Chapter 4 — Measurement
Chapter 4 — Measurement
4.1 Fair-Value-Based Measurement
ASC 718-10 — Glossary
Fair Value
The amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.
ASC 718-10
General
30-1 While some of the material in this Section was written in terms of awards classified as equity, it applies equally to awards classified as liabilities.
Fair-Value-Based
30-2 A share-based payment
transaction shall be measured based on the fair value (or in
certain situations specified in this Topic, a calculated
value or intrinsic value) of the equity instruments
issued.
30-3 An entity shall account
for the compensation cost from share-based payment
transactions in accordance with the fair-value-based method
set forth in this Topic. That is, the cost of goods obtained
or services received in exchange for awards of share-based
compensation generally shall be measured based on the
grant-date fair value of the equity instruments issued or on
the fair value of the liabilities incurred. The cost of
goods obtained or services received by an entity as
consideration for equity instruments issued or liabilities
incurred in share-based compensation transactions shall be
measured based on the fair value of the equity instruments
issued or the liabilities settled. The portion of the fair
value of an instrument attributed to goods obtained or
services received is net of any amount that a grantee pays
(or becomes obligated to pay) for that instrument when it is
granted. For example, if a grantee pays $5 at the grant date
for an option with a grant-date fair value of $50, the
amount attributed to goods or services provided by the
grantee is $45. An entity shall apply the guidance in
paragraph 606-10-32-26 when determining the portion of the
fair value of an equity instrument attributed to goods
obtained or services received from a customer.
30-4 However, this Topic provides certain exceptions (see paragraph 718-10-30-21) to that measurement method if it is not possible to reasonably estimate the fair value of an award at the grant date. A nonpublic entity also may choose to measure its liabilities under share-based payment arrangements at intrinsic value (see paragraphs 718-10-30-20 and 718-30-30-2).
Terms of the Award Affect Fair Value
30-5 The terms of a share-based
payment award and any related arrangement affect its value
and, except for certain explicitly excluded features, such
as a reload feature, shall be reflected in determining the
fair value of the equity or liability instruments granted.
For example, the fair value of a substantive option
structured as the exchange of equity shares for a
nonrecourse note will differ depending on whether the
grantee is required to pay nonrefundable interest on the
note.
ASC 718 requires entities to measure compensation cost for share-based payments
awarded to grantees on the basis of the fair value of the equity instruments
exchanged or the liabilities incurred. Such measurement is referred to as a
fair-value-based measurement because the entity does not consider the effects of
certain features that it would take into account in a true fair value measurement in
determining the fair value of the share-based payment award. Although ASC 820
excludes from its scope the valuation of share-based payments that are subject to
ASC 718, the concepts in ASC 820 and ASC 718 are closely aligned. When accounting
for share-based payment transactions, entities should apply the measurement guidance
in ASC 820 unless it is inconsistent with the requirements in ASC 718. The most
significant difference between the terms “fair value” as defined in ASC 820 and
“fair-value-based” as used in ASC 718 is that the latter term excludes the effects
of (1) service and performance conditions that apply only to vesting or
exercisability, (2) reload features, and (3) certain contingent features.
For the rare situations in which fair value is not reasonably estimated (e.g.,
the terms of an award are highly complex), ASC 718 provides an exception to
fair-value-based measurement under which entities measure an award at its intrinsic
value and remeasure it in each reporting period until settlement. See Section 4.11 for additional
information. Entities may also use a simplified method for determining an expected
term for their options and similar instruments if certain conditions are met. The
discussion in Section
4.9.2.2.2 applies to public entities, and the discussion in Section 4.9.2.2.3 applies to
nonpublic entities.
Further, two other exceptions to fair-value-based measurement are available to nonpublic entities.
Under the first exception, nonpublic entities that cannot reasonably estimate the expected volatility
of their share price for options or similar instruments are required to substitute the historical volatility
of an appropriate industry sector index for their expected volatility. This measure is referred to as a
calculated value rather than as a fair-value-based measure. Under the second exception, nonpublic
entities are permitted to make an accounting policy election to measure all liability-classified awards at
their intrinsic value (instead of at their fair-value-based measure or calculated value) as of the end of
each reporting period until the awards are settled. See Section 4.13 for additional discussion of each
measurement exception.
4.1.1 Vesting Conditions
ASC 718-10
Forfeitability
30-11 A restriction that
stems from the forfeitability of instruments to which
grantees have not yet earned the right, such as the
inability either to exercise a nonvested equity share
option or to sell nonvested shares, is not reflected in
estimating the fair value of the related instruments at
the grant date. Instead, those restrictions are taken
into account by recognizing compensation cost only for
awards for which grantees deliver the good or render the
service.
Performance or Service Conditions
30-12 Awards of share-based
compensation ordinarily specify a performance condition
or a service condition (or both) that must be satisfied
for a grantee to earn the right to benefit from the
award. No compensation cost is recognized for
instruments forfeited because a service condition or a
performance condition is not satisfied (for example,
instruments for which the good is not delivered or the
service is not rendered). Examples 1 through 2 (see
paragraphs 718-20-55-4 through 55-40) and Example 1 (see
paragraph 718-30-55-1) provide illustrations of how
compensation cost is recognized for awards with service
and performance conditions.
30-13 The fair-value-based
method described in paragraphs 718-10-30-6 and
718-10-30-10 through 30-14 uses fair value measurement
techniques, and the grant-date share price and other
pertinent factors are used in applying those techniques.
However, the effects on the grant-date fair value of
service and performance conditions that apply only
during the employee’s requisite service period or a
nonemployee’s vesting period are reflected based on the
outcomes of those conditions. This Topic refers to the
required measure as fair value.
Market, Performance, and Service Conditions
30-27 Performance or service
conditions that affect vesting are not reflected in
estimating the fair value of an award at the grant date
because those conditions are restrictions that stem from
the forfeitability of instruments to which grantees have
not yet earned the right. However, the effect of a
market condition is reflected in estimating the fair
value of an award at the grant date (see paragraph
718-10-30-14). For purposes of this Topic, a market
condition is not considered to be a vesting condition,
and an award is not deemed to be forfeited solely
because a market condition is not satisfied.
30-28 In some cases, the
terms of an award may provide that a performance target
that affects vesting could be achieved after an employee
completes the requisite service period or a nonemployee
satisfies a vesting period. That is, the grantee would
be eligible to vest in the award regardless of whether
the grantee is rendering service or delivering goods on
the date the performance target is achieved. A
performance target that affects vesting and that could
be achieved after an employee’s requisite service period
or a nonemployee’s vesting period shall be accounted for
as a performance condition. As such, the performance
target shall not be reflected in estimating the fair
value of the award at the grant date. Compensation cost
shall be recognized in the period in which it becomes
probable that the performance target will be achieved
and should represent the compensation cost attributable
to the period(s) for which the service or goods already
have been provided. If the performance target becomes
probable of being achieved before the end of the
employee’s requisite service period or the nonemployee’s
vesting period, the remaining unrecognized compensation
cost for which service or goods have not yet been
provided shall be recognized prospectively over the
remaining employee’s requisite service period or the
nonemployee’s vesting period. The total amount of
compensation cost recognized during and after the
employee’s requisite service period or the nonemployee’s
vesting period shall reflect the number of awards that
are expected to vest based on the performance target and
shall be adjusted to reflect those awards that
ultimately vest. An entity that has an accounting policy
to account for forfeitures when they occur in accordance
with paragraph 718-10-35-1D or 718-10-35-3 shall reverse
compensation cost previously recognized, in the period
the award is forfeited, for an award that is forfeited
before completion of the employee’s requisite service
period or the nonemployee’s vesting period. The
employee’s requisite service period and the
nonemployee’s vesting period end when the grantee can
cease rendering service or delivering goods and still be
eligible to vest in the award if the performance target
is achieved. As indicated in the definition of vest, the
stated vesting period (which includes the period in
which the performance target could be achieved) may
differ from the employee’s requisite service period or
the nonemployee’s vesting period.
SEC Staff Accounting Bulletins
SAB Topic 14.D.2, Certain Assumptions
Used in Valuation Methods: Expected Term [Excerpt]
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
______________________________
62 FASB ASC paragraph
718-10-30-11.
An entity should consider all relevant terms and conditions of a share-based
payment award in determining an appropriate fair-value-based measure. Each of
these terms and conditions may have a direct or indirect effect on the
fair-value-based measure of the award. A service or performance condition that
affects either the vesting or the exercisability of an award is considered a
vesting condition. Vesting conditions are not directly incorporated into an
award’s fair-value-based measure. Rather, they govern whether the award has been
earned and therefore whether an entity records compensation cost for it.
However, a vesting condition can indirectly affect the fair-value-based measure.
Since the expected term of an option award cannot be shorter than the vesting
period (because the expected term should not incorporate prevesting
forfeitures), a longer vesting period would typically result in an increase in
the expected term of an award. See Sections 3.4.1 and 3.4.2 for a discussion of
how service and performance conditions affect the recognition of compensation
cost.
By contrast, a service or performance condition that affects a factor (e.g., exercise price, contractual
term, quantity, conversion ratio) other than vesting or exercisability of an award will be directly factored
into the award’s fair-value-based measure. See Section 4.6 for a discussion of how service and
performance conditions that affect factors other than vesting or exercisability of an award affect the
award’s fair-value-based measure.
A market condition is not considered a vesting condition under ASC 718-10-30-27.
Accordingly, it will be directly factored into the fair-value-based measure of
an award and will not be used to determine (other than indirectly if a derived
service period is required to be determined) whether compensation cost will be
recorded. ASC 718-10-30-14 states, in part, that the “effect of a market
condition is reflected in the grant-date fair value of an award.” See Section 3.5 for a
discussion of how a market condition affects the recognition of compensation
cost and Section
4.5 for a discussion of how a market condition affects an award’s
fair-value-based measure.
If an award is indexed to a factor other than a market, performance, or service
condition, it contains an “other” condition. Other conditions are factored into
the fair-value-based measure of an award and result in its classification as a
liability. See Section 4.6.2 for
discussion of other conditions.
4.1.2 Reload and Contingent Features
ASC 718-10 — Glossary
Reload Feature and Reload Option
A reload feature provides for automatic grants of additional options whenever a
grantee exercises previously granted options using the
entity’s shares, rather than cash, to satisfy the
exercise price. At the time of exercise using shares,
the grantee is automatically granted a new option,
called a reload option, for the shares used to exercise
the previous option.
ASC 718-10
Reload and Contingent Features
30-23 The fair value of each award of equity instruments, including an award of options with a reload feature
(reload options), shall be measured separately based on its terms and the share price and other pertinent
factors at the grant date. The effect of a reload feature in the terms of an award shall not be included in
estimating the grant-date fair value of the award. Rather, a subsequent grant of reload options pursuant to that
provision shall be accounted for as a separate award when the reload options are granted.
30-24 A contingent feature of
an award that might cause a grantee to return to the
entity either equity instruments earned or realized
gains from the sale of equity instruments earned for
consideration that is less than fair value on the date
of transfer (including no consideration), such as a
clawback feature (see paragraph 718-10-55-8), shall not
be reflected in estimating the grant-date fair value of
an equity instrument.
Fair Value Measurement Objectives and Application
55-8 Reload features and
contingent features that require a grantee to transfer
equity shares earned, or realized gains from the sale of
equity instruments earned, to the issuing entity for
consideration that is less than fair value on the date
of transfer (including no consideration), such as a
clawback feature, shall not be reflected in the
grant-date fair value of an equity award. Those features
are accounted for if and when a reload grant or
contingent event occurs. A clawback feature can take
various forms but often functions as a noncompete
mechanism. For example, an employee that terminates the
employment relationship and begins to work for a
competitor is required to transfer to the issuing entity
(former employer) equity shares granted and earned in a
share-based payment transaction.
Contingency Features That Affect the Option Pricing Model
55-47 Contingent features
that might cause a grantee to return to the entity
either equity shares earned or realized gains from the
sale of equity instruments earned as a result of
share-based payment arrangements, such as a clawback
feature (see paragraph 718-10-55-8), shall not be
reflected in estimating the grant-date fair value of an
equity instrument. Instead, the effect of such a
contingent feature shall be accounted for if and when
the contingent event occurs. For instance, a share-based
payment arrangement may stipulate the return of vested
equity shares to the issuing entity for no consideration
if the grantee terminates the employment or vendor
relationship to work for a competitor. The effect of
that provision on the grant-date fair value of the
equity shares shall not be considered. If the issuing
entity subsequently receives those shares (or their
equivalent value in cash or other assets) as a result of
that provision, a credit shall be recognized in the
income statement upon the receipt of the shares. That
credit is limited to the lesser of the recognized
compensation cost associated with the share-based
payment arrangement that contains the contingent feature
and the fair value of the consideration received. The
event is recognized in the income statement because the
resulting transaction takes place with a grantee as a
result of the current (or prior) employment or vendor
relationship rather than as a result of the grantee’s
role as an equity owner. Example 10 (see paragraph
718-20-55-84) provides an illustration of the accounting
for an employee award that contains a clawback feature,
which also applies to nonemployee awards.
Some stock options include a “reload feature.” This feature entitles a grantee
to automatic grants of additional stock options whenever the grantee exercises
previously granted stock options and pays the exercise price in the entity’s
shares rather than in cash. Typically, the grantee is granted a new stock
option, called a reload option, for each share surrendered to satisfy the
exercise price of the previously granted stock option. The exercise price of the
reload option is usually set at the market price of the shares on the date the
reload option is granted. For stock options that include a reload feature, the
reload feature is not incorporated into the grant-date fair-value-based measure
of the stock option but is accounted for instead as a new award and calculated
on the basis of its grant-date fair-value-based measure.
Some awards also include contingent features that may require a grantee to
return earned equity instruments or gains realized from the sale of equity
instruments in certain situations (either for no consideration or for
consideration that is less than the fair value of the equity instrument on the
date of transfer). Such contingent features are not reflected in the
fair-value-based measurement of an equity instrument, and they do not affect the
recognition of compensation cost if they are triggered after the equity
instrument is earned. Therefore, a contingent feature has no day-one impact on
the accounting for an award; it is accounted for if and when the contingent
event occurs. Examples of contingent features, also referred to as clawback
features, include provisions triggered upon terminations for cause, noncompete
and nonsolicitation violations, and material misstatements. Clawback provisions
are discussed further in Section 3.9.
4.2 Measurement Objective
ASC 718-10
Measurement Objective — Fair Value at Grant Date
30-6 The measurement objective
for equity instruments awarded to grantees is to estimate
the fair value at the grant date of the equity instruments
that the entity is obligated to issue when grantees have
delivered the good or rendered the service and satisfied any
other conditions necessary to earn the right to benefit from
the instruments (for example, to exercise share options).
That estimate is based on the share price and other
pertinent factors, such as expected volatility, at the grant
date.
Fair Value Measurement Objectives and Application
55-4 The measurement objective
for equity instruments granted in share-based payment
transactions is to estimate the grant-date fair value of the
equity instruments that the entity is obligated to issue
when grantees have delivered the good or have rendered the
service and satisfied any other conditions necessary to earn
the right to benefit from the instruments. That estimate is
based on the share price and other pertinent factors
(including those enumerated in paragraphs 718-10-55-21
through 55-22, if applicable) at the grant date and is not
remeasured in subsequent periods under the fair-value-based
method.
55-5 A restriction that
continues in effect after the entity has issued instruments
to grantees, such as the inability to transfer vested equity
share options to third parties or the inability to sell
vested shares for a period of time, is considered in
estimating the fair value of the instruments at the grant
date. For instance, if shares are traded in an active
market, postvesting restrictions may have little, if any,
effect on the amount at which the shares being valued would
be exchanged. For share options and similar instruments, the
effect of nontransferability (and nonhedgeability, which has
a similar effect) is taken into account by reflecting the
effects of grantees’ expected exercise and postvesting
termination behavior in estimating fair value (referred to
as an option’s expected term).
55-6 In contrast, a restriction
that stems from the forfeitability of instruments to which
grantees have not yet earned the right, such as the
inability either to exercise a nonvested equity share option
or to sell nonvested shares, is not reflected in the fair
value of the instruments at the grant date. Instead, those
restrictions are taken into account by recognizing
compensation cost only for awards for which grantees deliver
the goods or render the service.
55-7 Note that performance and service conditions are vesting conditions for purposes of this Topic. Market
conditions are not vesting conditions for purposes of this Topic but market conditions may affect exercisability
of an award. Market conditions are included in the estimate of the grant-date fair value of awards (see
paragraphs 718-10-55-64 through 55-66).
55-8 Reload features and
contingent features that require a grantee to transfer
equity shares earned, or realized gains from the sale of
equity instruments earned, to the issuing entity for
consideration that is less than fair value on the date of
transfer (including no consideration), such as a clawback
feature, shall not be reflected in the grant-date fair value
of an equity award. Those features are accounted for if and
when a reload grant or contingent event occurs. A clawback
feature can take various forms but often functions as a
noncompete mechanism. For example, an employee that
terminates the employment relationship and begins to work
for a competitor is required to transfer to the issuing
entity (former employer) equity shares granted and earned in
a share-based payment transaction.
55-9 The fair value measurement
objective for liabilities incurred in a share-based payment
transaction is the same as for equity instruments. However,
awards classified as liabilities are subsequently remeasured
to their fair values (or a portion thereof until the
promised good has been delivered or the service has been
rendered) at the end of each reporting period until the
liability is settled.
