similar
entities, an entity would likely consider characteristics such as industry, stage of life cycle, size, and financial
leverage. Because of the effects of diversification that are present in an industry sector index, the volatility of
an index should not be substituted for the average of volatilities of otherwise similar entities in a fair value
measurement.
Selecting or Estimating the Expected Volatility
55-35 As with other aspects of estimating fair value, the objective is to determine the assumption about
expected volatility that marketplace participants would be likely to use in determining an exchange price for an
option.
55-36 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
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 shares can
be expected to vary — up or down. Because an
option’s value is unaffected by expected negative
returns on the shares, other things equal, an option
on a share with higher volatility is worth more than
an option on a share with lower volatility. This
Topic does not specify a method of estimating
expected volatility; rather, the following paragraph
provides a list of factors that shall be considered
in estimating expected volatility. An entity’s
estimate of expected volatility shall be reasonable
and supportable.
55-37 Factors to consider in estimating expected volatility include the following:
- Volatility of the share price, including changes in that volatility and possible mean reversion of that volatility. Mean reversion refers to the tendency of a financial variable, such as volatility, to revert to some long-run average level. Statistical models have been developed that take into account the mean-reverting tendency of volatility. In computing historical volatility, for example, an entity might disregard an identifiable period of time in which its share price was extraordinarily volatile because of a failed takeover bid if a similar event is not expected to recur during the expected or contractual term. If an entity’s share price was extremely volatile for an identifiable period of time, due to a general market decline, that entity might place less weight on its volatility during that period of time because of possible mean reversion. Volatility over the most recent period is generally commensurate with either of the following:
- The contractual term of the option if a lattice model is being used to estimate fair value
- The expected term of the option if a closed-form model is being used. An entity might evaluate changes in volatility and mean reversion over that period by dividing the contractual or expected term into regular intervals and evaluating evolution of volatility through those intervals.
- The implied volatility of the share price determined from the market prices of traded options or other traded financial instruments such as outstanding convertible debt, if any.
- For a public entity, the length of time its shares have been publicly traded. If that period is shorter than the expected or contractual term of the option, the term structure of volatility for the longest period for which trading activity is available shall be more relevant. A newly public entity also might consider the expected volatility of similar entities. In evaluating similarity, an entity would likely consider factors such as industry, stage of life cycle, size, and financial leverage. A nonpublic entity might base its expected volatility on the expected volatilities of entities that are similar except for having publicly traded securities.
- Appropriate and regular intervals for price observations. If an entity considers historical volatility in estimating expected volatility, it shall use intervals that are appropriate based on the facts and circumstances and that provide the basis for a reasonable fair value estimate. For example, a publicly traded entity would likely use daily price observations, while a nonpublic entity with shares that occasionally change hands at negotiated prices might use monthly price observations.
- Corporate and capital structure. An entity’s corporate structure may affect expected volatility (see paragraph 718-10-55-24). An entity’s capital structure also may affect expected volatility; for example, highly leveraged entities tend to have higher volatilities.
55-38 Although use of unadjusted historical volatility may be appropriate for some entities (or even for most
entities in some time periods), a marketplace participant would not use historical volatility without considering
the extent to which the future is likely to differ from the past.
55-39 A closed-form model, such as the Black-Scholes-Merton formula, cannot incorporate a range of expected
volatilities over the option’s expected term (see paragraph 718-10-55-18). Lattice models can incorporate
a term structure of expected volatility; that is, a range of expected volatilities can be incorporated into the
lattice over an option’s contractual term. Determining how to incorporate a range of expected volatilities into
a lattice model to provide a reasonable fair value estimate is a matter of judgment and shall be based on a
careful consideration of the factors listed in paragraph 718-10-55-37 as well as other relevant factors that are
consistent with the fair value measurement objective of this Topic.
55-40 An entity shall establish a process for estimating expected volatility and apply that process consistently
from period to period (see paragraph 718-10-55-27). That process:
- Shall comprehend an identification of information available to the entity and applicable factors such as those described in paragraph 718-10-55-37
- Shall include a procedure for evaluating and weighting that information.