Fair-Value-Based Instruments in a Share-Based Transaction
55-10 The definition of fair
value refers explicitly only to assets and liabilities, but
the concept of value in a current exchange embodied in it
applies equally to the equity instruments subject to this
Topic. Observable market prices of identical or similar
equity or liability instruments in active markets are the
best evidence of fair value and, if available, shall be used
as the basis for the measurement of equity and liability
instruments awarded in a share-based payment transaction.
Determining whether an equity or liability instrument is
similar is a matter of judgment, based on an analysis of the
terms of the instrument and other relevant facts and
circumstances. For example, awards to grantees of a public
entity of shares of its common stock, subject only to a
service or performance condition for vesting (nonvested
shares), shall be measured based on the market price of
otherwise identical (that is, identical except for the
vesting condition) common stock at the grant date.
55-11 If observable market
prices of identical or similar equity or liability
instruments of the entity are not available, the fair value
of equity and liability instruments awarded to grantees
shall be estimated by using a valuation technique that meets
all of the following criteria:
-
It is applied in a manner consistent with the fair value measurement objective and the other requirements of this Topic.
-
It is based on established principles of financial economic theory and generally applied in that field (see paragraph 718-10-55-16). Established principles of financial economic theory represent fundamental propositions that form the basis of modern corporate finance (for example, the time value of money and risk-neutral valuation).
-
It reflects all substantive characteristics of the instrument (except for those explicitly excluded by this Topic, such as vesting conditions and reload features).
That is, the fair values of equity and liability instruments granted in a
share-based payment transaction shall be estimated by
applying a valuation technique that would be used in
determining an amount at which instruments with the same
characteristics (except for those explicitly excluded by
this Topic) would be exchanged.
55-12 An estimate of the amount
at which instruments similar to share options and other
instruments granted in share-based payment transactions
would be exchanged would factor in expectations of the
probability that the good would be delivered or the service
would be rendered and the instruments would vest (that is,
that the performance or service conditions would be
satisfied). However, as noted in paragraph 718-10-55-4, the
measurement objective in this Topic is to estimate the fair
value at the grant date of the equity instruments that the
entity is obligated to issue when grantees have delivered
the good or rendered the service and satisfied any other
conditions necessary to earn the right to benefit from the
instruments. Therefore, the estimated fair value of the
instruments at grant date does not take into account the
effect on fair value of vesting conditions and other
restrictions that apply only during the employee’s requisite
service period or the nonemployee’s vesting period. Under
the fair-value-based method required by this Topic, the
effect of vesting conditions and other restrictions that
apply only during the employee’s requisite service period or
the nonemployee’s vesting period is reflected by recognizing
compensation cost only for instruments for which the good is
delivered or the service is rendered.
Valuation Techniques
55-13 In applying a valuation technique, the assumptions used shall be consistent with the fair value
measurement objective. That is, assumptions shall reflect information that is (or would be) available to form the
basis for an amount at which the instruments being valued would be exchanged. In estimating fair value, the
assumptions used shall not represent the biases of a particular party. Some of those assumptions will be based
on or determined from external data. Other assumptions, such as the employees’ expected exercise behavior,
may be derived from the entity’s own historical experience with share-based payment arrangements.
55-14 The fair value of any equity or liability instrument depends on its substantive characteristics. Paragraphs
718-10-55-21 through 55-22 list the minimum set of substantive characteristics of instruments with option
(or option-like) features that shall be considered in estimating those instruments’ fair value. However, a
share-based payment award could contain other characteristics, such as a market condition, that should be
included in a fair value estimate. Judgment is required to identify an award’s substantive characteristics and, as
described in paragraphs 718-10-55-15 through 55-20, to select a valuation technique that incorporates those
characteristics.
As indicated above, ASC 718-10-30-6 specifies that the measurement objective for
share-based payment arrangements is to estimate the fair-value-based measure, on the
measurement date, “of the equity [and liability] instruments that the entity is
obligated to issue when grantees have delivered the good or rendered the service and
satisfied any other conditions necessary to earn the right to benefit from the
instruments.” This estimate is based on the share price and other measurement
assumptions (e.g., the option pricing model inputs as described in ASC 718-10-55-21
in estimating the fair-value-based measure of stock options) on the measurement
date.
In SAB Topic 14, the SEC provides the following general guidance on estimating
the fair-value-based measure of share-based payment arrangements:
SEC Staff Accounting Bulletins
SAB Topic 14, Share-Based Payment
[Excerpt]
The staff recognizes that there is a range
of conduct that a reasonable issuer might use to make
estimates and valuations and otherwise apply FASB ASC Topic
718, and the interpretive guidance provided by this SAB.
Thus, throughout this SAB the use of the terms ”reasonable”
and ”reasonably” is not meant to imply a single conclusion
or methodology, but to encompass the full range of potential
conduct, conclusions or methodologies upon which an issuer
may reasonably base its valuation decisions. Different
conduct, conclusions or methodologies by different issuers
in a given situation does not of itself raise an inference
that any of those issuers is acting unreasonably. While the
zone of reasonable conduct is not unlimited, the staff
expects that it will be rare, except when observable market
prices of identical or similar equity or liability
instruments in active markets are available, when there is
only one acceptable choice in estimating the fair value of
share-based payment arrangements under the provisions of
FASB ASC Topic 718 and the interpretive guidance provided by
this SAB in any given situation. In addition, as discussed
in the Interpretive Response to Question 1 of Section C,
Valuation Methods, estimates of fair value are not intended
to predict actual future events, and subsequent events are
not indicative of the reasonableness of the original
estimates of fair value made under FASB ASC Topic 718.
SAB Topic 14.C, Valuation Methods
[Excerpt]
FASB ASC paragraph 718-10-30-6 (Compensation
— Stock Compensation Topic) indicates that the measurement
objective for equity instruments awarded to grantees is to
estimate at the grant date the fair value of the equity
instruments the entity is obligated to issue when grantees
have delivered the good or rendered the service and
satisfied any other conditions necessary to earn the right
to benefit from the instruments.15 The Topic also
states that observable market prices of identical or similar
equity or liability instruments in active markets are the
best evidence of fair value and, if available, should be
used as the basis for the measurement for equity and
liability instruments awarded in a share-based payment
transaction.16 However, if observable market
prices of identical or similar equity or liability
instruments are not available, the fair value shall be
estimated by using a valuation technique or model that
complies with the measurement objective, as described in
FASB ASC Topic 718.17
Question 1: If a
valuation technique or model is used to estimate fair value,
to what extent will the staff consider a company’s estimates
of fair value to be materially misleading because the
estimates of fair value do not correspond to the value
ultimately realized by the grantees who received the share
options?
Interpretive
Response: The staff understands that estimates of
fair value of share options, while derived from expected
value calculations, cannot predict actual future
events.18 The estimate of fair value
represents the measurement of the cost of the grantee's
goods or services to the company. The estimate of fair value
should reflect the assumptions marketplace participants
would use in determining how much to pay for an instrument
on the fair value measurement date.19 For
example, valuation techniques used in estimating the fair
value of share options may consider information about a
large number of possible share price paths, while, of
course, only one share price path will ultimately emerge. If
a company makes a good faith fair value estimate in
accordance with the provisions of FASB ASC Topic 718 in a
way that is designed to take into account the assumptions
that underlie the instrument's value that marketplace
participants would reasonably make, then subsequent future
events that affect the instrument's value do not provide
meaningful information about the quality of the original
fair value estimate. As long as the share options were
originally so measured, changes in a share option's value,
no matter how significant, subsequent to its grant date do
not call into question the reasonableness of the grant date
fair value estimate.
Question 2: In order
to meet the fair value measurement objective in FASB ASC
Topic 718, are certain valuation techniques preferred over
others?
Interpretive
Response: FASB ASC paragraph 718-10-55-17 clarifies
that the Topic does not specify a preference for a
particular valuation technique or model. As stated in FASB
ASC paragraph 718-10-55-11 in order to meet the fair value
measurement objective, a company should select a valuation
technique or model that (a) is applied in a manner
consistent with the fair value measurement objective and
other requirements of FASB ASC Topic 718, (b) is based on
established principles of financial economic theory and
generally applied in that field and (c) reflects all
substantive characteristics of the instrument (except for
those explicitly excluded by FASB ASC Topic 718).
The chosen valuation technique or model must
meet all three of the requirements stated above. In valuing
a particular instrument, certain techniques or models may
meet the first and second criteria but may not meet the
third criterion because the techniques or models are not
designed to reflect certain characteristics contained in the
instrument. For example, for a share option in which the
exercisability is conditional on a specified increase in the
price of the underlying shares, the Black-Scholes-Merton
closed-form model would not generally be an appropriate
valuation model because, while it meets both the first and
second criteria, it is not designed to take into account
that type of market condition.20
Further, the staff understands that a
company may consider multiple techniques or models that meet
the fair value measurement objective before making its
selection as to the appropriate technique or model. The
staff would not object to a company’s choice of a technique
or model as long as the technique or model meets the fair
value measurement objective. For example, a company is not
required to use a lattice model simply because that model
was the most complex of the models the company considered.
Question 3: [Omitted]
Question 4: Must
every company that issues share options or similar
instruments hire an outside third party to assist in
determining the fair value of the share options?
Interpretive
Response: No. However, the valuation of a company’s
share options or similar instruments should be performed by
a person with the requisite expertise.
______________________________
15 FASB ASC paragraph 718-10-30-1 states that this
guidance applies equally to awards classified as
liabilities.
16 FASB ASC paragraph
718-10-55-10.
17 FASB ASC paragraph
718-10-55-11.
18 FASB ASC paragraph
718-10-55-15 states, “The fair value of those instruments at
a single point in time is not a forecast of what the
estimated fair value of those instruments may be in the
future.”
19 Generally, the grant date for equity awards or
the reporting date for liability-classified awards.
20
See FASB ASC paragraphs 718-10-55-16 and
718-10-55-20.
As indicated in SAB Topic 14, fair-value-based estimates are not predictions of actual future events. As
long as an entity makes a good faith estimate in accordance with the principles in ASC 718, subsequent
changes to the fair-value-based measurement will not call into question the reasonableness of the
estimate. However, entities must consider the substantive terms of an award in a manner in which a
market participant would consider them. In addition, the SEC staff will not object to an entity’s valuation
technique provided that it meets all three of the following criteria in ASC 718-10-55-11:
- “It is applied in a manner consistent with the fair value measurement objective and the other requirements of this Topic [ASC 718].”
- “It is based on established principles of financial economic theory and generally applied in that field. . . . Established principles of financial economic theory represent fundamental propositions that form the basis of modern corporate finance (for example, the time value of money and risk-neutral valuation).”
- “It reflects all substantive characteristics of the instrument (except for those explicitly excluded by this Topic [ASC 718], such as vesting conditions and reload features).”
For example, if an award contains a market condition, a Monte Carlo simulation is often used as a
valuation technique rather than a Black-Scholes-Merton model.
Further, as long as fair-value-based estimates are prepared by a person with the “requisite expertise,”
entities are not required to hire an outside third-party expert to assist in the valuation. For example, if a
Black-Scholes-Merton model is applied, a valuation expert may not be required for many types of stock
options.
4.3 Observable Market Price
To determine the fair-value-based measure of the underlying instrument in a share-based payment
arrangement, an entity must first consider whether there is an observable market price; that is, the price
that buyers are paying for an instrument (with the same or similar terms) in an active market, which is
the best evidence of fair value. An observable market price will generally only be available for shares of
public entities or for shares of nonpublic entities with recent transactions. For example, for grants of
restricted stock subject only to service or performance conditions, the market price of a public entity’s
common stock would be used as the fair-value-based measurement. However, for grants of stock
options, observable market prices would typically not exist (see Section 4.9.3 for additional information).
If an observable market price does not exist, an acceptable valuation technique must be used to
estimate the fair-value-based measure of the award.
See Section 4.12 for a discussion of the valuation of awards issued by nonpublic entities, and see
Section 4.9 for a discussion of option pricing models, which are valuation techniques used to estimate
the fair-value-based measure of options and similar instruments.
4.4 Measurement Date
For equity-classified awards, the measurement date is the grant date (i.e., the
date on which the measurement of the award is fixed). As discussed in Chapter 3, the service
inception date may precede the grant date for both employee and nonemployee awards.
As a result, even though an entity may begin to record compensation cost before the
grant date, the fair-value-based measure of an equity-classified award is not fixed
until the grant date. In periods before the grant date, compensation cost is
remeasured on the basis of the award’s fair-value-based measure at the end of each
reporting period to the extent that service has been rendered in proportion to the
total requisite service period. See Section 3.6.4 for guidance on accounting for a
share-based payment award when the service inception date precedes the grant
date.
For liability-classified awards, the ultimate measurement date is the settlement
date. That is, unlike equity-classified awards, liability-classified awards are
remeasured at their fair-value-based measure in each reporting period until
settlement. The changes in the fair-value-based measure of the liability-classified
award at the end of each reporting period are recognized as compensation cost either
immediately or over the remaining vesting period (or both), depending on the
employee’s requisite service period or the nonemployee’s vesting period. See
Chapter 7 for
further discussion of the accounting for liability-classified awards.
4.5 Market Conditions
ASC 718-10
Market Conditions
30-14 Some awards contain a
market condition. The effect of a market condition is
reflected in the grant-date fair value of an award.
(Valuation techniques have been developed to value
path-dependent options as well as other options with complex
terms. Awards with market conditions, as defined in this
Topic, are path-dependent options.) Compensation cost thus
is recognized for an award with a market condition provided
that the good is delivered or the service is rendered,
regardless of when, if ever, the market condition is
satisfied.
Market, Performance, and Service Conditions
30-27 Performance or service
conditions that affect vesting are not reflected in
estimating the fair value of an award at the grant date
because those conditions are restrictions that stem from the
forfeitability of instruments to which grantees have not yet
earned the right. However, the effect of a market condition
is reflected in estimating the fair value of an award at the
grant date (see paragraph 718-10-30-14). For purposes of
this Topic, a market condition is not considered to be a
vesting condition, and an award is not deemed to be
forfeited solely because a market condition is not
satisfied.
Fair Value Measurement Objectives and Application
55-7 Note that performance and service conditions are vesting conditions for purposes of this Topic. Market
conditions are not vesting conditions for purposes of this Topic but market conditions may affect exercisability
of an award. Market conditions are included in the estimate of the grant-date fair value of awards (see
paragraphs 718-10-55-64 through 55-66).
As discussed in Section
4.1, a market condition is not considered a vesting condition. Unlike
service and performance conditions that affect vesting, the effect of market
conditions is reflected in an award’s fair-value-based measure. In addition,
compensation cost is recognized for equity-classified awards with market conditions,
regardless of whether the market condition is achieved, as long as the good is
delivered or the service is rendered. See Section 3.5 for a discussion of how a market
condition affects the recognition of compensation cost.
For an entity to effectively incorporate a market condition into an award’s
fair-value-based measure, the valuation technique used must take into account all
possible outcomes of the market condition. That is, the valuation technique must
permit the entity to estimate the value of “path-dependent options.” ASC
718-10-30-14 states, in part, that “[a]wards with market conditions, as defined in
this Topic, are path-dependent options.” Lattice models and Monte Carlo simulations
are valuation techniques used to value path dependent options. The
Black-Scholes-Merton formula typically will not be appropriate when there are market
conditions.
The implementation guidance in ASC 718-20 provides the following examples of awards with market
conditions:
ASC 718-20
Example 5: Share Option With a Market Condition — Indexed Exercise Price
55-51 This Example illustrates the guidance in paragraph 718-10-30-15.
55-51A This
Example (see paragraphs 718-20-55-52 through 55-60)
describes employee awards. However, the principles on how to
account for the various aspects of employee awards, except
for the compensation cost attribution and certain inputs to
valuation, are the same for nonemployee awards.
Consequently, the concepts about valuation in paragraphs
718-20-55-52 through 55-60 are equally applicable to
nonemployee awards with the same features as the awards in
this Example (that is, awards with market conditions that
affect exercise prices). Therefore, the guidance in those
paragraphs may serve as implementation guidance for similar
nonemployee awards.
55-51B
Compensation cost attribution for awards
to nonemployees may be the same or different for employee
awards. That is because an entity is required to recognize
compensation cost for nonemployee awards in the same manner
as if the entity had paid cash in accordance with paragraph
718-10-25-2C. Additionally, valuation amounts used in this
Example could be different because an entity may elect to
use the contractual term as the expected term of share
options and similar instruments when valuing nonemployee
share-based payment transactions.
55-52 Entity T grants share options whose exercise price varies with an index of the share prices of a group of
entities in the same industry, that is, a market condition. Assume that on January 1, 20X5, Entity T grants 100
share options on its common stock with an initial exercise price of $30 to each of 1,000 employees. The share
options have a maximum term of 10 years. The exercise price of the share options increases or decreases on
December 31 of each year by the same percentage that the index has increased or decreased during the year.
For example, if the peer group index increases by 10 percent in 20X5, the exercise price of the share options
during 20X6 increases to $33 ($30 × 1.10). On January 1, 20X5, the peer group index is assumed to be 400. The
dividend yield on the index is assumed to be 1.25 percent.
55-53 Each indexed share option may be analyzed as a share option to exchange 0.0750 (30 ÷ 400) shares
of the peer group index for a share of Entity T stock — that is, to exchange one noncash asset for another
noncash asset. A share option to purchase stock for cash also can be thought of as a share option to exchange
one asset (cash in the amount of the exercise price) for another (the share of stock). The intrinsic value of a
cash share option equals the difference between the price of the stock upon exercise and the amount — the
price — of the cash exchanged for the stock. The intrinsic value of a share option to exchange 0.0750 shares
of the peer group index for a share of Entity T stock also equals the difference between the prices of the two
assets exchanged.
55-54 To illustrate the equivalence of an indexed share option and the share option above, assume that an
employee exercises the indexed share option when Entity T’s share price has increased 100 percent to $60
and the peer group index has increased 75 percent, from 400 to 700. The exercise price of the indexed share
option thus is $52.50 ($30 × 1.75).
55-55 That is the same as the intrinsic value of a share option to exchange 0.0750 shares of the index for 1
share of Entity T stock.
55-56 Option-pricing models can be extended to value a share option to exchange one asset for another.
The principal extension is that the volatility of a share option to exchange two noncash assets is based on
the relationship between the volatilities of the prices of the assets to be exchanged — their cross-volatility.
In a share option with an exercise price payable in cash, the amount of cash to be paid has zero volatility, so
only the volatility of the stock needs to be considered in estimating that option’s fair value. In contrast, the
fair value of a share option to exchange two noncash assets depends on possible movements in the prices
of both assets — in this Example, fair value depends on the cross-volatility of a share of the peer group index
and a share of Entity T stock. Historical cross-volatility can be computed directly based on measures of Entity
T’s share price in shares of the peer group index. For example, Entity T’s share price was 0.0750 shares at the
grant date and 0.0857 (60 ÷ 700) shares at the exercise date. Those share amounts then are used to compute
cross-volatility. Cross-volatility also can be computed indirectly based on the respective volatilities of Entity T
stock and the peer group index and the correlation between them. The expected cross-volatility between Entity
T stock and the peer group index is assumed to be 30 percent.
55-57 In a share option with an exercise price payable in cash, the assumed risk-free interest rate (discount
rate) represents the return on the cash that will not be paid until exercise. In this Example, an equivalent share
of the index, rather than cash, is what will not be paid until exercise. Therefore, the dividend yield on the peer
group index of 1.25 percent is used in place of the risk-free interest rate as an input to the option-pricing
model.
55-58 The initial exercise price for the indexed share option is the value of an equivalent share of the peer
group index, which is $30 (0.0750 × $400). The fair value of each share option granted is $7.55 based on the
following inputs.
55-59 In this Example, the suboptimal exercise factor is 1.1. In Example 1 (see paragraph 718-20-55-4),
the suboptimal exercise factor is 2.0. See paragraph 718-20-55-8 for an explanation of the meaning of a
suboptimal exercise factor of 2.0.
55-60 The indexed share options have a three-year explicit service period. The market condition affects the
grant-date fair value of the award and its exercisability; however, vesting is based solely on the explicit service
period of three years. The at-the-money nature of the award makes the derived service period irrelevant in
determining the requisite service period in this Example; therefore, the requisite service period of the award
is three years based on the explicit service period. The accrual of compensation cost would be based on the
number of options for which the requisite service is rendered or is expected to be rendered depending on an
entity’s accounting policy in accordance with paragraph 718-10-35-3 (which is not addressed in this Example).
That cost would be recognized over the requisite service period as shown in Example 1 (see paragraph
718-20-55-4).
Example 6: Share Unit With Performance and Market Conditions
55-61 This Example illustrates the guidance in paragraphs 718-10-25-20 through 25-21, 718-10-30-27, and
718-10-35-4.
55-61A This
Example (see paragraphs 718-20-55-62 through 55-67)
describes employee awards. However, the principles on how to
account for the various aspects of employee awards, except
for the compensation cost attribution and certain inputs to
valuation, are the same for nonemployee awards.
Consequently, both of the following are equally applicable
to nonemployee awards with the same features as the awards
in this Example (that is, awards with a specified time
period for vesting and the recognition of compensation cost
based on the achievement of particular performance
conditions):
-
The performance conditions in paragraph 718-20-55-62
-
Concepts about valuation, compensation cost reversal, and total compensation cost that should be recognized (that is, the consideration of whether it is probable that performance conditions will be achieved) in paragraphs 718-20-55-63 and 718-20-55-65 through 55-67.
Therefore, the guidance in those paragraphs may serve as
implementation guidance for similar nonemployee awards.
55-61B
Compensation cost attribution for awards to nonemployees may
be the same or different for employee awards. That is
because an entity is required to recognize compensation cost
for nonemployee awards in the same manner as if the entity
had paid cash in accordance with paragraph 718-10-25-2C.
Additionally, valuation amounts used in this Example could
be different because an entity may elect to use the
contractual term as the expected term of share options and
similar instruments when valuing nonemployee share-based
payment transactions.
55-62 Entity T grants 100,000 share units to each of 10 vice presidents (1 million share units in total) on January
1, 20X5. Each share unit has a contractual term of three years and a vesting condition based on performance.
The performance condition is different for each vice president and is based on specified goals to be achieved
over three years (an explicit three-year service period). If the specified goals are not achieved at the end of
three years, the share units will not vest. Each share unit is convertible into shares of Entity T at contractual
maturity as follows:
- If Entity T’s share price has appreciated by a percentage that exceeds the percentage appreciation of the S&P 500 index by at least 10 percent (that is, the relative percentage increase is at least 10 percent), each share unit converts into 3 shares of Entity T stock.
- If the relative percentage increase is less than 10 percent but greater than zero percent, each share unit converts into 2 shares of Entity T stock.
- If the relative percentage increase is less than or equal to zero percent, each share unit converts into 1 share of Entity T stock.
- If Entity T’s share price has depreciated, each share unit converts into zero shares of Entity T stock.
55-63 Appreciation or depreciation for Entity T’s share price and the S&P 500 index is measured from the grant
date.
55-64 This market condition affects the ability to retain the award because the conversion ratio could be zero;
however, vesting is based solely on the explicit service period of three years, which is equal to the contractual
maturity of the award. That set of circumstances makes the derived service period irrelevant in determining the
requisite service period; therefore, the requisite service period of the award is three years based on the explicit
service period.
55-65 The share units’ conversion feature is based on a variable target stock price (that is, the target stock
price varies based on the S&P 500 index); hence, it is a market condition. That market condition affects the
fair value of the share units that vest. Each vice president’s share units vest only if the individual’s performance
condition is achieved; consequently, this award is accounted for as an award with a performance condition
(see paragraphs 718-10-55-60 through 55-63). This Example assumes that all share units become fully vested;
however, if the share units do not vest because the performance conditions are not achieved, Entity T would
reverse any previously recognized compensation cost associated with the nonvested share units.
55-66 The grant-date fair value of each share unit is assumed for purposes of this Example to be $36. Certain
option-pricing models, including Monte Carlo simulation techniques, have been adapted to value path-dependent
options and other complex instruments. In this case, the entity concludes that a Monte Carlo
simulation technique provides a reasonable estimate of fair value. Each simulation represents a potential
outcome, which determines whether a share unit would convert into three, two, one, or zero shares of stock.
For simplicity, this Example assumes that no forfeitures will occur during the vesting period. The grant-date
fair value of the award is $36 million (1 million × $36); management of Entity T expects that all share units will
vest because the performance conditions are probable of achievement. Entity T recognizes compensation
cost of $12 million ($36 million ÷ 3) in each year of the 3-year service period; the following journal entries are
recognized by Entity T in 20X5, 20X6, and 20X7.
55-67 Upon contractual maturity of the share units, four outcomes are possible; however, because all possible
outcomes of the market condition were incorporated into the share units’ grant-date fair value, no other entry
related to compensation cost is necessary to account for the actual outcome of the market condition. However,
if the share units’ conversion ratio was based on achieving a performance condition rather than on satisfying a
market condition, compensation cost would be adjusted according to the actual outcome of the performance
condition (see Example 4 [paragraph 718-20-55-47]).
4.6 Conditions That Affect Factors Other Than Vesting or Exercisability
ASC 718-10
Market, Performance, and Service Conditions That Affect Factors Other Than Vesting or Exercisability
30-15 Market, performance, and
service conditions (or any combination thereof) may affect
an award’s exercise price, contractual term, quantity,
conversion ratio, or other factors that are considered in
measuring an award’s grant-date fair value. A grant-date
fair value shall be estimated for each possible outcome of
such a performance or service condition, and the final
measure of compensation cost shall be based on the amount
estimated at the grant date for the condition or outcome
that is actually satisfied. Paragraphs 718-10-55-64 through
55-66 provide additional guidance on the effects of market,
performance, and service conditions that affect factors
other than vesting or exercisability. Examples 2 (see
paragraph 718-20-55-35); 3 (see paragraph 718-20-55-41); 4
(see paragraph 718-20-55-47); 5 (see paragraph
718-20-55-51); and 7 (see paragraph 718-20- 55-68) provide
illustrations of accounting for awards with such
conditions.
Market, Performance, and Service Conditions That Affect Factors Other Than
Vesting and Exercisability
55-64 Market, performance, and
service conditions may affect an award’s exercise price,
contractual term, quantity, conversion ratio, or other
pertinent factors that are relevant in measuring an award’s
fair value. For instance, an award’s quantity may double, or
an award’s contractual term may be extended, if a
company-wide revenue target is achieved. Market conditions
that affect an award’s fair value (including exercisability)
are included in the estimate of grant-date fair value (see
paragraph 718-10-30-15). Performance or service conditions
that only affect vesting are excluded from the estimate of
grant-date fair value, but all other performance or service
conditions that affect an award’s fair value are included in
the estimate of grant-date fair value (see that same
paragraph). Examples 3, 4, and 6 (see paragraphs
718-20-55-41, 718-20-55-47, and 718-20-55-61) provide
further guidance on how performance conditions are
considered in the estimate of grant-date fair value.
55-65 An award may be indexed to a factor in addition to the entity’s share price. If that factor is not a market,
performance, or service condition, that award shall be classified as a liability for purposes of this Topic (see
paragraphs 718-10-25-13 through 25-14A). An example would be an award of options whose exercise price is
indexed to the market price of a commodity, such as gold. Another example would be a share award that will
vest based on the appreciation in the price of a commodity, such as gold; that award is indexed to both the
value of that commodity and the issuing entity’s shares. If an award is so indexed, the relevant factors shall be
included in the fair value estimate of the award. Such an award would be classified as a liability even if the entity
granting the share-based payment instrument is a producer of the commodity whose price changes are part or
all of the conditions that affect an award’s vesting conditions or fair value.
As discussed in Section
4.1.1, service and performance conditions typically affect either the
vesting or the exercisability of a share-based payment award, and such vesting
conditions are not directly factored into the fair-value-based measure of an award
under ASC 718. However, if service or performance conditions affect factors other than vesting or exercisability (e.g., exercise price,
contractual term, quantity, or conversion ratio), the grant-date fair-value-based
measure should be calculated for each possible outcome. As discussed in Section 3.4.2, initial
accruals of compensation cost should be based on the probable outcome, and the final
measure of compensation cost should be adjusted to reflect the grant-date
fair-value-based measure of the outcome that is actually achieved. See the next
section for examples that illustrate the application of this guidance.
4.6.1 Market, Performance, and Service Conditions
The example below illustrates the accounting for an award that contains a
performance condition that affects the number of options that will vest.
ASC 718-20
Example 2: Share Option Award Under Which the Number of Options to Be Earned Varies
55-35 This Example illustrates the guidance in paragraph 718-10-30-15.
55-35A This
Example (see paragraphs 718-20-55-36 through 55-40)
describes employee awards. However, the principles on
how to account for the various aspects of employee
awards, except for the compensation cost attribution and
certain inputs to valuation, are the same for
nonemployee awards. Consequently, all of the following
are equally applicable to nonemployee awards with the
same features as the awards in this Example (that is,
the number of options earned varies on the basis of the
achievement of particular performance conditions):
-
Certain valuation assumptions in paragraph 718-20-55-36
-
Total compensation cost considerations provided in paragraphs 718-20-55-37 through 55-39 (that is, an entity must consider if it is probable that specific performance conditions will be achieved for an award with a specified time period for vesting and performance conditions)
-
Forfeiture adjustments in paragraph 718-20-55-40.
55-35B
Compensation cost attribution for awards to nonemployees
may be the same or different for employee awards. That
is because an entity is required to recognize
compensation cost for nonemployee awards in the same
manner as if the entity had paid cash in accordance with
paragraph 718-10-25-2C. Additionally, valuation amounts
used in this Example could be different because an
entity may elect to use the contractual term as the
expected term of share options and similar instruments
when valuing nonemployee share-based payment
transactions.
55-36 This Example shows the computation of compensation cost if Entity T grants an award of share options
with multiple performance conditions. Under the award, employees vest in differing numbers of options
depending on the amount by which the market share of one of Entity T’s products increases over a three-year
period (the share options cannot vest before the end of the three-year period). The three-year explicit service
period represents the requisite service period. On January 1, 20X5, Entity T grants to each of 1,000 employees
an award of up to 300 10-year-term share options on its common stock. If market share increases by at least
5 percentage points by December 31, 20X7, each employee vests in at least 100 share options at that date.
If market share increases by at least 10 percentage points, another 100 share options vest, for a total of 200.
If market share increases by more than 20 percentage points, each employee vests in all 300 share options.
Entity T’s share price on January 1, 20X5, is $30 and other assumptions are the same as in Example 1 (see
paragraph 718-20-55-4). The grant-date fair value per share option is $14.69. While the vesting conditions in
this Example and in Example 1 (see paragraph 718-20-55-4) are different, the equity instruments being valued
have the same estimate of grant-date fair value. That is a consequence of the modified grant-date method,
which accounts for the effects of vesting requirements or other restrictions that apply during the vesting period
by recognizing compensation cost only for the instruments that actually vest. (This discussion does not refer
to awards with market conditions that affect exercisability or the ability to retain the award as described in
paragraphs 718-10-55-60 through 55-63.)
55-37 The compensation cost of the award depends on the estimated number of options that will vest. Entity
T must determine whether it is probable that any performance condition will be achieved, that is, whether
the growth in market share over the 3-year period will be at least 5 percent. Accruals of compensation cost
are initially based on the probable outcome of the performance conditions — in this case, different levels
of market share growth over the three-year vesting period — and adjusted for subsequent changes in the
estimated or actual outcome. If Entity T determines that no performance condition is probable of achievement
(that is, market share growth is expected to be less than 5 percentage points), then no compensation cost
is recognized; however, Entity T is required to reassess at each reporting date whether achievement of any
performance condition is probable and would begin recognizing compensation cost if and when achievement
of the performance condition becomes probable.
55-38 Paragraph 718-10-25-20 requires accruals of cost to be based on the probable outcome of performance
conditions. Accordingly, this Topic prohibits Entity T from basing accruals of compensation cost on an amount
that is not a possible outcome (and thus cannot be the probable outcome). For instance, if Entity T estimates
that there is a 90 percent, 30 percent, and 10 percent likelihood that market share growth will be at least 5
percentage points, at least 10 percentage points, and greater than 20 percentage points, respectively, it would
not try to determine a weighted average of the possible outcomes because that number of shares is not a
possible outcome under the arrangement.
55-39 The following table shows the compensation cost that would be recognized in 20X5, 20X6, and 20X7 if
Entity T estimates at the grant date that it is probable that market share will increase at least 5 but less than 10
percentage points (that is, each employee would receive 100 share options). That estimate remains unchanged
until the end of 20X7, when Entity T’s market share has increased over the 3-year period by more than 10
percentage points. Thus, each employee vests in 200 share options.
55-40 As in Example 1, Case A (see paragraph 718-20-55-10), Entity T experiences actual forfeiture rates of
5 percent in 20X5, and in 20X6 changes its estimate of forfeitures for the entire award from 3 percent to 6
percent per year. In 20X6, cumulative compensation cost is adjusted to reflect the higher forfeiture rate. By the
end of 20X7, a 6 percent forfeiture rate has been experienced, and no further adjustments for forfeitures are
necessary. Through 20X5, Entity T estimates that 913 employees (1,000 × .973) will remain in service until the
vesting date. At the end of 20X6, the number of employees estimated to remain in service is adjusted for the
higher forfeiture rate, and the number of employees estimated to remain in service is 831 (1,000 × .943). The
compensation cost of the award is initially estimated based on the number of options expected to vest, which
in turn is based on the expected level of performance and the fair value of each option. That amount would
be adjusted as needed for changes in the estimated and actual forfeiture rates and for differences between
estimated and actual market share growth. The amount of compensation cost recognized (or attributed) when
achievement of a performance condition is probable depends on the relative satisfaction of the performance
condition based on performance to date. Entity T determines that recognizing compensation cost ratably over
the three-year vesting period is appropriate with one-third of the value of the award recognized each year.
The examples below illustrate the accounting for an award with either a
performance condition (Example 3) or a market condition (Example 7) that affects
the exercise price of stock options.
ASC 718-20
Example 3: Share Option Award Under Which the Exercise Price Varies
55-41 This Example illustrates the guidance in paragraph 718-10-30-15.
55-41A This
Example (see paragraphs 718-20-55-42 through 55-46)
describes employee awards. However, the principles on
how to account for the various aspects of employee
awards, except for the compensation cost attribution and
certain inputs to valuation, are the same for
nonemployee awards. Consequently, both of the following
are equally applicable to nonemployee awards with the
same features as the awards in this Example (that is, an
immediately vested and exercisable award with an
exercise price that varies on the basis of the
achievement of particular performance conditions):
-
Certain valuation assumptions in paragraphs 718-20-55-42 through 55-43
-
The total compensation cost considerations provided in paragraphs 718-20-55-44 through 55-46 (that is, an entity must consider if it is probable that specific performance conditions will be achieved).
Therefore, the guidance in those paragraphs may serve as
implementation guidance for similar nonemployee
awards.