55-41 The process developed by an entity shall be determined by the information available to it and its
assessment of how that information would be used to estimate fair value. For example, consistent with
paragraph 718-10-55-24, an entity’s starting point in estimating expected volatility might be its historical
volatility. That entity also shall consider the extent to which currently available information indicates that future
volatility will differ from the historical volatility. An example of such information is implied volatility (from traded
options or other instruments).
SEC Staff Accounting Bulletins
SAB Topic 14.D.1, Certain
Assumptions Used in Valuation Methods: Expected
Volatility [Excerpt]
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 [reproduced in Section 4.9.2.3.2 of
this Roadmap].)
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 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.
______________________________
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.
52 FASB ASC paragraph 718-10-50-1.
53 FASB ASC subparagraph
718-10-50-2(f)(2)(ii).
Volatility is a measure of the amount by which a share price has fluctuated (historical volatility) or is
expected to fluctuate (expected volatility) during a period. In option pricing models, expected volatility is
required to be an assumption because the option’s value is based on potential share returns over the
option’s term. ASC 718 does not specify a method for estimating the expected volatility of the underlying
share price; however, ASC 718-10-55-35 clarifies that the objective of such estimation is to ascertain
the “assumption about expected volatility [of the underlying share price] that marketplace participants
would be likely to use in determining an exchange price for an option.”
ASC 718-10-55-37 lists factors that entities would consider in estimating the expected volatility of the
underlying share price. The method selected to perform the estimation should be applied consistently
from period to period, and entities should adjust the factors or assign more weight to an individual
factor only on the basis of objective information that supports such adjustments. The Interpretive
Response to Question 1 of SAB Topic 14.D.1 notes that entities should incorporate into the estimate any
relevant new or different information that would be useful. Further, they 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” of
the underlying share price. See Section 4.9.2.3.1 through Section 4.9.2.3.3 for additional discussion of
the SEC staff’s views on estimating the expected volatility of an underlying share price.
Entities would consider the following factors in estimating expected volatility:
- Historical volatility of the underlying share price — Entities typically value stock options by using the historical volatility of the underlying share price. Under a closed-form model, such volatility is based on the most recent volatility of the share price over the expected term of the option; under a lattice model, it is based on the contractual term. ASC 718-10-55-37(a) states that an entity may disregard the volatility of the share price for an identifiable period if the volatility resulted from a condition (e.g., a failed takeover bid) specific to the entity, and the condition is not expected to recur during the expected or contractual term. If the condition is not specific to the entity (e.g., general market declines), the entity generally would not be allowed to disregard or place less weight on the volatility of its share price during that period unless objectively verifiable evidence supports the expectation that market volatility will revert to a mean that will differ materially from the volatility during the specified period. The SEC staff believes that an entity’s decision to disregard a period of historical volatility should be based on one or more discrete and specific historical events that are not expected to occur again during the term of the option. In addition, the entity should not give recent periods more weight than earlier periods.In certain circumstances, an entity may rely exclusively on historical volatility. However, because the objective of estimating expected volatility is to ascertain the assumptions that marketplace participants are likely to use, exclusive reliance may not be appropriate if there are future events that could reasonably affect expected volatility (e.g., a future merger that was recently announced). In addition, an entity that is valuing a spring-loaded award (see description in Section 4.9.2.6) would consider whether it should factor material nonpublic information into its determination of historical volatility.See Section 4.9.2.3.1 for a discussion of the SEC staff’s views on the computation of historical volatility and on circumstances in which an entity can rely exclusively on historical volatility.