55-41B
Compensation cost attribution for awards to nonemployees
may be the same or different for employee awards. That
is because an entity is required to recognize
compensation cost for nonemployee awards in the same
manner as if the entity had paid cash in accordance with
paragraph 718-10-25-2C. Additionally, valuation amounts
used in this Example could be different because an
entity may elect to use the contractual term as the
expected term of share options and similar instruments
when valuing nonemployee share-based payment
transactions.
55-42 This Example shows the computation of compensation cost if Entity T grants a share option award with
a performance condition under which the exercise price, rather than the number of shares, varies depending
on the level of performance achieved. On January 1, 20X5, Entity T grants to its chief executive officer 10-year
share options on 10,000 shares of its common stock, which are immediately vested and exercisable (an
explicit service period of zero). The share price at the grant date is $30, and the initial exercise price also is
$30. However, that price decreases to $15 if the market share for Entity T’s products increases by at least
10 percentage points by December 31, 20X6, and provided that the chief executive officer continues to be
employed by Entity T and has not previously exercised the options (an explicit service period of 2 years, which
also is the requisite service period).
55-43 Entity T estimates at the grant date the expected level of market share growth, the exercise price of the
options, and the expected term of the options. Other assumptions, including the risk-free interest rate and
the service period over which the cost is attributed, are consistent with those estimates. Entity T estimates at
the grant date that its market share growth will be at least 10 percentage points over the 2-year performance
period, which means that the expected exercise price of the share options is $15, resulting in a fair value of
$19.99 per option. Option value is determined using the same assumptions noted in paragraph 718-20-55-7
except the exercise price is $15 and the award is not exercisable at $15 per option for 2 years.
55-44 Total compensation cost to be recognized if the performance condition is satisfied would be $199,900
(10,000 × $19.99). Paragraph 718-10-30-15 requires that the fair value of both awards with service conditions
and awards with performance conditions be estimated as of the date of grant. Paragraph 718-10-35-3 also
requires recognition of cost for the number of instruments for which the requisite service is provided. For this
performance award, Entity T also selects the expected assumptions at the grant date if the performance goal is
not met. If market share growth is not at least 10 percentage points over the 2-year period, Entity T estimates
a fair value of $13.08 per option. Option value is determined using the same assumptions noted in paragraph
718-20-55-7 except the award is immediately vested.
55-45 Total compensation cost to be recognized if the performance goal is not met would be $130,800 (10,000
× $13.08). Because Entity T estimates that the performance condition would be satisfied, it would recognize
compensation cost of $130,800 on the date of grant related to the fair value of the fully vested award and
recognize compensation cost of $69,100 ($199,900 – $130,800) over the 2-year requisite service period related
to the condition. Because of the nature of the performance condition, the award has multiple requisite service
periods that affect the manner in which compensation cost is attributed. Paragraphs 718-10-55-67 through
55-79 provide guidance on estimating the requisite service period.
55-46 During the two-year requisite service period, adjustments to reflect any change in estimate about
satisfaction of the performance condition should be made, and, thus, aggregate cost recognized by the end of
that period reflects whether the performance goal was met.
Example 7: Share Option With Exercise Price That Increases by a Fixed Amount or Fixed Percentage
55-68 This Example illustrates the guidance in paragraph 718-10-30-15.
55-68A This Example (see
paragraphs 718-20-55-69 through 55-70) describes
employee awards. However, the principles on how to
account for the various aspects of employee awards,
except for the compensation cost attribution and certain
inputs to valuation, are the same for nonemployee
awards. Consequently, the concepts about valuation in
paragraphs 718-20-55-69 through 55-70 are equally
applicable to nonemployee awards with the same features
as the awards in this Example (that is, awards with
exercise prices that increase by a fixed amount or fixed
percentage). Therefore, the guidance in those paragraphs
may serve as implementation guidance for similar
nonemployee awards.
55-68B
Compensation cost attribution for awards to nonemployees
may be the same or different for employee awards. That
is because an entity is required to recognize
compensation cost for nonemployee awards in the same
manner as if the entity had paid cash in accordance with
paragraph 718-10-25-2C. Additionally, valuation amounts
used in this Example could be different because an
entity may elect to use the contractual term as the
expected term of share options and similar instruments
when valuing nonemployee share-based payment
transactions.
55-69 Some entities grant share options with exercise prices that increase by a fixed amount or a constant
percentage periodically. For example, the exercise price of the share options in Example 1 (see paragraph
718-20-55-4) might increase by a fixed amount of $2.50 per year. Lattice models and other valuation
techniques can be adapted to accommodate exercise prices that change over time by a fixed amount. Such an
arrangement has a market condition and may have a derived service period.
55-70 Share options with exercise prices that increase by a constant percentage also can be valued using an
option-pricing model that accommodates changes in exercise prices. Alternatively, those share options can be
valued by deducting from the discount rate the annual percentage increase in the exercise price. That method
works because a decrease in the risk-free interest rate and an increase in the exercise price have a similar
effect — both reduce the share option value. For example, the exercise price of the share options in Example
1 (see paragraph 718-20-55-4) might increase at the rate of 1 percent annually. For that example, Entity T’s
share options would be valued based on a risk-free interest rate less 1 percent. Holding all other assumptions
constant from that Example, the value of each share option granted by Entity T would be $14.34.
The example below illustrates the accounting for an award with performance
conditions that affect the vesting and transferability of stock options.
ASC 718-20
Example 4: Share Option Award With Other Performance Conditions
55-47 This Example
illustrates the guidance in paragraph 718-10-30-15.
55-47A This
Example (see paragraphs 718-20-55-48 through 55-50)
describes employee awards. However, the principles on
how to account for the various aspects of employee
awards, except for the compensation cost attribution and
certain inputs to valuation, are the same for
nonemployee awards. Consequently, the concepts about
valuation, expected term, and total compensation cost
that should be recognized (that is, the consideration of
whether it is probable that performance conditions will
be achieved) in paragraphs 718-20-55-48 through 55-50
are equally applicable to nonemployee awards with the
same features as the awards in this Example (that is,
awards with performance conditions that affect inputs to
an award’s fair value). Therefore, the guidance in those
paragraphs may serve as implementation guidance for
similar nonemployee awards.
55-47B
Compensation cost attribution for awards to nonemployees
may be the same or different for employee awards. That
is because an entity is required to recognize
compensation cost for nonemployee awards in the same
manner as if the entity had paid cash in accordance with
paragraph 718-10-25-2C. Additionally, valuation amounts
used in this Example could be different because an
entity may elect to use the contractual term as the
expected term of share options and similar instruments
when valuing nonemployee share-based payment
transactions.
55-48 While performance conditions usually affect vesting conditions, they may affect exercise price,
contractual term, quantity, or other factors that affect an award’s fair value before, at the time of, or after
vesting. This Topic requires that all performance conditions be accounted for similarly. A potential grant-date
fair value is estimated for each of the possible outcomes that are reasonably determinable at the grant date
and associated with the performance condition(s) of the award (as demonstrated in Example 3 [see paragraph
718-20-55-41)]. Compensation cost ultimately recognized is equal to the grant-date fair value of the award that
coincides with the actual outcome of the performance condition(s).
55-49 To illustrate the notion described in the preceding paragraph and attribution of compensation cost if
performance conditions have different service periods, assume Entity C grants 10,000 at-the-money share
options on its common stock to an employee. The options have a 10-year contractual term. The share options
vest upon successful completion of phase-two clinical trials to satisfy regulatory testing requirements related to
a developmental drug therapy. Phase-two clinical trials are scheduled to be completed (and regulatory approval
of that phase obtained) in approximately 18 months; hence, the implicit service period is approximately 18
months. Further, the share options will become fully transferable upon regulatory approval of the drug therapy
(which is scheduled to occur in approximately four years). The implicit service period for that performance
condition is approximately 30 months (beginning once phase-two clinical trials are successfully completed).
Based on the nature of the performance conditions, the award has multiple requisite service periods (one
pertaining to each performance condition) that affect the pattern in which compensation cost is attributed.
Paragraphs 718-10-55-67 through 55-79 and 718-10-55-86 through 55-88 provide guidance on estimating the
requisite service period of an award. The determination of whether compensation cost should be recognized
depends on Entity C’s assessment of whether the performance conditions are probable of achievement. Entity
C expects that all performance conditions will be achieved. That assessment is based on the relevant facts and
circumstances, including Entity C’s historical success rate of bringing developmental drug therapies to market.
55-50 At the grant date, Entity C estimates that the potential fair value of each share option under the 2
possible outcomes is $10 (Outcome 1, in which the share options vest and do not become transferable) and
$16 (Outcome 2, in which the share options vest and do become transferable). The difference in estimated fair
values of each outcome is due to the change in estimate of the expected term of the share option. Outcome 1
uses an expected term in estimating fair value that is less than the expected term used for Outcome 2, which
is equal to the award’s 10-year contractual term. If a share option is transferable, its expected term is equal to
its contractual term (see paragraph 718-10-55-29). If Outcome 1 is considered probable of occurring, Entity C
would recognize $100,000 (10,000 × $10) of compensation cost ratably over the 18-month requisite service
period related to the successful completion of phase-two clinical trials. If Outcome 2 is considered probable
of occurring, then Entity C would recognize an additional $60,000 [10,000 × ($16 – $10)] of compensation cost
ratably over the 30-month requisite service period (which begins after phase-two clinical trials are successfully
completed) related to regulatory approval of the drug therapy. Because Entity C believes that Outcome 2 is
probable, it recognizes compensation cost in the pattern described. However, if circumstances change and it is
determined at the end of Year 3 that the regulatory approval of the developmental drug therapy is likely to be
obtained in six years rather than four, the requisite service period for Outcome 2 is revised, and the remaining
unrecognized compensation cost would be recognized prospectively through Year 6. On the other hand, if it
becomes probable that Outcome 2 will not occur, compensation cost recognized for Outcome 2, if any, would
be reversed.
The example below illustrates the accounting for an award with a performance
condition that affects the quantity of restricted stock awards earned.
Example 4-1
On January 1, 20X6, Entity A grants 100,000 restricted stock awards to its employees. The restricted stock awards have a grant-date fair-value-based measure of $30 per share and vest at the end of the third year of service. The number of restricted stock awards that vest at the end of the three-year service period is based on the target EBITDA growth rate (performance condition) as indicated in the following table:
Compensation cost for the awards is based on the probable outcome of the performance condition. If, on the grant date, the probable outcome is that the EBITDA growth rate target of 8 percent will be met, initial accruals of compensation cost should reflect vesting of 100,000 restricted stock awards. Accruals of compensation cost should be adjusted for subsequent changes in the estimated or actual outcome. For example, if the actual EBITDA growth rate at the end of the three-year period is 6 percent, or it becomes probable that the EBITDA growth rate will be 6 percent, the cumulative compensation cost recognized should be adjusted to reflect vesting of 50,000 restricted stock awards (100,000 restricted stock awards × 50 percent payout).
The journal entries below illustrate the accounting for the awards.
As of December 31, 20X8, the actual EBITDA growth rate is 6 percent, resulting in a 50 percent payout.
4.6.2 Other Conditions
An entity must carefully evaluate the terms and conditions of an award. If the entity determines that
the award is indexed to a factor other than a market, performance, or service condition (i.e., an “other”
condition), the award is classified as a share-based liability under ASC 718-10-25-13 (unless certain
exceptions apply). Such other condition should also be reflected in the estimate of the award’s fair-value-based
measure. For example, an entity may grant a restricted stock award that indexes the quantity
of shares that will vest to oil price changes. Even if the entity is in the oil and gas industry, the award is
classified as a liability. Accordingly, the fair-value-based measure of the award should be remeasured at
the end of each reporting period until settlement and should reflect changes in the market price of oil.
4.7 Nonvested Shares
ASC 718-10 — Glossary
Nonvested Shares
Shares that an entity has not yet issued because the agreed-upon consideration,
such as the delivery of specified goods or services and any
other conditions necessary to earn the right to benefit from
the instruments, has not yet been satisfied. Nonvested
shares cannot be sold. The restriction on sale of nonvested
shares is due to the forfeitability of the shares if
specified events occur (or do not occur).
ASC 718-10
Nonvested or Restricted Shares
30-17 A nonvested equity share
or nonvested equity share unit shall be measured at its fair
value as if it were vested and issued on the grant date.
As discussed in Section
3.3, a nonvested share, commonly known as restricted stock, is an
award that a grantee earns once the grantee has provided the good or service
required under the terms of the share-based payment arrangement. Further, as
discussed throughout this Roadmap, the measurement basis under ASC 718 is a
fair-value-based measurement, which excludes the effects of service and performance
conditions that are vesting conditions. Therefore, restricted stock (with only
service and performance conditions) should generally be measured at the fair value
of the entity’s common stock as if the restricted stock were vested and issued on
the grant date (an entity may need to adjust the fair value for dividends, as
discussed below). It would not be appropriate for the fair value of the entity’s
common stock to be discounted to reflect that the shares being valued are not
vested.
While service and performance vesting conditions do not affect the
fair-value-based measure of restricted stock, the initial measurement of restricted
stock could be affected by factors such as a market condition, as discussed in ASC
718-10-30-14; a postvesting restriction, as discussed in ASC 718-10-30-10; or
whether the grantee is entitled to dividends. As indicated in paragraph B93 of FASB Statement 123(R), if a grantee holding a restricted stock award is not entitled to
receive dividends (i.e., the grantee does not have the right of a normal
shareholder), the fair-value-based measure of the award would be lower than the fair
value of a normal equity share if the entity is expected to pay dividends. An entity
should estimate the fair-value-based measure of restricted stock that does not
entitle the grantee to dividends during the service (vesting) period by reducing the
fair value of its common stock by the present value of expected dividends to be paid
before the end of the service (vesting) period. The present value of the expected
dividends should be calculated by using an appropriate risk-free interest rate as
the discount rate. See Section
4.9.2.4 for a discussion of how dividends paid on grantee stock
options during the expected term affect the valuation of such awards, and see
Section 12.4.3 for
a discussion of how dividend-paying restricted stock awards affect the computation
of EPS.
4.8 Restricted Shares
ASC 718-10 — Glossary
Restricted Share
A share for which sale is contractually or governmentally prohibited for a
specified period of time. Most grants of shares to grantees
are better termed nonvested shares because the limitation on
sale stems solely from the forfeitability of the shares
before grantees have satisfied the service, performance, or
other condition(s) necessary to earn the rights to the
shares. Restricted shares issued for consideration other
than for goods or services, on the other hand, are fully
paid for immediately. For those shares, there is no period
analogous to an employee’s requisite service period or a
nonemployee’s vesting period during which the issuer is
unilaterally obligated to issue shares when the purchaser
pays for those shares, but the purchaser is not obligated to
buy the shares. The term restricted shares refers only to
fully vested and outstanding shares whose sale is
contractually or governmentally prohibited for a specified
period of time. Vested equity instruments that are
transferable to a grantee’s immediate family members or to a
trust that benefits only those family members are restricted
if the transferred instruments retain the same prohibition
on sale to third parties. See Nonvested Shares.
ASC 718-10
Vesting Versus Nontransferability
30-10 To satisfy the
measurement objective in paragraph 718-10-30-6, the
restrictions and conditions inherent in equity instruments
awarded are treated differently depending on whether they
continue in effect after the requisite service period or the
nonemployee’s vesting period. A restriction that continues
in effect after an entity has issued awards, 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 equity 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).
30-10A 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.
30-10B When a nonpublic entity chooses
to measure a nonemployee share-based payment award by estimating
its expected term and applies the practical expedient in
paragraph 718-10-30-20A, it must apply the practical expedient
to all nonemployee awards that meet the conditions in paragraph
718-10-30-20B. However, a nonpublic entity may still elect, on
an award-by-award basis, to use the contractual term as the
expected term as described in paragraph 718-10-30-10A.
Nonvested or Restricted Shares
30-18 Nonvested shares granted
in share-based payment transactions usually are referred to
as restricted shares, but this Topic reserves that term for
fully vested and outstanding shares whose sale is
contractually or governmentally prohibited for a specified
period of time.
30-19 A restricted share
awarded to a grantee, that is, a share that will be
restricted after the grantee has a vested right to it, shall
be measured at its fair value, which is the same amount for
which a similarly restricted share would be issued to third
parties. Example 8 (see paragraph 718-20-55-71) provides an
illustration of accounting for an award of nonvested shares
to employees.
Fair Value Measurement Objectives and Application
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).
A restricted share is a fully vested and outstanding share whose sale is
prohibited for a specified period. For example, as described in Section 3.3, a grantee may be
granted a fully vested share but may be restricted from selling it for a two-year
period. If the grantee ceases delivering goods or rendering services to the entity
before the end of the two-year period, the grantee retains the share. However, the
grantee’s ability to sell the share remains contingent on the lapse of the two-year
period. When determining a share-based payment award’s fair-value-based measure, an
entity should generally consider restrictions that are in effect after a grantee has
vested in the award, such as the inability to transfer or sell vested shares for a
specified period, including any discounts relative to the fair value of the shares
without a postvesting restriction. This discount is often referred to as a discount
for lack of marketability (DLOM) or discount for illiquidity.
Entities must be able to provide objective and verifiable evidence supporting
the amount of the discount. In determining an appropriate discount, entities should
consider the following remarks by Barry Kanczuker, then associate chief accountant in
the SEC’s Office of the Chief Accountant, at the 2015 AICPA Conference on Current
SEC and PCAOB Developments:
I would now like to turn to an
observation regarding the impact of post-vesting restrictions on the measurement
of share-based awards. The measurement of share-based awards impacts
compensation expense. Post-vesting restrictions, such as transfer or sale
restrictions, are a common feature of many share-based payment
arrangements.
ASC 718 provides guidance on the
accounting for share-based awards when the sale of the underlying shares is
prohibited for a period of time subsequent to the awards vesting date. The
post-vesting restrictions should be considered when estimating the grant-date
fair value of the award [ASC 718-10-30-10]. I would expect that a post-vesting
restriction may result in a discount relative to the market value of common
stock to reflect that the market shares can be freely traded while restricted
shares cannot. The assumptions used in determining the value of the share-based
award should be attributes that a market participant would consider related to
the underlying award, rather than an attribute related to the individual holding
the award.
Some market participants have indicated that
post-vesting holding restrictions on share-based payment awards can result in
significantly lower stock compensation expense. While post-vesting restrictions
should be considered in estimating the fair value of share-based payments [ASC
718-10-30-10], when evaluating the appropriateness of measurement in this area,
we continue to look to the guidance in ASC 718-10-55-5, which states that “. . .
if shares are traded in an active market, post-vesting restrictions may have
little, if any, effect on the amount at which the shares being valued would be
exchanged”. With that being said, I would encourage you to consult with the
Staff if you believe that you have a fact pattern in which a post-vesting
restriction results in a significant discount being applied to the grant-date
fair value of a share-based award. [Footnotes omitted]
In addition, entities should consider remarks by Sandie Kim, then professional accounting fellow in
the SEC’s Office of the Chief Accountant, at the 2007 AICPA Conference on Current SEC and PCAOB
Developments:
Statement 123(R) establishes fair value as the measurement objective in accounting for share-based payment
arrangements. While the actual measurement of share-based payment arrangements is not necessarily at fair
value and Statement 157 does not apply to such arrangements, Statement 123(R) nonetheless states that the
valuation and assumptions used should be consistent with the fair value measurement objective.
One analysis that may sometimes be difficult in valuing any security, not just those issued in share-based
payment arrangements, is determining which assumptions should be incorporated in the valuation because
they are attributes a market participant would consider (it is an attribute of the security), versus an attribute a
specific holder of the security would consider. For example, one common term we see in share-based payment
arrangements is a restriction that prohibits the transfer or sale of securities. If the security contains such a
restriction that continues after the requisite service period, that post-vesting restriction may be factored as a
reduction in the value of the security. As a reminder, the staff has previously communicated that the discount
calculated should be specific to the security, and not derived based on general rules of thumb.
On the other hand, we have also seen instances in which assumptions related to a specific holder attribute
were incorporated in the valuation of share-based payments. While the determination of which assumptions
to incorporate is judgmental, we believe that it would be difficult to substantiate that assumptions that reflect
an attribute of a specific holder versus a market participant would be appropriate. Statement 123(R) specifies
that the assumptions should reflect information available to form the basis for an amount at which the
instrument being valued would be exchanged, and that the assumptions used should not represent the biases
of a particular party. For example, we have heard arguments that a significant discount should be taken on
certain share-based payment awards because the securities were issued to a group of executives that were
subject to higher taxes than other employees. The staff does not believe this assumption is consistent with a
fair value measurement objective. As an additional observation, Statement 157 also refers to assumptions that
are incorporated in the fair value of a security because they are specific to the security (that is, attributes of the
security) and would, therefore, transfer to market participants. [Footnotes omitted]
There are several valuation techniques used to determine a DLOM, as further
described in Section
4.12.1.
4.8.1 Options on Restricted Shares
If an entity grants options to acquire restricted shares (as defined in ASC 718), it should take into
account the effect of the postvesting restriction by using the restricted share value as an input in the
option pricing model. That is, the discount for the postvesting restriction should not be applied to the
output of the option pricing model.
For example, assume that a public entity issues an option with a four-year
service (vesting) condition and a postvesting restriction that prohibits the
grantee from selling the shares obtained upon exercising the option for another
two years. If the entity estimates the fair-value-based measure of the option by
using a Black-Scholes-Merton formula, the input used for the current market
price of the underlying share generally will not be the quoted market price of
the entity’s common stock since the underlying share contains a postvesting
restriction. Rather, the entity should generally use the fair value of a similar
restricted share as the input for the current market price (i.e., the fair value
of a share containing similar restrictions on transferability for a period of
two years). The fair value of a restricted share typically should be lower than
the fair value of a similar share without any restrictions. Therefore, using the
fair value of a restricted share in the Black-Scholes-Merton formula will result
in an estimated fair-value-based measure of the option that is lower than that
of an option without any postvesting restrictions on the underlying share (if
all other inputs remain the same).
A restriction on the ability to sell or transfer the option itself is different from a restriction on the
underlying share. If the option (as opposed to the underlying share) is nontransferable, which is typically
the case for employee stock options, the expected-term assumption is adjusted to reflect the restriction
rather than the input associated with the current market price of the underlying share. This restriction
generally leads to the early exercise of the option (before the end of the contractual term), and since a
discount is factored into the expected-term assumption, no additional discount should be applied to the
estimated fair-value-based measure derived from the option-pricing model. See Section 4.9.2.2.
4.8.2 Limited Population of Transferees
In certain cases, the terms of a share-based payment arrangement may permit the transfer of shares
only to a limited population, such as in an offering under Rule 144A of the Securities Act of 1933. A
limited population of transferees is not a prohibition on the sale of the instrument and therefore is
not considered a restriction under ASC 718. As described in Section 4.7, the fair-value-based measure
of restricted stock (i.e., nonvested shares) is calculated at the fair value of the entity’s common stock
as if the restricted stock were vested and issued on the grant date. An entity should not discount that
value solely because the entity’s common stock could be transferred to only a limited population of
transferees.
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.
An example of a closed-form model that is commonly used to value options and similar instruments is the Black-Scholes-Merton formula. In a closed-form 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. 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 OCA 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 OCA memorandum states that the “net
payment may be in the form of securities or cash.”
4.10 Valuation of Awards With Graded Vesting Schedule
ASC 718-20
55-26 The choice of attribution method for awards with graded vesting schedules is a policy decision that is not
dependent on an entity’s choice of valuation technique. In addition, the choice of attribution method applies to
awards with only service conditions.
Some share-based payment awards may have a graded vesting schedule (i.e., awards
that are split into multiple tranches in which each tranche legally vests
separately). For example, an entity may grant an employee 1,000 stock options that
vest over four years in increments of 25 percent each year. As discussed in
Section 4.9.2.2,
vesting indirectly affects the fair-value-based measure of a stock option by
affecting the expected-term assumption. For options and similar instruments with
graded vesting, an entity can either estimate separate fair-value-based measures for
each vesting tranche, each with a different expected term, or estimate the
fair-value-based measure of the entire award by using a single weighted-average
expected term. Regardless of the valuation approach, for employee awards with graded
vesting and only service conditions, an entity can still make a policy decision to
recognize compensation cost on a straight-line basis over the total requisite
service period of the entire award (see Section 3.6.5).
4.11 Difficulty of Estimation
ASC 718-10
Difficulty of Estimation
30-21 It should be possible to reasonably estimate the fair value of most equity share options and other equity
instruments at the date they are granted. Section 718-10-55 illustrates techniques for estimating the fair values
of several instruments with complicated features. However, in rare circumstances, it may not be possible
to reasonably estimate the fair value of an equity share option or other equity instrument at the grant date
because of the complexity of its terms.
Intrinsic Value Method
30-22 An equity instrument for which it is not possible to reasonably estimate fair value at the grant date shall
be accounted for based on its intrinsic value (see paragraph 718-20-35-1 for measurement after issue date).
ASC 718-20
Fair Value Not Reasonably Estimable
35-1 An equity instrument for
which it is not possible to reasonably estimate fair value
at the grant date shall be remeasured at each reporting date
through the date of exercise or other settlement. The final
measure of compensation cost shall be the intrinsic value of
the instrument at the date it is settled. Compensation cost
for each period until settlement shall be based on the
change (or a portion of the change, depending on the
percentage of the requisite service that has been rendered
for an employee award or the percentage that would have been
recognized had the grantor paid cash for the goods or
services instead of paying with a nonemployee award at the
reporting date) in the intrinsic value of the instrument in
each reporting period. The entity shall continue to use the
intrinsic value method for those instruments even if it
subsequently concludes that it is possible to reasonably
estimate their fair value.
ASC 718-10-30-21 states, in part, that “in rare
circumstances, it may not be possible to reasonably estimate [the
fair-value-based measure of a share-based payment award as of] the
grant date because of the complexity of its terms” (emphasis added).
That is, there is a strong presumption under ASC 718 that the
fair-value-based measure can be estimated unless there is
substantial evidence to the contrary. Paragraph B103 of FASB
Statement 123(R) emphasizes this presumption by stating that, “[i]n
light of the variety of options and option-like instruments
currently trading in external markets and the advances in methods of
estimating their fair values,” entities should be able to reasonably
estimate the fair-value-based measure of most awards as of the grant
date. Accordingly, accounting for a share-based payment award by
using the intrinsic-value method under ASC 718-20-35-1 would be
permitted only in the unlikely event that there is substantial
evidence indicating that it is not possible to reasonably estimate
the fair-value-based measure of the award.
4.12 Valuation of Nonpublic Entity Awards
ASC 718-10
Fair-Value-Based
30-2 A share-based payment
transaction shall be measured based on the fair value (or in
certain situations specified in this Topic, a calculated
value or intrinsic value) of the equity instruments
issued.
ASC 718 identifies three ways for a nonpublic entity to measure share-based payment awards:
- By using fair value, which is the amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties; that is, other than in a forced or liquidation sale.
- By using a calculated value, which is a measure of the value of a stock option or similar instrument determined by substituting the historical volatility of an appropriate industry sector index for the expected volatility of a nonpublic entity’s share price in an option-pricing model. See Section 4.13.2.
- By using intrinsic value, which is the amount by which the fair value of the underlying stock exceeds the exercise price of an option or similar instrument. See Section 4.13.3.
Nonpublic entities should make an effort to value their equity-classified awards
by using a fair-value-based measure. A nonpublic entity may look to recent sales of
its common stock directly to investors or common stock transactions in secondary
markets. However, observable market prices for a nonpublic entity’s equity shares
may not exist. In such an instance, a nonpublic entity could apply many of the
principles of ASC 820 to determine the fair value of its common stock, often by
using either a market approach or an income approach (or both). A “top-down method
may be applied,” which involves first valuing the entity, then subtracting the fair
value of debt, and then using the resulting equity valuation as a basis for
allocating the equity value among the entity’s equity securities. While not
authoritative, the AICPA’s Accounting and Valuation Guide Valuation of Privately-Held-Company
Equity Securities Issued as Compensation (the AICPA
Valuation Guide)4 emphasizes the importance of contemporaneous valuations from independent
valuation specialists to determine the fair value of equity securities.
4.12.1 Cheap Stock
The SEC often focuses on “cheap stock”5 issues in connection with a nonpublic entity’s preparation for an IPO. The
SEC staff is interested in the rationale for any difference between the fair
value measurements of the underlying common stock of share-based payment awards
and the anticipated IPO price. In addition, the SEC staff will challenge
valuations that are significantly lower than prices paid by investors to acquire
similar stock. If the differences cannot be reconciled, a nonpublic entity may
be required to record a cheap-stock charge. Since share-based payments are often
a compensation tool to attract and retain employees or nonemployees, a
cheap-stock charge could be material and, in some cases, lead to a restatement
of the financial statements.
An entity preparing for an IPO should refer to paragraph 7520.1 of the SEC Division
of Corporation Finance’s Financial Reporting Manual (FRM), which outlines
considerations for registrants when the “estimated fair value of the stock is
substantially below the IPO price.” In such situations, registrants should be
able to reconcile the change in the estimated fair value of the underlying
equity between the award grant date and the IPO by taking into account, among
other things, intervening events and changes in assumptions that support the
change in fair value.
The SEC staff has frequently inquired about a registrant’s
pre-IPO valuations. Specifically, during the registration statement process, the
SEC staff may ask an entity to (1) reconcile its recent fair values with the
anticipated IPO price (including significant intervening events), (2) describe
its valuation methods, (3) justify its significant valuation assumptions, and
(4) discuss the weight it gives to stock sale transactions. We encourage
entities planning an IPO in the foreseeable future to use the AICPA Valuation
Guide6 and to consult with their valuation specialists. Further, they should
ensure that their pre-IPO valuations are appropriate and that they are prepared
to respond to questions the SEC may have during the registration statement
process.
The AICPA Valuation Guide highlights differences between pre-IPO and post-IPO
valuations. One significant difference is that the valuation of nonpublic entity
securities often includes a DLOM. The DLOM can be determined by using several
valuation techniques and is significantly affected by the underlying volatility
of the stock and the period the stock is illiquid.
The AICPA Valuation Guide describes three foundational methods for estimating the
DLOM: the protective put model, the Longstaff model, and the quantitative
marketability discount model. However, it is assumed under the Longstaff model
that the investor is able to perfectly time the market and therefore maximize
proceeds. Since an investor typically does not have that timing ability, the
Longstaff model is generally not appropriate to use. In addition, use of the
quantitative marketability discount model may not be appropriate for complex
capital structures or when it is assumed that there are long holding periods.
While all put-based methods may have limitations, the protective
put model, also known as the Chaffee model or European7 protective put model, is widely used to calculate the DLOM. Entities
perform the calculation on the basis of an at-the-money put with a life equal to
the period of restriction, divided by the marketable stock value. The following
are two commonly used variations of the protective put model:
- Finnerty model — Under this model, also known as the average-strike put option model, an entity estimates the DLOM as an average-strike Asian8 put which measures the difference between the average price over the holding period and the final price.
- Asian protective put model — Under this model, an entity estimates the DLOM as an average-price Asian put that measures the difference between the current price and the average price over the holding period. The Asian protective put model results in DLOMs that are lower than those calculated under the protective put model and, for low volatility stocks, those calculated under the Finnerty model. For high volatility stocks, it results in DLOMs that are higher than those calculated under the Finnerty model.
4.12.2 ISOs, NQSOs, and Internal Revenue Code Section 409A
When granting share-based payment awards, a nonpublic entity should be mindful of
the tax treatment of such awards and the related implications. Section 409A of
the Internal Revenue Code (IRC) contains requirements related to nonqualified
deferred compensation plans that can affect the taxability of holders of
share-based payment awards. If a nonqualified deferred compensation plan (e.g.,
one issued in the form of share-based payments) fails to comply with certain IRC
rules, the tax implications and penalties at the federal level (and potentially
the state level) can be significant for holders.
Under U.S. tax law, stock option awards can generally be categorized into two groups:
- Statutory options, including incentive stock options (ISOs) and ESPPs that are qualified under IRC Sections 422 and 423, respectively. The exercise of an ISO or a qualified ESPP does not result in a tax deduction for the entity unless the employee or former employee makes a disqualifying disposition. While an ISO may result in favorable tax treatment for the recipient, certain eligibility conditions must be met.
- Nonstatutory options (also known as NQSOs or NSOs). The exercise of an NQSO results in a tax deduction for the issuing entity that is equal to the intrinsic value of the option when exercised.
The ISOs and ESPPs described in IRC Sections 422 and 423, respectively, are
specifically exempt from the requirements of IRC Section 409A. Other NQSOs are
outside the scope of IRC Section 409A if certain requirements are met. One
significant requirement is that the exercise price must not be below the fair
market value of the underlying stock as of the grant date. Accordingly, it is
imperative to establish a supportable fair market value of the stock to avoid
unintended tax consequences for the issuer and holder. While IRC Section 409A
also applies to public entities, the valuation of share-based payment awards for
such entities is subject to less scrutiny because the market prices of the
shares associated with the awards are generally observable. Among other details,
entities should understand (1) which of their compensation plans and awards are
subject to the provisions of IRC Section 409A and (2) how they can ensure that
those plans and awards remain compliant with IRC Section 409A and thereby avoid
unintended tax consequences of noncompliance.
A company’s failure to comply with the requirements in IRC
Section 409A related to nonqualified deferred compensation plans may affect how
the fair value of existing and future share-based compensation is determined and
how those awards are taxed. Specifically, if the form and operation of
compensation arrangements do not comply with the requirements in IRC Section
409A, service providers will be required to include the compensation in their
taxable income sooner than they would need to under general tax rules (e.g.,
vesting as opposed to exercise of an option) and service providers will be
subject to an additional 20 percent federal income tax plus interest on the
amount included in their taxable income. Although the tax is imposed on the
individuals receiving the compensation, in certain instances, an entity may
decide to pay the additional tax liabilities on behalf of its employees. Among
IRC Section 409A’s many requirements, valuation of the stock on the grant date
is critical, and grantees should establish the fair market value of their shares
to ensure compliance with IRC Section 409A. Both nonqualified and statutory
options are subject to IRC Section 409A unless they otherwise meet its criteria
for treatment as exempt stock rights. It is important for an entity to consult
with tax advisers regarding the tax effects of both existing and planned
share-based compensation plans to determine whether it is subject to the
requirements in IRC Section 409A or other IRC sections.
In addition, when recognizing compensation cost, many nonpublic entities use
their IRC Section 409A assessments to value their share-based payments. Because
those assessments are used for tax purposes, nonpublic entities should carefully
consider whether they are also appropriate for measuring share-based payment
awards under ASC 718.
See Chapter 10 of Deloitte’s Roadmap
Income
Taxes for a discussion of the income tax effects of
share-based payments.