- Implied volatility of the underlying share price — The implied volatility of the underlying share price is not the same as the historical volatility of the underlying share price because it is derived from the market prices of an entity’s traded options or other traded financial instruments with option-like features and not from the entity’s own shares. Entities can use the Black-Scholes-Merton formula to calculate implied volatility by including the fair value of the option (i.e., the market price of the traded option) and other inputs (stock price, exercise price, expected term, dividend rate, and risk-free interest rate) in the calculation and solving for volatility. When valuing employee or nonemployee stock options, entities should carefully consider whether the implied volatility of a traded option is an appropriate basis for expected volatility of the underlying share price. For example, traded options usually have much shorter terms than employee or nonemployee stock options, and the calculated implied volatility may not take into account the possibility of mean reversion. To compensate for mean reversion, entities use statistical tools for calculating a long-term implied volatility. For example, entities with traded options whose terms range from 2 to 12 months can plot the volatility of these options on a curve and use statistical tools to plot a long-term implied volatility for a traded option with an expected or a contractual term equal to an employee or nonemployee stock option.Generally, entities that can observe sufficiently extensive trading of options and can therefore plot an accurate long-term implied volatility curve should place greater weight on implied volatility than on the historical volatility of their own share price (particularly if they do not meet the SEC’s conditions for relying exclusively on historical volatility). That is, a traded option’s volatility is more informative in the determination of expected volatility of an entity’s stock price than historical stock price volatility, since option prices take into account the option trader’s forecasts of future stock price volatility. In determining the extent of reliance on implied volatility, an entity should consider the volume of trading in its traded options and its underlying shares, the ability to synchronize the variables used to derive implied volatility (as close to the grant date of employee or nonemployee stock options as reasonably practicable), the similarity of the exercise prices of its traded options to its employee or nonemployee stock options, and the length of the terms of its traded options and employee or nonemployee stock options. In addition, an entity that is valuing a spring-loaded award (see description in Section 4.9.2.6) would consider whether material nonpublic information affects the extent of reliance on implied volatility when estimating the expected volatility.See Section 4.9.2.3.2 for a discussion of the SEC staff’s views on the extent of reliance on implied volatility and on circumstances in which an entity can rely exclusively on implied volatility.
- Limitations on availability of historical data — Public entities should compare the length of time an entity’s shares have been publicly traded with the expected or contractual term of the option. A newly public entity may also consider the expected volatility of the share prices of similar public entities. In determining comparable public entities, that entity would consider factors such as industry, stage of life cycle, size, and financial leverage. See Section 4.9.2.3.3 for a discussion of the SEC staff’s views on the use of comparable public entities to estimate expected volatility.Nonpublic entities may also base the expected volatility of their share prices on the expected volatility of similar public entities’ share prices, and they may consider the same factors as those described above for a newly public entity. When a nonpublic entity is unable to reasonably estimate its entity-specific volatility or that of similar public entities, it may use a calculated value. See Section 4.13.2 for a discussion of when a nonpublic entity may use the historical volatility of an appropriate industry sector index and what a nonpublic entity should consider in selecting and computing the historical volatility of an appropriate industry sector index.
- Data intervals — An entity that considers the historical volatility of its share price when estimating the expected volatility of its share price should use intervals for price observations that (1) are appropriate on the basis of its facts and circumstances (e.g., given the frequency of its trades and the length of its trading history) and (2) provide a basis for a reasonable estimate of a fair-value-based measure. Daily, weekly, or monthly price observations may be sufficient; however, if an entity’s shares are thinly traded, weekly or monthly price observations may be more appropriate than daily price observations. See the next section for a discussion of the SEC staff’s views on frequency of price observations.
- Changes in corporate and capital structure — An entity’s corporate and capital structure could affect the expected volatility of its share price (e.g., share price volatility tends to be higher for highly leveraged entities). In estimating expected volatility, an entity should take into account significant changes to its corporate and capital structure, since the historical volatility of a share price for a period when the entity was, for example, highly leveraged may not represent future periods when the entity is not expected to be highly leveraged (or vice versa).
4.9.2.3.1 Historical Volatility
The SEC staff provides the following guidance on computing historical volatility of the underlying share
price in the valuation of a share-based payment award:
SEC Staff Accounting
Bulletins
SAB Topic 14.D.1, Certain
Assumptions Used in Valuation Methods: Expected
Volatility [Excerpt]
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.
______________________________
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.