4.12.3 Purchases of Shares From Grantees
4.12.3.1 Entity Purchases of Shares From Grantees
ASC 718-20
Repurchase or Cancellation
35-7 The amount of cash or
other assets transferred (or liabilities incurred)
to repurchase an equity award shall be charged to
equity, to the extent that the amount paid does not
exceed the fair value of the equity instruments
repurchased at the repurchase date. Any excess of
the repurchase price over the fair value of the
instruments repurchased shall be recognized as
additional compensation cost. An entity that
repurchases an award for which the promised goods
have not been delivered or the service has not been
rendered has, in effect, modified the employee’s
requisite service period or nonemployee’s vesting
period to the period for which goods have already
been delivered or service already has been rendered,
and thus the amount of compensation cost measured at
the grant date but not yet recognized shall be
recognized at the repurchase date.
To provide liquidity or for other reasons, entities may sometimes repurchase
vested common stock from their share-based payment award grantees. In some
cases, the price paid for the shares exceeds their fair value at the time of
the transaction, and the excess would generally be recognized as additional
compensation cost in accordance with ASC 718-20-35-7. In addition, an
entity’s practice of repurchasing shares, or an arrangement that permits
repurchase, could affect the classification of share-based payment awards.
See Sections
5.6 and 6.10 for additional discussion of how an entity’s past
practice affects classification.
4.12.3.2 Investor Purchases of Shares From Grantees
ASC 718-10
15-4 Share-based payments
awarded to a grantee by a related party or other
holder of an economic interest in the entity as
compensation for goods or services provided to the
reporting entity are share-based payment
transactions to be accounted for under this Topic
unless the transfer is clearly for a purpose other
than compensation for goods or services to the
reporting entity. The substance of such a
transaction is that the economic interest holder
makes a capital contribution to the reporting
entity, and that entity makes a share-based payment
to the grantee in exchange for services rendered or
goods received. An example of a situation in which
such a transfer is not compensation is a transfer to
settle an obligation of the economic interest holder
to the grantee that is unrelated to goods or
services to be used or consumed in a grantor’s own
operations.
ASC 718-10 — Glossary
Economic Interest in an Entity
Any type or form of pecuniary interest or arrangement that an entity could issue or be a party to, including
equity securities; financial instruments with characteristics of equity, liabilities, or both; long-term debt and
other debt-financing arrangements; leases; and contractual arrangements such as management contracts,
service contracts, or intellectual property licenses.
On occasion, existing investors (such as private equity or venture capital
investors) intending to increase their stake in an emerging nonpublic entity
may undertake transactions with other shareholders in connection with or
separately from a recent financing round. These transactions may include the
purchase of shares of common or preferred stock by investors from the
founders of the nonpublic entity or other individuals who are also
considered employees. Because the transactions are between grantees of the
nonpublic entity and existing shareholders and are related to the transfer
of outstanding shares, the nonpublic entity may not be directly involved in
them (though it may be indirectly involved by facilitating the exchange or
not exercising a right of first refusal). If the price paid for the shares
exceeds their fair value at the time of the transaction, it may be difficult
to demonstrate that the transaction is not compensatory and the nonpublic
entity would most likely be required to recognize compensation cost for the
excess, even if the entity is not directly involved in the transaction. It
is important for a nonpublic entity to recognize that transactions such as
these may be subject to the guidance in ASC 718-10-15-4 because the
investors are considered holders of an economic interest in the entity.
Although the presumption in such transactions is that any consideration in
excess of the fair value of the shares is compensation paid to employees,
entities should consider whether the amount paid is related to an existing
relationship or to an obligation that is unrelated to the employees’
services to the entity in assessing whether the payment is “clearly for a
purpose other than compensation for services to the reporting entity.” Even
though it is difficult to demonstrate that a non–fair value transaction with
employees is clearly for other purposes, AIN-APB 25 (superseded by FASB Statement 123(R)) describes situations when doing so may be possible,
including those in which:
-
“[T]he relationship between the stockholder and the corporation’s employee is one which would normally result in generosity (i.e., an immediate family relationship).”
-
“[T]he stockholder has an obligation to the employee which is completely unrelated to the latter’s employment (e.g., the stockholder transfers shares to the employee because of personal business relationships in the past, unrelated to the present employment situation).”
In all situations, the determination of whether a transaction should be accounted for under ASC 718
should be based on an entity’s specific facts and circumstances.
In addition, there may be situations in which, as part of a financing
transaction between a nonpublic entity and a new investor that is acquiring
a significant ownership interest in the nonpublic entity, the new investor
repurchases common shares in the nonpublic entity from employees of the
nonpublic entity. For example, the investor may not have participated in a
prior financing arrangement and may be purchasing convertible preferred
stock from the nonpublic entity and common stock from the nonpublic entity’s
existing employees. In this scenario, the investor pays the same price to
purchase the preferred stock from the nonpublic entity and the common stock
from the employees. While it did not hold an economic interest before
entering into the transaction with the nonpublic entity, the new investor is
not unlike a party that already holds such an interest and may be similarly
motivated to compensate employees.
As noted in ASC 718-10-15-4, a share-based payment arrangement between the
holder of an economic interest in a nonpublic entity and an employee of the
nonpublic entity should be accounted for under ASC 718 unless the
arrangement “is clearly for a purpose other than compensation for goods or
services.” If a new investor purchases common stock valued at an amount
based on the value of the preferred stock, we would generally expect the
analysis to be similar to that performed by a preexisting investor that
purchases common stock from a nonpublic entity’s employees.
Shares purchased from grantees by a related party or an economic interest
holder may include shares that have been vested (or have been issued as a
result of the exercise of options) for less than six months (i.e., the
shares are considered immature). We do not believe that a reporting entity
would generally consider a history of investor purchases of immature shares
from grantees (regardless of whether such purchases are conducted at fair
value or at an amount that exceeds fair value) when assessing whether it has
established a past practice of settling immature shares that results in a
substantive liability (see Sections 5.6 and 6.10 for additional discussion
of how an entity’s past practice affects classification). Generally, if the
reporting entity otherwise classifies the shares as equity, purchases of
such shares by the related party or economic interest holder do not satisfy
a liability on the reporting entity’s behalf. Rather, the purchaser (often
through a tender offer to grantees that is, in part, organized by the
reporting entity) is making an investment decision to establish or increase
its ownership interest in the reporting entity and thereby is the party
making a payment as the principal in the purchase transaction with grantees.
Accordingly, a related party or an economic interest holder that directly
makes such a purchase from grantees would not change the substantive terms
of the share-based payment arrangement that requires the reclassification of
the shares from equity to a liability.
4.12.3.2.1 Valuation Considerations
While the examples above describe situations in which it
is likely that the nonpublic entity would recognize additional
compensation cost, we are aware of circumstances in which a secondary
market transaction between an investor and a nonpublic entity’s
employees represents an orderly arm’s-length transaction conducted at
fair value. In such cases, the nonpublic entity has adequate support for
a conclusion that the transaction was conducted at fair value and
therefore did not result in additional compensation cost. Such secondary
transactions are likely to be relevant in the nonpublic entity’s common
stock valuation, which is typically performed by a third-party valuation
firm to ensure compliance with IRC Section 409A and determine the
fair-value-based measure of the nonpublic entity’s share-based payment
arrangements (see Section 4.12.2).
When an entity does conclude that a secondary transaction includes a
compensatory element that must be recognized, there may have also been
indicators that the secondary transaction was conducted at fair value.
In such situations (i.e., there are indicators that (1) the transaction
was conducted at fair value and (2) there is a compensatory element), an
entity should consider whether to give some weight to the transaction
when determining the fair value of the common shares.
4.12.3.2.2 Tax Considerations
For tax purposes, stock repurchases are generally treated either as
capital (e.g., capital gain) or as dividend-equivalent redemptions
(e.g., ordinary dividend income to the extent that the entity has
earnings and profits). Repurchases from current or former service
providers (i.e., current or former employees or independent contractors)
give rise to questions about whether any of the proceeds should be
treated as compensation for tax purposes.
In the assessment of whether a portion of the payment is compensation, a
critical tax issue is what value is appropriate for the nonpublic entity
to use when determining the effect of the capital redemption. That is,
the nonpublic entity must determine whether some portion of the
consideration for the repurchase represents something other than fair
value for the common stock (e.g., compensation cost). When a repurchase
exceeds the fair value of the common stock, there is risk that some of
the purchase consideration is compensation for tax purposes. The
determination of whether such excess is compensatory depends on the
facts and circumstances, and there can be disparate treatment for book
and tax purposes with respect to compensation transactions as well as
ambiguity in the existing tax code. Relevant factors include whether the
repurchase is (1) performed by the nonpublic entity or an existing
investor or (2) part of arm’s-length negotiations with a new investor
that may not have the same information as the nonpublic entity about
what is considered to be the fair market value of the stock. If the
purchaser is not the nonpublic entity, it is relevant whether the shares
will be held by the buyer, or whether they can be converted into a
different class of stock or put back to the nonpublic entity. Another
factor is whether an offer to sell at a higher price is limited to
service providers or is available to shareholders more generally.
If the repurchase resulted in compensation for tax purposes, the
nonpublic entity would include such compensation on Form W-2 (for
employees) or Form 1099-MISC (for independent contractors). While any
tax liability resulting from additional compensation is the obligation
of the individual, the nonpublic entity has an obligation to (1)
withhold income and payroll taxes from payments to employees and (2)
remit the employer share of payroll tax. A nonpublic entity that does
not withhold payroll taxes from an employee in a transaction in which
the excess purchase price is compensatory becomes responsible for the
tax and should evaluate whether to accrue a liability in accordance with
the guidance in ASC 450. That guidance addresses the proper accounting
treatment of non-income-tax contingencies such as sales and use taxes,
property taxes, and payroll taxes.
An estimated loss contingency, such as a payroll tax liability, is
accrued (i.e., expensed) if (1) it is probable that the liability has
been incurred as of the date of the financial statements and (2) the
amount of the liability is reasonably estimable. A loss contingency must
be disclosed if (1) the loss is probable as of the date of the financial
statements or it is reasonably possible that the liability has been
incurred and (2) the amount is material to the financial statements.
With respect to a payroll tax liability, the liability recorded as a tax
transaction should be the best estimate of the probable amount due to
the tax authority under the applicable law, which would include interest
and penalties. In addition, the nonpublic entity would need to evaluate
whether it has any arrangements in place with its employees that would
make it responsible for its employees’ tax liability. If the best
estimate of the liability is a range, and if one amount in the range
represents a better estimate than any other amount in the range, that
amount should be recorded in accordance with ASC 450-20-30-1. If no
amount in the range is a better estimate than any other amount, the
minimum amount in the range should be used to record the liability in
accordance with ASC 450-20-30-1.
An entity has a legal right to seek reimbursement for the payroll tax
liability (although not for income tax withholding, penalties, or
interest) from employees if the IRS makes a determination to seek the
withholdings from the entity. Accordingly, an entity could record an
offsetting receivable from the employees for the payroll tax
withholdings. However, the entity will need to assess the collectability
of such a receivable, including whether the entity has sufficient
evidence of an employee’s ability to reimburse the entity for the
payroll tax liability and whether the entity has the intent to collect
this liability from the employee.
The following is an example of a disclosure that an
entity may make about its repurchase of common stock from its employees
when it has incurred a payroll tax liability as a result of not
withholding payroll taxes:
In connection with our
Series A financing, we repurchased common shares from our employees.
The transaction was undertaken to provide liquidity to our employees
and allows us to offer investors additional Series A shares without
further dilution of the existing shareholders. While we have viewed
the transaction to be a capital transaction for tax purposes, tax
authorities could challenge this characterization and consider a
portion of the payment to be compensation to the employees, which
would require us to remit payroll tax withholdings to the tax
authorities. For the probable amount of taxes and penalties that may
be payable, the Company has recorded a liability of $5 million,
which represents the low end of the range of probable amounts of
payroll tax withholdings and penalties that would be payable. The
ultimate payment amount could exceed the liability recorded, and we
estimate that the reasonably possible range of such payment could be
up to $8 million.
Given the complexities of this type of transaction, including the
evaluation of existing tax law, entities should consult with their
auditors and tax specialists when quantifying the liability under ASC
450.
Note that if a payment is considered compensation, a deduction of the
same amount would also be allowed (subject to all applicable rules
related to deductions for compensation expense).
4.12.4 Interpolation Considerations for Valuing Share-Based Compensation
Early-stage companies often obtain independent valuations once
per year. However, the dates of the valuations do not always coincide with the
grant date, or other relevant measurement date, for a share-based payment award.
As a result, management must assess the current fair value of the underlying
shares as of the measurement date.
Management should consider qualitative and quantitative factors
when assessing the current fair value of the underlying shares as of the
measurement date if a current independent valuation is not readily available. A
current independent valuation could be based on a recent arm’s-length willing
buyer, on a willing seller transaction (an “orderly transaction”9), or on value indications under the income and market approaches that are
reconciled to a value estimate. The relevance of qualitative and quantitative
factors becomes greater as the period between the most recent valuation and the
measurement date increases.
We believe that when management performs its assessment of fair
value, it should consider the factors outlined in the AICPA Valuation Guide.
However, those factors are not all-inclusive since an entity’s specific
circumstances may affect valuation. In the absence of an orderly transaction or
of the data needed for an entity to apply the income and market approaches, the
entity should work with its auditor and an independent valuation specialist to
ensure that it has properly identified all relevant factors that could affect
the fair value of the underlying share price.
When evaluating the factors in the AICPA Valuation Guide,
management should determine whether there have been any positive or negative
changes to the fair value of the underlying shares since the most recent
independent valuation. Accordingly, management may consider the following in
making its determination:
- Material changes in strategic relationships with major suppliers or customers — A loss or gain of a major supplier or customer that was not factored into the previous valuation can materially affect the entity. Changes in the financial health and profitability of strategic suppliers or customers can also affect the entity’s valuation.
- Material changes in enterprise cost structure and financial condition — A change in the cost structure flexibility (i.e., relationship between fixed and variability cost) may affect the entity’s previous expectations regarding its cash burn rate and future financial strength.
- Material changes in the management team’s competence — A change in the experience and competence of the management team may affect the entity’s future strategic objectives and direction.
- Material changes in existing proprietary technology, products, or services — The nature of the industry, patents, exclusive license arrangements, and enterprise-owned and developed intellectual property may significantly affect an entity’s valuation. Entities that do not have proprietary technology should evaluate whether there is a high likelihood of product obsolescence.
- Material changes in workforce and workforce skills — The quality of the workforce as a result of specialized knowledge or skills of key employees can be a significant input into certain entities’ valuation.
- Material change in the state of the industry and economy — Local, national, and global economic conditions may adversely or positively affect an entity.
- Material third-party arm’s-length transactions in the entity’s equity10 — These types of transactions may be indicators of fluctuation in the fair value of the underlying shares.
- Material changes in valuation assumptions used in the last valuation — The likelihood of the occurrence of a liquidity event, such as an IPO or a merger or an acquisition, or significant changes in the financial metrics or the valuations of the entity’s publicly traded comparable companies.
Entities that grant equity between two independent valuations or
after an independent valuation should consider using an interpolation or
extrapolation framework to estimate the fair value of the underlying shares.
Such frameworks may include linear interpretation, hockey stick interpolation,
or the consideration of equity granted after the most recent valuation
(extrapolation). Entities should evaluate the appropriateness of using an
interpolation framework and should consider the factors outlined above if they
use such a framework.
The examples below illustrate circumstances in which the use of
an interpolation framework may be appropriate.
Example 4-6
Company X performed an independent
valuation of its common stock as of December 15, 20X8,
and September 18, 20X9. Company X’s common stock value
increased from $1.50 to $2.25 between December 15, 20X8,
and September 18, 20X9. On April 1, 20X9, X granted
500,000 options on its common stock to its employees,
with an exercise price of $1.50. Company X evaluated the
qualitative and quantitative factors discussed above and did not identify any
significant events that occurred during this interim
period that would have caused a material change in fair
value of the common stock. Further, over this period,
management monitored its industry and peer group
multiples and observed that these valuation inputs did
not suggest a change in the fair value of X’s common
stock.
We believe that in the absence of an
orderly transaction or data necessary for an entity to
apply the income and market approaches, it is acceptable
for management to perform a linear interpolation between
the December 15, 20X8, and September 18, 20X9, valuation
dates to determine the fair value of the common stock as
of April 1, 20X9.
After performing a linear interpolation,
X concluded that the fair value of the common stock as
of April 1, 20X9, was $1.79. When valuing the 500,000
options granted on April 1, 20X9, management would use
$1.79 as the fair value of the common stock. The graphic
below illustrates X’s linear interpolation.
Example 4-7
Hockey Stick Interpolation
Assume the same facts as in the example
above; however, Company X’s operating results were
higher than originally forecasted in the December 15,
20X8, valuation model. Specifically, X performed above
expectations during the interim period July 1, 20X9,
through September 18, 20X9. Its performance was
primarily influenced by higher than expected customer
acquisitions and improved pricing. Before July 1, 20X9,
management evaluated the qualitative and quantitative
factors discussed above and did
not identify any significant events that occurred before
July 1, 20X9, that would have caused a material change
in fair value of the common stock. Management therefore
concluded that the common stock valuation was flat
during this period.
We believe that in the absence of an
orderly transaction or of the data necessary for the
application of the income and market approaches, it is
acceptable for management to perform a “hockey stick”
interpolation between the December 15, 20X8, and
September 18, 20X9, valuation to determine the fair
value of the common stock as of April 1, 20X9. This is
because management has evidence that the increase in the
fair value of the common stock was primarily
attributable to better-than-expected growth from July 1,
20X9, through September 18, 20X9. The graphic below
illustrates X’s interpolation.
As suggested in the graphic above, X
concluded that the fair value of the common stock as of
April 1, 20X9, was $1.50. However, if management had
granted options on its common stock between July 20X9
and September 20X9, management would use the
interpolation framework above to determine the fair
value of the common stock.
Example 4-8
Equity Granted After
the Most Recent Valuation (Extrapolation)
After performing an independent
valuation of its common stock as of July 1, 20X9,
Company Y, which has a calendar year-end, concluded that
the fair value of the common stock was $2.00. On
December 1, 20X9, Y granted 500,000 options that can be
exercised on Y’s common stock. On March 1, 20X0, Y will
issue its financial statements without having an updated
independent valuation of its common stock (i.e., it will
only have the July 1, 20X9, valuation).
Company Y is generating revenue but is
currently operating at a loss. At the time of Y’s July
1, 20X9, common stock valuation, management forecasted
FYX9 revenue of $10 million and FYX0 revenue of $25
million. As of December 1, 20X9, management revaluated
its actual and forecasted revenue and concluded that
there were no material changes to its original revenue
forecast. Management considered the qualitative and
quantitative factors discussed above in determining
whether the common stock fair value had changed. On the
basis of its assessment as well as its unchanged revenue
forecast, management concluded that the common stock
fair value had remained flat and that there was no
evidence that the fair value of the common stock had
materially increased or decreased since the July 1,
20X9, valuation. As a result, when valuing the options
granted on December 1, 20X9, management used $2.00 as
the fair value of the common stock.
Assume the same facts as those above;
however, revenue for fiscal year 20X9 and forecasted
fiscal year 20X0 is 10 percent above the July 1, 20X9,
amount forecasted in the previous valuation. In this
scenario, management should develop a reasonable method
to reflect an increase in the fair value of the common
stock between July 1, 20X9, and December 1, 20X9. For
example, on the basis of Y’s July 1, 20X9, valuation,
management can approximate the incremental impact on its
common stock as a result of the revenue increase in
fiscal years 20X9 and 20X0. Using this amount as a
benchmark, management could approximate the fair value
of the common stock as of December 1, 20X9.
See Deloitte’s March 17, 2017, Financial Reporting Alert for a
discussion of disclosure considerations.
Footnotes
4
The AICPA Valuation Guide provides best-practice guidance
for valuing the equity securities of nonpublic entities. It discusses, among
other topics, possible methods of allocating enterprise value to underlying
securities, enterprise-and industry-specific attributes that should be
considered in the determination of fair value, best practices for supporting
fair value, and recommended disclosures for a registration statement.
5
Cheap stock refers to issuances of equity securities
before an IPO in which the value of the shares is below the IPO
price.
6
See footnote 4.
7
A European option can be exercised only on the
expiration date.
8
An Asian option, or average option, is an option
contract in which the payoff is based on the average price of
the stock over a specific period (as opposed to a single
point).
9
ASC 820 defines an orderly transaction as a “transaction
that assumes exposure to the market for a period before the measurement
date to allow for marketing activities that are usual and customary for
transactions involving such assets or liabilities; it is not a forced
transaction (for example, a forced liquidation or distress sale).” In
private-company financing transactions, the usual and customary
marketing activities generally include time for the investors to perform
due diligence and to discuss the company’s plans with management, the
board of directors, or both.
4.13 Practical Expedients for Nonpublic Entities
4.13.1 Application
There are several practical expedients in ASC 718 that are available only to nonpublic entities. To apply
them, an entity will need to first ensure that it meets the definition of a nonpublic entity as defined in
ASC 718 (see Section 1.7).
4.13.1.1 Fair-Value-Based Measurement Exceptions
Two alternatives to fair-value-based measurement are available to nonpublic entities:
- Calculated value — A nonpublic entity that cannot reasonably estimate the fair-value-based measure of its options and similar instruments (because it is not practicable to estimate the expected volatility of its stock price) should use the historical volatility of an appropriate industry sector index to calculate an award’s value. This amount is referred to as a calculated value. See Section 4.13.2 for a discussion of a nonpublic entity’s use of the historical volatility of an appropriate industry sector index in valuing a share-based payment award.
- Intrinsic value — For liability-classified awards, nonpublic entities can elect as an accounting policy to measure all of their liability-classified awards at either intrinsic value or a fair-value-based measure. See Section 4.13.3 for additional information.
The table below summarizes the use of these measurement alternatives.
Public Entities | Nonpublic Entities | |
---|---|---|
Equity-classified awards | Fair-value-based measure | Either:
|
Liability-classified awards | Fair-value-based measure,
remeasured in each reporting
period until settlement | Either:
|
* Expected volatility is based on the entity’s own share price or
comparable public entities. ** Expected volatility is based on the historical volatility of an
appropriate industry sector index; a calculated
value is used when it is not practicable to estimate
the expected volatility of an entity’s own share
price. |
4.13.1.2 Expected-Term Practical Expedient
A nonpublic entity may make an entity-wide accounting policy election to use a practical expedient to
estimate the expected term of certain options and similar instruments. The practical expedient can be
used only for awards that meet certain conditions. See Section 4.9.2.2.3 for additional information.
4.13.1.3 Practical Expedient for the Current Price Input for Equity Classified Awards
ASC 718-10
30-20C As a practical
expedient, a nonpublic entity may use a value
determined by the reasonable application of a
reasonable valuation method as the current price of
its underlying share for purposes of determining the
fair value of an award that is classified as equity
in accordance with paragraphs 718-10-25-6 through
25-18 at grant date or upon a modification. This
practical expedient may not be used for awards
classified as liabilities in accordance with
paragraphs 718-10-25-6 through 25-18.
Nonpublic entities may elect to use a practical expedient to
determine the current price input of equity-classified share-based payment
awards issued to both employees and nonemployees on a
measurement-date-by-measurement-date basis. The guidance in ASC
718-10-30-20G notes that a valuation performed in accordance with specified
U.S. Treasury regulations related to IRC Section 409A is an example of a
reasonable valuation method under the practical expedient. It also
explicitly refers to other valuation approaches under IRC Section 409A that
are presumed to be reasonable.
Unlike the transition guidance provided by the SEC for
entities that elect the intrinsic value or calculated value practical
expedients when changing from nonpublic to public entity status (see
Section
4.13.4), there is no similar transition guidance related to
the practical expedient for the current price input. Therefore, an entity
that no longer meets the criteria to be a nonpublic entity would have to
reverse the practical expedient’s effect in its historical financial
statements. Consequently, before electing the practical expedient, nonpublic
entities that could become public entities should carefully consider the
potential future costs of having to perform such a reversal.
4.13.2 Calculated Value
ASC 718-10
Nonpublic Entity — Calculated Value for Nonemployee
Awards
30-19A
Similar to employee equity share options and similar
instruments, a nonpublic entity may not be able to
reasonably estimate the fair value of nonemployee awards
because it is not practicable for the nonpublic entity
to estimate the expected volatility of its share price.
In that situation, the nonpublic entity shall account
for nonemployee equity share options and similar
instruments on the basis of a value calculated using the
historical volatility of an appropriate industry sector
index instead of the expected volatility of the
nonpublic entity’s share price (the calculated value) in
accordance with paragraph 718-10-30-20. A nonpublic
entity’s use of calculated value shall be consistent
between employee share-based payment transactions and
nonemployee share-based payment transactions.
Nonpublic Entity — Calculated Value
30-20 A nonpublic entity may not be able to reasonably estimate the fair value of its equity share options and
similar instruments because it is not practicable for it to estimate the expected volatility of its share price. In
that situation, the entity shall account for its equity share options and similar instruments based on a value
calculated using the historical volatility of an appropriate industry sector index instead of the expected volatility
of the entity’s share price (the calculated value). Throughout the remainder of this Topic, provisions that apply
to accounting for share options and similar instruments at fair value also apply to calculated value. Paragraphs
718-10-55-51 through 55-58 and Example 9 (see paragraph 718-20-55-76) provide additional guidance on
applying the calculated value method to equity share options and similar instruments granted by a nonpublic
entity.
Calculated Value for Certain Nonpublic Entities
55-51 Nonpublic entities may have sufficient information available on which to base a reasonable and
supportable estimate of the expected volatility of their share prices. For example, a nonpublic entity that has
an internal market for its shares, has private transactions in its shares, or issues new equity or convertible debt
instruments may be able to consider the historical volatility, or implied volatility, of its share price in estimating
expected volatility. Alternatively, a nonpublic entity that can identify similar public entities for which share or
option price information is available may be able to consider the historical, expected, or implied volatility of
those entities’ share prices in estimating expected volatility. Similarly this information may be used to estimate
the fair value of its shares or to benchmark various aspects of its performance (see paragraph 718-10-55-25).
55-52 This Topic requires all
entities to use the fair-value-based method to account
for share-based payment arrangements that are classified
as equity instruments. However, if it is not practicable
for a nonpublic entity to estimate the expected
volatility of its share price, paragraphs 718-10-30-19A
through 30-20 require it to use the calculated value
method. Alternatively, it may not be possible for a
nonpublic entity to reasonably estimate the fair value
of its equity share options and similar instruments at
the date they are granted because the complexity of the
award’s terms prevents it from doing so. In that case,
paragraphs 718-10-30-21 through 30-22 require that the
nonpublic entity account for its equity instruments at
their intrinsic value, remeasured at each reporting date
through the date of exercise or other settlement.
55-53 Many nonpublic entities
that plan an initial public offering likely will be able
to reasonably estimate the fair value of their equity
share options and similar instruments using the guidance
on selecting an appropriate expected volatility
assumption provided in paragraphs 718-10-55-35 through
55-41.
55-54 Estimating the expected volatility of a nonpublic entity’s shares may be difficult and that the resulting
estimated fair value may be more subjective than the estimated fair value of a public entity’s options. However,
many nonpublic entities could consider internal and industry factors likely to affect volatility, and the average
volatility of comparable entities, to develop an estimate of expected volatility. Using an expected volatility
estimate determined in that manner often would result in a reasonable estimate of fair value.
55-55 For purposes of this Topic, it is not practicable for a nonpublic entity to estimate the expected volatility of
its share price if it is unable to obtain sufficient historical information about past volatility, or other information
such as that noted in paragraph 718-10-55-51, on which to base a reasonable and supportable estimate
of expected volatility at the grant date of the award without undue cost and effort. In that situation, this
Topic requires a nonpublic entity to estimate a value for its equity share options and similar instruments by
substituting the historical volatility of an appropriate industry sector index for the expected volatility of its share
price as an assumption in its valuation model. All other inputs to a nonpublic entity’s valuation model shall be
determined in accordance with the guidance in paragraphs 718-10-55-4 through 55-47.
55-56 There are many different indexes available to consider in selecting an appropriate industry sector index.
For example, Dow Jones Indexes maintain a global series of stock market indexes with industry sector splits
available for many countries, including the United States. The historical values of those indexes are easily
obtainable from its website. An appropriate industry sector index is one that is representative of the industry
sector in which the nonpublic entity operates and that also reflects, if possible, the size of the entity. If a
nonpublic entity operates in a variety of different industry sectors, then it might select a number of different
industry sector indexes and weight them according to the nature of its operations; alternatively, it might select
an index for the industry sector that is most representative of its operations. If a nonpublic entity operates in
an industry sector in which no public entities operate, then it shall select an index for the industry sector that is
most closely related to the nature of its operations. However, in no circumstances shall a nonpublic entity use
a broad-based market index like the S&P 500, Russell 3000, or Dow Jones Wilshire 5000 because those indexes
are sufficiently diversified as to be not representative of the industry sector, or sectors, in which the nonpublic
entity operates.
55-57 A nonpublic entity shall use the selected index consistently, unless the nature of the entity’s operations
changes such that another industry sector index is more appropriate, in applying the calculated value method
in both the following circumstances:
- For all of its equity share options or similar instruments
- In each accounting period.
55-58 The calculation of the historical volatility of an appropriate industry sector index shall be made using
the daily historical closing values of the index selected for the period of time prior to the grant date (or service
inception date) of the equity share option or similar instrument that is equal in length to the expected term
of the equity share option or similar instrument. If daily values are not readily available, then an entity shall
use the most frequent observations available of the historical closing values of the selected index. If historical
closing values of the index selected are not available for the entire expected term, then a nonpublic entity shall
use the closing values for the longest period of time available. The method used shall be consistently applied
(see paragraph 718-10-55-27). Example 9 (see paragraph 718-20-55-77) provides an illustration of accounting
for an equity share option award granted by a nonpublic entity that uses the calculated value method.
As discussed in Section 4.12, nonpublic entities should try to use a fair-value-based measure to value
their equity-classified awards. However, there may be instances in which a nonpublic entity may not
be able to reasonably estimate the fair-value-based measure of its options and similar instruments
because it is not practicable for it to estimate the expected volatility of its share price. In these cases, the
nonpublic entity should substitute the historical volatility of an appropriate industry sector index for the
expected volatility of its own share price. In assessing whether it is practicable to estimate the expected
volatility of its own share price, the entity should consider the following factors:
- Whether the entity has an internal market for its shares (e.g., investors or employees can purchase and sell shares).
- Previous issuances of equity in a private transaction or convertible debt provide indications of the historical or implied volatility of the entity’s share price.
- Whether there are similarly sized public entities (including those within an index) in the same industry whose historical or implied volatilities could be used as a substitute for the nonpublic entity’s expected volatility.
If, after considering the relevant factors, the nonpublic entity determines that estimating the expected
volatility of its own share price is not practicable, it should use the historical volatility of an appropriate
industry sector index as a substitute in estimating the fair-value-based measure of its awards.
An appropriate industry sector index would be one that is narrow enough to reflect the nonpublic
entity’s nature and size (if possible). For example, the use of the Philadelphia Exchange (PHLX)
Semiconductor Sector Index is not an appropriate industry sector index for a small nonpublic software
development entity because it represents neither the industry in which the nonpublic entity operates
nor the size of the entity. The volatility of an index of smaller software entities would be a more
appropriate substitute for the entity’s expected volatility of its own share price.
Under ASC 718-10-55-58, an entity that uses an industry sector index to determine the expected
volatility of its own share price must use the index’s historical volatility (rather than its implied volatility).
However, ASC 718-10-55-56 states that “in no circumstances shall a nonpublic entity use a broad-based
market index like the S&P 500, Russell 3000, or Dow Jones Wilshire 5000” (emphasis added).
A nonpublic entity’s conclusion that estimating the expected volatility of its
own share price is not practicable may be subject to scrutiny. We would
typically expect that a nonpublic entity that can identify an appropriate
industry sector index would be able to identify similar entities from the
selected index to estimate the expected volatility of its own share price and
would therefore be required to use the fair-value-based measurement method.
In measuring awards, a nonpublic entity should switch from using a calculated
value to using a fair-value-based measure when it (1) can subsequently estimate
the expected volatility of its own share price or (2) becomes a public entity.
ASC 718-10-55-27 states, in part, that the “valuation technique an entity
selects [should] be used consistently and [should] not be changed unless a
different valuation technique is expected to produce a better estimate” of a
fair-value-based measure (or, in this case, a change to a fair-value-based
measure). The guidance goes on to state that a change in valuation technique
should be accounted for as a change in accounting estimate under ASC 250 and
should be applied prospectively to new awards. Therefore, for existing
equity-classified awards (i.e., unvested equity awards that were granted before
an entity switched from the calculated value method to a fair-value-based
measure), an entity would continue to recognize compensation cost on the basis
of the calculated value determined as of the grant date unless the award is
subsequently modified. An entity should use the fair-value-based method to
measure all awards granted after it switches from the calculated value method.
ASC 718 provides the example below of when it may be appropriate for a nonpublic
entity to use the calculated value method.
ASC 718-20
Example 9: Share Award Granted by a Nonpublic Entity That Uses the Calculated Value Method
55-76 This Example illustrates
the guidance in paragraphs 718-10-30-19A through
30-20.
55-76A This
Example (see paragraphs 718-20-55-77 through 55-83)
describes employee awards. However, the principles on
how to account for the various aspects of employee
awards, except for the compensation cost attribution and
certain inputs to valuation, are the same for
nonemployee awards. Consequently, an entity should
substitute the historical volatility of an appropriate
industry sector index for expected volatility in
accordance with paragraph 718-10-30-20 when measuring
the grant-date fair value of nonemployee awards with
similar facts and circumstances (that is, an entity has
determined that it is not practicable for it to estimate
the expected volatility of its share price), as
illustrated in paragraphs 718-20-55-77 through 55-80.
Therefore, the guidance in those paragraphs may serve as
implementation guidance for similar nonemployee
awards.
55-76B Compensation cost
attribution for awards to nonemployees may be the same as or
different from that which is illustrated in paragraph
718-20-55-81 for employee awards. That is because an entity
is required to recognize compensation cost for nonemployee
awards in the same manner as if the entity had paid cash in
accordance with paragraph 718-10-25-2C. Additionally,
valuation amounts used in this Example could be different
because an entity may elect to use the contractual term as
the expected term of share options and similar instruments
when valuing nonemployee share-based payment
transactions.
55-77 On January 1, 20X6, Entity W, a small nonpublic entity that develops, manufactures, and distributes
medical equipment, grants 100 share options to each of its 100 employees. The share price at the grant date is
$7. The options are granted at-the-money, cliff vest at the end of 3 years, and have a 10-year contractual term.
Entity W estimates the expected term of the share options granted as 5 years and the risk-free rate as 3.75
percent. For simplicity, this Example assumes that no forfeitures occur during the vesting period and that no
dividends are expected to be paid in the future, and this Example does not reflect the accounting for income
tax consequences of the awards.