In addition, the SEC staff provides the following guidance on determining when an entity may rely
exclusively on historical volatility in estimating expected volatility:
SEC Staff Accounting
Bulletins
SAB Topic 14.D.1, Certain
Assumptions Used in Valuation Methods: Expected
Volatility [Excerpt]
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 historical
volatility when the following factors are present,
so long as the methodology is consistently applied:
-
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
-
The computation of historical volatility uses a simple average calculation method;
-
A sequential period of historical data at least equal to the expected or contractual term of the share option, as applicable, is used; and
-
A reasonably sufficient number of price observations are used, measured at a consistent point throughout the applicable historical period.51
______________________________
46 FASB ASC
paragraphs 718-10-55-36 through 718-10-55-37.
47 FASB ASC paragraph
718-10-55-35.
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.
4.9.2.3.2 Implied Volatility
The SEC staff guidance on the extent of an entity’s reliance on implied
volatility in estimating expected volatility is provided below.
SEC Staff Accounting
Bulletins
SAB Topic 14.D.1, Certain
Assumptions Used in Valuation Methods: Expected
Volatility [Excerpt]
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.
______________________________
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.
In addition, the SEC staff provides the following guidance on when it may be acceptable for an entity to
rely exclusively on implied volatility in estimating expected volatility:
SEC Staff Accounting
Bulletins
SAB Topic 14.D.1, Certain
Assumptions Used in Valuation Methods: Expected
Volatility [Excerpt]
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:
-
Company B utilizes a valuation model that is based upon a constant volatility assumption to value its share options;48
-
The implied volatility is derived from options that are actively traded;
-
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;
-
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.
______________________________
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.
4.9.2.3.3 Estimating Expected Volatility by Using Other Comparable Entities
If an entity is newly public or nonpublic, it may have limited historical data and no other traded financial
instruments from which to estimate expected volatility. In such cases, as discussed in the SEC guidance
below, it may be appropriate for the entity to base its estimate of expected volatility on the historical,
expected, or implied volatility of comparable entities.
SEC Staff Accounting
Bulletins
SAB Topic 14.D.1, Certain
Assumptions Used in Valuation Methods: Expected
Volatility [Excerpt]
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
______________________________
54 FASB ASC paragraphs 718-10-55-25 and
718-10-55-51.
55 FASB ASC paragraph
718-10-55-25.
4.9.2.4 Expected Dividends
ASC 718-10
Selecting or Estimating Expected Dividends
55-42 Option-pricing models generally call for expected dividend yield as an assumption. However, the models
may be modified to use an expected dividend amount rather than a yield. An entity may use either its expected
yield or its expected payments. Additionally, an entity’s historical pattern of dividend increases (or decreases)
shall be considered. For example, if an entity has historically increased dividends by approximately 3 percent
per year, its estimated share option value shall not be based on a fixed dividend amount throughout the share
option’s expected term. As with other assumptions in an option-pricing model, an entity shall use the expected
dividends that would likely be reflected in an amount at which the option would be exchanged (see paragraph
718-10-55-13).
55-43 As with other aspects of estimating fair value, the objective is to determine the assumption about expected
dividends that would likely be used by marketplace participants in determining an exchange price for the option.
Dividend Protected Awards
55-44 Expected dividends are taken into account in using an option-pricing model to estimate the fair value
of a share option because dividends paid on the underlying shares reduce the fair value of those shares and
option holders generally are not entitled to receive those dividends. However, an award of share options
may be structured to protect option holders from that effect by providing them with some form of dividend
rights. Such dividend protection may take a variety of forms and shall be appropriately reflected in estimating
the fair value of a share option. For example, if a dividend paid on the underlying shares is applied to reduce
the exercise price of the option, the effect of the dividend protection is appropriately reflected by using an
expected dividend assumption of zero.