55-78 Entity W does not maintain an internal market for its shares, which are rarely traded privately. It has not
issued any new equity or convertible debt instruments for several years and has been unable to identify any
similar entities that are public. Entity W has determined that it is not practicable for it to estimate the expected
volatility of its share price and, therefore, it is not possible for it to reasonably estimate the grant-date fair value
of the share options. Accordingly, Entity W is required to apply the provisions of paragraph 718-10-30-20 in
accounting for the share options under the calculated value method.
55-79 Entity W operates exclusively in the medical equipment industry. It visits the Dow Jones Indexes website
and, using the Industry Classification Benchmark, reviews the various industry sector components of the Dow
Jones U.S. Total Market Index. It identifies the medical equipment subsector, within the health care equipment
and services sector, as the most appropriate industry sector in relation to its operations. It reviews the current
components of the medical equipment index and notes that, based on the most recent assessment of its share
price and its issued share capital, in terms of size it would rank among entities in the index with a small market
capitalization (or small-cap entities). Entity W selects the small-cap version of the medical equipment index as
an appropriate industry sector index because it considers that index to be representative of its size and the
industry sector in which it operates. Entity W obtains the historical daily closing total return values of the selected
index for the five years immediately before January 1, 20X6, from the Dow Jones Indexes website. It calculates
the annualized historical volatility of those values to be 24 percent, based on 252 trading days per year.
55-80 Entity W uses the inputs that it has determined above in a Black-Scholes-Merton option-pricing formula,
which produces a value of $2.05 per share option. This results in total compensation cost of $20,500 (10,000 ×
$2.05) to be accounted for over the requisite service period of 3 years.
55-81 For each of the 3 years ending December 31, 20X6, 20X7, and 20X8, Entity W will recognize
compensation cost of $6,833 ($20,500 ÷ 3). The journal entry for each year is as follows.
55-82 The share option award granted by a nonpublic entity that used the calculated value method is as follows.
55-83 Assuming that all 10,000 share options are exercised on the same day in 20Y2, the accounting for the
option exercise will follow the same pattern as in Example 1, Case A (see paragraph 718-20-55-10) and will
result in the following journal entry.
At exercise the journal entry is as follows.
4.13.3 Intrinsic Value
ASC 718-30
Nonpublic Entity
30-2 A nonpublic entity shall
make a policy decision of whether to measure all of its
liabilities incurred under share-based payment
arrangements (for employee and nonemployee awards)
issued in exchange for distinct goods or services at
fair value or at intrinsic value. However, a nonpublic
entity shall initially and subsequently measure awards
determined to be consideration payable to a customer (as
described in paragraph 606-10-32-25) at fair value.
Nonpublic Entity
35-4
Regardless of the measurement method initially selected
under paragraph 718-10-30-20, a nonpublic entity shall
remeasure its liabilities under share-based payment
arrangements at each reporting date until the date of
settlement. The fair-value-based method is preferable
for purposes of justifying a change in accounting
principle under Topic 250. Example 1 (see paragraph
718-30-55-1) provides an illustration of accounting for
an instrument classified as a liability using the
fair-value-based method. Example 2 (see paragraph
718-30-55-12) provides an illustration of accounting for
an instrument classified as a liability using the
intrinsic value method. A nonpublic entity shall
subsequently measure awards determined to be
consideration payable to a customer (as described in
paragraph 606-10-32-25) at fair value.
Nonpublic entities can make a policy election to measure all
liability-classified awards (not including awards determined to be consideration
payable to a customer under ASC 606) at intrinsic value (instead of at their
fair-value-based measure or calculated value) as of the end of each reporting
period until the award is settled. However, it is preferable for an entity to
use the fair-value-based method to justify a change in accounting principle
under ASC 250 (see Section
4.13.4 for a discussion of how to record the effects of the
change when a nonpublic entity becomes a public entity). Therefore, a nonpublic
entity that has elected to measure its liability-classified awards at a
fair-value-based measure (or calculated value) would not be permitted to
subsequently change to the intrinsic-value method.
The example below illustrates the application of the intrinsic value method for
liability-classified awards granted by a nonpublic entity.
ASC 718-30
Example 2: Award Granted by a Nonpublic Entity That Elects the Intrinsic Value Method
55-12 This Example illustrates the guidance in paragraphs 718-30-35-4 and 718-740-25-2 through 25-4.
55-12A This
Example (see paragraphs 718-30-55-13 through 55-20)
describes employee awards. However, the principles on
how to account for the various aspects of employee
awards, except for the compensation cost attribution and
certain inputs to valuation, are the same for
nonemployee awards. Consequently, a nonpublic entity can
make the accounting policy election in paragraph
718-30-30-2 to change its measurement of all
liability-classified nonemployee awards from fair value
to intrinsic value and remeasure those awards each
reporting period as illustrated in this Example.
Therefore, the guidance in this Example may serve as
implementation guidance for similar liability-classified
nonemployee awards.
55-12B Compensation cost
attribution for awards to nonemployees may be the same or
different for liability-classified employee awards. That is
because an entity is required to recognize compensation cost
for nonemployee awards in the same manner as if the entity
had paid cash in accordance with paragraph 718-10-25-2C.
Additionally, valuation amounts used in this Example could
be different because an entity may elect to use the
contractual term as the expected term of share options and
similar instruments when valuing nonemployee share-based
payment transactions.
55-13 On January 1, 20X6, Entity W, a nonpublic entity that has chosen the accounting policy of using the
intrinsic value method of accounting for share-based payments that are classified as liabilities in accordance
with paragraphs 718-30-30-2 and 718-30-35-4, grants 100 cash-settled stock appreciation rights with a 5-year
life to each of its 100 employees. Each stock appreciation right entitles the holder to receive an amount in
cash equal to the increase in value of 1 share of Entity W’s stock over $7. The awards cliff-vest at the end
of three years of service (an explicit and requisite service period of three years). For simplicity, the Example
assumes that no forfeitures occur during the vesting period and does not reflect the accounting for income tax
consequences of the awards.
55-14 Because of Entity W’s accounting policy decision to use intrinsic value, all of its share-based payments
that are classified as liabilities are recognized at intrinsic value (or a portion thereof, depending on the
percentage of requisite service that has been rendered) at each reporting date through the date of settlement;
consequently, the compensation cost recognized in each year of the three-year requisite service period will
vary based on changes in the liability award’s intrinsic value. As of December 31, 20X6, Entity W stock is valued
at $10 per share; hence, the intrinsic value is $3 per stock appreciation right ($10 – $7), and the intrinsic value
of the award is $30,000 (10,000 × $3). The compensation cost to be recognized for 20X6 is $10,000 ($30,000
÷ 3), which corresponds to the service provided in 20X6 (1 year of the 3-year service period). For convenience,
this Example assumes that journal entries to account for the award are performed at year-end. The journal
entry for 20X6 is as follows.
55-15 As of December 31, 20X7, Entity W stock is valued at $8 per share; hence, the intrinsic value is $1 per
stock appreciation right ($8 – $7), and the intrinsic value of the award is $10,000 (10,000 × $1). The decrease
in the intrinsic value of the award is $20,000 ($10,000 – $30,000). Because services for 2 years of the 3-year
service period have been rendered, Entity W must recognize cumulative compensation cost for two-thirds of
the intrinsic value of the award, or $6,667 ($10,000 × 2/3); however, Entity W recognized compensation cost of
$10,000 in 20X5. Thus, Entity W must recognize an entry in 20X7 to reduce cumulative compensation cost to
$6,667.
55-16 As of December 31, 20X8, Entity W stock is valued at $15 per share; hence, the intrinsic value is $8 per
stock appreciation right ($15 – $7), and the intrinsic value of the award is $80,000 (10,000 × $8). The cumulative
compensation cost recognized as of December 31, 20X8, is $80,000 because the award is fully vested. The
journal entry for 20X8 is as follows.
55-17 The share-based liability award at intrinsic value is as follows.
55-18 For simplicity, this Example assumes that all of the stock appreciation rights are settled on the day that
they vest, December 31, 20X8, when the share price is $15 and the intrinsic value is $8 per share. The cash paid
to settle the stock appreciation rights is equal to the share-based compensation liability of $80,000.
55-19 At exercise the journal entry is as follows.
55-20 If the stock appreciation rights had not been settled, Entity W would continue to remeasure those
remaining awards at intrinsic value at each reporting date through the date they are exercised or otherwise
settled.
4.13.4 Transition From Nonpublic to Public Entity Status
SEC Staff Accounting Bulletins
SAB Topic 14.B, Transition From
Nonpublic to Public Entity Status
Facts: Company A
is a nonpublic entity4 that first files a
registration statement with the SEC to register its
equity securities for sale in a public market on January
2, 20X8. As a nonpublic entity, Company A had been
assigning value to its share options5 under
the calculated value method prescribed by FASB ASC Topic
718, Compensation — Stock Compensation,6 and
had elected to measure its liability awards based on
intrinsic value. Company A is considered a public entity
on January 2, 20X8 when it makes its initial filing with
the SEC in preparation for the sale of its shares in a
public market.
Question 1: How should Company A
account for the share options that were granted prior to
January 2, 20X8 for which the requisite service has not
been rendered by January 2, 20X8?
Interpretive
Response: Prior to becoming a public entity,
Company A had been assigning value to its share options
under the calculated value method. The staff believes
that Company A should continue to follow that approach
for those share options that were granted prior to
January 2, 20X8, unless those share options are
subsequently modified, repurchased or
cancelled.7 If the share options are
subsequently modified, repurchased or cancelled, Company
A would assess the event under the public company
provisions of FASB ASC Topic 718. For example, if
Company A modified the share options on February 1,
20X8, any incremental compensation cost would be
measured under FASB ASC subparagraph 718-20-35-3(a), as
the fair value of the modified share options over the
fair value of the original share options measured
immediately before the terms were
modified.8
Question 2: How should Company A
account for its liability awards granted prior to
January 2, 20X8 that are fully vested but have not been
settled by January 2, 20X8?
Interpretive
Response: As a nonpublic entity, Company A had
elected to measure its liability awards subject to FASB
ASC Topic 718 at intrinsic value.9 When
Company A becomes a public entity, it should measure the
liability awards at their fair value determined in
accordance with FASB ASC Topic 718.10 In that
reporting period there will be an incremental amount of
measured cost for the difference between fair value as
determined under FASB ASC Topic 718 and intrinsic value.
For example, assume the intrinsic value in the period
ended December 31, 20X7 was $10 per award. At the end of
the first reporting period ending after January 2, 20X8
(when Company A becomes a public entity), assume the
intrinsic value of the award is $12 and the fair value
as determined in accordance with FASB ASC Topic 718 is
$15. The measured cost in the first reporting period
after December 31, 20X7 would be $5.11
Question 3:
After becoming a public entity, may Company A
retrospectively apply the fair-value-based method to its
awards that were granted prior to the date Company A
became a public entity?
Interpretive
Response: No. Before becoming a public entity,
Company A did not use the fair-value-based method for
either its share options or its liability awards. The
staff does not believe it is appropriate for Company A
to apply the fair-value-based method on a retrospective
basis, because it would require the entity to make
estimates of a prior period, which, due to hindsight,
may vary significantly from estimates that would have
been made contemporaneously in prior
periods.12
Question 4: Upon
becoming a public entity, what disclosures should
Company A consider in addition to those prescribed by
FASB ASC Topic 718?13
Interpretive
Response: In the registration statement filed on
January 2, 20X8, Company A should clearly describe in
MD&A the change in accounting policy that will be
required by FASB ASC Topic 718 in subsequent periods and
the reasonably likely material future
effects.14 In subsequent filings, Company
A should provide financial statement disclosure of the
effects of the changes in accounting policy. In
addition, Company A should consider the requirements of
Item 303(b)(3) of Regulation S-K regarding critical
accounting estimates in MD&A.
______________________________
4 Defined in the FASB ASC
Master Glossary.
5 For purposes of this staff
accounting bulletin, the phrase “share options” is used
to refer to “share options or similar instruments.”
6 FASB ASC paragraph
718-10-30-20 requires a nonpublic entity to use the
calculated value method when it is not able to
reasonably estimate the fair value of its equity share
options and similar instruments because it is not
practicable for it to estimate the expected volatility
of its share price. FASB ASC paragraph 718-10-55-51
indicates that a nonpublic entity may be able to
identify similar public entities for which share or
option price information is available and may consider
the historical, expected, or implied volatility of those
entities’ share prices in estimating expected
volatility. The staff would expect an entity that
becomes a public entity and had previously measured its
share options under the calculated value method to be
able to support its previous decision to use calculated
value and to provide the disclosures required by FASB
ASC subparagraph 718-10-50-2(f)(2)(ii).
7 This view is consistent with the FASB’s basis for rejecting full retrospective application of FASB ASC Topic 718 as described in the basis for conclusions of Statement 123R, paragraph B251.
8 FASB ASC paragraph
718-20-55-94. The staff believes that because Company A
is a public entity as of the date of the modification,
it would be inappropriate to use the calculated value
method to measure the original share options immediately
before the terms were modified.
9 FASB ASC paragraph
718-30-30-2.
10 FASB ASC paragraph
718-30-35-3.
11 $15 fair value less $10
intrinsic value equals $5 of incremental cost.
12 This view is consistent with the FASB’s basis for rejecting full retrospective application of FASB ASC Topic 718 as described in the basis for conclusions of Statement 123R, paragraph
B251.
13 FASB ASC Section
718-10-50.
14
See Item 303 of Regulation S-K.
The calculated value and intrinsic value measurement alternatives available to a
nonpublic entity are no longer appropriate once the entity is considered a
public entity.11 In addition, public entities use the expected-term practical expedient
(for determining the expected term of certain options and similar instruments)
differently than nonpublic entities. To estimate the expected term as a midpoint
between the requisite service period and the contractual term of an award,
entities will need to comply with the requirements of the SEC’s simplified
method (see Section
4.9.2.2.2).
In SAB Topic 14.B, the SEC discusses various transition issues associated with
the valuation of share-based payment awards related to an entity that becomes a
public entity (e.g., when it files its initial registration statement with the
SEC), including the following:
-
If a nonpublic entity historically measured equity-classified share-based payment awards at their calculated value, the newly public entity should continue to use that approach for share-based payment awards granted before the date on which it becomes a public entity unless those awards are subsequently modified, repurchased, or canceled, in which case the entity would assess the event under the public company provisions of ASC 718.
-
If a nonpublic entity historically measured liability-classified share-based payment awards on the basis of their intrinsic value and the awards are still outstanding, the newly public entity should measure those liability awards at their fair-value-based measurement upon becoming a public entity.
-
Upon becoming a public entity, the entity is prohibited from retrospectively applying the fair-value-based method to measure its awards if it used calculated value or intrinsic value before the date on which it became a public entity.
-
Upon becoming a public entity, the entity should clearly describe in its MD&A the change in accounting policy that will be required by ASC 718 in subsequent periods and any reasonably likely material future effects of the change.
SAB Topic 14 does not provide transition guidance for entities that are changing
from nonpublic to public entity status and have applied the practical expedient
for determining the current price of their underlying shares (see Section 4.13.1.3). Thus, an entity that no
longer meets the criteria to be a nonpublic entity would have to reverse the
practical expedient’s effect in its historical financial statements.
In addition, the SEC’s guidance does not address how an entity should account
for a change from the intrinsic value method for measuring liability-classified
awards to the fair-value-based method. In informal discussions, the SEC staff
indicated that it would be acceptable to record the effect of such a change as
compensation cost in the current period or to record it as the cumulative effect
of a change in accounting principle in accordance with ASC 250. While the
preferred approach is to treat the effect of the change as a change in
accounting principle under ASC 250, with the cumulative effect of the change
recorded accordingly, recording it as compensation cost is not objectionable
given the SEC’s position. Under either approach, entities’ financial statements
should include the appropriate disclosures.
ASC 250-10-45-5 states, in part, that an “entity shall report a change in
accounting principle through retrospective application of the new accounting
principle to all prior periods, unless it is impracticable to do so.”
Retrospective application of the effects of a change from intrinsic value to
fair value would be impracticable because objectively determining the
assumptions an entity would have used for the prior periods would be difficult
without the use of hindsight. Therefore, the change would be recorded as a
cumulative-effect adjustment to retained earnings and applied prospectively, as
discussed in ASC 250-10-45-6 and 45-7. This conclusion is consistent with the
guidance in SAB Topic 14.B that states that entities changing from nonpublic to
public status are not permitted to apply the fair-value-based method
retrospectively.
The example below illustrates how to record the effects of a change from the
intrinsic value method to the fair-value-based method.
Example 4-9
Company A (with a calendar year-end) uses the intrinsic value method to account
for its liability-classified SARs, which are fully
vested on December 31, 20X6. On February 15, 20X7, A
files its initial registration statement with the SEC
for an IPO. Assume the following intrinsic values and
fair values:
In its financial statements included in the initial registration statement, A should use the intrinsic value method to account for the SARs. As a result of filing its initial registration statement with the SEC, A must change its method for valuing its SARs from the intrinsic value method to the fair-value-based method. For the period from January 1, 20X7, through February 15, 20X7, A should therefore record compensation cost of $3 under the intrinsic value method and should record $2 as either an adjustment to retained earnings or compensation cost to account for the change from the intrinsic value method to the fair-value-based method.
Footnotes
11
The definition of a “public entity” in ASC 718 includes
an entity that “[m]akes a filing with a regulatory agency in preparation
for the sale of any class of equity securities in a public market.” The
definition therefore includes an entity that has filed its initial
registration statement with the SEC before the effective date of an
IPO.