In using an option-pricing model to estimate the fair-value-based measure of a
stock option, an entity usually takes into account expected dividends
because dividends paid on the underlying shares are part of the fair value
of those shares, and option holders generally are not entitled to receive
those dividends. However, an award of stock options may be structured to
protect holders by giving them dividend rights that take various forms. An
entity should appropriately reflect such dividend protection in estimating
the fair-value-based measure of a stock option. For example, the entity
could appropriately reflect the effect of the dividend protection by using
an expected dividend yield input of zero if all dividends paid to
shareholders are applied to reduce the exercise price of the options being
valued.
Another example is an option that entitles the grantee to receive dividends
if dividends are paid to shareholders of the shares. We believe that options
that provide for cash payments to option holders if dividends are paid to
shareholders are more valuable to the option holder than options whose
exercise price is reduced for dividend payments. This is because the option
holder can receive the value of the dividends without ever having to
exercise the options. We further believe that such an option should be
valued as two separate components. The first component would be the present
value of the estimated dividend payments to which the holder would be
entitled before exercise by using an appropriate risk-free interest rate as
the discount rate. The second component would be valued by using an
option-pricing model that excludes from the share price input assumption the
value of the expected dividend payments before exercise.
For a discussion of the recognition of dividends or dividend equivalents, see
Section
3.10.
4.9.2.5 Credit Risk and Dilution
ASC 718-10
Selecting or Considering Credit Risk
55-46 An entity may need to consider the effect of its credit risk on the estimated fair value of liability awards
that contain cash settlement features because potential cash payoffs from the awards are not independent
of the entity’s risk of default. Any credit-risk adjustment to the estimated fair value of awards with cash
payoffs that increase with increases in the price of the underlying share is expected to be de minimis because
increases in an entity’s share price generally are positively associated with its ability to liquidate its liabilities.
However, a credit-risk adjustment to the estimated fair value of awards with cash payoffs that increase with
decreases in the price of the entity’s shares may be necessary because decreases in an entity’s share price
generally are negatively associated with an entity’s ability to liquidate its liabilities.
Consider Dilution
55-48 Traded options
ordinarily are written by parties other than the
entity that issues the underlying shares, and when
exercised result in an exchange of already
outstanding shares between those parties. In
contrast, exercise of share options as part of a
share-based payment transaction results in the
issuance of new shares by the entity that wrote the
option (the grantor), which increases the number of
shares outstanding. That dilution might reduce the
fair value of the underlying shares, which in turn
might reduce the benefit realized from option
exercise.
55-49 If the market for an
entity’s shares is reasonably efficient, the effect
of potential dilution from the exercise of share
options that are part of a share-based payment
transaction will be reflected in the market price of
the underlying shares, and no adjustment for
potential dilution usually is needed in estimating
the fair value of the grantee share options. For a
public entity, an exception might be a large grant
of options that the market is not expecting, and
also does not believe will result in commensurate
benefit to the entity. For a nonpublic entity, on
the other hand, potential dilution may not be fully
reflected in the share price if sufficient
information about the frequency and size of the
entity’s grants of equity share options is not
available for third parties who may exchange the
entity’s shares to anticipate the dilutive
effect.
55-50 An entity shall consider whether the potential dilutive effect of an award of share options needs to be
reflected in estimating the fair value of its options at the grant date. For public entities, the expectation is that
situations in which such a separate adjustment is needed will be rare.
ASC 718-10-55-46 states that in estimating the fair-value-based measure of share-based payment
awards that are classified as liabilities, “[a]n entity may need to consider the effect of its credit risk.” The
entity may need to do so if the award is settled in cash “because potential cash payoffs from the awards
are not independent of the entity’s risk of default.” Since the fair-value-based measure of awards that
are settled in cash typically increases with increases in the entity’s stock price, a significant credit risk
adjustment is not expected. However, if the opposite is true (i.e., the fair-value-based measure of the
award increases with decreases in the entity’s stock price), a credit risk adjustment may be necessary.
ASC 718 also indicates that a dilution adjustment for public entities is
expected to be rare.
4.9.2.6 Current Market Price of the Underlying Share
SEC Staff Accounting Bulletins
SAB Topic 14.D.3, Certain
Assumptions Used in Valuation Methods: 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
______________________________
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.
SAB 120 amends SAB Topic 14.D to add considerations related
to spring-loaded awards. Under SAB 120, an entity that grants or modifies a
share-based payment award while in possession of positive material nonpublic
information should consider whether adjustments to the current price of the
underlying share are appropriate when determining the award’s
fair-value-based measure. We believe that any adjustments required as a
result of the SAB would be related only to the determination of a
fair-value-based measure in accordance with ASC 718 and would not extend to
the determination of fair value under ASC 820. As discussed in Section 4.1, the
definition and determination of fair value differ under these two standards.
In SAB 120, the SEC staff acknowledges that an entity should
use significant judgment when determining whether an adjustment to the
observable market price is necessary. The SAB also notes that a material
increase in the market price of the entity’s shares upon the release of
“material non-public information within a short period of time after the
measurement date” indicates that “marketplace participants would have
considered an adjustment to the observable market price on the measurement
date.” SAB 120 further indicates that it is not uncommon for entities to
possess nonpublic information when entering into share-based payment
transactions and that an observable market price on the measurement 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, the SAB does not limit
an entity’s consideration of grants or modifications to those that are
nonroutine. Therefore, an entity should have policies and procedures in
place that allow it to identify when a grant or a modification is
spring-loaded in nature. SAB 120 also provides the SEC staff’s views on the
disclosure expectation regarding spring-loaded awards (see Section 13.10 for
more information).
4.9.3 Market-Based Measure of Stock Options
In FASB Statement 123(R) (which was issued in 2004 and later codified as ASC
718), the Board observed in paragraph B62 of the Basis for Conclusions that at
some future date, market prices for equity share options with conditions similar
to those in certain employee options may become available. Currently, it is not
common for an entity to establish a fair-value-based measure for employee or
nonemployee stock options by issuing similar instruments to third-party
investors. If such an approach is taken, entities should exercise judgment in
determining whether an option or similar instrument is being traded in an active
market and whether the instrument being traded is similar to the employee or
nonemployee stock option being valued.
In a memorandum issued in August 2005, the SEC’s Office of
Economic Analysis (OEA) presented its conclusions regarding a review of various
market-based approaches for estimating the fair-value of employee stock options.
The OEA indicated that any market-based approach must contain the following
three elements:
-
A credible information plan that enables prospective buyers and sellers to price the instrument. For example, the plan should provide information about the exercise behavior of the employees in the grant. It should be easily accessible to all market participants to reduce the potential for adverse selection.
-
A market pricing mechanism through which the instrument can be traded to generate a price. It should encourage participation in the market in order to promote competition among willing buyers and sellers.
The OEA memorandum does not provide additional guidance on the last two elements
above. However, the OEA discussed two approaches related to instrument design:
(1) the “tracking” approach and (2) a “terms-and-conditions” approach. Under the
tracking approach, an entity issues an instrument that incorporates rights to
future payouts that are identical to the future flows of net receipts by
employees or net obligations of the entity under the grant. Under a
terms-and-conditions approach, an entity issues an instrument that replicates
the substantive terms and conditions of the employee stock options. For example,
the holder of the instrument would face the same restrictions against trading
and hedging that an employee faces under the terms of the granted options. On
the basis of its analysis of each approach, the OEA concluded that instruments
designed for valuing employee stock options under the tracking approach can
yield reasonable estimates of fair value as defined in ASC 718. Conversely, the
OEA indicated that instruments designed under a terms-and-conditions approach do
not result in reasonable estimates of fair value.
Footnotes
1
If the award contains market conditions, the use
of this practical expedient is not permitted.
[2]
The OEA memorandum states, “Under the
proposals that we have seen, the amount of market
instruments that would be issued is a fraction of the
total option grant (generally 5–15 percent of the
grant). Alternatively, a company could transfer part or
all of its grant obligations to a third party that would
meet the grant’s stock delivery obligation. We have not
evaluated the adequacy of any grant size or volume to
the achievement of the valuation objective.”
[3]
The OEA memorandum states that the “net
payment may be in the form of securities or cash.”